u.s. banking regulatory update ii - iii . durbin amendment . volcker . cost . operational efficiency...

U.S. Banking Regulatory Update

February 2013

kpmg.com

Change – or Beware If we do not take change by the hand it will surely take us by the throat.

Winston Churchill

© 2012 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. NDPPS 111930

2

Make Up of the Industry (2003 to 2012)

Source: FDIC.

$100 million to $1B 4,244 Institutions (58.6%)


3

Top 10 banks control > Half of industry’s assets

$0 $5,000 $10,000 $15,000

2012

2006

2003

Combined Assets of All Others Combined Assets of Top 10 Banks

52%

40%

29% 71%

60%

48%

Dollar figures in Trillions Source: SNL, used with permission


4

Net improving; Earnings under pressure (2ndQ, 2012)

Source: FDIC – Quarterly Banking Profile, 2nd Q, 2012 – used with permission


5

ROA (2ndQ, 2012)



6

“Problem” institutions (2ndQ, 2012)



7

Growth in branches slows; Deposits increase

Source: SNL – Used with permission.


8

Preferred banking method – All age groups

Source: ABA – used with permission.


9

Focus areas of U.S. Banks

Regulation

Basel II - III

Durbin Amendment

Volcker

Cost

Operational Efficiency

Divesting non-core

businesses

Discretionary spend

Growth

Inorganic growth (e.g.

M&A) New product

/market development

Re-pricing

Change

“The pessimist sees difficulty in every opportunity. The optimist sees the opportunity in every difficulty.” Winston Churchill


The “New” U.S. Regulatory Landscape & Impacts


12

Dodd-Frank Act Financial Regulatory Reform: Areas of Focus

Federal Bank Supervision

Systemic Risk Systemically important (“SIFI”) designation Financial Stability Oversight Counsel and Office of

Federal Register oversight . Stress testing and “living will” requirements

Financial Stability & Capital Requirements Liquidation authority Bank capital requirements Emergency stabilization

Volcker Rule Proprietary trading restrictions Hedge fund and Private Equity fund restrictions

Regulation of OTC Derivatives Swaps pushout rule Derivatives clearing and reporting requirements

Other Areas of Reform Conflict minerals disclosure requirements Interest on business deposits

Registration of Advisers SEC registration and exams Record keeping and reporting Private client disclosure

Amendments to bank regulations Deposit insurance reforms Office of Thrift Supervision elimination

Consumer Protection & Mortgage Reform Broker/dealer and securities regulation Securitization risk retention Expanded mortgage documentation requirements Consumer Financial Protection Bureau

0 500 1,000 1,500 2,500 Number of Pages

Dodd-Frank (2010): 2,319 pgs

Gramm Leach Bliley (1999): 145 pgs

Sarbanes Oxley (2002): 66 pgs

Glass Steagall (1933): 37 pgs

The Dodd-Frank Wall Street Reform and Consumer Protection Act (“The Dodd-Frank Act”) provided the most sweeping overhaul of the U.S. financial services industry and financial markets since the Great Depression

Areas of Focus

Major Financial Legislation


13

The Dodd-Frank Act The “New” U.S. Regulatory Landscape

Regulatory reporting requirements can be expected to change further (increase) as the regulatory structure changes.

Banks Insurance Securities Commodities/

Futures Consumers

New Agencies Changing Merging Unchanged

Federal Reserve Board Office of Thrift Supervision Office of the Comptroller of the Currency Federal Deposit Insurance Corporation Financial Stability Oversight Council Consumer Financial Protection Bureau State Bank Regulators

State Insurance Regulators

Federal Insurance Office

Security and Exchange Commission

Financial Industry Regulatory Authority

State Securities Regulators

Commodity Futures Trading Commission

Consumer Financial Protection Bureau

Graphic updated/adapted from Financial Times article

National Futures Assoc.


14

Impact on business and financial strategy

Intensified regulatory pressure & risks

Strategic Risk

Fee revenue from ancillary and core products & services

Increased risk management & compliance costs


15

Impact on infrastructure & operations

Product innovation and marketing tactics

Prioritization for operations & technology investment

M&A due diligence


16

Impact on behaviors & culture

Reputation Risk

Customer Experience vs. Consumer Compliance

Risks from affiliates and third parties


17

Implications and Challenges for US Banks

Implications & Challenges

1. Enhanced Prudential Standards for key Safety & Soundness areas affecting U.S. banks: – Enterprise risk management process and Board Risk Management oversight – Capital adequacy - Basel III; stress-testing (CCAR & CaPR); enhanced capital plans – Liquidity and Funding plans – Legal entities – oversight and rationalization; Resolution & Recovery Planning (“Living Will”) for large

banks – Enterprise Risk Management (*) – Risk Appetite and enhanced Risk Dashboards (*) – Credit exposures and concentrations (e.g., counterparties, CRE, sovereign debt) – Internal Audit process (*) – Transactions with affiliates (Reg W/23a &b) – Information security – Vendor risk management (including off-shoring) – Executive incentive compensation process (* OCC “Strong” principles)


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Implications and Challenges for US Banks (continued)

Implications & Challenges

2. Increased Federal Reserve and OCC supervisory requirements for Enterprise-wide Governance, Risk Reporting, Risk Appetite and Internal Audit functions – Especially for SIFIs – but there is already a “spillover” effect on smaller firms – Expectations for “Strong” Board oversight, Risk Management, Risk Appetite & Internal Audit

processes – “Satisfactory” is no longer acceptable 3. Systemic Risk oversight under the Federal Reserve, the FDIC and the Financial Services

Oversight Council (FSOC) means a wider cross-section of U.S. financial institutions will come under federal scrutiny

4. Consumer Financial Protection Bureau (CFPB) has raised the bar on consumer protection laws, rules and requirements, including reporting

5. Increased regulatory scrutiny of Proprietary Trading and Derivatives Activities 6. Impact of regulatory reform requirements on bank product pricing and profitability, especially:

– Increased capital and liquidity requirements – Loss of revenue due to potential Volcker and derivative push out provisions move activities into non-

bank affiliates or outside the firm entirely – More rigorous consumer protection requirements and associated costs and impact on profitability – Increased regulatory reporting burden


19

Basel III Capital Requirements

Basel III Regulatory Capital Ratios • New ratio

• Common Equity Tier 1 • Existing ratios with adjustments to calculations. Certain adjustments phased in

• Tier 1 Capital • Tier 2 Capital • Total Capital • Leverage

Impact on Equity Calculation

• Accumulated Other Comprehensive Income (AOCI) now flows through Tier 1 Capital • Trust Preferred Securities

• Phased out of Tier 1 Capital and into Tier 2 Capital • Other Deductions to be phased in between 2013 and 2018

• Certain Deferred Tax Assets (DTAs), MSR Limits • Gain on sale associated with securitization • Defined pension benefit assets

Sample Impacts on Risk Weighted Assets (RWA) Calculation

• Residential Loans

• 2 Groups – Category 1 (35% - 100% RWA) and Category 2 (100% - 200% RWA) risk weighted based on LTV • Commercial Loans

• New risk weight for High Volatility Commercial Real Estate (HVCRE) (150%) • Investments

• Certain AFS securities receive new risk weighting (0% - 600%) • Off-Balance Sheet and Derivatives

• Unfunded Commitments – Original Maturity of one year or less now subject to risk weighting (20% Credit Conversion Factor (CCF))

• Derivatives – Removal of 50% Risk Weight cap for counterparty risk


20

Basel III – Buffer Requirements

Capital Conservation Buffer Counter-cyclical Buffer

Comprised of Tier 1 components

Minimum of 2.5% above the regulatory requirements

Banks build up capital buffers to draw down as losses are incurred

To be monitored and implemented by National Jurisdictions

Enforced by national authority as deemed necessary

Requirements between 0 and 2.5% of risk-weighted assets

Ensures that banking sector capital requirements account for the macro-financial environment


21

Basel III – Liquidity Requirements

Liquidity Coverage Ratio:

Stock of high-quality liquid assets/Total net cash outflows over the next 30 calendar days

Minimum requirement = 100%

Ensures that the bank has adequate level of assets to meet liquidity needs over the next 30 days

Net Stable Funding Ratio:

Available amount of stable funding/Required amount of stable funding

Minimum requirement = 100%

Establishes minimum acceptable amount of stable funding based on asset and activity characteristics of an institution over a period of 1 year


22

Basel III – Transition

Planned to be implemented from 2013 – 2019

Deadline of transposition into national law: 1st January 2013

BUT: the Agencies announced a delay in the Final Rule pending further review of industry comments

During transition: the Basel Committee and US Regulators are expected to monitor economic effects


23

Implementation Timeline for New Regulatory Capital Minimums

Importantly, certain deductions from Common Equity Tier 1 (DTAs from operating losses and credit carryforwards, gain-on-sale associated with securitization, defined pension benefit assets, excess of expected credit loss over allowance for loan and lease losses, and change in fair value arising from the bank’s own creditworthiness) will be deducted in full from Tier 1 Capital on January 1, 2013, and transition to deductions from Common Equity Tier 1 according to the timeline above. – Throughout the transition period, the balance of the deduction that has not yet transitioned to Common Equity Tier 1 will continue to be made to

Tier 1 Capital. Goodwill will be fully deducted from Common Equity Tier 1 beginning January 1, 2013. Deductions for intangible assets other than goodwill and mortgage servicing

rights (“MSRs”) will be deducted from Common Equity Tier 1 according to the transition timeline above for phase-in of Common Equity Tier 1 deductions. Threshold deductions relating to MSRs, certain DTAs arising from temporary differences, and significant investments in unconsolidated financial entities will be phased

in according to the transition timeline above for phase-in of Common Equity Tier 1 deductions.

The US federal banking agencies are proposing to adopt an implementation timeline that is in line with the Basel III framework.

As of January 1, 2013 2014 2015 2016 2017 2018 2019

Common Equity Tier 1 3.500% 4.000% 4.500% 4.500% 4.500% 4.500% 4.500% Capital Conservation Buffer 0.625% 1.250% 1.875% 2.500% Total Common Equity Tier 1 3.500% 4.000% 4.500% 5.125% 5.750% 6.375% 7.000% Tier 1 Capital 4.500% 5.500% 6.000% 6.625% 7.250% 7.875% 8.500% Total Capital 6.500% 7.500% 8.000% 8.625% 9.250% 9.875% 10.500% Phase-In of Certain CET1

Deductions and AOCI Inclusion

0.0% 20.0% 40.0% 60.0% 80.0% 100.0%

Leverage Ratio 3.000% Advanced Approaches Banks Only Reporting Begins 2015 Minimum Effective 2018

Source: Interagency Notice of Proposed Rulemaking, “Regulatory Capital Rules: Regulatory Capital, Implementation of Basel III, Minimum Regulatory Capital Ratios, Capital Adequacy, Transition Provisions, and Prompt Corrective Action,” June 7, 2012.

Phase-in of Minimum Capital Ratios

Phase-in of Capital Conservation Buffer


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What are Banks Doing?

Can be separated into the 3 categories:

1. GSIFI (Global Systemically Financial Institutions) such as BofA, JPM, Citi etc. are responding to the NPRs while alerting shareholders of the additional capital that will be required. JPM calculated Basel III ratios based on the original Basel guidance in its 2011 Annual Report.

2. Medium sized banks are discussing internally what it means for them and those who have implemented Basel II or are a subsidiary of an overseas mandatory Basel II bank so report some Basel II requirements are probably more comfortable with the requirements.

3. Smaller banks are taking steps by completing the Basel 3 regulatory capital calculation spreadsheet and having a discussion with KPMG and other third parties.


The “New” U.S. Regulatory Landscape & Impacts


26

Capital Planning, CCAR, and the Strategic Planning Process Sustainability is Key to Success

Many banks struggle with converting CCAR submissions from a “project compliance” perspective into the fully integrated business planning cycle.

CCAR can be built into the business planning cycle. To be sustainable, the following items need to be addressed:

Defined governance structure

Documented processes, procedures, and tools

Clear understanding of roles, responsibilities, and staffing needs

Monthly Quarterly Quarterly Monthly Monthly / Quarterly Monthly / Quarterly

Step 1:Develop

Macroeconomic View

Step 2:Review and

Confirm Loss Forecast

Assumptions

Step 3:Generate

Loss Forecasts

Step 4:Review Financial Assumptions & Develop and

Refine Financial Forecast

Step 5:Determine Capital

Levels

Step 6:Obtain Board

Approval

Economic Forecast Committee Meeting

Macro-Economic Forecast

Report

Consumer Loss

Forecasting Assumptions

IRE Loss Forecasting Assumptions

Commercial Loss

Forecasting Assumptions

B/S & NII, & NIE/NIR Assumptions Review

Meeting

Financial Projections

Capital Plan Report

Loss Forecasting Results Analytics

Management Review Meeting

Commercial Loss Forecasting

Assumptions Team Meeting

IRE Loss Forecasting Assumptions Team

Meeting

Consumer Loss Forecasting

Assumptions Team Meeting

A

Loss Forecasting Assumption

Report

B

Board Meeting

Capital Planning Team Leadership Meeting

E

Executive Meeting

Working Group

Loss Forecasts,

ALLL Analysis and

NPLs

C

D

NII Technical Meeting

Loss Forecasting Committee

Capital Planning & Investment Committee

Risk AnalyticsCredit Finance TreasuryFunctional Area : ABCInterdependency:

Step 1:Develop

Macroeconomic View

Step 2:Review and Confirm

Loss Forecast Assumptions

Step 3:Generate Loss

Forecasts

Step 5:Determine

Capital Levels

Step 6:Obtain Board

Approval

Step 4:Review Financial Assumptions &

Develop and Refine Financial Forecast

BOD

BOD Sponsored Committees

Special Purpose Committees

Working Groups

Associates / Lines of Business / Geographies

Strategy and Capital

Planning

Review & confirm Consumer

assumptions with team

Review and confirm IRE assumptions

with team

1a

1c

Review & confirm Commercial

assumptions with team

1b

Macro-Economic

Forecasting Report

A

Review and approve assumptions at Loss

Forecasting Committee Meeting

Generate combined assumption set

Loss Forecasting Assumption

Report

B

2 3

STRATEGIC PLAN Business strategies refreshed New Initiatives identified Capital Plan informs investment priority

BUDGET Derived from Year

1 Base Case of Capital plan

Targets and metrics drilled down from Strategic Plan

CAPITAL PLAN and CCAR Collaborative process

with cross functional participation

Leverage process for both Regulatory Reporting and Strategic Planning

Multi-Year Capital

Plan

Year 2

Year 3

Budget

Business

Other LOBS Consumer

Strategic Plan

Business Consumer

Other LOBs

Risk

Appetite Statement

Risk Appetite Statement Board of Directors set

Risk Appetite Budget should reflect

investment in acceptable business strategies

Business Planning Cycle + CCAR


27

“All banking organizations should have the capacity to understand fully their risks and the potential impact of stressful events and circumstances on their financial condition” – SR Letter 12-7

The stress testing framework includes clearly defined objectives, well-designed scenarios, well-documented assumptions, ongoing review, and recommended actions.

General Stress Testing Principles Elements of a Robust Program

1. Includes activities and exercises that are tailored to and sufficiently capture the banking organization’s exposures, activities, and risks.

Includes credit, market, operational, interest-rate, liquidity, country, strategic , and reputational risk.

Aligned to Risk Appetite and part of regular risk identification and monitoring practices.

Applied at various levels in the organization.

2. Employs multiple conceptually sound stress testing activities and approaches.

Uses scenario, sensitivity, enterprise-wide, and reverse stress testing approaches.

Relies on high-quality data. Documents assumptions, and degree of uncertainty.

3. Is forward-looking and flexible. Incorporates changes in the organizations activates, portfolio composition, asset quality, operating environment, business strategy, and other risks that arise over time.

Ensures MIS are capable of incorporating changes.

4. Ensures results are clear, actionable, well supported, and inform decision making.

Includes regular, documented communication to Board, management, and staff. Informs decisions related to strategies, limits, and risk profile.

5. Includes strong governance and effective internal controls.

Requires critical review of key assumptions, uncertainties, and limitations. Integrated into business lines, capital and asset-liability committees, and other

decision-making bodies; not isolated to risk management.

CCAR Framework Elements of a Robust Program


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Issue Description of Issue

Process Sustainability

Incomplete design and installation of suitable controls to fully integrate a sustainable, end-to-end capital planning process in the Company's financial, operational, and enterprise risk management framework, converting from a "project compliance" perspective to a fully integrated business process.

Roles, Responsibilities, and Resources

Lack of documentation (roles and responsibilities) needed to evaluate whether management has the appropriate management oversight, adequate staffing and proper segregation of duties for certain key departments involved in the capital planning process. Lack of quantitative resources to support capital reporting and analysis.

Data Quality and Data Management

Limited historical data availability (e.g. PD, LGD, EAD for specific portfolios) may impact ability to identify trends or back-test models. Data integrity concerns due to data handoffs between technology platforms and limited reporting between systems (e.g.

loan system to GL) makes reconcilement and audit difficult. Changes in certain key assumptions may have a cascading effect in other areas not easily reconcilable across

disparate systems.

Risk Identification and Communication

Limited processes to document whether the key stakeholders in the capital planning process are considering significant business decisions made by the Company that may have an impact on the forecasted information used in the capital planning process (e.g., Risk Appetite Statement, and New Initiatives Review). Senior leadership from certain groups may not be sufficiently involved in the capital planning forecasting process to

determine if the impact of key business decisions are accurately reflected in the forecasted information used in capital planning.

Board Review of Capital Forecast

The bank’s Board and executive management and board may not be provided with sufficient and consistent information to effectively conclude on necessary capital plan revisions, including dividend policy, share repurchases or suspension, capital raising or other funding strategies.

Process and Model Imprecision

Models may not be fully back tested and validated (specifically Risk Rating tools). Imprecision in models or data quality may need to be accounted for in a “buffer” (i.e. an additional amount of capital

reserved for planning imprecision).

Common CCAR/Stress Testing Challenges


29

Example Successful Quarterly Capital Planning Overview of Key Steps

Primary Functional Area(s)

Treasury Risk Analytics Credit

Risk Analytics Credit

Finance Treasury

Finance Treasury

Finance

Inputs Macroeconomic Data

Regional Market Data

Macroeconomic Forecast Report

Macroeconomic Forecasting Report

Loss Forecasting Assumptions Report

Macroeconomic Forecasting Report

Loss Forecasts, NPLs, and ALLL Analysis

Financial Projections Economic Capital Output

Results

Capital Plan Report Completed CCAR

Templates

Outputs Macroeconomic Forecast Report

Loss Forecasting Assumptions Report

Loss Forecasts, NPLs, and ALLL Analysis

Financial Projections (BS & Net Interest Income, & Non Interest Expense /Non Interest Revenue)

Capital Plan Report

n/a

Update Frequency

Monthly economic forecasting committee meeting

Quarterly assumption meeting

Quarterly run of all of the loss forecasting models based on the loss forecast assumptions and latest macroeconomic forecasts

Monthly forecast development

Monthly capital determination process

Capital Planning Working Group (monthly)

Capital Planning Investment Committee (quarterly)

Executive review (monthly)

Board review and approval (quarterly)

The example capital planning process below is organized across six key steps that require significant cross functional coordination in order to develop the CCAR submission in a timely manner. The Fed requires each step in the process to be documented and repeatable making it crucial that sustainable processes are in places for each step.

Risk Analytics Credit Finance Treasury Functional Area :

Example Quarterly Capital Planning Process

Monthly Quarterly Quarterly Monthly Monthly / Quarterly Monthly / Quarterly

Step 1: Develop

Macroeconomic View

Step 2: Review and

Confirm Loss Forecast

Assumptions

Step 3: Generate

Loss Forecasts

Step 4: Review Financial Assumptions & Develop and

Refine Financial Forecast

Step 5: Determine Capital

Levels

Step 6: Obtain Board

Approval


30

Model Governance and Validation Requirements

The new guidance (OCC 2011-12 and FRB SR Letter 11-07) was issued on April 4, 2011. Its main objective is to broaden the scope of the existing model risk management guidance (i.e. OCC Bulletin 2000-16) to include all key aspects of model risk management. This guidance applies to national banks, bank holding companies, state member banks, and all other institutions for which the OCC or Fed is the primary supervisor. “Previous guidance and other publications issued by the OCC and the Federal Reserve on the use of models pay particular attention to model validation … Rigorous model validation plays a critical role in model risk management; however, sound development, implementation, and use of models are also vital elements.” OCC 2011-12, pp. 2

Model Development

Developer Model Testing

Independent Model Validation

Model Implementation

and Usage

On-going Governance and

Control

The term “model” is broadly referred to as a quantitative approach, method, framework, or system that applies statistical, economic, financial, mathematical, or computational / numerical theories, techniques, and assumptions to process input data into quantitative estimates.

“Models are simplified representations of real-world relationships and dynamics among observed characteristics, values, and events.” By design, they are not perfect and are meant to operate in a very “specific” environment.

Model Cycle

The Capital Planning Process is heavily reliant on modeling assumptions and output.

Certain models may be used elsewhere – consistency and suitability for use must be evaluated.

Use of unvalidated models will conflict with the new guidance and increase risk.


31

KPMG – CCAR Projection Process

Inputs Loss Data Market Data Position Data Scenarios

Baseline and Stress Projections

Analytical processes Models

Preliminary Projections

Balance Sheet Income Stmt Capital

Sensitivity Analysis

Professional Judgment

Potential On-Top by Model/Process Owner

14A schedules Final Projections are populated in 14A schedules

and capital plan Sensitivity analysis included in capital plan

Return to ‘Inputs’ step

Outcome

Projection Process

Return to ‘Sensitivity Analysis’ step

Challenge/Review Process

Projections Challenged

Includes On-Top and Sensitivity Analysis

Challenge Results

Projection and Sensitivity Analysis Pass

2nd On Top for Projection, Sensitivity Analysis Pass

Projection Pass, Sensitivity Analysis Not Pass

Projection and Sensitivity Analysis Not Pass

Risk Analytics Treasury Financial Planning Functional areas involved in projection process: Lines of Business