Federal Reserve Issues Instructions and Guidance for the 2015 Comprehensive Capital Analysis and Review Program On October 16, the Board of Governors of the Federal Reserve System (the Federal Reserve ) issued its summary instructions and guidance 1 (the CCAR 2015 Instructions ) for its supervisory Comprehensive Capital Analysis and Review program for 2015 ( CCAR 2015 ) applicable to bank holding companies with $50 billion or more of total consolidated assets ( Covered BHCs ). Thirty-one institutions will participate in CCAR 2015, including the 30 Covered BHCs 2 that participated in CCAR in 2014, as well as one institution that is new to the program. 3 CCAR 2015 is being conducted in conjunction with the Federal Reserve s capital plan rule, which requires the submission and supervisory review of a Covered BHC s capital plan under stressed conditions (the Capital Plan Rule ), 4 and the Federal Reserve s rules implementing the stress test requirements of Section 165(i) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Stress Test Rules ). CCAR entails a supervisory detailed evaluation of the capital adequacy of large, complex U.S. BHCs, focusing on their ability to maintain sufficient capital levels to continue their operations in stressed economic environments. The Federal Reserve first introduced CCAR in 2011; CCAR 2015 will be the fifth cycle. Under the Capital Plan Rule, Covered BHCs must submit a plan outlining their proposed capital actions over the course of a multiple-quarter planning horizon. This capital plan is evaluated by the Federal Reserve on both quantitative grounds (that is, whether the Covered BHC can meet applicable numerical regulatory capital minimums based on the Federal Reserve s own estimates of Covered BHCs pro forma capital ratios over the nine-quarter planning horizon) and qualitative grounds. New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney www.sullcrom.com
Concurrently with the release of the CCAR 2015 Instructions, the Federal Reserve published a final rule amending certain aspects of the Capital Plan Rule and Stress Test Rules (the Amendment ). 5 The CCAR 2015 Instructions incorporate many of the changes included in the Amendment. Covered BHCs must submit their capital plans for CCAR 2015 to the Federal Reserve on or before January 5, 2015. The Federal Reserve will release the CCAR results and its objection or non-objection to Covered BHCs capital plans by no later than March 31, 2015. A. CCAR 2015 INSTRUCTIONS In general, the CCAR 2015 Instructions are substantively similar to the instructions provided in prior CCAR cycles. However, the CCAR 2015 Instructions include several changes, updates and other notable provisions, including: Operational Risk and Litigation Related Losses. The CCAR 2015 Instructions provide additional substantive guidance (as compared to the CCAR 2014 instructions) regarding the projection of operational risk losses in both the baseline and stress scenarios. Significantly, the Federal Reserve states that baseline projections should align with historical, realized losses while taking into account any pending litigation or other operational events. Stress projections should be conservative. Covered BHCs should be able to demonstrate a detailed understanding of the operational risks facing the organization and provide reasonable estimates of the potential operational risk losses. 6 The Federal Reserve expects a Covered BHC s operational risk losses in a stress scenario to be higher than baseline projections regardless of whether the losses are directly correlated with the stressed economic environment. Covered BHCs should take a detailed approach to developing their operational risk loss projections, focusing on bank-specific operational risks (including litigation risk) and demonstrating a comprehensive understanding of the institution s challenges. In light of recent events, Covered BHCs may also want to consider potential risks posed by cybersecurity breaches when projecting operational losses. Any data issues that may impact the credibility of a Covered BHC s operational risk loss projections should also be addressed. More specifically as to legal costs, the CCAR 2015 Instructions state that Covered BHCs must estimate legal costs (including expenses, judgments, fines, and settlements) that could occur under baseline and stressful environments. When projecting legal costs in stress scenarios, a [Covered BHC] should assume unfavorable stressed outcomes on current, pending, threatened, or otherwise possible claims of all types. Estimates of stressed legal losses and other costs and expenses should be well supported by detailed underlying analysis. 7 As such, it is likely that for the 2015 cycle, the Federal Reserve will pay particular attention to Covered BHCs operational risk, including, in particular, litigation related loss projections, and the qualitative processes and procedures employed by institutions to derive this data for purposes of their capital plan submissions. The Federal Reserve has been suggesting in various forums that banks have been too slow to establish legal reserves, and it is worth noting that the Federal Reserve indicated that its supervisory pro forma projection of operational losses for Covered BHCs in the 2014 CCAR cycle was $151 billion. 8 Accordingly, Covered BHCs should carefully evaluate operational risk losses and the conservatism of their own projections. Organization of Capital Plan Submissions. The CCAR 2015 Instructions now include an outline to assist Covered BHCs in organizing their capital plan submissions. The suggested outline divides the submission into two parts: a capital plan narrative and supporting documentation. Within these parts, it identifies the relevant topics and/or materials a Covered BHC should include in order to adequately cover the mandatory elements of a capital plan required under the Capital Plan Rule. Adherence to the suggested narrative outline will presumably assist in the Federal Reserve s horizontal review of Covered BHCs capital plans. -2-
Capital Plan Narrative. The suggested capital plan narrative would consist of 10 subparts: (i) the Covered BHC s capital plan and associated pro forma financial results under the various scenarios assessed under the capital adequacy process; (ii) the Covered BHC s capital policy; (iii) a description of all planned capital actions over the planning horizon; (iv) a description of the Covered BHC s process for assessing capital adequacy; (v) a description of the Covered BHC s risk-identification process to support its stress testing; (vi) a description of the Covered BHC s process and approach to developing its baseline and stress scenarios; (vii) a discussion of any material business plan changes that would impact the Covered BHC s capital adequacy; (viii) a summary of the assumptions, limitations and weaknesses that could materially impact a Covered BHC s consolidated results, material loss or revenue estimates; (ix) a description of a Covered BHC s internal governance structure for developing its comprehensive capital plan; and (x) the results of the most recent review of a Covered BHC s capital adequacy process by its internal audit department or an independent party. Supplemental Documentation. The CCAR 2015 Instructions recommend that model and methodology documentation submitted to support a Covered BHC s capital plan be organized based on topic: retail, wholesale, fair value option and held-for-sale loans, securities, trading, counterparty, operational risk, pre-provision net revenue, mortgage-servicing rights and regulatory capital transitions. Supporting documentation should include: (i) all policies and procedures related to the capital adequacy process; (ii) an inventory of all models and methodologies used to estimate losses, revenues, expenses, balances and risk-weighted assets; and (iii) methodology documents. Assessment of Models. Under the CCAR 2015 Instructions, Covered BHCs must provide a thorough assessment of the models used in developing their capital plan projections. Methodology documents submitted to the Federal Reserve should include: (i) documents outlining key methodologies and assumptions in performing stress tests; (ii) documents evidencing the design, theory and logic underlying a Covered BHC s methodology; and (iii) documents providing model validation to evidence the conceptual soundness, model robustness and limitations, use of qualitative adjustments or other expert judgments, exception reports, and outcome analysis of a Covered BHC s capital plan projections. Documents should meet the requirements outlined in the appendix of the FR Y-14A instructions. The Federal Reserve indicates these materials will be used to evaluate the strength of a Covered BHC s internal control framework and regulatory reporting. CCAR Communications Mailbox. All questions and associated correspondence about CCAR 2015 must be submitted through the Federal Reserve s CCAR communications mailbox. While Covered BHC-specific questions still will be addressed privately, responses to all other questions will be made available to all Covered BHCs through a frequently asked questions feature maintained by the Federal Reserve. The CCAR communications mailbox is the Federal Reserve s official channel of communication regarding CCAR 2015. The Federal Reserve may set up meetings to discuss specific issues with Covered BHCs, but any feedback provided during such meetings will not be considered official. Supervisory Expectations for Reviews of Covered BHCs Regulatory Reporting. The CCAR 2015 Instructions emphasize that Covered BHCs are expected to have a strong internal control framework that helps govern [their] internal capital planning processes including comprehensive documentation of the BHC s policies and procedures such as documentation that outlines the [Covered] BHC s procedures used to ensure the accuracy of regulatory reports affecting CCAR, including the FR Y-9C and FR Y-14. 9 Additionally, Covered BHCs are expected to have identified any weaknesses in controls regarding regulatory reporting and plans to enhance such control structure. Advanced Approaches Covered BHCs. The CCAR 2015 Instructions indicate that Covered BHCs that are subject to the Advanced Approaches and have exited the parallel-run process are not required to use the models-based approach to calculating capital for the 2015 CCAR cycle. -3-
Pipeline Risk. The Federal Reserve emphasizes that Covered BHCs capital plans and stress testing should consider and include so-called pipeline risk that is, not just losses with respect to loans already in the pipeline, but the risk that the pipeline itself may grow under adverse circumstances in connection with loan syndications, securitization and other similar activities. Model Risk Management and Expert Judgment. The CCAR 2015 Instructions note that where expert judgments are used as an overlay or override to modeled outputs, those expert judgments should themselves be subject to oversight and review by the Covered BHC s internal validation group or other independent reviewers. Capital Conservation Buffer. While the capital conservation buffer will begin to be phased-in during the last four quarters of the planning horizon (that is, commencing January 1, 2016 for the planning horizon that began on October 1, 2014), the CCAR 2015 Instructions indicate that such buffer will not be taken into account by the Federal Reserve when computing its supervisory stressed capital ratios for Covered BHCs. The Federal Reserve is considering how to take the capital conservation buffer into account for future CCAR cycles. Hypothetical Behavioral Responses. The CCAR 2015 Instructions state that a Covered BHC should not treat any hypothetical or potential action by its management in a stressed scenario as a mitigating factor when analyzing its internal capital adequacy. Covered BHCs may take into account current safeguards, such as existing hedges, but should not assume that similar measures will be taken in the future. Projection of Out-Quarters Distributions. In past CCAR cycles, the Federal Reserve has observed that some Covered BHCs projected notably lower distributions in the final quarters of a planning horizon when the quarters were not subject to objection (referred to as out-quarters ) as compared to the projected distributions in earlier quarters which were subject to possible objection. The Federal Reserve emphasizes in the CCAR 2015 Instructions that Covered BHCs must base their projected distributions on realistic assumptions and should not artificially depress distributions in the out-quarters of capital plans. The CCAR 2015 Instructions warn that an inexplicable increase in planned capital actions once a quarter becomes subject to Federal Reserve review and objection may be viewed as a sign of shortcomings in a Covered BHC s capital adequacy or capital plan and may lead to the Federal Reserve s objection to the relevant plan. One-time Adjustment to Capital Distributions. Similarly, the Federal Reserve cautions Covered BHCs that take advantage of the one-time downward adjustment mechanism for planned capital distributions in order to meet the CCAR quantitative test to avoid decreasing capital distributions only in the out-quarters of the planning horizon that are not subject to objection for this cycle without good explanation. Subsidiaries of Foreign Banking Organizations. For CCAR 2015, the Federal Reserve will allow Covered BHCs that will be designated as U.S. intermediate holding companies under the Federal Reserve s enhanced prudential standards 10 to exclude the transfer of subsidiaries that may accompany their reorganization into U.S. intermediate holding companies from their capital plan projections. The Federal Reserve acknowledges the complexities in modelling the effects of the transfer of subsidiaries, as Covered BHCs would need to adjust their management information and accounting systems to account for their exposures to nonbank subsidiaries. The CCAR 2015 Instructions state that this is a one-time exemption and the Federal Reserve expects that Covered BHCs that take advantage of this exemption will maintain capital comparable to previous capital plans and their capital distributions will be capped at those in previous cycles. Covered BHCs will be required to reflect the effects of any transfers associated with their transformation into U.S. intermediate holding companies in their 2016 capital plans. B. COMMON THEMES FROM CCAR 2014 The CCAR 2015 Instructions include an appendix that summarizes common themes identified by supervisors during the 2014 CCAR cycle with respect to the qualitative element of the capital plan review. -4-
These common themes build upon the best practices guide published by the Federal Reserve in August 2013 11 and cover similar topics. However, the common themes also provide additional insight to the specific observations and trends, both positive and negative, which the Federal Reserve noted from its CCAR 2014 review. The Federal Reserve indicated that these observations were previously provided to Covered BHCs as part of the supervisory feedback from the CCAR 2014 cycle. These observations include: Operational Risk Loss Estimation. The Federal Reserve acknowledges the challenge of identifying a correlation between operational losses and macroeconomic factors. It notes, however, that Covered BHCs should not force a relationship between the two. Instead, Covered BHCs should adopt a conservative approach and estimate operational risk losses based on the potential operational risk events that would occur in a stressed environment. Covered BHCs should build significant operational risk into their stress scenarios, regardless of whether this is directly related to the stressed environment. The Federal Reserve expects Covered BHCs to assume that operational risk events will occur during the nine-quarter planning horizon. The CCAR 2015 Instructions also specify certain requirements that Covered BHC s should meet in conducting their regression analysis, loss-distribution approaches, historical averages or scenario analysis when analyzing operational risk. Sensitivity Analysis. The common themes emphasize the importance of sensitivity analysis to test the robustness of models used in the CCAR process and to improve reporting for Covered BHC directors, management and supervisors. The Federal Reserve observed that some Covered BHCs did not engage in sufficient sensitivity analysis during model development in CCAR 2014 and instead overly relied on testing performed by the model validation function. During the 2015 cycle, Covered BHCs should expand their use of sensitivity analysis to test key assumptions and input variables in order to better understand how changing assumptions and variables can materially alter results. At a minimum, the Federal Reserve expects Covered BHCs to conduct sensitivity analysis on the following assumptions: projected market share; size of the mortgage market; cost and flow of deposits; utilization rate of credit lines; discount rates; and level and composition of trading assets. This list is not exhaustive and the Federal Reserve indicates that testing only these assumptions will not be sufficient. Assumptions Management. Covered BHCs should document the assumptions used in their capital plan and stress tests, including the rationale and any empirical support for the assumptions as well as evidence of how the assumptions are consistent with the scenario conditions. The Federal Reserve notes that many Covered BHCs relied on unclear or unsubstantiated assumptions, especially for loan- and deposit-pricing assumptions, during CCAR 2014. Assumptions should be conservative, consistent with scenario conditions and within each scenario, subject to sensitivity analysis and supported by quantitative analysis or empirical evidence, where available. Assumptions do not need to be based on historical experience, but, if assumptions do depart from historical practice, Covered BHCs should provide documented support for why the assumptions are plausible, conservative and consistent. Model Overlays. Most Covered BHCs employed some management overlay to their modeled outputs during CCAR 2014. The Federal Reserve stresses that [Covered] BHCs should ensure that they have a transparent and repeatable process; that assumptions are clearly outlined and consistent with assumed scenario conditions; and that results are provided with and without adjustments. [emphasis in the original]. Overreliance on management overlays suggests that Covered BHCs may need to improve their models. Model overlays should be tied to specific model weaknesses and should not be used as a general catch-all to adjust model outputs to achieve more conservative results. Model Risk Management. The Federal Reserve believes that Covered BHCs can improve upon their model risk management, especially in testing the conceptual soundness of modelling approaches used in stress tests. During CCAR 2014, certain Covered BHCs did not conduct sufficiently rigorous validation activities, failing to investigate key assumptions and model sensitivities -5-
or to evaluate their models for intended use (including vendor models). Model overrides and overlays should be subject to review by validation staff and independent reviewers. While not all validation activities can be completed before every model is used, Covered BHCs should strive to at least complete the conceptual soundness evaluation. Where completion is not possible, model outputs should be approached conservatively and with greater caution. Capital Policy. Some Covered BHCs, according to the Federal Reserve, submitted capital policies during CCAR 2014 that need improvement. Capital policies should (i) address the major components of a Covered BHC s capital planning processes; (ii) reference supporting policies; (iii) detail how the management and board manages, monitors and makes decisions regarding capital planning; and (iv) outline expectations for information included in a Covered BHC s capital plan. Capital policies should also include limits on capital distributions and guidelines regarding the analysis Covered BHCs must complete to support their capital actions. Capital goals or limits were omitted or poorly defined for many Covered BHCs during the 2014 cycle. Moreover, even if a Covered BHC received a nonobjection for the 2014 CCAR, it may none the less have faced significant criticism from the Federal Reserve. Those criticisms obviously must be remediated. Presentation of Consolidated Pro Forma Results. The Federal Reserve encourages all Covered BHCs to continue to improve upon their processes for review, challenge and aggregation of estimates used in their capital planning process. In particular, these review and challenge processes should include: (i) an effective review of processes used at both the business/sub-aggregated and enterprise level and sign off by a third party; (ii) documentation of the entire process including identification of accountable parties; (iii) evidence of communication across different functions in the organization; (iv) a process for aggregating and finalizing results; (v) documentation of key assumptions, sensitivities, limitations and judgments applied in the processes and communication of these items to senior management; and (vi) evidence of management oversight and challenge throughout the processes. Risk-Weighted Assets Methodologies. Covered BHCs must facilitate an independent review of their risk-weighted asset regulatory reporting by either their internal audit team or another control function. The Federal Reserve found many of the 2014 reviews to be inadequate, as they were outdated, not targeted to RWA or not conducted at all. Reviews must be designed to ensure that point-in-time RWA processes capture all on- and off-balance sheet exposures and are consistent with the Covered BHC s applicable risk-weighting frameworks. Covered BHCs subject to the market risk capital rule should calibrate their projections of market risk RWAs to capture the risk in their trading books as well as the relationship between market risk RWA and total RWA. All Covered BHCs are expected to ensure that their reported projections of market risk RWAs reflect the impact of each scenario. In general, documentation and support of RWA methodologies also should be improved in CCAR 2014 and Covered BHCs should provide proper evidence of the appropriateness of its assumptions. AFS Fair Value OCI. Advanced Approaches Covered BHCs should evaluate all available for sale ( AFS ) securities for changes in unrealized gains and losses that flow through other comprehensive income ( OCI ) under stress scenarios. AFS fair value OCI in a stress scenario should reflect movements in projected spreads, interest rates, foreign exchange rates and any other factors relevant to each asset class. Data used in the projection should be derived from a sufficiently long time period which should include a period of vulnerability for the relevant asset class. Some Advanced Approaches Covered BHCs relied on too short of a time frame in 2014. Models used to project unrealized gains and losses should be independently validated and their associated methodologies and assumptions should be documented. The continued emphasis by the Federal Reserve on common qualitative themes from one CCAR cycle to the next is suggestive of a continued supervisory focus on horizontal reviews and an expectation that Covered BHCs should make continued improvements to their capital planning process on an iterative, -6-
year-to-year basis, even if they did not receive a formal qualitative objection to their submitted capital plan in the previous year. * * * Copyright Sullivan & Cromwell LLP 2014-7-
ENDNOTES 1 2 3 4 5 6 7 8 9 10 See Federal Reserve, Comprehensive Capital Analysis and Review 2015: Summary Instructions and Guidance (October 17, 2014), available at http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20141017a1.pdf. The 30 bank holding companies that were previous CCAR participants are: Ally Financial Inc.; American Express Company; Bank of America Corporation; The Bank of New York Mellon Corporation; BB&T Corporation; BBVA Compass Bancshares, Inc.; BMO Financial Corp.; Capital One Financial Corporation; Citigroup Inc.; Comerica Incorporated; Discover Financial Services; Fifth Third Bancorp; The Goldman Sachs Group, Inc.; HSBC North America Holdings Inc.; Huntington Bancshares Inc.; JPMorgan Chase & Co.; KeyCorp; M&T Bank Corporation; Morgan Stanley; MUFG Americas Holdings Corporation; Northern Trust Corporation; The PNC Financial Services Group, Inc.; RBS Citizens Financial Group, Inc.; Regions Financial Corporation; Santander Holdings USA, Inc.; State Street Corporation; SunTrust Banks, Inc.; U.S. Bancorp; Wells Fargo & Co.; and Zions Bancorporation. Deutsche Bank Trust Corporation will participate in CCAR for the first time in 2015. See 12 C.F.R. 225.8. For additional information on the Capital Plan Rule, please refer to our Memorandums to Clients, dated November 29, 2011, Bank Capital Plans: Federal Reserve Board Issues Final Rule Regarding Capital Plan and Formal Stress Test Requirements for Certain Large Bank Holding Companies, available at http://www.sullcrom.com/bank-capital- Plans-11-29-2011; and, dated October 2, 2013, : Federal Reserve Issues Interim Final Rules Addressing Application of New Basel III-Based Capital Framework for Purposes of the 2013-2014 Capital Plan and Stress Test Cycle, available at http://www.sullcrom.com/bank-capital-plans-and-stress-tests-10-02-2013/. See Federal Reserve, Amendments to the Capital Plan and Stress Test Rules (October 17, 2014), available at http://www.federalreserve.gov/newsevents/press/bcreg/20141017a.htm. For additional information on the Amendment, please refer to our Memorandum to Clients, dated October 24, 2014, : Federal Reserve Approves Final Rule Amending Certain Aspects of Existing Capital Plan and Stress Test Rules, available at http://sullcrom.com/bank-capital-plans-and-stress-tests10-24-14. CCAR 2015 Instructions, at 21. Id. (Emphasis added). See Federal Reserve, Dodd-Frank Stress Test 2014: Supervisory Stress Test Methodology and Results (April 22, 2014), available at http://www.federalreserve.gov/bankinforeg/stresstests/2014-executive-summary.htm. CCAR 2015 Instructions, at 1. On February 18, 2014, the Federal Reserve issued a final rule requiring foreign banking organizations with U.S. non-branch assets of $50 billion or more to establish in the United States an intermediate holding company for its U.S. subsidiaries that must be organized under U.S. law, and, with certain limited exceptions, will be subject to the full range of U.S. regulatory requirements applicable to U.S. bank holding companies, including capital planning and stress testing requirements. 79 Fed. Reg. 17240 (March 27, 2014). For additional information on these new requirements for U.S. intermediate holding companies, please refer to our Memorandum to Clients, dated February 24, 2014, Enhanced Prudential Standards for Large U.S. Bank Holding Companies and Foreign Banking Organizations: Federal Reserve Approves Final Rule Implementing Certain Provisions of Section 165 of the Dodd-Frank Act Increasing Supervision and Regulation of Large U.S. Bank Holding Companies and Foreign Banking Organizations, available at http://sullcrom.com/enhanced-prudential-standards-for-large-us-bank-holdingcompanies-and-foreign-banking-organizations. -8-
ENDNOTES (CONTINUED) 11 See Federal Reserve, Capital Planning at Large Bank Holding Companies: Supervisory Expectations and Current Range of Practice (August 2013), available at: http://www.federalreserve.gov/bankinforeg/stress-tests/ccar/august-2013-introduction.htm. -9-
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