Why your bank needs a capital plan

Three significant events have altered expectations for capital plans.

First, as of Jan. 1, 2015, banks had to comply with the new BASEL III capital requirements, including the new “capital conservation buffer.”

Second, regulatory authorities now view strategic planning and capital planning documents as risk appetite and risk mitigation documents, respectively. 

Finally, the demise of the market for trust preferred securities has reduced the ability to raise just-in-time capital, which was a prevalent concept from 2005 to 2009.

Every board should ask the hard question of whether or not their bank has sufficient capital to address BASEL III regulatory requirements; navigate the current economic environment; and implement the bank’s strategic plan. If the answer is no, to any of these, management should focus on how much capital is needed, and the board and management should determine the sources for funding those needs.

Capital plans before 2008. Prior to the financial crisis, most capital plans were adopted by depository institutions in response to regulatory administrative order, requiring the depository institution to adopt and implement a capital plan. Virtually every formal administrative action, and many informal actions, require the institution to adopt a capital plan.

Most often, institutions under a regulatory order need capital immediately--or what we refer to as just-in-time capital. Many depository institutions did not have a capital plan, and when the time came to implement a plan to address immediate capital needs, it was often too late. Absent deep-pocket shareholders or directors, trying to raise just-in-time capital can be quite difficult from both a marketing and regulatory standpoint if the depository institution is in or approaching a troubled condition.

Capital plans today. In the wake of the financial crisis, we have seen an increasing regulatory push for every depository institution, even healthy ones, to adopt and adhere to a comprehensive capital plan. The regulatory agencies are clearly steering institutions away from just-in-time capital. Some regulators have even hinted at reducing the examination burden on low risk depository institutions, and they have noted that activities that point to a low risk institution include comprehensive capital planning. 

The regulatory agencies clearly are steering institutions away from the concept of just-in-time capital that compounded the difficulties faced by many depository institutions in 2008 and 2009. Some regulators have even hinted that a comprehensive capital plan may soon be an integral part of the safety and soundness examination process, perhaps showing up as an element in the Capital or Management component of the CAMELS rating system. Some of our clients have already received questions in this regard in light of upcoming regulatory examinations, so it is likely a trend that will only continue to become more frequent and ultimately a requirement.

Even if you currently have a capital plan, it may not chin the bar with the regulators. Traditional two-page or even five-page capital plans are falling short of what regulators expect to see in capital plans.  Such plans are now becoming much more robust and are expected to be a management planning tool rather than simply something that is nice to have.

A strong capital plan is a critical document, as it ensures that there is enough fuel to drive the bank’s strategic plan and ensures that there is adequate insurance against the bank’s risk profile. Every depository institution, even healthy depository institutions, should have a comprehensive capital plan that dovetails with its strategic plan and its enterprise risk management plan. 

Components of a capital plan. The breadth and depth of a comprehensive capital plan will, of course, depend on the risk profile of the depository institution. While there is no magic outline for a capital plan, almost all capital plans should have a few critical components:

• Background on the depository institution’s strategic plan, operations, economic environment and current capital situation.

• Tolerances and triggers.

• Alternatives for available capital.

• Perhaps a dividend policy. 

• Financial projections. 

The tolerances and triggers may be the most important part of the capital plan, as this is how the institution will avoid just-in-time capital. The tolerances and triggers operate as an early warning system to alert management that capital may become stressed in the near future. Tolerances and triggers should be tailored to each institution’s specific situation, but typically we see triggers related to asset quality, liquidity, core funding, CAMELS ratings, and, of course, capital ratios. Careful planning should take place when considering what the tolerances and triggers will be, as these are the key drivers in making the capital plan a true planning tool.

The plan should be tailored to the institution’s shareholder base. If the institution is owned by a holding company, the capital plan should typically be a joint plan of both the bank and the holding company. Frequently, holding company controlled institutions will have a plan to raise additional equity or borrow funds at the holding company (the proceeds of which, when injected into the subsidiary institution, will count as Tier 1 capital at the subsidiary). 

Just as important as implementing the capital plan, however, is stress testing that capital plan.  Our recommendation is that the capital plan be stress tested at least annually, and perhaps more often than that if the institution’s situation, or the economic or regulatory environment warrants more frequent testing.

Finally, the capital plan cannot simply sit on the shelf. In conjunction with its stress testing, the plan should be reviewed and updated. Like the strategic plan, the capital plan should be treated as a living, breathing document that will need to be revised as the strategic direction and capital resources available to the institution change.

About the authors

Robert Flowers and Brian Marek are partners in the Dallas office of Hunton & Williams LLP. They focus on the corporate and regulatory representation of commercial banks, thrifts, holding companies, and other financial institutions. They can be reached at [email protected] and [email protected].