Community Banking Connections

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Capital Planning: Not Just for Troubled Times
by Jennifer Burns, Senior Vice President, Supervision, Regulation and Credit, Federal Reserve Bank of Richmond

Since the inception of Community Banking Connections last year, we have published a series of articles on effective corporate governance and sound risk management. In late 2012, Kevin Moore wrote about how material loss reviews of failed banks from the recent crisis revealed that, in many cases, the boards of directors and senior management had not ensured that "risk management processes, internal controls, and capital were sufficient to mitigate the increased risk exposure."¹ Then, in early 2013, Teresa Curran wrote about how "successful management teams and boards of directors typically identify and mitigate risks before considering and introducing new products and services."² Finally, in the most recent issue, Ron Feldman challenged the "this time it will be different" thinking and cautioned that "effective bank management recognizes that risks from the past can occur again in the future."³ A common thread woven throughout these articles is the importance of holding capital commensurate with risk.

In this article, I will focus on that thread of ensuring capital adequacy through effective capital planning. I will share with you my perspectives on this subject by focusing first on lessons learned from the recent crisis and the importance of capital planning, and then looking at capital adequacy and assessing risks, capital maintenance activities, and governance over capital planning processes.

Capital planning is not just for troubled times; it is a key component of a sound risk management framework. Similarly, capital adequacy is broader than just meeting the minimum regulatory capital requirements. It speaks to the level of capital held by individual institutions in relation to their risk profiles and risk management strategies. When bank examiners evaluate and assign a capital rating, they consider both planning and adequacy, among other factors.

Lessons from the Crisis and the Importance of Capital Planning

Supervisors have long emphasized that banks of all sizes should have risk-sensitive and forward-looking capital planning processes. Unfortunately, leading up to the recent financial crisis, some bankers were not forward looking enough. During the crisis, many banks did not have risk management programs that linked capital needs to the bank’s risk profile, nor did they have early warning systems to provide advance notice of looming capital shortages so that mitigating actions could be taken sooner. The acute problems encountered by many of the largest banking organizations are well documented. Moreover, as financial conditions deteriorated and higher capital levels were needed to absorb losses, the ability of community banks⁴ to raise capital was challenging for some and impossible for many others. By the time these organizations recognized that they needed more capital, in many cases it was too late to obtain it, particularly without significant dilution of existing shareholders. A key lesson learned is that effective capital planning programs would have alerted bank leadership of the need to improve capital positions while options were still available.

Alan Lakein, a well-known author on personal time management, said, "Planning is bringing the future into the present so that you can do something about it now." That applies to capital planning as well: Think about the future so that you can take action today.

During the crisis, the Federal Reserve reaffirmed the importance of capital planning for institutions of all sizes.⁵ Capital planning should be a forward-looking process to help the board of directors and senior management ensure that the bank has adequate capital based on its current and prospective risk profile. Capital planning, coordinated with the bank’s strategic planning and new product adoption processes, provides the board and management with a more holistic view, which should better prepare the bank for less likely outcomes by considering both short- and long-term capital needs. Having a capital planning process consistent with the bank’s risk levels and growth plans helps the board and management plan more effectively for both capital and business line decisions.

Capital Adequacy and the Assessment of Risks

Effective capital planning begins with identifying and assessing material risks. The board and senior management should establish a process to identify material risks, both actual and anticipated, on an ongoing basis. The process should consider not only the primary banking risks — credit, market (including interest rate), liquidity, operational, reputational, and legal⁶ — but also risks from off-balance-sheet exposures and contingent liabilities, regional and macroeconomic factors, vendor or third-party relationships, and any other risks to which the bank is exposed.

Risks that can be quantified should be measured. Those that cannot be measured should be evaluated qualitatively using bank management’s judgment and expertise about the nature and potential exposure from these risks. When evaluating risks, management should consider the strength of its risk management practices to mitigate those risks.

Approaches for Assessing Risks

One common misconception is that capital planning is synonymous with stress testing. Capital planning is a process that can include some form of stress testing, but it is not limited to stress testing, since it involves assessing capital positions, making capital decisions, and evaluating capital contingencies. For example, a bank with historically high capital levels relative to its risks, a conservative no- or low-growth business model, and a demonstrated capacity to determine capital needs based on its risk profile could effectively conduct capital planning without stress testing. That said, it is prudent for banks to consider adverse events and the potential impact on the bank (for example, if a major employer were to close operations).

As reinforced last year by the federal banking agencies, community banks are not subject to Dodd-Frank Wall Street Reform and Consumer Protection Act stress testing requirements.⁷ However, it is always appropriate for banks of all sizes to ask themselves the "what could happen to us?" questions. Some accomplish this through stress testing. Essentially, stress testing is a risk management tool that uses hypothetical extreme, but conceivable, events and measures how these events would affect the bank’s condition. When used as part of capital planning, stress testing enables management to think through the impact on earnings, and ultimately capital, and make decisions about whether changes to business strategy or the balance sheet are needed.

Two stress testing approaches often used are 1) sensitivity analysis and 2) scenario analysis. Sensitivity analysis examines how sensitive a portfolio is to variations (or shocks) in certain inputs (for example, recovery or loss rates). It can help answer the question, "Given a change in loan past due and loss rates by loan type, what is the impact on asset quality, earnings, and capital?" Scenario analysis involves looking at historical or hypothetical scenarios as part of a specific narrative — such as a major recession, an inflation crisis, or a regional natural disaster — to determine the effect on profit and loss in various "what if" situations.

The approach used does not need to be a complicated, expensive, or burdensome process for community banking organizations with traditional business models but should be more developed at banks with higher risk profiles. Riskier business strategies require more comprehensive planning because of the greater degree of uncertainty.

Moreover, it is not necessary to buy a vendor stress testing tool for capital planning purposes. Simple spreadsheets, for example, can serve as effective tools for noncomplex community banks. We have seen some instances in which a community bank developed in-house spreadsheet-based stress tests on its portfolios to supplement its capital planning.

If a bank chooses to use a vendor tool, it should be properly customized. For the tool to be effective, bank management should take the time to input bank-specific data into the tool and fully understand the tool’s computations and limitations when applied to that organization. For example, using a bank’s own historical loss rates rather than the industry loss rates would be considered a sound approach, particularly if the bank’s underwriting standards had remained relatively constant over this period and its own historical loss rates were appropriate for the current lending environment. Moreover, in order to make the tool most effective for capital planning, it is important to consider that during the financial crisis and subsequent recession, the timing, degree, and length of the crisis played out very differently depending upon geography, market, and product. So, using a one-size-fits-all tool may not always be appropriate.

If a bank uses a stress testing tool for capital planning, whether developed in-house or obtained from a vendor, all documentation, including assumptions, should be maintained. Above all, discussions of key assumptions and results should be captured in board meeting minutes to show that the board of directors is aware of the actual and potential risks the bank has accepted or plans to accept. Any quantitative models used for capital planning, whether developed internally or by third parties, are subject to existing supervisory expectations for model risk management.⁸

Finally, capital planning and strategic planning should be linked. In addition to determining the amount of capital needed to support existing risks, a bank should consider strategic initiatives, such as new businesses or services, growth plans, and/or entering into new markets when assessing future capital needs. Sensitivity and scenario analyses can be helpful not only in understanding the capital needed to support current risks but also in evaluating new strategies.

Capital Maintenance Activities

Once risks and strategies have been assessed, appropriate capital levels should be established based on the unique risk profile of the firm and should incorporate both short- and long-term capital needs. Capital levels should be expressed as ratios that relate to regulatory definitions and requirements (that is, leverage and risk-based capital ratios), as well as any other ratios that are used by key stakeholders.

For capital planning, banks should have explicit capital targets, which in some cases may include a "cushion" for unexpected circumstances. One of the most frequent deficiencies we see when examining community banks’ capital planning processes is the use of regulatory capital minimums, or a prompt corrective action (PCA) level of "well capitalized," for capital targets. Banking organizations should operate well above the regulatory minimums, and the targets should be based upon the quantitative and qualitative assessments of risk.

The more effective bank capital policies typically also establish early warning thresholds for key measures. These triggers should be proactive and provide sufficient early warning to allow bank leadership to take action in advance of adverse scenarios (that is, capital levels are a concern or might catch the attention of regulators). The triggers should inspire discussion early enough so that bank leadership has many options to choose from to improve capital. Specific triggers for capital maintenance could be linked (for example, concentration levels, levels of nonperforming assets to capital, liquidity and interest rate risk levels, or absolute levels of capital).

I would like to note two common pitfalls to avoid in order to develop a capital policy and planning process that is both realistic and effective. First, capital plans should be realistic and incorporate appropriate triggers for taking action.⁹ Establishing thresholds, for example, that would not be breached despite significant financial stress or growth may not sufficiently alert the board or senior management that capital was too low relative to risk. In addition, setting capital thresholds so low that, by the time they were breached, regulatory concerns would have already been raised would not be an appropriate practice. Second, capital plans should sufficiently address new exposures, concentrations in lending exposures or revenue sources, or reliance on wholesale funding, for example, to be considered "commensurate with the bank’s risk profile."

Capital planning should include potential sources of capital, both internal and external, and should note the timeframes within which these various sources of capital could be acquired. It should also include the types of events and actions that could affect capital (for example, shareholder dividends and repaying holding company debt). Specific strategies to build capital, both in the short and long term, should also be outlined as part of this process. These strategies could include, for example:

• Earnings retention (reduction of capital distributions/elimination of dividends)
• Restrictions on asset growth (ceasing expansion plans/deleveraging)
• Infusion from principal shareholder or parent company
• Public offering

Capital Planning Governance

As with all risk management processes, board oversight is critical in the capital planning process. The board should be actively engaged in setting approved capital limits and triggers and should ensure that senior management has processes in place for monitoring risk limits and other capital measures. The board should review the capital planning process annually.

It is essential that the board receives periodic reporting and documents discussions about capital levels and trends in the minutes. Oftentimes, board packages include information that is more transactional in nature rather than information focused on aggregate risk taken in the portfolio. One of the senior bank supervisors from my Reserve Bank recently advised a group of bank directors to take their board package and divide the reports into two piles — the reports in the first pile provided transaction-based information and those in the second were aggregated on a portfolio level. If the latter pile was fairly small, she told them they may want to question whether they are receiving the right information on overall risk levels and trends. I believe this is good advice and particularly important when monitoring capital adequacy.

Conclusion

Banks are expected to maintain sufficient capital relative to risks and have processes to ensure that capital remains adequate. Examiners evaluate both the adequacy of capital levels and the effectiveness of the capital planning process. Effective capital planning is a key component of an ongoing sound risk management framework and is not just for use in an economic downturn or during troubled times.

Capital planning should include identifying and assessing all material risks, establishing capital levels that are tailored to the bank’s risk profile — not just the regulatory minimums — and documenting strategies to raise capital when necessary. Stress testing is not a required element of capital planning, but it can be a useful tool for understanding the impact of adverse conditions on the bank’s earnings and capital if it is properly tailored to the bank’s risk profile. Management should establish an ongoing process to ensure adequate capital levels and effective capital planning, and the board of directors should provide effective oversight of management’s processes.