Renewed Emphasis on Capital Adequacy in Strategic Planning

By: Laura Pringle

June 19, 2012

Introduction

Several recent regulatory issuances and experiences during safety and soundness examinations have highlighted a renewed emphasis on issues which are important for boards of directors and senior management in strategic planning. This article briefly explains those issuances and the issues raised and encourages their consideration prior to examinations and in preparation of agendas for strategic planning purposes.

Several Important Agenda Items Must be Addressed by Every Financial Institution

Recent publications have addressed the issue of stress testing for all financial institutions particularly to clarify that, even though an institution is not large and complex, it is not excused from a failure to comply with current supervisory guidances on stress testing. Also, these issuances explain that, regardless of size or charter type and regardless of whether the institution currently has adequate capital, capital planning under stress must be addressed by every financial institution. Clearly one capital adequacy plan does not fit for all and, instead, all financial institutions must be certain to measure risks, to find the right capital adequacy fit, and be prepared to have a level of capital which leaves room to move strategically, as needed.

Stress Testing and Sound Risk Management

One recent issuance by Federal regulators trying to explain the supervisory expectations for stress testing by smaller financial institutions is the Federal Reserve, FDIC and OCC release on May 14, 2012, a “Statement to Clarify Expectations for Stress Testing by Community Banks.” www.federalreserve.gov/newsevents/press/bcreg/20120514b.htm. We have noted for financial institutions in that Statement the regulators specifically provided this helpful information:

The agencies continue to emphasize that all banking organizations, regardless of size, should have the capacity to analyze the potential impact of adverse outcomes on their financial condition.  Certain portions of existing interagency guidance applicable to all banking organizations discuss addressing potential adverse outcomes as part of sound risk management practices.  The agencies note that such existing guidance, including that covering interest rate risk management, commercial real estate concentrations, and funding and liquidity management (among others), continues to apply.  

In addition, on June 7, 2012, the FDIC released its publication “Supervisory Insights” for Summer 2012, and, specifically readdressed stress testing for community banks. www.fdic.gov/news/news/press/2012/pr12063.html. Citing the interagency statement issued on May 14, 2012, the FDIC went on to explain that existing supervisory guidance already sets forth four particular areas of stress testing for all sizes of financial institutions. The FDIC in this publication explained that one area of stress testing does apply specifically to those banks with significant concentrations in commercial real estate (“CRE”) or subprime lending. But, importantly, the FDIC went on to explain that the other three areas apply to every financial institution even if the institution does not have those sorts of concentrations, i.e., the following three areas require stress testing:

1)      Credit risk stress testing;

2)      Asset-liability risk including among other testing techniques, interest-rate shocks and other interest-rate simulations; and

3)      Funding needs under stressed conditions.

The FDIC in this publication specifically addressed the first of these three areas, credit risk stress testing, and provided two simple examples of stress-testing methodologies, emphasizing that these examples are offered as an informational resource only and not as a supervisory directive. The FDIC also emphasized that stress tests are most useful when customized to reflect the characteristics particular to the institution performing the tests and that institution’s market area. The FDIC explained that stress testing can be used to evaluate credit risk in each institution’s overall portfolio, segments of portfolios, or individual loans. The FDIC also explained that stress testing work can be prioritized based on the largest exposures or portfolio concentrations, the riskiest segments of the portfolio, and watch-list credits.

The FDIC emphasized the usefulness of stress testing in risk management and in strategic planning processes and for other purposes by each financial institution. For instance, each financial institution can use this information as boards of directors establish risk tolerances, evaluate the adequacy of capital and the allowance for loan and lease losses and underwriting standards, and make informed strategic decisions.

Other Capital Adequacy Issues in Strategic Planning

You should be aware that, as required by the Dodd-Frank Act, the Federal Reserve, OCC and FDIC on June 7, 2012, released three proposed rules with a comment period open until September 7, 2012, to revise and replace current capital adequacy rules. www.federalreserve.gov/newsevents/press/bcreg/20120607a.htm. One of the proposals is an “Advanced Approaches Risk-Based” and “Market Risk” Capital Rule that would apply to large banking and savings banks and holding companies. The other two proposals apply to all banking organizations.

The “Standardized Approach for Risk-weighted Assets; Market Discipline and Disclosure Requirements” proposal would take effect on January 1, 2015, with an option for early adoption, and includes methodologies for determining risk-weighted assets for residential mortgages, securitization exposures, and counterparty credit risk. The other proposed rule that would apply to all banking organizations that are currently subject to minimum capital requirements is the proposal titled “Regulatory Capital, Implementation of Basel III, Minimum Regulatory Capital Ratios, Capital Adequacy, Transition Provisions, and Prompt Corrective Action,” and generally proposes the adoption of the Basel III revisions related to increased capital requirements.

While the agencies stated that they believe that most banking organizations already hold sufficient capital to meet the proposed requirements, it does appear that for both strategic planning and regulatory reporting purposes a clear understanding of the revisions will be important once these proposals are finalized and the transition periods established. This proposal does provide for a new capital conservation buffer, i.e., common equity tier 1 capital in excess of minimum risk-based capital ratios by at least 2.5% of risk-weighted assets will be required to avoid limits on capital distributions and certain bonuses to a defined level of officers including executive officers and heads of major lines of business. Also, this proposal impacts leverage ratio requirements due to a revised definition of “capital.”

In each of these two proposals the agencies have placed an asterisk next to those sections in the Table of Contents which would generally not apply to less-complex banking organizations and there is an Appendix with each of these two proposals specifically summarizing the proposed rule for smaller, non-complex banking organizations titled, “Appendix 1: Summary of this NPR for Community Banking Organizations.” These summaries are very helpful and provide a good beginning point for generally informing your boards of directors of these proposed rules and responding to requests for comments. 

Another helpful issuance for all financial institutions was released on June 7, 2012, by the Office of the Comptroller of the Currency (“OCC”) is a “Guidance for Evaluating Capital Planning and Adequacy (OCC 2012-16). www.occ.treas.gov/news-issuances/bulletins/2012/bulletin-2012-16.html. This Guidance stresses the importance of each institution’s processes to (1) assess capital adequacy in relation to overall risks and (2) plan for maintaining appropriate capital levels. The OCC stated specifically as follows:

The most effective capital planning considers both short- and longer-term capital needs and is coordinated with a bank’s overall strategy and planning cycles, usually with a forecast horizon of at least two years. Banks need to factor events that occur outside of the normal capital planning cycle into the capital planning process; for example, a natural disaster could have a major impact on future capital needs.

Examples and methodologies are presented in this Guidance as components of capital planning. In addition to contingency and back-up plans, the OCC explained one of the components of the capital planning process as follows:

The third component of capital planning is having a strategy to maintain capital adequacy and build capital if needed. Through discussions with senior management, the board or its designee should evaluate both internal and external sources of capital in defining a strategy to build capital when necessary. One strategy may be strengthening capital through earnings retention. Another option may be an infusion from principal shareholders or a parent holding company, or, in the case of a mutual institution, a partial or full conversion to stock. A bank may also be able to raise capital from external sources. During strong economic times, financially sound banks or banks that are subsidiaries of strong bank holding companies can generally find purchasers for their equity and debt issuances. In evaluating external sources of capital, banks should consider their history of public or private offerings, current equity market conditions, and the cost of equity.

Of course, for many smaller and less complex financial institutions, earnings is one of the most important factors in capital growth and retention; thus, stress testing of credit risks, asset-liability risks, and funding needs under stressed conditions is again particularly important. Likewise, many financial institutions primarily rely on their current shareholders and board members for capital infusions, as necessary, and must document the ability and commitment of those individuals, or determine that other sources may be needed and identify those sources.

Conclusion

It is important to prioritize the scheduling of time and resources to appropriately address capital adequacy in strategic planning and preparation for upcoming safety and soundness examinations. Reference to recent regulatory issuances and reminders of current guidances in board meetings and on strategic planning agendas can be helpful to frame these issues for board members and senior management of all financial institutions. Then, scaling stress testing to specifically address the factors which are most applicable to the particular institution’s risks and plans becomes a manageable and valuable process. Documentation of these efforts can be expected to be well received in upcoming safety and soundness examinations.

©PRINGLE® 2012

This Article was also published at Wolters Kluwer’s Compliance Headquarters™ website: www.complianceheadquarters.com.