By David Harper, CFA FRM CIPM
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- Lisa Hampton
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1 P2.T7. Operatinal Risk Measurement and Management Capital Planning at Large Bank Hlding Cmpanies: Supervisry Expectatins and Range f Current Practice Binic Turtle FRM Study Ntes By David Harper, CFA FRM CIPM
2 Capital Planning at Large Bank Hlding Cmpanies: Supervisry Expectatins and Range f Current Practice DESCRIBE THE FEDERAL RESERVE S CAPITAL PLAN RULE AND EXPLAIN THE SEVEN PRINCIPLES OF AN EFFECTIVE CAPITAL ADEQUACY PROCESS FOR BANK HOLDING COMPANIES (BHC S) SUBJECT TO THE CAPITAL PLAN RULE DESCRIBE PRACTICES WHICH CAN RESULT IN A STRONG AND EFFECTIVE CAPITAL ADEQUACY PROCESS FOR A BHC IN THE FOLLOWING AREAS: RISK IDENTIFICATION, INTERNAL CONTROLS, CORPORATE GOVERNANCE, CAPITAL POLICY, STRESS TESTING AND STRESS SCENARIO DESIGN, ESTIMATING LOSSES, REVENUES, AND EXPENSES, INCL. QUANTITATIVE AND QUALITATIVE METHODOLOGIES
3 Capital Planning at Large Bank Hlding Cmpanies: Supervisry Expectatins and Range f Current Practice Describe the Federal Reserve s Capital Plan Rule and explain the seven principles f an effective capital adequacy prcess fr bank hlding cmpanies (BHC s) subject t the Capital Plan Rule. Describe practices which can result in a strng and effective capital adequacy prcess fr a BHC in the fllwing areas: Risk identificatin, Internal cntrls (including mdel review and validatin), Crprate gvernance, Capital plicy (including setting f gals and targets and cntingency planning), Stress testing and stress scenari design, Estimating lsses, revenues, and expenses, including quantitative and qualitative methdlgies. Assessing the impact f capital adequacy, including RWA and balance sheet prjectins Describe the Federal Reserve s Capital Plan Rule and explain the seven principles f an effective capital adequacy prcess fr bank hlding cmpanies (BHC s) subject t the Capital Plan Rule. The Federal Reserve s Capital Plan Rule (CPR) requires all U.S.-dmiciled, tp-tier BHCs with ttal cnslidated assets f $50 billin r mre t develp and maintain a capital plan supprted by a rbust prcess fr assessing their capital adequacy. The Federal Reserve s Capital Plan Rule and the assciated annual Cmprehensive Capital Analysis and Review (CCAR) emphasize the imprtance the Federal Reserve places n BHCs internal capital planning prcesses, and n the supervisry assessment f all aspects f these prcesses. CCAR is the Federal Reserve s supervisry prgram fr assessing the capital plans. In 2013, CCAR cvered 18 BHCs that participated in the 2009 Supervisry Capital Assessment Prgram (SCAP). These initiatives (CPR & CCAR) have fcused nt just n the amunt f capital that a BHC has, but als n the internal practices and plicies a firm uses t determine the amunt and cmpsitin f capital that wuld be adequate, given the firm s risk expsures and crprate strategies as well as supervisry expectatins and regulatry standards. The Federal Reserve s assessment f a BHC s capital planning prcess includes an evaluatin f the risk-identificatin, -measurement, and -management practices that supprt the BHC s capital planning and stress scenari analysis, an assessment f stressed lss and revenue estimatin practices, and a review f the gvernance and cntrls arund these practices. The preamble t the Capital Plan Rule utlines the elements n which the Federal Reserve evaluates the rbustness f a BHC s internal capital planning als referred t as the capital adequacy prcess, r CAP. 3
4 There are seven principles f an effective capital adequacy prcess fr bank hlding cmpanies (BHC s) subject t the Capital Plan Rule: Principle 1: Sund fundatinal risk management The BHC has a sund risk-measurement and risk-management infrastructure that supprts the identificatin, measurement, assessment, and cntrl f all material risks arising frm its expsures and business activities. Principle 2: Effective lss-estimatin methdlgies The BHC has effective prcesses fr translating risk measures int estimates f ptential lsses ver a range f stressful scenaris and envirnments and fr aggregating thse estimated lsses acrss the BHC. Principle 3: Slid resurce-estimatin methdlgies The BHC has a clear definitin f available capital resurces and an effective prcess fr estimating available capital resurces (including any prjected revenues) ver the same range f stressful scenaris and envirnments used fr estimating lsses. Principle 4: Sufficient capital adequacy impact assessment The BHC has prcesses fr bringing tgether estimates f lsses and capital resurces t assess the cmbined impact n capital adequacy in relatin t the BHC s stated gals fr the level and cmpsitin f capital. Principle 5: Cmprehensive capital plicy and capital planning The BHC has a cmprehensive capital plicy and rbust capital planning practices fr establishing capital gals, determining apprpriate capital levels and cmpsitin f capital, making decisins abut capital actins, and maintaining capital cntingency plans. Principle 6: Rbust internal cntrls The BHC has rbust internal cntrls gverning capital adequacy prcess cmpnents, including plicies and prcedures; change cntrl; mdel validatin and independent review; cmprehensive dcumentatin; and review by internal audit. Principle 7: Effective gvernance The BHC has effective bard and senir management versight f the CAP, including peridic review f the BHC s risk infrastructure and lss- and resurceestimatin methdlgies; evaluatin f capital gals; assessment f the apprpriateness f stressful scenaris cnsidered; regular review f any limitatins and uncertainties in all aspects f the CAP; and apprval f capital decisins. 4
5 Describe practices which can result in a strng and effective capital adequacy prcess fr a BHC in the fllwing areas: Risk identificatin, Internal cntrls, Crprate gvernance, Capital plicy, Stress testing and stress scenari design, estimating lsses, revenues, and expenses, incl. quantitative and qualitative methdlgies. Risk Identificatin A key lessn frm the recent financial crisis is that many financial cmpanies simply failed t identify the ptential expsures and risks stemming frm their firm-wide activities. Many cmpanies culd nt assess the full scale and scpe f expsures and hw the size and risk characteristics f their expsures and business activities might evlve as ecnmic and market cnditins change. Because f this, the Federal Reserve prescribes that the BHCs shuld have riskidentificatin prcesses t ensure that all risks are accunted fr when assessing capital needs. These prcesses shuld evaluate the full set f ptential expsures stemming frm nand ff-balance sheet psitins, including thse that culd arise frm prvisins f nncntractual supprt t ff-balance-sheet entities 1, and risks cnditinal n changing ecnmic and financial market cnditins during perids f stress. BHCs shuld have a systematic and repeatable prcess t identify all risks and cnsider the ptential impact t capital frm these risks. BHCs shuld clsely assess any assumptins abut risk reductin resulting frm risk transfer (by insurance rute) and/r mitigatin (cllateral, guarantees r expsureliability netting) techniques. Fr example, analysis f the enfrceability and effectiveness f any guarantees r netting and cllateral agreements and the access t and valuatin f cllateral as expsures and asset values are changing rapidly in a stressed market. Strnger risk-identificatin practices include standardized prcesses thrugh which senir management regularly update risk assessments, review risk expsures and cnsider hw their risk expsures might evlve under a variety f stressful situatins. Many BHCs maintain a cmprehensive inventry f risks t which they are expsed, and refresh it as cnditins warrant (such as changes in the business mix and the perating envirnment) with input frm varius units acrss the BHC. 1 Nn cntractual supprt is extended by the BHCs twards the SPE (Special Purpse Entities) flated by them. These are als called Nn-cntractual bligatins which include assciatins with, r spnsrship f, prducts sld r services prvided (via SPE) that may require the supprt r extensin f funds in the future under stressed cnditins. 5
6 Cnsideratin f the risks inherent in new prducts and activities shuld be a key part f risk-identificatin and -assessment prgrams, which shuld als cnsider risks that, may be assciated with any change in the BHC s strategic directin. Risk measures shuld be able t capture changes in an institutin s risk prfile n a timely basis and may be helpful in capital cntingency plans as early warning indicatrs r cntingency triggers, where apprpriate. BHCs shuld be able t demnstrate hw their identified risks are accunted fr in their capital planning prcesses. If certain risks are mitted frm the enterprise-wide scenari analysis, BHCs shuld nte hw these risks are accunted fr in the capital planning prcess. See Bx 1 belw fr illustratin f hw BHCs identified and captured certain risks that are mre difficult t quantify in their capital planning prcess. Bx 1. Incrprating Risks That Are Mre Difficult t Quantify Scenari-based stress testing is a critical element f rbust capital planning. Hwever, stress testing based n a limited number f discrete scenaris cannt and is nt expected t capture all ptential risks faced by a BHC, and therefre, it shuld serve as ne f several inputs t the capital planning prcess. Given the scpe f peratins at and the assciated breadth f risks facing large, cmplex BHCs including the risk f lsses frm expsures and f reduced revenue generatin they are ften expsed t risks ther than credit r market risk, that are either difficult t quantify r nt directly attributable t any f the specific integrated firm-wide scenaris that are evaluated as part f the BHC s scenari-based stress testing ( ther risks ). Examples f these ther risks include reputatinal risk, strategic risk, and cmpliance risk. As nted in the sectin n risk identificatin, a BHC shuld identify and assess all risks as part f its risk-identificatin prcess and shuld capture the ptential effect f all risks in its capital planning prcess. A BHC s capital planning prcess shuld assess the ptential impact f these ther risks n the BHC s capital psitin t ensure that its capital prvides a sufficient buffer against all risks t which the BHC is expsed. There is a wide range f practices arund hw BHCs accunt fr ther risks as part f their capital planning prcess. Many BHCs used internal capital targets t accunt fr such risks, putting in place an incremental cushin abve their targets t allw fr difficult-t-quantify risks and the inherent uncertainty represented by any frward-lking capital planning prcess. Other BHCs assessed the effect f in terms f sme cmbinatin f reduced revenue, added expenses, r a management verlay n tp f lss estimates. BHCs with lagging practices did nt even attempt t accunt fr ther risks in their capital planning prcess. T the extent pssible, BHCs shuld incrprate the effect f these ther risks int their prjectins f net incme ver the nine-quarter planning hrizn. BHCs shuld clearly articulate and supprt any relevant assumptins and the methds used t quantify the effect f risks n their revenue, expenses, r lsses. Fr thse BHCs that did nt incrprate the ptential impact f these ther risks int their capital targets, strnger practices included a clear articulatin f which risks were being addressed by putting in place a cushin abve the capital target, and hw this cushin is related t identified risks. BHCs shuld clearly supprt the methd they used t measure the ptential effect f such risks. Using a simple rule (such as a percent f capital) r expert judgments t determine the cushin abve the capital target, withut prviding analysis r supprt, is a lagging practice. 6
7 Internal Cntrls A BHC shuld have a strng internal cntrl framewrk that helps gvern its internal capital planning prcesses. These cntrls shuld include: regular and cmprehensive review by internal audit; rbust and independent mdel review and validatin practices; cmprehensive dcumentatin, including plicies and prcedures; and change cntrls Scpe f Internal Cntrls A BHC s internal cntrl framewrk shuld address its entire capital planning prcess. This includes: the risk measurement and management systems used t prduce input data, the mdels and ther techniques used t generate lss and revenue estimates; the aggregatin and reprting framewrk used t prduce reprts t management and bards; and the prcess fr making capital adequacy decisins. The cntrl framewrk shuld ensure that BHC management recnciles the separate cmpnents in a cherent manner. The cntrl framewrk shuld help assure that all aspects f the capital planning prcess are functining as intended in supprt f rbust assessments f capital needs. BHCs with strnger cntrl cverage reviewed the cntrls arund capital planning n an integrated basis and applied them cnsistently. Management respnded quickly and effectively t issues identified by cntrl areas and devted resurces t ensure that cntrls were functining effectively. Internal Audit Audit shuld perfrm a review f the full prcess, peridically t ensure that the entire endt-end prcess is functining in accrdance with supervisry expectatins and with a BHC s bard f directrs expectatins as detailed in apprved plicies and prcedures. Internal audit shuld review the manner in which deficiencies are identified, tracked, and remediated. Audit staff shuld have the cmpetence and influence t identify and escalate key issues, and the internal audit functin shuld reprt regularly n the status f all aspects f the capital planning prcess t senir management and the bard f directrs. BHCs with strnger audit practices prvided a cmprehensive, rbust review f all cmpnents f the capital planning prcess, including all f the cntrl elements nted earlier. BHCs with leading internal audit practices arund internal capital planning had strng issue identificatin and remediatin tracking. They ensured that audit staff had strng technical expertise, elevated stature in the rganizatin, and prper independence frm management. 7
8 Independent Mdel Review and Validatin BHCs shuld cnduct independent review and validatin f all mdels used in internal capital planning, cnsistent with existing supervisry guidance n mdel risk management. The mdel review and validatin prcess shuld include: an evaluatin f cnceptual sundness; nging mnitring that includes verificatin f prcesses and benchmarking; and an utcmes analysis. BHCs shuld maintain an inventry f all mdels used in the capital planning prcess, including all input r feeder mdels that prduce prjectins r estimates used by the mdels that generate the final lss, revenue r expense prjectins. BHCs shuld maintain a prcess t incrprate well-supprted adjustments t mdel estimates when mdel weaknesses and uncertainties are identified. BHCs shuld attempt t cmpensate fr the challenges inherent in back-testing stress mdels by cnducting sensitivity analysis r by using benchmark r challenger mdels. BHCs shuld ensure that validatin cvers all mdels and assumptins used fr capital planning purpses, including any adjustments management has made t the mdel estimates. BHCs shuld give mre attentin t mdel risk management, including strengthening practices arund mdel review and validatin. Sme BHCs exhibited strnger practices in their capital planning, including Plicies and Prcedures maintaining an updated inventry f all mdels used in the prcess; ensuring that mdels had been validated fr their intended use; and being transparent abut the validatin status f all mdels used fr capital planning and addressing any mdels that had nt been validated by restricting their use, r using benchmark r challenger mdels t help assess the reasnableness f the primary mdel utput. BHCs shuld ensure they have plicies and prcedures cvering the entire capital planning prcess. Plicies and prcedures shuld ensure a cnsistent and repeatable prcess fr all cmpnents f the capital planning prcess and prvide transparency t third parties regarding this prcess. Plicies shuld be reviewed and updated at least annually and mre frequently when warranted. There shuld als be evidence that management and staff are adhering t plicies and prcedures in practice, and there shuld be a frmal prcess fr any plicy exceptins. Such exceptins shuld be rare and apprved by the apprpriate level f management. 8
9 Ensuring Integrity f Results BHCs shuld have internal cntrls that ensure the integrity f reprted results and the dcumentatin, review, and apprval f all material changes t the capital planning prcess and its cmpnents. A BHC shuld ensure that such cntrls exist at all levels f the capital planning prcess. Specific cntrls shuld be in place t: ensure that MIS are sufficiently rbust t supprt capital analysis and decisin making, with sufficient flexibility t run ad hc analysis as needed; prvide fr recnciliatin and data integrity prcesses fr all key reprts; address the presentatin f aggregate, enterprise-wide capital planning results, which shuld describe any manual adjustments made in the aggregatin prcess and hw thse adjustments cmpensate fr identified weaknesses; and ensure that reprts prvided t senir management and the bard cntain the apprpriate level f detail and are accurate and timely. The party respnsible fr this reprting shuld assess and reprt whether the BHC is in cmpliance with its internal capital gals and targets, and ensure the ratinale fr any deviatins frm stated capital bjectives is clearly dcumented and btain any necessary apprvals. BHCs with strnger practices in this area ensured that gd infrmatin flws existed t supprt decisins, with significant investment in cntrls fr data and infrmatin. Fr example, sme BHCs had an internal audit grup review the data fr accuracy and ensured that any data reprted t the bard and senir management were given extra scrutiny and crss-checking. BHCs with strnger practices had strng MIS in place that enabled them t cllect, synthesize, analyze, and deliver infrmatin quickly and efficiently. These systems als had the ability t run ad hc analysis t supprt capital planning as needed withut emplying substantial resurces. Other BHCs cntinue t face challenges with MIS. Many BHCs have systems that are antiquated and/r siled and nt fully cmpatible, requiring substantial human interventin t recncile acrss systems. Dcumentatin BHCs shuld have clear and cmprehensive dcumentatin fr all aspects f their capital planning prcesses. Dcumentatin shuld cntain sufficient detail, accurately describe BHCs practices, allw fr review and challenge, and prvide relevant infrmatin t decisin makers. 9
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