stress testing and capital management in the world of basel iii and the dodd frank act
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© 2013 Protiviti Inc. CONFIDENTIAL: This document is for your company's internal use only and may not be copied nor distributed to another third party.
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Stress Testing and Capital Management in the World of Basel III
and the Dodd-Frank Act
February 2013
© 2013 Protiviti Inc. CONFIDENTIAL: This document is for your company's internal use only and may not be copied nor distributed to another third party.
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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
m
New York, NY
Shaheen DilManaging Director
Powerful Insights. Proven Delivery.®
Phone: +1 212-708-6313
om
New York, NY
Cory GundersonManaging Director
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