Basel Committee on Banking Supervision

Capital planning is a necessary complement to a robust regulatory framework. Sound capital planning is critical for determining the prudent amount, type and composition of capital that is consistent with a longer-term strategy of being able to pursue business objectives, while also withstanding a stressful event. Sound capital planning processes enable banks’ management to make informed judgments about the appropriate amount and composition of capital needed to support a bank’s business strategies across a range of potential scenarios and outcomes. Results of stress testing should, where appropriate, inform banks’ capital planning process (see RMA30).

The sound practices described in this chapter are not intended to describe an ideal state, or to outline a one-size-fits-all approach to capital planning, since banks require solutions that are tailored to their individual circumstances.

Sound practice generally involves incorporating conservative assumptions about the plausibility of capital actions under stress into a capital plan, and applying an appropriate degree of scepticism about management’s ability to execute on those actions presuming the bank is impaired as a severe scenario unfolds. In the best of examples, a capital plan includes a clear indication to decision-makers as to what capital actions they might feasibly consider taking at the group or business line level.

Banks can take different approaches to structure their capital planning processes. One approach divides the various responsibilities associated with capital planning along functional lines. For example, experts assigned to a business unit have responsibility for establishing capital targets and managing their business in relation to them. Those estimates are then aggregated to obtain a bank-wide view of capital adequacy. Another approach relies on a more centralised model, whereby a central group develops assumptions to be used bank-wide and has the authority and responsibility to review and challenge the estimates produced by individual areas of the bank. Irrespective of how a bank’s capital planning process is structured, it should produce an internally consistent and coherent view of a bank’s current and future capital needs.

The capital planning process reflects the input of different experts from across a bank, including but not limited to staff from business, risk, finance and treasury departments. There should be a strong link between the capital planning, budgeting and strategic planning processes within a bank. Collectively, these experts provide a view of the bank’s current strategy, the risks associated with that strategy and an assessment of how those risks contribute to capital needs as measured by internal and regulatory standards. Otherwise, banks may run the risk of developing capital plans that do not accurately reflect the strategy individual business lines are pursuing, or that are incomplete in their scope, resulting in capital targets at the group level that may be overly optimistic.

Banks with sound capital processes have a formal process in place to identify situations where competing assumptions are made. In this context, differences in strategic planning and capital allocation across the bank are escalated for discussion and approval by senior executives. This may include, for example, whether it is acceptable for one business unit to anticipate a rapid growth in loan balances while a complementary business unit assumes a sharp decline in such balances. Not identifying such competing assumptions could also result in overly optimistic capital targets.

Banks’ capital plans and their underlying processes and models can benefit from being subject to regular independent validation. This layer of review is important for confirming that the processes are strong, are applied consistently, and remain relevant for the bank’s business model and risk profile.

As a general matter, both senior management and the board of directors1 are involved in the capital planning process.2 Sound practice typically involves a management committee or similar body that works under the auspices of a bank’s board of directors and guides and reviews efforts related to capital planning. Typically, the board of directors sets forth the principles that underpin the capital planning process. Those principles may include the forward strategy for the bank, an expression of risk appetite and a perspective on the right balance between reinvesting capital in the bank’s operations and providing returns to shareholders.

Banks with a stronger governance of the capital planning process require the board of directors or one or more committees thereof to review and approve capital plans at least annually. Those bodies are also required to consider the outcome of the capital planning process when appraising business developments and strategy. The analysis captured in a capital plan informs the capital actions contemplated by the board of directors including, for example, whether to reconfirm or change a common stock dividend or common stock repurchase plan and/or issue regulatory capital instruments. In cases where this decision-making has been delegated to one or more committees of a board of directors, approval of the capital plan typically falls within the remit of the board’s risk committee.

Capital policy and risk capture

A capital policy is a written document agreed by the senior management of a bank. It generally specifies the principles that management will follow in making decisions about how to deploy a bank’s capital.

A leading practice is for a board of directors to hold a management team accountable for demonstrating that adherence to a capital policy will allow the bank to maintain ready access to funding, meet its obligations to creditors and other counterparties, and continue to serve as a credit intermediary before, during and after a stressful scenario. Implicitly, this means that a sound capital policy also details the range of strategies management can employ to address anticipated and unexpected capital shortfalls.

Typically, a capital policy will reference a suite of capital- and performance-related metrics against which management monitors the bank’s condition. Regulatory capital measures feature prominently in banks’ capital policies. Among the key metrics, banks focus on the Common Equity Tier 1 ratio and on ensuring that enough capital is retained to meet current and future requirements. Non‑regulatory based metrics tend to focus on returns. Some of the more common return measures employed by banks include return on equity, return on risk‑adjusted capital, and risk‑adjusted return on capital.

Management teams employing sound capital planning practices may seek to evaluate their capital adequacy from different perspectives. For example, some banks use economic capital for a complementary view of a bank’s condition. A bank employing this practice aggregates economic capital need, inclusive of any risk diversification benefits and capital cushions for model risks, cyclicality or other factors, and compares it to the available financial resources. The last section of this chapter sets out some recommendations for banks and supervisors to consider when assessing economic capital.3

Even when a bank is diligent in defining a broad set of potential adverse outcomes, actual events can be worse. Sound capital policies may incorporate minimum thresholds that are monitored by managers to ensure that the bank remains strong. Banks generally identify triggers and limits for every metric specified in the capital policy. The considerations of many stakeholders are taken into account when setting a minimum threshold, including those of market participants, shareholders, rating agencies and regulators.

It is important for a monitoring framework to be in place and complemented by a clear and transparent formal escalation protocol for those situations when a trigger or limit is approached and/or breached, at which point a timely decision needs to be taken. Some banks adopt a protocol that results in increasing levels of scrutiny and/or action when thresholds are approached.

An important input to a capital policy is an expression of risk tolerance by management and the board of directors. A risk tolerance statement is approved by the board of directors and renewed annually. It directly informs the bank’s business strategy and capital management, including, for example, through the establishment of return targets, risk limits and incentive compensation frameworks at the group and business unit levels.

The credibility of a bank’s capital planning can be questioned if the process does not adequately reflect material risks, some of which may be difficult to quantify. Banks routinely quantify and hold capital against those risks that are specified in the Basel framework. Sound practices include having a comprehensive process in place to regularly and systematically identify, and understand the limitations of, their risk quantification and measurement methods.4 In addition, banks seek to capture in their capital plans those risks for which an explicit regulatory capital treatment is not present, such as, but not limited to, reputational risk and strategic risk. It is also important to establish clear links between capital and liquidity monitoring.

For risks that are more difficult to quantify, carefully validated assumptions made in the estimation process are widely discussed and understood by senior management to ensure the potential for these to negatively impact a bank is not underestimated. Risks arising from the application of a model that is unable to capture embedded risks of a complex portfolio, for example, from limitations in data and/or quantification methods may fall within this category.

Some banks have developed formal processes for determining the severity of risk management gaps and developing appropriate responses, including for monitoring and limiting the exposure in question and holding regulatory capital to serve as a buffer to absorb these risks where warranted. The Basel Committee acknowledges that there are many different means by which such risks or exposures could be addressed. Sound practice exists where those risk identification and mitigation efforts, together with an appraisal of their limitations, are incorporated into the capital planning process. Otherwise, management teams and boards of directors may have a false sense of comfort about the capitalisation of their banks.

Another key element of a sound capital planning process is stress testing or scenario analyses. These techniques are often used to obtain a forward view on the sufficiency of a bank’s capital base. As noted in RMA30, results of stress testing should, where appropriate, inform banks’ capital planning process.

Stress testing and scenario analyses provide a view as to how the bank’s capitalisation could be affected if there were a dramatic bank-specific or economic shock. Absent such a component, a bank’s capital plan would be highly vulnerable, and thus any actions pursuant to it may not adequately insulate the bank against future adverse developments. For capital planning purposes, banks estimate the impact of at least a baseline and a downturn scenario over several years that incorporate a combination of economic, market and bank-specific indicators.

The impact of a scenario reflects estimated changes to a bank’s revenue, profit and loss, balance sheet, exposure measures and risk-weighted assets. Practices include exploring the impact of scenarios that captured plausible, severe market-wide and idiosyncratic events that could negatively impact the bank. RMA30 sets out principles for robust stress testing.

Many of the banks that perform stress testing as part of the capital planning process do not incorporate diversification effects across risk dimensions or businesses. By not incorporating a diversification assumption, a bank is presuming that the impact of a scenario is additive. That is, it would negatively affect all aspects of a bank’s business, rather than presuming that some activities would continue to perform well in the scenario while others would experience difficulties. While conservative, this assumption leads to greater prudence in capital deployment decisions.

Consistent with the expectations outlined in the internal controls and governance section of this chapter, it is important that senior executives are aware of and have approved assumptions regarding potential management actions that banks could reasonably undertake to mitigate the capital impact of the stress scenario on a particular business.5 It is a sound practice for actions, like significant portfolio sales or substantial staff reductions, to be scrutinised. Management in those cases determines whether experts are making overly optimistic assumptions about their ability to react in a stressed environment, and question whether the implied benefit of such actions is reasonably conservative – particularly if many banks are trying to execute on the same strategies during the stress scenario being modelled.

For a capital planning process to be meaningful, a bank’s senior management and directors should rely on it to provide them with views of the degree to which a bank’s business strategy and capital position may be vulnerable to unexpected changes in conditions.

Sound practice entails senior management and the board of directors ensuring that the capital policy and associated monitoring and escalation protocols remain relevant alongside an appropriate risk reporting and stress testing framework. In addition, they are responsible for prioritising and quantifying the capital actions available to them to cushion against unexpected events.

In practice, those actions include but are not limited to reductions in or cessation of dividends, coupon payments, equity raises and share repurchases, and/or balance sheet reductions. This last set of potential actions could, for instance, include the disposition of capital markets inventory, monetising business units or reducing credit origination. It is critical that management teams assess the feasibility of the proposed contingent actions under stress, including potential benefits and long-term costs, and have a high degree of confidence that such actions can be executed as described. Otherwise, they should not be captured in a bank’s capital plan.

Sound practice also includes developing guiding principles for determining the appropriateness of particular actions under different scenarios, which take into account relevant considerations, such as economic value added, costs and benefits, and market conditions. In summary, it is important that actions to maintain capital are clearly defined in advance and that the management process allows for plans to be updated swiftly to allow for better decision-making in changing circumstances.

Economic capital models and the overall frameworks for their internal use can provide supervisors with information that is complementary to other assessments of bank risk and capital adequacy. While there is benefit from engaging with banks on the design and use of the models, supervisors should guard against placing undue reliance on the overall level of capital implied by the models in assessing capital adequacy. The following recommendations identify issues that should be considered by banks and supervisors to make effective use of internal measures of risk that are not designed for regulatory purposes.

1. Use of economic capital models in assessing capital adequacy. A bank using an economic capital model in its dialogue with supervisors, should be able to demonstrate how the economic capital model has been integrated into the business decision making process to assess its potential impact on the incentives affecting the bank’s strategic decisions about the mix and direction of inherent risks. The bank’s board of directors should also be able to demonstrate conceptual awareness and understanding of the gap between gross (standalone) and net enterprise wide (diversified) risk when they define and communicate measures of the bank’s risk appetite on a net basis.
2. Senior management. The viability, usefulness, and ongoing refinement of a bank’s economic capital processes depend critically on the existence of credible commitment or “buy-in” on the part of senior management to the process. For this to occur, senior management should recognise the importance of using economic capital measures in conducting the bank’s business and capital planning, and should take measures to ensure the meaningfulness and integrity of economic capital measures. In addition, adequate resources should be committed to ensure the existence of a strong, credible infrastructure to support the economic capital process.
3. Transparency and integration into decision-making. A bank should effectively document and integrate economic capital models in a transparent way into decision making. Economic capital model results should be transparent and taken seriously to be useful to senior management for making business decisions and for risk management. A bank should take a careful approach to its use of economic capital in internal assessments of capital adequacy. For this purpose, greater emphasis should be placed on achieving robust estimates of stand-alone risks on an absolute basis, as well as developing the flexible capacity for enterprise-wide stress testing.
4. Risk identification. Risk measurement begins with a robust, comprehensive and rigorous risk identification process. If relevant risk drivers, positions or exposures are not captured by the quantification engine for economic capital, there is great room for slippage between inherent risk and measured risk. Not all risks can be directly quantified. Material risks that are difficult to quantify in an economic capital framework (eg funding liquidity risk or reputational risk) should be captured in some form of compensating controls (sensitivity analysis, stress testing, scenario analysis or similar risk control processes).
5. Risk measures. All risk measures have advantages and disadvantages which need to be understood within the context of their intended application. There is no singularly preferred risk measure for economic capital purposes. A bank should understand the limitations of the risk measures it uses, and the implications associated with its choice of risk measures.
6. Risk aggregation. A bank’s aggregation methods should address the implications stemming from the definition and measurement of individual risk components. The accuracy of the aggregation process depends on the quality of the measurement of individual risk components, as well as on the interactions between risks embedded in the measurement process. Aggregation of individual risk components often requires the harmonisation of risk measurement parameters such as the confidence level or measurement horizon. Care must be taken to ensure that the aggregation methodologies used (eg variance-covariance matrices, use of broad market proxies, and simple industry averages of correlations) are, to the extent possible, representative of the bank’s business composition and risk profile.
7. Validation. Economic capital model validation should be conducted rigorously and comprehensively. Validation of economic capital models should be aimed at demonstrating that the model is fit for purpose. Evidence is likely to come from multiple techniques and tests. To the extent that a bank uses models to determine an overall level of economic capital, validation tools should demonstrate to a reasonable degree that the capital level generated by the model is sufficient to absorb losses over the chosen horizon up to the desired confidence level. The results of such validation work should be communicated to senior management to enhance economic capital model usage.
8. Dependency modelling in credit risk. Since the dependency structures embedded in portfolio credit risk models have an important impact on the determination of economic capital needs for credit risk, banks should carefully assess the extent to which the dependency structures they use are appropriate for their credit portfolio. Banks should identify and understand the main limitations of their credit portfolio models and their implementation. They should address those limitations by using adequate supplementary risk management approaches (eg sensitivity analysis, scenario analysis, timely review of parameters).
9. Counterparty credit risk. A bank should understand the trade-offs involved in choosing between the currently used methodologies for measuring counterparty credit risk. Complementary measurement processes such as stress testing should also be used, though it should be recognised that such approaches may still not fully cover all counterparty credit risk exposures. The measurement of counterparty credit risk is complex and entails unique market and credit risk related challenges. A range of aggregation challenges need to be overcome before a bank can have a bank-wide view of counterparty credit risk for economic capital purposes.
10. Interest rate risk in the banking book. Close attention should be paid to measuring and managing instruments with embedded option features, which if not adequately performed can present risks that are significantly greater than suggested by the risk measure. Trade‑offs between using an earnings-based or economic value-based approach to measuring interest rate risk in the banking book need to be recognised. The use of an earnings-based measure creates aggregation challenges when other risks are measured based on economic value. Conversely, the use of an economic value-based approach may create inconsistencies with business practices.