Community Banking Connections

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Helping to Ensure Capital Resiliency Through Effective Capital Planning
by Alexander Shelton, Senior Examiner/Portfolio Central Point of Contact, Federal Reserve Bank of Richmond

One of the most important lessons learned from the 2008 recession was championed by the Community Banking Connections article “Capital Planning: Not Just for Troubled Times,” which promoted the importance of holding capital commensurate with risk through effective capital planning.¹ That article covered various aspects of capital planning as part of an effective risk management framework. Now as banking organizations contemplate the current and future COVID-19 environment, it is an appropriate time to revisit the topic.

In the July 9, 2020, Ask the Fed session discussing the resumption of examination work, Governor Michelle Bowman stated, “The Federal Reserve’s goals are to promote capital and liquidity resiliency in the industry, while not impeding the flow of credit.”² Institutions have been encouraged to employ capital buffers to promote lending activity in a safe and sound manner. With increased lending and related inflows from both deposits and government programs, banks may experience significant but temporary balance sheet growth. As a result, capital ratios may decline. With this potential decrease, banks need to remain diligent in monitoring risk levels so that capital adequacy can be maintained.

Capital Levels and Bank Examinations

At upcoming examinations, examiners will evaluate capital levels in relation to the nature and extent of an institution’s risk profile. As a part of these evaluations, examiners will consider an institution’s capital planning efforts. The examiners will review whether institutions are measuring the effect of COVID-19 on a bank’s risk profile and whether a bank is appropriately assessing the need to bolster reserves and capital. Examiners will evaluate the effectiveness of a bank’s capital planning process in connection with the bank’s assessment of its risks and the adequacy of its capital.

In June, the Board issued Supervision and Regulation (SR) letter 20-15, “Interagency Examiner Guidance for Assessing Safety and Soundness Considering the Effect of the COVID-19 Pandemic on Institutions.”³ This guidance instructs examiners to consider a variety of factors when assessing capital adequacy, including an institution’s regulatory capital ratios, capital planning and capital distribution plans, and risk management practices, as well as whether the institution is in generally sound condition. While capital planning is not the sole determinant of capital adequacy, it is an important aspect of maintaining capital adequacy. The details of effective plans can vary based on a bank’s size and risk profile; however, the basic building blocks are consistent for all institutions.

Capital Planning Revisited

Capital planning in its basic form contains five essential components: an assessment of a bank’s risks, a targeted capital level that supports a bank’s risk profile, meaningful metrics that alert management when risk is increasing, a defined process to follow when these metrics exceed established risk tolerances, and predetermined actions that may be taken when capital levels are no longer commensurate with the bank’s risk profile. To address each of these components, bankers should work with their boards to establish the organizational risk appetite and the tools and processes necessary to promote capital resiliency. Institutions can easily leverage existing management information systems (MIS) reports, risk assessments, or other current processes to monitor, measure, and mitigate threats to an institution’s capital.

The first step to effective capital planning is to determine whether current capital levels are consistent with the institution’s risk profile and the risk appetite of the bank’s board. In order to determine current risk levels, banks should perform a risk assessment that identifies potential issues that may have implications for the bank’s capital. These issues can be macro in nature, such as liquidity levels or credit risk exposures, or more granular, such as concentration risk to particular industries. This assessment could leverage other risk assessments performed for the institution, such as the audit risk assessment. Whatever approach an institution selects to assess risks, the results should allow the institution to quantify or grade the current level of exposure (e.g., high, moderate, or low). The goal is to establish a baseline of the institution’s risk profile against which increases or decreases in risk can be evaluated and which can be updated periodically as the risk profile changes.

From there, the board should establish targeted capital levels that can adequately support the bank’s current risk profile. These targets could be stated as ranges to accommodate the changing inherent risk at an institution, with the institution holding more capital within those ranges as risks increase. The chosen level of capital should also be realistic in terms of the board’s overall risk appetite and not just set at minimum regulatory requirements. A bank with a relatively lower risk profile coupled with a slow growth strategy may find it appropriate to set a lower targeted capital level. However, for other institutions with a more significant risk profile or a fast growth strategy, the targeted level of capital should be higher.

Once the risk profile is determined and the appropriate target capital level is set, an institution should establish meaningful metrics or triggers to alert management to increasing risk levels. These metrics should consider the various risks to which an institution is subject. Using credit risk as an example, some familiar metrics include the level of deferrals or loan modifications and trends in industry concentrations. Other examples of meaningful credit metrics could include loan rating migration patterns, trends in past due or noncurrent loans, or increases in underwriting exceptions, technical exceptions, or covenant breaches. The goal is to identify metrics that can signal an increasing level of risk early enough to afford management a range of mitigation options.

Metrics that rely solely on backward-looking data are not as effective in providing an early warning that affords an institution sufficient time to take corrective action. For instance, using loan classification ratios would not be considered a strong warning of increasing risk, as these loans have already been identified as problems. Overall, the idea is to leverage MIS reports in risk areas to find the appropriate early-warning metrics to track and set the associated triggering thresholds at levels that give management enough time to take action before capital adequacy is affected. Waiting for capital to fall below the established targets before commencing remediation efforts is not a prudent form of capital management.

The final two parts of effective capital planning are intertwined: management’s actions when triggers are breached and the related set of mitigation tools approved by an institution’s board. There are a range of options for management to consider when early-warning metrics signal that risk is increasing. Depending on which metric or combination of metrics is breached and the degree of any such breach relative to established tolerance levels, management should carefully evaluate whether the increasing risk is temporary in nature or something more systemic. The goal, of course, is to assess the situation and take appropriate action to help ensure continuing capital adequacy.

While raising capital is always an option when more permanent risk trends are evident, there are other risk mitigation techniques that an institution’s management and board should consider as part of capital planning. These risk mitigation tools can be noncomplex balance sheet changes, such as slowing the growth in certain products to reduce concentration levels, selling loans, or tightening underwriting standards. Various capital actions, such as whether to repurchase shares or to declare a dividend, should also be considered. For each mitigation strategy, management should understand the timeline and effort needed to achieve the desired outcome. While a temporary suspension of stock buybacks or a reduction of dividends can be enacted quickly, raising equity capital is a much longer process. An institution’s management and board need to consider the time to enact any mitigation strategy and match the mitigation tool with the pace of increasing risk.

Final Thoughts

The banking industry entered the COVID-19 pandemic well prepared from a capital perspective because lessons learned from the 2008 recession led to higher capital levels in 2020. Using these same principles now can help banks in assessing the risks arising from the pandemic and in making sound choices to mitigate these new risks through meaningful capital planning.