The Seven Principles of an Effective Capital Adequacy Process

Spero Risk Associates has substantial experience with all aspects of CCAR, especially model development and validation. We have asked the questions, and we have successfully answered when others have asked.

The seven principles of an effective capital adequacy process were published in August, 2013, in the Federal Reserve’s Capital Planning at Large Bank Holding Companies: Supervisory Expectations and Range of Current Practice. We have direct and deep experience with each of the seven. In particular, we excel where other have the most difficulty–with Principles 1, 2 and 6.

1.  The Bank Holding Company (BHC) has a sound risk-measurement and risk-management infrastructure that supports the identification, measurement, assessment, and control of all material risks arising from its exposures and business activities.

2.  The BHC has effective processes for translating risk measures into estimates of potential losses over a range of stressful scenarios and environments and for aggregating those estimated losses across the BHC.

3. The BHC has a clear definition of available capital resources and an effective process for estimating available capital resources (including any projected revenues) over the same range of stressful scenarios and environments used for estimating losses.

4.  The BHC has processes for bringing together estimates of losses and capital resources to assess the combined impact on capital adequacy in relation to the BHC’s stated goals for the level and composition of capital.

5. The BHC has a comprehensive capital policy and robust capital planning practices for establishing capital goals, determining appropriate capital levels and composition of capital, making decisions about capital actions, and maintaining capital contingency plans.

6. The BHC has robust internal controls governing capital adequacy process components, including policies and procedures; change control; model validation and independent review; comprehensive documentation; and review by internal audit.

7. The BHC has effective board and senior management oversight of the CAP, including periodic review of the BHC’s risk infrastructure and loss- and resource-estimation methodologies; evaluation of capital goals; assessment of the appropriateness of stressful scenarios considered; regular review of any limitations and uncertainties in all aspects of the CAP; and approval of capital decisions.

Initially, the focus of SCAP and CCAR seemed to be about the size of the loss estimates and the remaining capital. Those numbers are still important as they determine quantitative success or failure.

Given that view, Principles 1 & 2 are crucial, as is 6, which ensures and evidences that 1 & 2 were performed in a rigorous, justifiable and transparent manner. Fortunately, those areas are where we have deep and successful experience with CCAR and loss-forecasting. It is also where we can help firms succeed faster and at a lower cost than they thought possible.