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The landscape of the banking industry has experienced drastic changes over the last 18 months. The rapid succession of massive devaluations in certain assets, freezing of credit markets, and deposit runoffs, to name a few, have brought about volatile conditions, causing even the largest of financial institutions to collapse. Given this backdrop, banking organizations have been challenged with containing credit risk, ensuring access to liquidity, and maintaining sufficient capital.
While liquidity and credit risk challenges command heightened attention, capital adequacy remains the cornerstone for a safe and sound institution. Institutions are encouraged to review capital planning practices to ensure that capital levels are, among other things, appropriate to support risk profiles and absorb unanticipated losses or declines in asset values in turbulent markets. It is also important to develop or revise capital policies to incorporate the results of the planning process. Although external influences cannot be controlled, capital planning activities can help an institution to be more prepared for both the expected and unexpected. The following topics should be considered when performing capital assessment activities.
Strategic planning is one of the board and management's most important functions and should be considered when evaluating the institution's capital needs. The strategic plan usually outlines the bank's capital base, desirable capital levels, and external capital sources.1 Capital should also be evaluated in view of projected asset growth and dividend payout targets. Above all, the nature and magnitude of risks that the board and management are willing to accept should be taken into account when determining appropriate capital levels.
An institution's financial condition could negatively impact capital levels and ratios. Institutions should consider the severity of problem and classified assets, loan concentrations, and the adequacy of the allowance for loan and lease losses.2 Poor earnings performance could make it difficult to internally generate capital, while net losses erode the capital base. Other financial factors, such as off-balance-sheet items, should also be reviewed. Capital levels should be adequate to support assets that would result from a significant portion of these items being funded on the balance sheet in a short time.3
All material risks should be identified and measured consistently to assess the current and prospective risk profile. The risk profile should be a compilation of the six major risks: credit, market, liquidity, operational, legal, and reputational. From there, an assessment of the six risks should incorporate banking functions, business lines, activities, products, and legal entities from which significant risks emanate.
As an example, consider an institution with a sizeable credit card operation. In this institution, credit card volume is originated for securitization purposes to provide liquidity. While securitizations may have been successful in the past, capital adequacy should be considered in the event market conditions prevent credit card receivables from being securitized and sold. In essence, an evaluation should be made to determine whether warehousing the credit cards on the balance sheet for a longer period of time would significantly impact capital ratios.
An assessment of the six risks should result in a comprehensive risk-based view of the organization. After evaluating the potential impact to capital, capital levels could be adjusted or contingency plans put in place, as necessary, to reflect the risk profile.
An institution should perform stress tests or a sensitivity analysis on certain investment securities and loan portfolio segments, as necessary. This practice will help to quantify the impact of changing economic conditions on asset quality, earnings, and capital. The sophistication of stress testing practices and sensitivity analysis should be consistent with the size, complexity, and risk characteristics of the asset(s).4
As an example, consider an investment security that has significantly depreciated for several months. Although there may be an indication that the security may soon be designated as other-than-temporarily impaired, the bank's management decides to continually monitor the asset. In this case, it would be prudent for management to also perform stress tests. Management would be able to assess the potential impact on capital ratios if an impairment charge were to be taken.5
It is a normal course of business for holding companies to generate cash flow through dividend payments upstreamed from their bank subsidiaries. The dividends are generally used for corporate activities, such as interest payments on debt, corporate dividend payments, mergers and acquisitions, and operating expenses. Capital planning activities should ensure that capital at the bank is maintained at appropriate levels to sustain its risk profile.
For banking organizations that are designated as financial holding companies (FHCs), management must be mindful that the institution's FHC status could be jeopardized if any of its subsidiary banks fall below a well-capitalized position.
The unexpected market and economic events of 2008 significantly diminished access to various capital sources. Once again, it is prudent to develop several alternative options to raise capital in an expedited manner, if necessary. Options should include internal and external sources. In the event that external sources are not available or are cost-prohibitive, the focus must be placed on improving capital levels internally. The solution may be to retain earnings rather than pay dividends, sell assets, or restructure the balance sheet.
Although the above-mentioned topics do not comprise an all-inclusive list, they reflect issues that are common amongst most banking organizations. Once an assessment of relevant factors is complete, there should be an indication of whether additional capital is necessary. To be most effective, capital planning should also be performed periodically and reviewed by the board of directors. Financial institutions are strongly encouraged to be prudent in conducting capital planning activities in order to be better prepared for both the expected and unexpected.
The views expressed in this article are those of the author and are not necessarily those of this Reserve Bank or the Federal Reserve System.