Book 3. Operational Risk

FRM Part 2

OR 20. Capital Planning at Large Bank Holding Companies- Supervisory Expectations and Range of Current Practice

Presented by: Sudhanshu

Module 1. Federal Reserve's Capital Plan Rule

Module 2. Capital Adequacy Process

Module 3. Assessing the Impact of Capital Adequacy

Module 1. Federal Reserve's Capital Plan Rule

Topic 1. The Federal Reserve's Capital Plan Rule

Topic 2. Seven Principles of the CAP

Topic 1. The Federal Reserve's Capital Plan Rule

• Critical Capital Role: Bank holding companies must maintain adequate capital for survival and growth, providing cushion against unexpected losses and preventing failure that would burden taxpayers and deposit insurance funds.
• Systemic Importance: Effective capital management policies are critical for BHC health and the smooth functioning and stability of the entire financial system.
• Federal Reserve Oversight: The Federal Reserve maintains interest in BHC survivability through the Capital Plan Rule and annual Comprehensive Capital Analysis and Review (CCAR) supervisory program.
• Capital Plan Requirements: The Capital Plan Rule mandates BHCs develop capital plans and processes to evaluate and monitor capital adequacy, covering all U.S. domiciled BHCs with $50 billion or more in total consolidated assets.
• Assessment Principles: The Federal Reserve uses specific principles to evaluate adequacy and appropriateness of BHC internal capital planning processes, referred to as the capital adequacy process (CAP).

Practice Questions: Q1

Q1. The Federal Reserve's Capital Plan Rule requires BHCs to maintain an effective process for assessing their capital adequacy for:

A. BHCs, U.S. or non-U.S. domiciled.

B. BHCs with more than five years of operational history.

C. BHCs with a net annual income of more than $5 billion.

D. BHCs with total consolidated assets of $50 billion or greater.

Practice Questions: Q1 Answer

Explanation: D is correct.

BHCs with total consolidated assets of $50 billion or greater. The other answers are not part of the requirements under the Capital Plan Rule.

1. Risk Management Foundation: Effective capital risk management plan encompassing all key firm-wide risk exposures (identification, evaluation, measurement, control).

2. Resource Estimation Methods: Clearly defined plan to estimate available capital resources over a stress scenario time horizon.

3. Loss Estimation Methods: Process for estimating potential losses and aggregating them firm-wide over a stress scenario time horizon.

4. Impact on Capital Adequacy: Process to evaluate the combined impact on capital adequacy, considering loss estimates and capital resources against stated capital goals and composition.

5. Capital Planning Policy: Sound capital policy to develop capital goals, determine appropriate capital levels and composition, define capital distributions, and establish contingency plans.

6. Internal Controls: Vigorous internal controls policy for independent review, model validation, documentation, and internal audit of the capital adequacy process.

7. Effective Oversight: Board and senior management responsibility for thorough oversight of all dimensions of the internal capital risk plan.

Topic 2. Seven Principles of the CAP

Practice Questions: Q2

Q2. The seven principles of an effective capital adequacy process for bank holding companies (BHCs) subject to the Capital Plan Rule include which of the following?

I. Oversight from peer BHCs.

II. Annual reporting to the stock exchange (where their stock is listed).

A. I only.

B. II only.

C. Both I and II.

D. Neither I nor II.

Practice Questions: Q2 Answer

Explanation: D is correct.

Oversight from peer BHCs and annual reporting to the stock exchange are not included in the seven principles of an effective capital adequacy process.

Module 2. Capital Adequacy Process

Topic 1. Risk Identification

Topic 2. Internal Controls

Topic 3. Governance

Topic 4. Capital Policy

Topic 5. Stress Testing and Stress Scenario Design

Topic 6. Estimating Losses, Revenues, and Expenditures

Topic 1. Risk Identification

• Comprehensive Identification: BHCs must have a process to identify all risk exposures from various sources:

  • Stress conditions

  • Changing economic and financial environments

  • On- and off-balance sheet items

  • Impact on capital adequacy

• Scrutiny of Assumptions: Critical scrutiny of underlying assumptions regarding risk reduction through mitigation or transfer techniques.

• Regular Review: Senior management should regularly update and review the risk identification plan, especially considering how risk profiles might change under stress scenarios.

• Early Detection: Techniques should detect changes in overall risk profile and signs of capital inadequacy in early stages.

• Integration into Planning: Identified risk exposures must be integrated into internal capital planning processes.

• "Other Risks": Include risks difficult to quantify or not captured by scenario-based stress testing (e.g., compliance, reputational, strategic risks) using methods like internal capital targets.

Practice Questions: Q3

Q3. How many of the following statements are most likely correct? BHCs should have risk identification processes that evaluate:

I. on- and off-balance sheet positions.

II. risk transfer and/or risk mitigation techniques.

III. changes in institutions’ risk prole due to porolio quality.

IV. reputational risk.

A. One statement.

B. Two statements.

C. Three statements.

D. Four statements.

Practice Questions: Q3 Answer

Explanation: D is correct.

All of the statements are correct. BHCs should have risk identification processes effectively identifying all risk exposures for assessing capital needs.

Reputational risk, like strategic risk and compliance risk, falls under the category of “other risks” and are more difficult to quantify. Nevertheless, there are a wide range of methods BHCs employ to evaluate other risks.

Topic 2. Internal Controls

• Data Accuracy: Internal audit team must carefully scrutinize internal control data for accuracy before submission to senior management and the board.

• Management Information Systems (MIS): Efficiently running MIS for quick and accurate collection and analysis of pertinent information.

• Detailed Documentation: Comprehensive and organized documentation system covering all dimensions of capital planning processes (risk identification, loss estimation, capital adequacy, capital decision processes).

• Model Review and Validation:

  • Thorough, independent, and regular review and validation of all models used for internal capital planning.

  • Assessment of conceptual soundness and verification of processes.

  • Validation team must possess required technical skills and be completely independent from business areas and model developers to ensure unbiased verdicts.

• Input/Assumption Management: Maintain and update a list of all inputs, assumptions, and adjustments for models generating projections and estimates.

• Validation Under Stress: Models should be validated under both normal and stress conditions.

• Disclosure and Restriction: Full disclosure of validation process and outcome; restrict the use of unvalidated models.

Topic 3. Governance

• Board Expertise and Involvement: Boards should have sufficient expertise and involvement to fully understand and evaluate information from senior management regarding capital planning.

• Comprehensive Information for Board: Board must be furnished with comprehensive information on:

  • Risk exposures

  • Loss estimates

  • Determinants of revenues and losses

  • Underlying models and assumptions

  • Weaknesses and strengths of capital planning processes

  • Stress scenarios and corrective measures

• Management Responsibilities: Management is required to furnish key information to the board for approval of internal capital adequacy plans, including stress testing assumptions/results, internal audit outcomes, and model validation checks.

• Ongoing Evaluation by Senior Management: Senior management should continuously evaluate the internal capital plan, focusing on weaknesses, strengths, assumptions, scenarios, estimates, and models.

• Adjustments and Remediation: Senior management should make appropriate adjustments and remediation if reviews reveal shortcomings.

• Detailed Meeting Minutes: Maintain detailed minutes of board meetings, documenting issues, discussions, information used, and recommendations.

Topic 4. Capital Policy

• Clear Principles and Guidelines: A capital policy should clearly define principles and guidelines for capital goals, issuance, usage, and distributions.

• Comprehensive Details: Fully spell out details of the BHC's capital planning processes, including decision rules for capital usage, distribution, financing, and other policies.

• Unique Needs and Supervisory Expectations: Policy should focus on the BHC's unique needs and financial situation while considering supervisory expectations.

• Common Stock Dividends and Repurchase Agreements: Policies should include:

  • Key metrics influencing size, timing, and form of distributions.

  • Materials used in distribution decisions.

  • Specific scenarios causing distribution reduction or suspension.

  • Situations prompting consideration of replacing common equity with other capital forms.

  • Key roles and responsibilities for producing reference materials, making recommendations/decisions, and reviewing analysis.

• Compatibility of Capital Goals: Capital goals must be compatible with risk tolerance, risk profile, regulatory requirements, and stakeholder expectations.

• Specific Goals for Level and Composition: Establish specific goals for both capital level and composition under normal and stress conditions.

• Capital Targets: Set capital targets above capital goals for adequacy under stress, considering future economic outlooks, stress scenarios, and market conditions.

• Distribution Considerations: Consider numerous factors when setting distribution levels, including future growth plans, associated risk, and current/future economic conditions (especially macroeconomic and global events under stress).

• Connection to Capital Goals: Capital distribution decisions must be linked to capital goals or capital adequacy requirements.

• Contingency Planning: Develop strong contingency plans with numerous options for stress situations, based on realistic and futuristic assumptions (not solely historical data). Actions should be feasible and easy to implement.

• Capital Triggers: Base early warning capital deterioration triggers on projected results, regulatory requirements, and stakeholder expectations.

Topic 4. Capital Policy

Topic 5. Stress Testing and Stress Scenario Design

• BHC-Specific Focus: Scenario design and stress testing should focus on the unique situations of BHCs:

  • Asset and liability mix

  • Portfolio composition

  • Business lines

  • Geographical territory

  • Revenue and loss factors

  • Impact of macroeconomic and firm-specific vulnerabilities and risks.

• Beyond General Guidelines: Stress test design should exceed general supervisory guidelines.

• Avoid Optimistic Assumptions: Do not employ optimistic assumptions that unduly benefit the BHC.

• Combined Approach: Employ both internal models and expert judgment (outside expert opinion). If a third-party model is used, it must be tailored to the BHC's unique risk profile and business model.

• Severe Strain: Designed scenarios should assume a strong strain on BHC revenue and income.

• Multiple Variables: Stress testing models should be based on multiple variables encompassing all firm-wide risk exposures.

• Clear Risk Addressal: Scenarios should clearly spell out how they address specific risks faced by BHCs, explaining how a scenario stresses BHC weaknesses and how variables are related.

Practice Questions: Q4

Q4. Which of the following statements is most likely correct?

A. The internal controls policy of BHCs requires that senior management should furnish the board of directors with sufficient information to comprehend the BHC risk exposures.

B. A governance policy offers fundamental guidelines and principles to BHCs for the capital issuance, use, distribution, and planning purposes.

C. Suspension or reduction in dividends or repurchase programs do not fall under the capital policy of BHCs.

D. Designing and testing a scenario-related default of a major counterparty is an example of BHC stress testing and a stress scenario design policy.

Practice Questions: Q4 Answer

Explanation: D is correct.

The first statement is the requirement of the governance policy and not the internal control policy. The second statement falls under capital policy and not the governance policy. Regarding the third statement, capital contingency plans (e.g., suspension or reduction in dividends or repurchase programs) are a key part of capital policies of BHCs detailing the actions intended to be taken under deficiencies in capital position.

The fourth statement is correct. Many different scenarios, including counterparty default, fall under the BHCs’ stress testing and scenario design policy.

Topic 6. Estimating Losses, Revenues, and Expenditures

• Quantitative and Qualitative Basis

  • Data Preference: Prefer using internal data for estimation; use external data only when appropriate, ensuring it reflects the BHC's risk profile and making necessary adjustments.

  • Quantitative Methods: 

    • A range of quantitative methods are available; the outcome should identify key risk factors and the impact of changing macro/financial conditions under normal and stress conditions firm-wide.

    • Business Line Segmentation: Segment lines of business and portfolios by common risk characteristics with marked differences in past performance (e.g., credit score ranges). Each segment needs sufficient data.

    • Sensitivity Analysis: Employ sensitivity analysis ("what if" questions) when using models based on historical interactions, as past relationships may not hold.

• Qualitative Methodologies:

  • Used as substitute or complement to quantitative methods (e.g., expert judgment, management overlay).

  • Must be based on sound assumptions, logical, reasonable, and clearly spelled out for external review.

  • Sensitivity analysis should also be used for qualitative approaches.

  • Supervisory Expectation: Use conservative (not favorable) assumptions for estimations under normal and stress conditions.

• ​Loss Estimation Methods:

  • Theoretical Soundness and Empirical Validity: Employ loss estimation methods that offer both.

  • Specific Variables: Models should use general macroeconomic explanatory variables and specific variables directly linked to particular exposures and portfolios.

  • Uniform Aggregation: Use uniform, reputable methods to aggregate losses across business lines and portfolios for firm-wide scenario analysis.

  • Automated Processes: Use automated processes with clear linkage from data sources to loss estimation and aggregation, minimizing manual intervention.

Topic 6. Estimating Losses, Revenues, and Expenditures

• Data Sources:

  • ​Retail loan losses: Often use internal data.

  • Wholesale loss estimation: Internal data supplemented with external data.

  • External data use: Demonstrate it reflects BHC's risk exposures (geographic, industry, etc.).

  • Risk segmentation: Supported by data capturing unique characteristics of each risk pool.

• Credit Loss Approaches:

  • Economic Loss Approach (Expected Losses): Categorize losses into PD,LGD, and EAD. Identify determinants of each component.

  • EADs modeled to vary with macroeconomic conditions.​

  • LGD linked to underlying risk factors (e.g., collateral value fall under stress) and estimated at segmentation level.

  • Avoid long-run averages for PDs, LGDs, and EADs.

• Accounting-Based Loss Approach (Charge-off and Recovery):

  • If using rating systems: Recognize limitations and make adjustments.

  • Role-rate models: Utilize robust time series with sufficient granularity.

  • Charge-off models: Include variables representing portfolio risk characteristics and estimate statistical relationship between charge-off rates and macroeconomic variables at portfolio level.

Topic 6. Estimating Losses, Revenues, and Expenditures

Practice Questions: Q5

Q5. Which of the following statements is most likely correct?

I. Under the expected losses methodologies, loss estimation involves

three elements: probability of default, loss given default, and exposure at default.

II. Net interest income projections should incorporate changing conditions for balance sheet positions, including embedded options, prepayment rates, loan performance, and repricing rates.

A. I only.

B. II only.

C. Both I and II.

D. Neither I nor II.

Practice Questions: Q5 Answer

Explanation: C is correct.

Both statements are correct. Loss estimation involves probability of default, loss given default, and exposure at default. Net interest income projections should incorporate changing conditions for balance sheet positions, including embedded options, prepayment rates, loan performance, and repricing rates.

Module 3. Assessing The Impact Of Capital Adequacy

Topic 1. Operational Risk

Topic 2. Market Risk and Counterparty Credit Risk

Topic 3. Pre-Provision Net Revenue (PPNR) Forecasting Requirements

Topic 4. Net Interest Income Projection Requirements and Integration

Topic 5. Non Interest Income Projection Requirements

Topic 6. Macroeconomic Modeling and Expense Projection Requirements

Topic 7. Generating Projections

Topic 1. Operational Risk

• Correlation with Macroeconomic Factors: Many BHCs estimate correlation between operational risk and macroeconomic factors.

• Combination of Techniques: If no significant statistical relationship, employ other methods like scenario analysis (historical data, management input).

• Strong Loss Estimates: Employ a combination of techniques for strong loss estimates under stress, including past loss records, future expected events, macro conditions, and firm-specific risks.

• Regression Models: For regression models estimating loss frequency and severity, provide statistical support for chosen estimation period (avoid arbitrary selection).

• Modified Loss Distribution Approach (LDA): Used to estimate Value at Risk (VaR) for operational risk losses at a chosen confidence interval.

  • Provide sound justification for choice and perform sensitivity analysis.

• Scenario Analyses for Limitations: Use scenario analyses when encountering model or data limitations to incorporate a wide range of risks; provide rationale for chosen scenario.

Topic 2. Market Risk and Counterparty Credit Risk

• Counterparty Credit Risk: BHCs involved in trading are subject to counterparty credit risk from changes in risk exposure value and counterparty creditworthiness due to macroeconomic conditions.

• Loss Estimation Approaches:

  • Probabilistic Approaches: Produce a probability distribution of expected portfolio losses.

    • Evidence: Must yield more severe risk scenarios than historical ones.

    • Explanation: How tail loss scenarios detect and address firm-specific risks.

  • Deterministic Approaches: Yield point estimates of an expected portfolio loss.

    • Demonstration: Employ a wide range of scenarios covering key risk exposures (including mark-to-market positions under stress).

    • Clarity: Clearly spell out underlying assumptions in stress testing scenarios and corrective measures.

• ​Counterparty Default Scenarios: Some BHCs explicitly incorporate default scenarios of key counterparties using probabilistic approaches (involving PD, LGD, EAD estimates) to focus on large risk exposures.

• Risk Mitigation Assumptions: If used, such assumptions should be conservative, recognizing that BHCs' ability to take desired actions may be limited in stress scenarios.

Topic 3. Pre-Provision Net Revenue (PPNR) Forecasting Requirements

• PPNR Definition and Horizon: Pre-provision net revenue represents net revenue before loss provision adjustments, requiring BHC forecasts over nine quarters under stressed conditions per Capital Plan Rule requirements.
• Comprehensive Future Planning: BHCs must consider current situations plus possible future business activity paths and operational environments affecting on- and off-balance sheet risk exposures, assumptions, and assets/liabilities.
• Regulatory Impact Assessment: Projections should incorporate regulatory changes' impact on performance and ability to achieve stated targets and goals within the planning horizon.
• Coherent Variable Relationships: Projections must be based on clearly defined relationships among relevant variables like revenues, expenses, and balance sheet items, ensuring consistent assumptions across related projections (e.g., origination assumptions for loans, fees, costs, and losses).
• Sound Theoretical Foundation: Underlying assumptions for revenues, expenses, and loss estimates should be theoretically and empirically sound, with central and corporate planning groups engaged in enterprise-wide projection aggregation.
• Data Integration Requirements: When internal data is limited, BHCs should employ external data in conjunction with internal data to support robust forecasting processes.

Topic 4. Net Interest Income Projection Requirements and Integration

• Integrated Planning Approach: Net interest income projections must be integrated with other capital adequacy plan items, requiring consistent balance sheet assumptions across all projections including loss estimates.
• Dynamic Balance Sheet Integration: Methods for projecting net interest income should incorporate ongoing changes in current and projected balance sheet positions to maintain accuracy and relevance.
• Scenario-Based Product Analysis: BHC projections under various scenarios must clearly explain product characteristics, underlying assumptions, and rationale by product, including changes like deposit mix shifts toward time deposits.
• Loss-Income Linkage: BHCs must clearly establish connections between loss projections and net interest income projections using modeling approaches that incorporate loan portfolio behavioral characteristics.
• Premium/Discount Adjustments: Net interest income projections should use methodologies incorporating discount or premium amortization adjustments for non-par value assets under different scenarios.
• New Business Pricing Consistency: New business pricing projections and assumptions, such as constant add-ons to designated indices, must align with historical data, scenario conditions, and balance sheet projections.

Topic 5. Non Interest Income Projection Requirements

• Comprehensive Projection Methods: BHCs should project noninterest income using scenario-specific methods that fully encompass underlying major risk exposures and business line characteristics, such as asset management groups using both brokerage and money management revenue projections.
• Trading Portfolio Linkages: BHCs with trading portfolios must establish clear connections between trading revenue projections and trading assets/liabilities while ensuring compatibility with all stress scenario condition elements.
• Off-Balance Sheet Integration: BHCs with off-balance sheet items should demonstrate clear linkage between revenue projections and changes in both on- and off-balance sheet components.
• Index Correlation Assumptions: BHCs should avoid assuming perfect correlation between revenues from trading or private equity activities and broad indices, instead estimating sensitivity coefficients for revenue changes resulting from broad index movements.
• MSRA Assumption Design: BHCs holding mortgage servicing rights assets should carefully design robust, scenario-specific assumptions for default, prepayment, and delinquency rates, with hedging entities generating scenario-specific assumptions.
• Effective vs. Weak Processes: Strong capital adequacy processes consider individual business models, client profiles, and capacity constraints when projecting mortgage loan volumes, rather than simply projecting increases while ignoring market saturation and key factors.

Topic 6. Macroeconomic Modeling and Expense Projection Requirements

• Theoretical Foundation: Macroeconomic relationships must be based on sound theoretical constructs supported by empirical evidence, such as declining credit card fee revenues during recessions due to reduced consumer spending.
• Weak Practice Example: Insufficient practices include BHCs failing to show adequate revenue declines in stressed conditions despite obvious macroeconomic relationships and impacts.
• Comprehensive Variable Usage: BHCs should utilize wide sets of explanatory variables to develop statistical relationships and consider macroeconomic impacts on noninterest expense projections during economic downturns.
• Projection Consistency: Noninterest expense projections must align with revenue and balance sheet estimates, generating consistent underlying strategic assumptions across all financial projections.
• Mitigation Strategy Feasibility: When assuming revenue decline offsets through mitigating strategies, BHCs must clearly demonstrate action feasibility rather than relying solely on past relationships in potentially unfavorable future environments.
• Factor-Based Estimation: Estimation methods should focus on uncovering determinants of individual expense items and their sensitivity to changing macroeconomic conditions and business strategies.

Topic 7. Generating Projections

• Net Interest Income Projections:

  • Not isolated; entrenched with other capital adequacy plan items.

  • Balance sheet assumptions must be consistent.

  • Methodologies must incorporate ongoing changes in current and projected balance sheet positions.

  • Link loss projections to net interest income projections using models incorporating loan portfolio behavioral characteristics.

  • Incorporate discount or premium amortization adjustments for assets not held at par value.

• New Business Pricing Projections: Assumptions (e.g., constant add-ons to index value) should be compatible with past data, scenario conditions, and BHC balance sheet projections.

• Noninterest Income Projections:

  • Project in light of stated scenarios and business strategies.

  • Methods should encompass underlying major risk exposures and specific business line characteristics (e.g., brokerage, money management revenues for asset management).

• Trading Portfolios: Establish a clear link between trading revenue projections to trading assets and liabilities, and compatibility with stress scenario conditions.

• Off-Balance Sheet Items: Demonstrate linkage between revenue projections and changes in on- and off-balance sheet items.

• Correlation Assumptions: Do not assume perfect correlation between revenues (trading/private equity) and broad indices; estimate sensitivity coefficients for revenue changes due to broad index movements.

• Mortgage Servicing Rights Assets (MSRAs):

  • Carefully design robust and scenario-specific assumptions for default, prepayment, and delinquency rates.

  • Generate scenario-specific assumptions for hedging MSRA risk exposure.

• Volume Projections: Avoid projecting volume increases (e.g., mortgage loans) while ignoring market saturation or other key factors; consider individual business models, client profiles, and capacity constraints.

Topic 7. Generating Projections

Practice Questions: Q6

Q6. An analyst is discussing net interest income projections with a colleague. Which of the following items should not be incorporated into net interest income projections?

A. Prepayment rates.

B. Balance sheet positions.

C. Forward earnings guidance.

D. Embedded options.

Practice Questions: Q6 Answer

Explanation: C is correct.

Net interest income projections should incorporate changing conditions for balance sheet positions, including embedded options, prepayment rates, loan performance, and repricing rates.