The FDIC recently announced a joint agency proposal revising the capital requirement framework for banks with total assets of $100 billion or more. The proposal would implement the final components of the Basel III agreement and further strengthen the banking system following the banking turmoil in March 2023.
We believe this is a good time for banks to review their regulatory capital framework. In our experience, banks tend to focus on meeting the required amount of regulatory capital. We recommend that banks take a more wholistic approach to assessing their framework because that is exactly what the regulators are going to do when they perform an examination. According to the Office of Comptroller of the Currency, “The core assessment of a bank’s capital adequacy and the assignment of the capital component rating include an analysis of many different risks and factors, individually and in the aggregate, that affect a bank’s capital. Examiners’ assessments of capital adequacy consider the totality of a bank’s circumstances beyond meeting minimum regulatory capital ratios (i.e., the OCC’s conclusions on a bank’s capital adequacy may differ significantly from conclusions that might be drawn solely from an evaluation of compliance with minimum regulatory capital requirements).”
Regulators rate a bank’s capital adequacy based on each bank’s specific circumstances, not just minimum risk-weighted standards. Factors that affect a regulator’s capital adequacy rating include:
- Amount and quality of capital
- The bank’s overall financial condition
- The composition of the balance sheet, including intangible assets and the associated risks (concentration risk, market risk, etc.)
- The amount, composition and trend of problem assets, and the adequacy of related valuation reserves
- Access to credit markets and additional sources of capital
- The effectiveness of capital planning activities
- The risk level of off-balance sheet activities
- The amount quality and trend of earnings
- The banks growth strategy and track record of managing growth
In our experience, three primary areas of focus for a capital adequacy examination, and where many banks fall short are the bank’s strategic and capital planning processes, the quality of capital risk management, and the effectiveness of capital adequacy internal controls. We will be discussing each of these topics in a series of articles pertaining to this timely topic.
Strategic and Capital Planning
Your bank’s strategic plan should define your long-term goals and the strategy intended to achieve those goals. The strategic planning process should consider the capital planning process and be consistent with your capital plan and stated risk appetite.
The capital planning process should be ongoing and tailored to the overall risk, complexity, and corporate structure of the bank. The process should anticipate and account for changes that could impact capital adequacy, including but not limited to, operating environment (political, regulatory and economic considerations), the bank’s strategic priorities, business plan, and risk tolerance.
Effective capital plans account for both short- and long-term capital needs and are synchronized with the bank’s strategic planning cycles. The level of detail should be consistent with the level of complexity of the bank’s operations and risk levels.
The capital planning process should:
- Set risk-based Capital Adequacy goals
- Identify and evaluate risk and vulnerabilities that could impact capital
- Integrate strategic planning, risk management, liquidity planning
- Reinforce senior management’s understanding of the bank’s inherent risks, control environment, and risk appetite
- Ensure the integrity, objectivity, and consistency of capital planning and adequacy assessments
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Annual review of capital planning policies, procedures, and risk and control assessments. The review should confirm that:
- Actual capital ratios are consistent with the capital plan and any material differences have been recognized and addressed by senior management
- Capital planning forecasts and assumptions are reasonable considering current capital levels, historic financial performance, and future plans for growth
- The capital plan considered:
- Earnings levels, quality and trends
- Effectiveness of risk management, internal control, and audit processes
- Quality and availability of capital sources
- Capital intensive business decisions such as mergers or acquisitions and significant IT and operational upgrades
- Historic and planned growth rates
- Dividend policies
- Anticipation of special situations that could affect future earnings and capital
- Balance sheet structure and market risk
- Plans to introduce new products and services and the effectiveness of related risk management and controls
Conclusion
It should not be surprising that, following the string of bank failures earlier this year, that regulators are shining a spotlight on capital adequacy as a critical component of bank safety and soundness. Banks should be taking a proactive approach to reviewing their capital management processes and controls to avoid any unpleasant surprises when their regulators inevitably perform an in-depth examination.
Technology Considerations
Many banks, especially small- and mid-sized banks, are utilizing spreadsheet based EUCs to perform capital adequacy calculations. These spreadsheets need to be quite large and complex (often employing complex macros) and are very error-prone and inefficient. These spreadsheets are not only subject to data entry error, but errors resulting from erroneous spreadsheet logic, formulas and links to outside data. In fact, studies by Raymond Panko at the University of Hawaii show that 90% of spreadsheets with more than 150 rows contain errors and the European Spreadsheet Risks Interest Group estimated that more than 90% of all spreadsheets contain errors. Another risk associated with EUCs is that turnover can create a problem if critical knowledge of the EUC is lost.
These banks should be considering looking at tailored technology solutions to automate their capital adequacy process that are tailored to their specific size, complexity and business model. Such solutions can consist of basic financial risk automation (FRM) services to modular asset liability management solutions such as Moodys that can be integrated with security trading platforms to monitor the volume, mix, maturity structure, interest rate sensitivity and liquidity of the bank’s assets and liabilities that provides a comprehensive strategic planning and risk management solution.
Automated Regulatory Reporting using tools like AxiomSL are being used extensively by banks because of increasingly frequent, complex and dynamic reporting requirements.
Doran Jones can provide the regulatory compliance and risk management expertise with extensive technological knowledge and experience to design and implement a cost-effective solution that will increase efficiency and lower risk by upgrading your risk and compliance systems, or identifying and remediating gaps in existing processes.
Contact us to learn how a strategic partnership with Doran Jones can provide you with cost-effective solutions by leveraging our expertise with these and other critical risk and compliance functions.