Posted by David Wright, Deloitte Advisory Director on January 26, 2016.
Ever since the first bank stress tests were conducted during the financial downturn, regulatory expectations for capital planning and stress testing have been evolving as both bank supervisors and the industry have gained knowledge and experience. Over the years, those rising expectations have been communicated through examination letters, regulations, range of practice guidance, and capital planning instructions. While those various communications were helpful, they were not memorialized in one set of comprehensive guidance, nor did they address how expectations might differ depending on a firm’s size and complexity—until now.
On December 21, 2015, the Federal Reserve Board (FRB) released guidance—in the form of two Supervision and Regulation Letters (SR Letters)—that consolidates the capital planning expectations for all large financial institutions and clarifies differences in those expectations based on firm size and complexity.
The FRB emphasizes that the guidance sets forth only “minimum expectations,” and that the largest and most complex firms are “expected to exceed those minimum standards and have the most sophisticated, comprehensive, and robust capital planning practices for all of their portfolios and activities.”
Three Tiers of Institutions
The SR Letters differentiate between three tiers of institutions:
SR Letter 15-18 applies to LISCC Firms and LCFs while SR Letter 15-19 applies to LNFs.
The guidance is effectively immediately for BHCs already subject to the FRB’s Capital Plan Rule and will become effective on January 1, 2017 for IHCs of foreign banks.
Overview of the Guidance
The guidance sets forth capital planning expectations with respect to the following areas:
- Risk Management;
- Internal Controls;
- Capital Policy;
- Incorporating Stressful Conditions and Events; and
- Estimating Impact on Capital Positions
Emphasizing that the FRB has different capital planning expectations based on a firm’s size, scope of activities, and systemic importance, among other factors, the guidance outlines several differences in its expectations for LISCC Firms, LCFs, and LNFs.
Below are some of the most notable differences in the six overarching areas.
Senior management of LISCC Firms and LCFs should review the firm’s capital planning process at least quarterly while senior management of LNFs should review the process at least semi-annually.
All firms are expected to identify risks that may be “difficult to quantify” and explain how they are addressed in the capital planning process (the FRB has higher expectations for LISCC firms and LCFs in this regard). LISCC firms and LCFs are also expected to develop a scenario directly linked to idiosyncratic risks.
In addition, LISCC Firms and LCFs are expected to have a “more formal risk identification process” that includes seeking input from multiple stakeholders across the organization (e.g., senior management, finance and risk professionals, front office leadership) while LNFs are not expected to have such a process.
LISCC Firms and LCFs are expected to complete a “conceptual soundness review of all models prior to use, maintain comprehensive documentation of its capital planning process, and have compensating controls for known model uncertainties,” while LNFs must only “make an effort to review its material models prior to use.”
In addition, LISCC firms and LCFs, which are expected to subject benchmark models to validation, don’t need full validation for these models if they are only used to challenge models and are not used in estimation itself. LNFs are not expected to use benchmark models.
The FRB expects the capital policy (i.e., a written assessment of principles and guidelines used for capital planning, issuance, usage, and distributions) of LISCC Firms and LCFs to cover a broader set of topics than the capital policy of LNFs, including roles and responsibilities of key parties and metrics influencing capital distributions.
All firms should reevaluate their capital policy at least annually and make revisions as necessary to address changes in business strategy, risk appetite, organizational structure, and governance structure, among other things.
Incorporating Stressful Conditions and Events
LISCC Firms and LCFs must develop a scenario that is directly linked to the firm’s risk identification process and its risk assessment, while LNFs are expected to develop a firm-specific scenario or adjust the FRB’s scenario to its own risk profile. Overall, the FRB has higher expectations for the scenario narrative of LISCC Firms and LCFs.
Estimating Impact on Capital Positions
The FRB has “elevated expectations” for LISCC Firms and LCFs with respect to the use of models in loss and revenue estimation. LISCC Firms and LCFs are generally expected to use quantitative approaches in estimating losses and pre-provision net revenue, while LNFs may use either quantitative or qualitative approaches.
For LISCC Firms and LCFs, the guidance is largely consistent with feedback from prior FRB examinations as well as past practices and instructions under the Comprehensive Capital Analysis and Review (CCAR) program. For LNFFs, the guidance scales back expectations to a level that is more appropriately tailored to their less systemic nature, which has been a longstanding goal of FRB supervision with respect to the diverse portfolio of firms subject to Dodd-Frank-mandated regulations.
Importantly, the specificity and clarity of expectations under SR Letters 15-18 and 15-19 should greatly assist future implementation and remediation efforts and assist examiners in appropriately scaling expectations across institutions subject to the Capital Plan Rule.
As developments regarding the 2016 CCAR program occur, Deloitte Advisory will issue additional updates as appropriate.
For more information regarding the FRB’s guidance, refer to our analysis here.
Banking and Securities