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

  1. 1. Stress Testing and Capital Management in the World of Basel III and the Dodd-Frank Act February 20131 © 2013 Protiviti Inc. CONFIDENTIAL: This document is for your companys internal use only and may not be copied nor distributed to another third party.
  2. 2. 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 Compliance2 © 2013 Protiviti Inc. CONFIDENTIAL: This document is for your companys internal use only and may not be copied nor distributed to another third party.
  3. 3. I. Implications of Basel III for Bank Capital and Liquidity3 © 2013 Protiviti Inc. CONFIDENTIAL: This document is for your companys internal use only and may not be copied nor distributed to another third party.
  4. 4. Basel III Framework Designed to Bolster Capital and Liquidity Basel III Framework Strengthen Capital Framework Introduce a Global Liquidity Standard Re-define capital Build conservative capital buffer Build countercyclical buffer Liquidity Net stable Define and calculate the leverage ratio coverage ratio funding ratio Stress tests Scenario analysis4 © 2013 Protiviti Inc. CONFIDENTIAL: This document is for your companys internal use only and may not be copied nor distributed to another third party.
  5. 5. Implications for Bank Capital and Liquidity Key Change Implication • 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 Increased quality and quantity significant capital as common equity along with retention of profits and reduced of capital 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 • The introduction of the leverage ratio could lead to reduced lending and is expected to further motivate banks to strengthen their capital position Leverage ratio • Banks may be required by the market and rating agencies to maintain a higher leverage ratio than required by regulators • LCR would contribute to reducing the risk of a bank run, resulting in higher stability of the financial sector Liquidity coverage ratio (LCR) • The introduction of the LCR will require banks to hold significantly more liquid, low yielding assets which may negatively impact profitability • 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 Net stable funding ratio (NSFR) 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 assets5 © 2013 Protiviti Inc. CONFIDENTIAL: This document is for your companys internal use only and may not be copied nor distributed to another third party.
  6. 6. Introduces Capital Conservation Buffer and Countercyclical Buffer Capital Conservation Countercyclical Capital • The capital conservation buffer is aimed at • The countercyclical buffer aims to ensure ensuring that banks build up capital buffers that banking sector capital requirements outside periods of stress, which can be take account of the macro-financial drawn down as losses are incurred. environment in which banks operate. • A capital conservation buffer of 2.5%, • The level of buffer ranges between 0% comprised of Common Equity Tier 1, is and 2.5% of RWA and has to be met by established above the regulatory minimum Capital Common Equity Tier 1 capital. capital requirement. Buffers • The buffer would be applied when a • It will begin at 0.625% of RWAs and period of excess credit growth leading to increase each subsequent year by an the build up of system-wide risk is additional 0.625 percentage points. identified. • The capital conservation buffer would be • The countercyclical buffer regime will be phased in between 1 January 2016 and phased-in in parallel with the capital year end 2018, becoming fully effective on conservation buffer, becoming fully 1 January 2019. effective on 1 January 2019.6 © 2013 Protiviti Inc. CONFIDENTIAL: This document is for your companys internal use only and may not be copied nor distributed to another third party.
  7. 7. Introduces Two Minimum Standards for Funding Liquidity The 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. 1 Liquidity Coverage Ratio (LCR) 2 Net Stable Funding Ratio (NSFR) Promotes short-term resilience of a bank’s liquidity risk Promotes resilience over a longer time horizon by profile by ensuring that it has sufficient high-quality liquid requiring institutions to fund their activities with more assets to survive a significant stress scenario lasting for stable sources of funding on an ongoing basis. one month. Stock of high quality liquid assets Available amount of stable funding LCR = >=100% NSFR = >100% Total net liquidity outflows over the Required amount of stable funding next 30 days • The framework also defines ‘high quality’ liquid assets • Stable funding is the portion of those types and (HQLA), their characteristics. The definition of HQLA amounts of equity and liability financing expected to be was changed by the BIS in January 2013 to include reliable sources of funds over a one-year time horizon some Level 2B assets. under conditions of extended stress. • Total net liquidity outflows = Outflows – min (inflows, 75% of outflows)7 © 2013 Protiviti Inc. CONFIDENTIAL: This document is for your companys internal use only and may not be copied nor distributed to another third party.
  8. 8. 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. Tier 1 Capital Leverage Ratio = >= 3% Total Exposure 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 2017.8 © 2013 Protiviti Inc. CONFIDENTIAL: This document is for your companys internal use only and may not be copied nor distributed to another third party.
  9. 9. II. Dodd Frank Act (DFA) Stress Testing Requirements9 © 2013 Protiviti Inc. CONFIDENTIAL: This document is for your companys internal use only and may not be copied nor distributed to another third party.
  10. 10. 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.10 © 2013 Protiviti Inc. CONFIDENTIAL: This document is for your companys internal use only and may not be copied nor distributed to another third party.
  11. 11. 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 billion11 © 2013 Protiviti Inc. CONFIDENTIAL: This document is for your companys internal use only and may not be copied nor distributed to another third party.
  12. 12. Stress Testing must be Integrated and Forward-Looking Collect reliable data Credit Risk Impact Factor 1 Asset Credit Losses Stressed Factor 2 Market Risk Capital Impact Cash Planning Trading P/L flows Determine Factor 3 hypothetical Liquidity Risk Stressed or historical Liquidity Cash Liquidity Factor 4 Impact Earning scenarios Flow Gap Management Projection Factor 5 Funding Effects Operational Other Stressed Impact business ……. Losses Operational decisions Losses Reputational Factor N Impact Provide forward-looking model output Assess potential loss under exceptional environment12 © 2013 Protiviti Inc. CONFIDENTIAL: This document is for your companys internal use only and may not be copied nor distributed to another third party.
  13. 13. Stress Testing Models must be Supported by a Comprehensive Company-wide Model Risk Governance Structure 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. Board of Directors Bank Model Governance Committee The anchor of effective Internal challenge resides with Audit Model Owners and Model Validation Model Governance Model Validation Model Owners Model Users13 © 2013 Protiviti Inc. CONFIDENTIAL: This document is for your companys internal use only and may not be copied nor distributed to another third party.
  14. 14. Model Risk Governance: Three Lines of Defense Firms need three lines of defense to ensure the validity and accuracy of stress testing models. 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. 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. 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, SR13-01.14 © 2013 Protiviti Inc. CONFIDENTIAL: This document is for your companys internal use only and may not be copied nor distributed to another third party.
  15. 15. III. Challenges of Complying with Basel III and DFA Stress Testing Requirements15 © 2013 Protiviti Inc. CONFIDENTIAL: This document is for your companys internal use only and may not be copied nor distributed to another third party.
  16. 16. Challenges of Complying with Basel III Capital Requirements and DFA Stress Testing Requirements Key Challenge Description • Model Development and Validation • Implementation of the Stress Testing framework, especially for first-time participants, may require significant resources; Implementation Costs • Banks with inadequate ERM frameworks may have to depend on external advisors and consultants to comply • Cross-border Implementation • Incremental Internal Audit Costs • Ensuring adequate understanding of complex stress testing models by senior management and the Board of Directors, who are responsible for governing and Adequate Understanding and overseeing the stress testing process. Gaining Confidence • Lack of confidence in the stress testing framework has hindered senior management from making important decision based on the results; • 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; Integration to Risk Management • 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. • Data constraints • Consistency of risk modeling across both capital and stress testing models Model Framework • Model governance • Effective challenge16 © 2013 Protiviti Inc. CONFIDENTIAL: This document is for your companys internal use only and may not be copied nor distributed to another third party.
  17. 17. IV. Getting Value from Regulatory Compliance17 © 2013 Protiviti Inc. CONFIDENTIAL: This document is for your companys internal use only and may not be copied nor distributed to another third party.
  18. 18. Leverage Compliance to Enhance Risk Management Stress Testing Stress Testing Dodd-Frank Act Basel III Guideline Guideline Enterprise Risk Management Framework Infrastructure Process Integration Identify Risks Policies Integrate Processes Business Assess Risks Results Goals, Organization Objectives Key Planning Reporting and Processes Strategies Methodology Systems & Data Test and Prioritize Monitor Risks Risks Develop Action Plans Culture: Enabling Activities Become Part of the Company’s DNA18 © 2013 Protiviti Inc. CONFIDENTIAL: This document is for your companys internal use only and may not be copied nor distributed to another third party.
  19. 19. Move from Risk Control to Risk Management Debt holders and regulators Serving Two Masters Shareholders Capital Adequacy Capital Productivity Financial Strength Executives Risk Adjusted Return (Risk vs. Capital) (Risk vs. Reward) Capital Capital Expected Structure Management Return Risk Control Risk Optimization19 © 2013 Protiviti Inc. CONFIDENTIAL: This document is for your companys internal use only and may not be copied nor distributed to another third party.
  20. 20. 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 indicators E.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)20 © 2013 Protiviti Inc. CONFIDENTIAL: This document is for your companys internal use only and may not be copied nor distributed to another third party.
  21. 21. Contact Details Shaheen Dil Cory Gunderson Managing Director Managing Director Phone: +1 212-603-8378 Phone: +1 212-708-6313 shaheen.dil@protiviti.com cory.gunderson@protiviti.com New York, NY New York, NY Powerful Insights. Proven Delivery.® Powerful Insights. Proven Delivery.®21 © 2013 Protiviti Inc. CONFIDENTIAL: This document is for your companys internal use only and may not be copied nor distributed to another third party.
  22. 22. 22 © 2013 Protiviti Inc. CONFIDENTIAL: This document is for your companys internal use only and may not be copied nor distributed to another third party.

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