Capital Planning at Large Bank Holding Companies: Supervisory Expectations and Range of Current Practice
- Estimation Methodologies for Losses, Revenues, and Expenses
- Assessing Capital Adequacy Impact
- Concluding Observations
Assessing Capital Adequacy Impact
Balance Sheet and RWAs
BHCs should have a well-documented process for generating projections of the size and composition of on- and off-balance sheet positions and RWA over the scenario horizon.48 Balance projections are a key input to enterprise-wide scenario analysis given their direct impact on the estimation of losses, PPNR, and RWA. Estimating the evolution of balance sheet size and composition under stress integrates many interrelated features. For example, loan balances and the stock of AFS securities at a point in time will depend upon origination, purchase, and sale activity from period to period, as well as maturities, prepayments, and defaults. Due to complexities related to dynamically projecting and integrating various components (e.g., originations, prepayments and defaults), most BHCs made direct projections of balances for each major segment of the balance sheet (e.g., loans, deposits, trading assets and liabilities, and other assets) for each quarter of the scenario horizon.
BHCs often faced challenges in integrating the ultimate balance projections with other aspects--for example, borrower or depositor behavior. BHCs with stronger practices separately considered the drivers of change to asset and funding balances, such as contractual paydowns, modeled prepayments, nonperformance, and new business activity for assets, rather than simply projecting targeted balances directly. At these BHCs, each element was separately assessed for consistency with scenario conditions and other management assumptions. BHCs with stronger practices also either directly considered the impact of these various factors in their balance projections or had procedures to evaluate the reasonableness of any implied behavior by including input from business-line leaders in the process and iterating to reasonable estimates in a well-supported and transparent manner.
BHCs should clearly establish and incorporate into their scenario analysis the relationships among and between revenue, expense, and on- and off-balance-sheet items under stressful conditions. Most BHCs used asset-liability management (ALM) software as a part of their enterprise-wide scenario-analysis toolkit, which helps integrate these items. BHCs that do not use ALM software must have a process that integrates balance sheet projections with revenue, loss, and new business projections. BHCs with more tightly integrated procedures were better able to ensure appropriate relationships among the scenario conditions, losses, expenses, revenue, and balances.
As noted above, BHCs should not rely on favorable assumptions that cannot be reasonably assured in stress scenarios given the high level of uncertainty around market conditions. Examples of aggressive or favorable balance sheet assumptions include (1) large changes in asset mix that serve to decrease BHCs' risk weights and improve post-stress capital ratios but that are not adequately supported or reflected in PPNR or loss estimates; (2) "flight-to-quality" assumptions and funding mix changes that increase deposits and reduce the dollar cost of funding; (3) significant balance sheet shrinkage with no consideration of the potential losses associated with reducing positions in periods of market stress; and (4) operating margin improvement. BHCs that make favorable assumptions should have sufficient evidence that they can be reasonably assured in the assumed stress scenario.
BHCs' RWA projections should be based on corresponding projections of on- and off-balance-sheet exposures and their risk attributes and should be consistent with the severity of the stress conditions under each scenario. For general credit-risk exposures, BHCs should project balances for material asset categories with sufficient granularity to facilitate application of regulatory risk-weighting approaches associated with different asset categories. For trading exposures, BHCs should translate changes in scenario variables into risk-parameter estimates that drive RWA calculations (e.g., the potential for RWA per dollar of some trading book positions to increase in periods of higher levels of general market volatility). Where RWA projections are based on internal risk models, BHCs should not assume any RWA reductions from potential data or model enhancements to RWA calculation methodologies over the projection period. In all cases, BHCs should document any assumptions made as part of the balance sheet and RWA projection process and perform independent reviews and validations of balance sheet and RWA projection methodologies and resulting estimates.49
Allowance for Loan and Lease Losses (ALLL)
BHCs should maintain an adequate ALLL along the scenario path and at the end of the scenario horizon. Reserve adequacy should be assessed against projected size, composition, and risk characteristics of the loan portfolio throughout the scenario horizon. In general, the ALLL build and release should be consistent with the scenario path, portfolio credit quality, loss recognition approach, loan loss estimates, and loan portfolio balance projections (including any portfolio growth assumptions). If BHCs use estimation approaches that implicitly delay the recognition of losses, such as net charge-off models, they should adequately build reserves to account for losses not recognized during the scenario horizon. If the approach relies on top-down coverage levels, BHCs should compare coverage ratios and loss-emergence periods to historical stress environments and to internal policies and explain the differences if material differences exist.
Aggregation of Projections
BHCs should have a well-established and consistently executed process for aggregating loss, revenue and expense, and on- and off-balance sheet and RWA estimates, as part of enterprise-wide scenario analysis, to assess the post-stress impact of those estimates on capital ratios. BHCs that are more effective at implementing such a process have established centralized groups with responsibility for
- combining loss, revenue, balance sheet, and RWA projections;
- providing strong governance and controls around the process;
- ensuring coherence of component estimates and aggregate results; and
- applying and documenting any adjustments.50
These centralized groups have been able to source estimates from a range of internal parties involved in enterprise-wide scenario analysis and develop consolidated pro forma financial results that are internally consistent and conform to accounting standards.
BHCs should develop a governance structure around the enterprise-wide scenario analysis process that provides for a robust analysis and challenge of the coherence of the aggregate results and determine whether any adjustments need to be made based on the analysis. In particular, BHCs should assess whether the paths of individual loss and revenue components are consistent with the paths of balance sheet and RWA estimates and the overall scenario path. For example, an increase in PPNR amid declining balances would appear generally inconsistent and should warrant further investigation. In assessing consolidated financial results, BHCs should account for any potential changes in relationships between losses and financial performance drivers during periods of stress.
BHCs should have good understanding of instances when exposures with similar underlying risk characteristics that are part of different portfolios or business lines exhibit different sensitivities to scenario conditions. BHCs should identify instances where the differences are due to inconsistent assumptions or modeling approaches that require management attention, rather than differences in accounting treatment. In addition, if a BHC's enterprise-wide scenario analysis results in post-stress outcomes that are more favorable than those under baseline conditions, BHCs should critically evaluate the reasonableness and consistency of assumptions across portfolios, business lines, and other areas of loss and revenue estimation.
BHCs that had an effective aggregation process leveraged their business planning and financial and regulatory reporting systems as part of that process. Using standalone tools or spreadsheets in the aggregation process is a weak process. If a BHC needs to use standalone tools or spreadsheets due to systems limitation, management should ensure robust controls are in place, including access and change controls, and should maintain an audit trail and document all approvals for any adjustments made. BHCs should also have reconciliation procedures and data-quality and logic checks in place to ensure that the results from the enterprise-wide scenario analysis reconcile to both management reporting and regulatory reports, with a transparent mapping between various reporting taxonomies.
BHCs with weaker practices had limited or no reconciliation procedures or other controls in place to ensure the integrity, completeness, and accuracy of the consolidated post-stress capital metrics. BHCs with weaker practices also had no process to ensure consistency in the BHC-wide application of scenario assumptions and management adjustments, and had weak governance and documentation standards.