By: Gary J. Young, President and CEO
The need for community banks to complete a Capital Plan has intensified since the Office of the Comptroller of the Currency issued guidance which closely corresponds with the manner in which the FDIC and Federal Reserve assess capital adequacy according to information in their examiner’s handbook. The concept is that the bank (1) assess capital adequacy in relation to its unique overall risks, and (2) plan for maintaining appropriate capital levels in all economic environments. A bank should maintain a sufficient level of capital based on the associated risk at the bank and within the economic environment comprised within the bank’s market. This sounds a lot like Enterprise Risk Management. In fact, I believe that Enterprise Risk Management is morphing into Capital Planning based on risk.
This article outlines the methodology that Young & Associates. Inc. recommends in meeting this guidance.
Step 1 – Developing a Base Case
A five-year projection of asset generation and capital formation (earnings less dividends) would be used to project the future tier-1 leverage ratio and risk-based capital ratios. This is the base case scenario. Within this scenario, minimum capital adequacy standards will be established. At this point, there will be no additional capital for risk. As an example, for the tier-1 leverage ratio, the bank might establish a 5.0 percent minimum plus a 1.5 percent additional for unknown risk. This approach would be similar to the Basil III calculation. This would establish a 6.5 percent leverage ratio minimum. This example is for the leverage ratio only. A separate calculation would be needed to examine risk-based capital.
Step 2 – Identification and Evaluation of Risk
The focus here will be in identifying and evaluating all risk within the Enterprise:
- Credit risk
- Operational risk
- Interest rate risk
- Liquidity risk
- Strategic risk
- Reputation risk
- Price risk
- Compliance risk
The risk would be assigned a level (i.e., extreme, high, moderate, and low) and a trend (i.e., decreasing, stable, or increasing). Based on these assignments, additional capital may be added to the base. In the analysis of risk you should examine the current position, as well as potential risk in a stressed environment. You should also look closely at regulatory examinations, audit reports, and observation of current systems. Consider assigning additional capital for each position within the risk levels. It is acceptable and advisable that differing risk areas would have differing impacts on capital need. As an example, credit risk might have a greater capital contribution than price risk. Let’s assume that an additional 1.25 percent in capital is required based on the bank’s risk profile. This is similar to the use of Qualitative Factors in the Allowance for Loans and Lease Losses. Added to the 6.5 percent from above, the new capital adequacy level based on risk would be 7.75 percent.
It is possible that your directors would want the leverage ratio to exceed 7.75 percent. Let’s assume that percentage is 9.0 percent. While directors want 9.0 percent, those directors could also state that based on our risk compared with others, 7.75 percent is the measure for regulatory capital adequacy. This is not inconsistent.
Step 3 – Capital after Lending Stress
Both the FDIC and the OCC have suggested models for banks to stress capital based on stress from loan losses by loan classification. Young & Associates, Inc. strongly recommends that the appropriate model should be included in your bank’s planning process. The goal is for the model to indicate that the bank could survive a significant stress. This will also help in formulating your capital contingency which is discussed as Step 4.
Step 4 – Contingency Planning for Stressed Events
If development of the base case and identification of risk is perfect with no internal or external errors, there would be no need for a contingency plan. However, as we all know, plans don’t work perfectly. Therefore, it is critical to stress all assumptions in the development of the base case and in the identification and evaluation of risk. The stress or worst-case scenario in these areas will determine the amount of capital needed to be raised. The analysis would then examine all realistic possibilities for increasing capital including, but not limited to:
- Reducing assets from the base case
- Asset diversification (impacts risk-based capital)
- All profitability enhancement measures
- Dividend reduction, if applicable
- Branch sale, if applicable
- Downstream cash from holding company
- Capital raise from existing shareholders
- Capital raise from new shareholders
- Additional holding company debt
- Sale of the bank
A brief word for mutual companies that are now regulated by the OCC: Many of the capital raising opportunities do not exist for a mutual. We would suggest that this is an additional risk for these banks. We would suggest that an additional 0.5 percent, or so, of additional capital is necessary for mutual banks compared with stock banks.
Step 5 – Policy
All of the preceding will be placed in policy and would include:
- Assignment of roles and responsibilities
- Process for monitoring risk tolerance levels, capital adequacy, and status of capital planning
- Key planning assumptions and methodologies, as well as limitations and uncertainties
- Risk exposures and concentrations that could impair or influence capital
- Measures that will be taken based on differing stress events
- Actions that will be taken based on stress testing
Young & Associates, Inc. has been working with banks to develop capital adequacy standards, a capital contingency, and the related policies. In addition, we have developed a product that will help you complete this risk assessment on your own in as little as one day. You can find this product by clicking here, or you can call our office. If you have any questions about this article or would like to discuss having Young & Associates assist your bank, please call Gary J. Young, President and CEO, at 330.283.4121, or click here to send an email.