A sound capital planning process: fundamental elements
The Basel Committee has issued these sound practices to foster overall improvement in banks' capital planning practices. Indeed, an important lesson from the financial crisis concerned the need for banks to improve and strengthen their capital planning. Some of the observed weaknesses reflected processes that were not sufficiently comprehensive, appropriately forward-looking or adequately formalised. As a consequence, some banks underestimated the risks inherent in their business strategies and, in turn, misjudged their capital needs.
In the absence of comprehensive information, some banks continued to pay dividends and repurchase common shares when capital could have been retained to insulate them against potential future losses. Some banks also issued large amounts of capital instruments - such as hybrid debt - that ultimately proved ill-equipped to absorb realised losses. In sum, many banks did not scale their decisions about the level and composition of regulatory capital to the potential impact of changing economic conditions.
During and after the financial crisis, the official sector in certain jurisdictions conducted ad hoc stress tests to assess the capital adequacy of banks in their jurisdictions. Because of the pressing need to determine whether banks were appropriately capitalised, those first rounds of official stress tests often did not include an assessment of the processes banks employ to project potential capital needs and to manage capital sources and uses on an ongoing basis. More recently, supervisors have begun to codify their expectations for what constitutes sound capital planning. Those planning processes enable a bank's management to make informed judgments about the appropriate amount and composition of capital needed to support the bank's business strategies across a range of potential scenarios and outcomes.