Capital Planning at Large Bank Holding Companies: Supervisory Expectations and Range of Current Practice
BHC Scenario Design
Under the Capital Plan Rule, a BHC is required to use a BHC-developed stressed scenario that is appropriate for its business model and portfolios.26 Accordingly, BHCs should have a process for designing scenarios for enterprise-wide scenario analysis that reflects the BHC's unique business activities and associated vulnerabilities.
The range of observed practice for developing BHC stress scenarios was broad. Some BHCs designed stress scenarios using internal models and expertise. Other BHCs used vendor-defined macroeconomic scenarios or used vendor models to define customized macroeconomic scenarios. For BHCs with internally developed scenarios, those with stronger scenario-design practices used internal models in combination with expert judgment rather than relying solely on either models or expert judgment to define scenario conditions and variables. Among BHCs that used third-party scenarios, those with stronger practices tailored third-party-defined scenarios to their own risk profiles and unique vulnerabilities.
Regardless of the method used to develop the scenario, BHCs should have a scenario-selection process that engages a broad range of internal stakeholders such as risk experts, business managers, and senior management. Although they are required to submit only one BHC stress scenario for CCAR, BHCs should develop a suite of scenarios that collectively capture their material risks and vulnerabilities under a variety of stressful circumstances and should incorporate them into their overall capital planning processes.
Scenario Design and Severity
As indicated in the preamble to the Capital Plan Rule, "the bank holding company-designed stress scenario should reflect an individual company's unique vulnerabilities to factors that affect its firm-wide activities and risk exposures, including macroeconomic, market-wide, and firm-specific events."27 Thus, BHC stress scenarios should reflect macroeconomic and financial conditions that are tailored specifically to stress a BHC's key vulnerabilities and idiosyncratic risks, based on factors such as its particular business model, mix of assets and liabilities, geographic footprint, portfolio characteristics, and revenue drivers. A BHC stress scenario that simply features a generic weakening of macroeconomic conditions similar in magnitude to the supervisory severely adverse scenario does not meet these expectations.
BHCs with stronger scenario-design practices clearly and creatively tailored their BHC stress scenarios to their unique business-model features, emphasizing important sources of risk not captured in the supervisory severely adverse scenario. Examples of such risks observed in practice included a significant counterparty default; a natural disaster or other operational-risk event; and a more acute stress on a particular region, industry, and/or asset class as compared to the stress applied to general macroeconomic conditions in the supervisory adverse and severely adverse scenarios.
At the same time, BHC stress scenarios should not feature assumptions that specifically benefit the BHC. For example, some BHCs with weaker scenario-design practices assumed that they would be viewed as strong compared to their competitors in a stress scenario and would therefore experience increased market share. Such assumptions are contrary to the supervisory expectations for and the intent of a stress testing exercise that informs capital planning.
While a broad-based recession adversely affects a wide range of most BHCs' business activities, BHCs may have business models or important business activities that generate vulnerabilities that are not particularly well captured by scenario analysis based on a stressed macroeconomic environment (or for which even a severe recession is not the primary source of potential vulnerability). These BHCs should incorporate into their stress scenarios elements that address the key revenue vulnerabilities and sources of loss for their specific businesses and activities. In combination, the recession incorporated into the BHC stress scenario and any additional elements intended to address specific businesses or activities should result in a substantial stress for the organization, including a significant reduction in capital ratios relative to baseline projections. However, a BHC stress scenario that produces post-stress capital ratios lower than those under the supervisory severely adverse scenario is not, in and of itself, a safe harbor. The stress scenario included in a BHC's capital plan should place substantial strains on its ability to generate revenue and absorb losses, consistent with its unique risks and vulnerabilities.
The set of variables that a BHC includes in its stress scenario should be sufficient to address all material risks arising from its exposures and business activities. A business line could face significant stress from multiple sources, requiring more than one risk factor or macroeconomic variable. The scenario should generally contain the relevant variables to facilitate pro forma financial projections that capture the impact of changing conditions and environments. BHCs should have a consistent process for determining the final set of variables and provide this rationale as part of the scenario narrative.
Overall, BHCs with stronger scenario-design practices generated scenarios in which the link between the variables included in the scenario and sources of risk to the BHC's financial outlook were transparent and straightforward. Clear narratives helped make these links more transparent. BHCs with weaker scenario-design practices developed stress scenarios that excluded some variables relevant to the BHC's risk profile and idiosyncratic vulnerabilities. For example, some BHCs with significant trading activities and revenues included a limited set of relevant financial variables. Other BHCs with significant regional and/or industry concentrations did not include relevant geographic or industry variables.
The scenario should be supported by a clear narrative describing how the scenario addresses the particular vulnerabilities and material risks facing the BHC. BHCs with stronger scenario-design practices provided narratives describing how the scenario variables related to the risks faced by a BHC's significant business lines and, in some cases, how the scenario variables corresponded to variables in the BHC's internal risk-management models. The narratives also provided explanations of how a scenario stressed a BHC's unique vulnerabilities specific to its business model and how the paths of the scenario variables related to each other in an economically intuitive way. Weaker practices included scenario narratives that did not provide any context for the variable paths as well as scenario narratives that described features that were not reflected in any variables considered in a BHC's internal capital planning.