stress testing and capital management in the world of basel iii and the dodd frank act

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Stress Testing and Capital Management in the World of Basel III

and the Dodd-Frank Act

February 2013


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Agenda

I. Implications of Basel III for Bank Capital and Liquidity

II. Dodd Frank Act Stress Testing Requirements

III. Challenges of Complying with Basel III and DFA Stress Testing Requirements

IV. Getting Value from Regulatory Compliance


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I. Implications of Basel III for Bank Capital and Liquidity


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Basel III Framework Designed to Bolster Capital and Liquidity

Introduce a Global Liquidity Standard

Basel III Framework

Strengthen Capital Framework

Re-define capital

Build conservative capital buffer

Build countercyclical buffer

Define and calculate the leverage ratioLiquidity

coverage ratio Net stable

funding ratio

Stress testsScenario analysis


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Implications for Bank Capital and Liquidity

Key Change Implication

Increased quality and quantity of capital

• Banks will have to pay more attention to their balance sheet items• Banks will be faced with additional capital requirement, and are likely to raise

significant capital as common equity along with retention of profits and reduced dividends

• There are expected to be further add-ons for Pillar 2 risks, SIFIs and the counter cyclical capital buffer so banks may target a total capital ratio of 13-15 percent

Leverage ratio

• The introduction of the leverage ratio could lead to reduced lending and is expected to further motivate banks to strengthen their capital position

• Banks may be required by the market and rating agencies to maintain a higher leverage ratio than required by regulators

Liquidity coverage ratio (LCR)

• LCR would contribute to reducing the risk of a bank run, resulting in higher stability of the financial sector

• The introduction of the LCR will require banks to hold significantly more liquid, low yielding assets which may negatively impact profitability

Net stable funding ratio (NSFR)

• NSFR motivates banks to increase the stability of their funding mix and reduce reliance on short term wholesale funding

• Since it may be difficult to increase the proportion of wholesale deposits with maturities greater than one year, it may result in higher funding costs

• Stronger banks with a higher NSFR will be able to influence marketing pricing of assets


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Introduces Capital Conservation Buffer and Countercyclical Buffer

• The countercyclical buffer aims to ensure that banking sector capital requirements take account of the macro-financial environment in which banks operate.

• The level of buffer ranges between 0% and 2.5% of RWA and has to be met by Common Equity Tier 1 capital.

• The buffer would be applied when a period of excess credit growth leading to the build up of system-wide risk is identified.

• The countercyclical buffer regime will be phased-in in parallel with the capital conservation buffer, becoming fully effective on 1 January 2019.

Countercyclical Capital

• The capital conservation buffer is aimed at ensuring that banks build up capital buffers outside periods of stress, which can be drawn down as losses are incurred.

• A capital conservation buffer of 2.5%, comprised of Common Equity Tier 1, is established above the regulatory minimum capital requirement.

• It will begin at 0.625% of RWAs and increase each subsequent year by an additional 0.625 percentage points.

• The capital conservation buffer would be phased in between 1 January 2016 and year end 2018, becoming fully effective on 1 January 2019.

Capital Conservation

Capital Buffers


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Introduces Two Minimum Standards for Funding LiquidityThe financial crisis highlighted the importance of liquidity to the proper functioning of the banking sector. Market conditions can result in liquidity evaporating quickly, and illiquidity can extend over large periods.

Liquidity Coverage Ratio (LCR)1 Net Stable Funding Ratio (NSFR)2

Promotes short-term resilience of a bank’s liquidity risk profile by ensuring that it has sufficient high-quality liquid assets to survive a significant stress scenario lasting for one month.

Stock of high quality liquid assets

Total net liquidity outflows over the next 30 days

• The framework also defines ‘high quality’ liquid assets (HQLA), their characteristics. The definition of HQLA was changed by the BIS in January 2013 to include some Level 2B assets.

• Total net liquidity outflows = Outflows – min (inflows, 75% of outflows)

Promotes resilience over a longer time horizon by requiring institutions to fund their activities with more stable sources of funding on an ongoing basis.

• Stable funding is the portion of those types and amounts of equity and liability financing expected to be reliable sources of funds over a one-year time horizon under conditions of extended stress.

LCR = >=100% NSFR =Available amount of stable funding

Required amount of stable funding>100%


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Retains the Leverage Ratio

The framework includes a simple, transparent, non-risk based leverage ratio to act as a supplementary measure to the risk based capital requirements. The leverage ratio is intended to prevent an excessive build up of leverage in the banking sector.

Leverage Ratio =Tier 1 Capital

Total Exposure>= 3%

The ratio should be calculated as the simple arithmetic mean of the monthly leverage ratios over a quarter.

The Committee will test the 3% requirement during the parallel run period from 1 January 2013 to 1 January 2017.

Any final adjustments to the definition and calibration of the leverage ratio would be carried out in first half of 2017.


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II. Dodd Frank Act (DFA) Stress Testing Requirements


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DFA Stress Tests

• Final rules issued in October 2012

• Institutions covered:

• For bank holding companies with $50 billion or more in consolidated assets and other nonbank firms regulated by the Federal Reserve, semi-annual internal stress tests, plus Federal Reserve stress tests.

• For other bank holding companies with assets of $10 billion or more, annual internal stress tests and no Federal Reserve test.


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DFA Stress Tests

• Stress testing elements

• Tests are based on firm’s Q3 financial data

• Federal Reserve supplied assumptions in mid-November 2012 for three scenarios

‒ Assumptions were at the macro-economic level: GDP, unemployment, housing

• Methodology is left to firm

• Annual stress tests must be completed in time to file capital plan by January 5 of each year, for institutions with assets greater than $50 billion, and March 31 for institutions with assets between $10-50 billion


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Stress Testing must be Integrated and Forward-Looking

Determine hypothetical or historical scenarios

Credit Risk Impact

Market Risk Impact

Liquidity Risk Impact

Operational Impact

Reputational Impact

Collect reliable data

Factor 1

Factor 2

Factor 3

……

.

Factor N

Factor 4

Factor 5

Asset Credit Losses

Trading P/L

Liquidity Cash Flow Gap

Funding Effects

Operational Losses

Stressed Cash flows

Stressed Earning

Projection

Stressed Losses

Capital Planning

Liquidity Management

Other business decisions

Assess potential loss under exceptional environmentProvide forward-looking model output


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Stress Testing Models must be Supported by a Comprehensive Company-wide Model Risk Governance Structure

Model Users

Internal Audit

Model Owners

Multiple regulatory guidelines, including the DFA Stress Testing Requirements, SR 12-17 “Consolidated Supervision for Large Financial Institutions”, SR 11-7 “Guidance on Model Risk Management” and SR 10-6 “Interagency Policy Statement on Funding and Liquidity Risk Management” require that all quantitative models, including stress testing models are supported by a strong model risk governance framework.

Model Governance

Model Validation

Bank Model Governance Committee

Board of Directors

The anchor of effective challenge resides with

Model Owners and Model Validation


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Model Risk Governance: Three Lines of Defense

3rd Line of Defense – Internal Audit / Assurance

Embedding internal audit into model governance is part of the supplemental policy issued by the Fed in January, SR13-01.

2nd Line of Defense – Model Governance & Validation

Responsible for implementing and monitoring adherence to company policies. The supervisory framework prescribed by the Fed in December 2012, SR 12-17, states requirements for governance and review of stress testing models and other quantitative capabilities.

1st Line of Defense – Line of Business

Model users and owners are accountable for and manage the quality, accuracy, and completeness of the model and identifying, reporting and mitigating risk throughout the model life cycle.

Firms need three lines of defense to ensure the validity and accuracy of stress testing models.


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III. Challenges of Complying with Basel III and DFA Stress Testing Requirements


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Challenges of Complying with Basel III Capital Requirements andDFA Stress Testing Requirements

Key Challenge Description

Implementation Costs

• Model Development and Validation• Implementation of the Stress Testing framework, especially for first-time participants,

may require significant resources;• Banks with inadequate ERM frameworks may have to depend on external advisors

and consultants to comply• Cross-border Implementation• Incremental Internal Audit Costs

Adequate Understanding and Gaining Confidence

• Ensuring adequate understanding of complex stress testing models by senior management and the Board of Directors, who are responsible for governing and overseeing the stress testing process.

• Lack of confidence in the stress testing framework has hindered senior management from making important decision based on the results;

Integration to Risk Management

• Preparing adequate levels of documentation for the stress testing process, including policies, procedures, and model documentation to integrate the process into the Bank’s risk management framework;

• Increased reporting requirements, including semi-annual/annual for DFA stress testing and monthly reporting for Basel II liquidity reporting;

• Identification of stress scenarios to be tested that are applicable across all the risks faced by a bank.

Model Framework

• Data constraints• Consistency of risk modeling across both capital and stress testing models• Model governance• Effective challenge


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IV. Getting Value from Regulatory Compliance


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Leverage Compliance to Enhance Risk Management

Identify Risks

Integrate Results

Develop Action Plans

Prioritize Risks

Business Goals,

Objectives and

Strategies

Test and Monitor Risks

Assess Risks

Enterprise Risk Management Framework

Basel IIIDodd-Frank ActStress Testing

Guideline

Infrastructure Process Integration

Culture: Enabling Activities

Become Part of the Company’s DNA

PoliciesProcesses

OrganizationReporting

MethodologySystems & Data

Key Planning Processes

Stress Testing Guideline


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Move from Risk Control to Risk Management

Shareholders

Capital Productivity

Risk Adjusted Return

(Risk vs. Reward)

Serving Two MastersDebt holders and

regulators

Capital Adequacy

Financial Strength

(Risk vs. Capital)

Executives

Expected Return

Capital Management

Capital Structure

Risk Control Risk Optimization


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Optimize Performance through Appropriate Incentives

• ERM emphasizes incentives & performance measurement systems to align shareholder interests with those of managers

– Risk and Performance are very often measured separately

o Performance based on accounting indicatorsE.g.: Operating Profit = Revenues - Costs

o Capital allocated to risky assets without reference to profitability

• Overcoming this discrepancy, capital management builds an integrated approach

– Setting performance indicators per the organization’s strategic objective and risk appetite, to impact manager’s incentives

– Quantifying the impact of risk on capital and earnings, to benchmark performance relative to capital consumed (risk-adjusted returns)


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Contact Details

Powerful Insights. Proven Delivery.®

Phone: +1 212-603-8378

[email protected]

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New York, NY

Shaheen DilManaging Director

Powerful Insights. Proven Delivery.®

Phone: +1 212-708-6313

[email protected]

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New York, NY

Cory GundersonManaging Director


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