By Vincent Clevenger, Darling Consulting Group
The end of summer here in New England is bittersweet. Great summer weather is drawing to a close. Long, cold winter is right around the corner. On the other hand, beautiful fall foliage and football’s return provide plenty to look forward to.
I’ve always felt that the change in seasons also gives us the opportunity to re-evaluate, and make some changes for the better. This is probably the case down in Foxboro, Mass., where the region’s beloved coach is making changes to the Patriots playbook in preparation for a title defense.
One thing he may be evaluating: How to comply with new oversight regarding “ball preparation” and proper PSI levels. Until recently, this was nothing more than a procedural exercise which was not taken seriously by either the teams nor the officials.
As I followed the “Deflategate” saga, I couldn’t help but compare it to community banks’ capital planning activities. A theme that has emerged over the course of the past several quarters is that banks are going to be required to fortify their capital plans. So as community bankers start to lay out their playbooks for the 2016 budgeting season, they should be forewarned of the ever-increasing standards for capital planning /policies and procedures that regulators are starting to impose.
Expectations are changing
As an indication of these increased expectations, the number of inquiries from our client base with regard to capital planning and credit stress testing has absolutely exploded. Examiners have heightened expectations for community banks of all shapes and sizes.
In retrospect, we should have seen this coming.
The introduction of capital stress testing at the systemically important financial institutions (CCAR banks) after the great recession should have alerted smaller institutions to the inevitability of similar regulation trickling into the community banking space (as is usually the case).
Several years ago, the only banks who took this exercise seriously were those who had regulatory orders to do so or significant credit-related problems. This is no longer the case.
Within the past six months alone, we have worked with banks that have been put on notice for deficiencies in their capital planning process. Yet these are banks that would be characterized as having strong credit, minimal historical loss experiences, and adequate levels of capital. So, what gives?
In fact, the language of specific MRAs (Matters Requiring Attention) is precisely similar across several of these banks, which have assets ranging from $250 million to $6 billion.
Regulatory attitude has definitely shifted. The days of pawning off a one-page budget report with a host of ratios and some simple language is no longer acceptable in the eyes of the examiners.
So what should playbook look like?
To start with, banks need to document their general policies and communicate why the policies they have adopted for capital minimums are appropriate given current business operations.
While this may seem like a remedial exercise, we have found that setting policies in a “willy-nilly” fashion is what precipitated MRAs in the first place.
For example, if you have policy minimums which are too low relative to newly instituted BASEL III guidelines (accounting for “buffers”), rest assured—it will raise flags. Conversely, we work with banks that arbitrarily maintain capital minimums at levels above peers, who restrict themselves from prudent growth opportunities given the policy.
Regardless, the process of determining the appropriate capital policies for your institution needs to be vetted across the entire executive management team in context of the strategic goals and business lines of the institution.
Time for some heavy lifting
As part of this process, the bank needs to simulate what the capital ratios are going to look like over the next several years. This is where the budgeting process is taken to the next level.
Of particular importance is the formulation of assumptions that are embedded into the pro-forma model. This is a critical part of the process.
Banks should recognize that these assumptions are going to be subjected to regulatory scrutiny. Some banks have had to re-cast growth figures from their budget given the impact on capital from “growth.”
On other occasions, we have seen banks assume that loans will be funded exclusively with DDA accounts even though prior history would suggest otherwise. As part of this exercise of establishing a capital plan “baseline,” the bank can get a feel for its ability to absorb unanticipated loss. This is powerful knowledge for both the management team and the board of directors.
The forecast also serves as a gauge of growth capacity which, when quantified, can be equally significant given an improving economic environment and prospects for loan growth across the country.
“I’ve stress tested the stress test. What now?”
The next step is to evaluate the impact of stress tests on the “baseline” capital forecast. This is where the crystal ball of budgeting meets the paint brush of stress testing.
Most banks will simulate adverse liquidity, interest rate risk, operational risk, and credit-related events. In general, although most bankers understand the utility and spirit of stress testing, often the scenarios are dismissed as low-probability events.
However, whatever stress is imparted—regulators are going to want more!
Furthermore, be ready to defend the assumptions in the stress tests. What has become clear over the past year is that regulators want to see substantiation of these assumptions.
For example, in prior years, some banks would analyze their historical loss for credit stress testing and take some multiple for the basis of that stress test. This approach has been met with resistance. A current best practice would be to incorporate empirical results from a more robust credit stress-testing exercise.
We have also seen banks simulate an environment akin to a “perfect storm” scenario in which all of the above events are combined to create a situation where the bank would have to “turn in its keys to the regulators.” While this type of “reverse stress testing” may seem over the top to most, it can serve as a signal of the current vitality of the capital profile versus a hypothetical scenario of very low probability.
Develop early warning indicators
Another important component of a capital plan is to establish appropriate monitors which may forewarn management of potential capital duress.
While most bankers are acutely aware of all key metrics of their business, regulators want to see evidence that the executive management team is continually measuring and monitoring key triggers.
The most progressive banks will establish a set of key ratios which they track on a quarterly basis at committee meetings and document the levels of stress which may have been triggered as well as management’s response (if any).
While this initially may seem like regulatory “window dressing,” it also serves as an early warning system for issues which may be bubbling below the surface.
Get a backup plan
In my opinion, the most important part of the capital planning process is a bank’s ability to demonstrate the specific actions it would take to instantaneously improve its capital profile.
The utility of itemizing pre-determined capital remediation strategies is worth its weight in gold with examiners.
For example, any examiner who observed a ‘”technical” policy breach in one of the stress tests would certainly inquire into the bank’s response. Having this clearly outlined in the plan communicates management’s roadmap to improving their position. In many cases, these strategies could be as straightforward as simply de-leveraging the balance sheet, but in others it may require greater detail addressing the bank’s access to the capital markets. These strategies need to be prioritized and approved by the board in advance of execution.
Get the “gameplan” ready!
One thing is for certain: If a bank is put on notice for a deficient capital planning process, it is going to have to expend significant effort to adhere to elevated standards.
This was certainly the case for the New England Patriots subsequent to the deflated football scandal. The NFL levied unprecedented fines and suspensions in the wake of something which seemed trivial, but ultimately took on a life of its own.
You may believe that your capital position, policies and procedures are appropriate given the level of complexity of your bank, understand that somebody else may see it another way.
Understand that the rules of the game are changing, and that expectations have been increased. Now is the time to fortify your institution’s capital plan. After all, who would want capital planning to become your bank’s “deflategate”?
About the author
Vincent Clevenger is a managing director at Darling Consulting Group. In this position, he currently advises financial institutions on balance sheet management strategies. He takes a practical approach to the demands that the economic and regulatory environment place on his clients. Since joining the firm in 2003, he has worked in a number of capacities within DCG assisting clients in all aspects of ALM including process reviews, model validations, policy reviews, capital management, and contingency liquidity planning. He also serves as the product manager for DCG’s capital planning and stress testing products.