The Basel Committee on Banking Supervision (BCBS) released a paper titled “A Sound Capital Planning Process: Fundamental Elements” in January 2014. This paper does not propose changes to standards or capital requirements. Instead, it reports on a study carried out by BCBS on the capital planning process at a number of banks.
The paper has a good overview of what is good capital planning and is worth reading if you work in bank capital management. It covers the following fundamental elements: internal control and governance, capital policy and risk capture, forward-looking view and management framework for preserving capital.
Banks must forecast future capital needs under a range of conditions as part of their internal capital adequacy assessment process (ICAAP). ICAAP is an part of Basel 2, Pillar 2 requirements. The BCBS document “Enhancements to the Basel II framework” outlined measures to strengthen Pillar 2 requirements. For Australian banks, the requirements are set out in Australian Prudential Regulation Authority’s standards and practice guides (APS 110 and CPG 110 respectively).
A number of the components of a sound capital planning process are already requirements under the current standards or guidance that Australian banks need to follow.
Internal control and governance
The paper outlines sound practices, such as escalating conflicting views on capital usage from different divisions to senior management for discussion and approval. Strong governance practices includes Board level review and approval of capital plans annually. I expect that this is common practice at most large complex banks.
The paper also notes that banks should carry out independent validation of the processes and models used. Under APS110, Australian banks must subject their ICAAP to independent review at least once every three years. Under CPG110, the review should also include, “the appropriateness of planned capital outcomes”.
Capital policy and risk capture
The capital policy documents the principles applied in deciding how to use capital. For BCBS, leading practice, goes beyond just having a policy – it is holding a management team accountable to demonstrating adherence to policy. The paper has a good discussion on what a capital policy should include e.g. minimum thresholds, expression of risk tolerance.
Risk capture is an important consideration when looking at ICAAP. Pillar 2 should address all material risks which are not covered in Pillar 1 explicitly. All risks should be considered and captured as part of the capital planning process. Banks with stronger practices, proactively consider the limitations of risk quantification methods.
CPG110 has a list of risk types that Financial Institutions (FIs) should consider such as reputation, contagion and strategic risks. This guidance also requires FIs to consider the volatility of correlations.
The key here is to consider capital requirements and availability of capital under a range of conditions. Stress testing and scenario analysis in the capital planning process are a key component. As per the report, if stress testing is not part of the process, “a bank’s capital plan would be highly vulnerable, and thus any actions pursuant to it may not adequately insulate the bank against adverse development.”
According to BCBS, banks must be able to repeat and do stress tests regularly and on an ad-hoc basis. This is a challenge for many financial institutions. Running calculations requires collection of data from disparate sources and processing this data. Models need to be run across a number of assets classes, and the results aggregated, analysed and communicated. This requires well designed frameworks, models, and systems and tools for data capture and calculation.
The report notes that banks tend to incorporate management actions such as changes to business strategy, growth limits, changes to dividends or issuance of capital instruments. Management actions assumed and their impact particularly under adverse scenarios should be reviewed and approved.
Management framework for preserving capital
Management should have plans in place that can be actioned to preserve capital if the capital position worsens. According to BCBS, sound practice requires thinking of and adopting principles on determining appropriate plans and measure to be used.
The paper from BCBS outlines what is sound practice in capital planning. It provides a good overview of the requirements for banks and other financial institutions to follow, grouped into the four areas noted above. For Australian FIs, most of the sound practices are covered in APS110 and/or CPG110.