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International Association of Risk and Compliance
Professionals (IARCP)
1200 G Street NW Suite 800 Washington, DC 20005-6705 USA
Tel: 202-449-9750 www.risk-compliance-association.com
Top 10 risk and compliance management related news stories
and world events that (for better or for worse) shaped the
week's agenda, and what is next
Dear Member,
I am always interested in regulatory
arbitrage opportunities (as an
investor) and challenges (as a
consultant) between the banking and
the insurance sector.
Today we can see some very
important regulatory differences.
Insurance sector - Under Solvency II,
capital requirements are determined
on the basis of a 99.5% value-at-risk
measure over one year, meaning that enough capital must be held to cover
the market-consistent losses that may occur over the next year with a
confidence level of 99.5%, resulting from changes in market values of assets
held by insurers.
Banking sector - By contrast, under CRR/CRDIV (Basel III rules in the EU),
the risk measure is a 99% value-at-risk measure over 10 days for the trading
book, while risk weightings in the non-trading book capture credit risk, not
market-consistent price fluctuations.
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The different risk measures applied mean that the resultant capital charges
should in any event not be identical.
In contrast to the risk weights applicable to the banking book, the risk
factors in Solvency II do not translate directly into capital requirements.
Risk factors in Solvency II are applied as stress scenarios on asset values,
and the capital requirement is equal to the net impact on own funds, taking
into account the entire balance sheet.
Therefore, capital requirements in Solvency II depend on diversification
between different sources of risk and the loss-absorbing effect of
discretionary benefits and deferred taxes.
These combined effects can reduce the capital charge resulting from the
stress factors by about half.
Capital requirements in Solvency II depend on the liabilities of each
undertaking. The better the asset proceeds match the liabilities of an
undertaking in all the various stressed scenarios, the lower the final capital
charge will be.
Interesting differences…
In terms of implementation costs, the one-off net cost of implementing
Solvency II for the whole EU insurance industry has been assessed to be
around EUR 3 billion to EUR 4 billion.
Consultants love these numbers. The European Commission believes that
this cost is relatively small compared to the annual turnover of the sector
(around EUR 1.1 trillion of written premiums).
The European Commission also believes that over its 40 years of existence,
the 'Solvency I' regime showed structural weaknesses - I love the European
language – look what they mean:
“It was not risk-sensitive, and a number of key risks, including market,
credit and operational risks were either not captured at all in capital
requirements or were not properly taken into account in the
one-model-fits-all approach.”
Oh I see the structural weaknesses …
The Solvency II Directive (Directive 2009/138/EC), as amended by the
Omnibus II Directive (Directive 2014/51/EC) sets out the basic principles
of the regime.
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The Directive lays down many empowerments for the European
Commission to adopt delegated acts, and for the European Insurance and
Occupation Pensions Authority (EIOPA) to draft Regulatory Technical
Standards (RTS) and Implementing Technical Standards (ITS).
(Yes, it is a nightmare).
Read more at Number 2 below.
Welcome to the Top 10 list.
Best Regards,
George Lekatis
President of the IARCP
General Manager, Compliance LLC
1200 G Street NW Suite 800,
Washington DC 20005, USA
Tel: (202) 449-9750
Email: [email protected]
Web: www.risk-compliance-association.com
HQ: 1220 N. Market Street Suite 804,
Wilmington DE 19801, USA
Tel: (302) 342-8828
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45th Annual Meeting to Convene under Theme
“The New Global Context”, as World Faces
Critical Global Challenges
Over 2,500 participants from more than 140 countries representing
business, government, academia and civil society participate in the World
Economic Forum Annual Meeting 2015.
On the agenda are the key challenges of “The New Global Context”,
including economic growth and social inclusion, climate change and the
future of the internet, as well as the main current affairs topics.
Solvency II Overview – Frequently asked
questions
The Solvency II regime introduces for the first time
a harmonised, sound and robust prudential
framework for insurance firms in the EU.
It is based on the risk profile of each individual insurance company in order
to promote comparability, transparency and competitiveness.
Solvency II (Directive 2009/138/EC) - as amended by Directive
2014/51/EU ('Omnibus II') - replaces 14 existing directives commonly
known as 'Solvency I'.
BIS Working Papers No 480 - Trilemmas and
trade-offs: living with financial globalization
Maurice Obstfeld, comments by Otmar Issing and
Takatoshi Ito, Monetary and Economic Department
January 2015
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The rationale for discontinuing the
minimum exchange rate and
lowering interest rates
Introductory remarks by Mr Thomas Jordan, Chairman of the Governing
Board of the Swiss National Bank, at the press conference of the Swiss
National Bank, Zurich
“The Swiss National Bank (SNB) has decided to discontinue the minimum
exchange rate of CHF 1.20 per euro with immediate effect and to cease
foreign currency purchases associated with enforcing it.”
Comprehensive Capital Analysis and Review 2015
Summary Instructions and Guidance
Part A - Introduction
The Federal Reserve’s annual Comprehensive Capital Analysis and Review
(CCAR) is an intensive assessment of the capital adequacy of large, complex
U.S. bank holding companies (BHCs) and of the practices these BHCs use
to assess their capital needs.
The Federal Reserve expects these BHCs to have sufficient capital to
withstand a highly stressful operating environment and be able to continue
operations, maintain ready access to funding, meet obligations to creditors
and counterparties, and serve as credit intermediaries.
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Comprehensive Capital Analysis and Review 2015, Part B
Comprehensive Capital Analysis and Review 2015 - Part C
The rewards of an ethical culture
Remarks by Mr Thomas C Baxter, Executive Vice
President and General Counsel of the Federal Reserve
Bank of New York, at the Bank of England, London, 20
January 2015.
“At the New York Fed, we have made ethical culture a
priority for financial services.
We have done this not as a formal part of a supervisory
program, but more as a call for reform. In the short time that I have this
afternoon, I will speak about the reasons why I believe reform is necessary,
highlight some of the important practical features of a strong ethical
culture, and conclude by setting out a few of the rewards that might result
from it.”
Comments on the Fair and Effective
Markets Review
Speech by Mr Jerome H Powell, Member of the
Board of Governors of the Federal Reserve System,
at "Making Markets Fair and Effective for All",
sponsored by The Brookings Institution,
Washington DC, 20 January 2015.
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“Although London is perhaps the leading center for many fixed-income,
currency, and commodities (FICC) markets, these markets are global, and
the United States and the largest U.S. firms play key roles in them.”
An overview of the financial
landscape in Barbados
Speech by Dr DeLisle Worrell,
Governor of the Central Bank of
Barbados, at the Domestic Financial Institutions Conference, Bridgetown
“The main impact of the global recession on our financial system has been
to reduce profitability among commercial banks, and to arrest the growth of
insurance business.”
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45th Annual Meeting to Convene under Theme
“The New Global Context”, as World Faces
Critical Global Challenges
Over 2,500 participants from more than 140 countries representing
business, government, academia and civil society participate in the World
Economic Forum Annual Meeting 2015.
On the agenda are the key challenges of “The New Global Context”,
including economic growth and social inclusion, climate change and the
future of the internet, as well as the main current affairs topics.
Over 40 heads of state and government will be present, among which
François Hollande, Li Keqiang, and Angela Merkel.
This context consists of 10 global challenges affecting the world today:
1. Environment and resource scarcity
2. Employment skills and human capital
3. Gender parity
4. Long-term investing, infrastructure and development
5. Food security and agriculture
6. International trade and investment
7. Future of the internet
8. Global crime and anti-corruption
9. Social inclusion
10. Future of financial systems. Current affairs, such as the escalating
geopolitical conflicts, pandemics, diverging growth and the new
energy context are on the agenda as well.
“The World Economic Forum serves the international community as a
platform for public-private cooperation,” said Klaus Schwab, Founder and
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Executive Chairman of the World Economic Forum. “Such cooperation, to
address the challenges we all face, is more vital than ever before.
But it requires mutual trust. My hope is that the Annual Meeting serves as
the starting point for a renaissance of global trust.”
Ahmet Davutoğlu, Prime Minister of Turkey, Béji Caïd Essebsi, President
of Tunisia, François Hollande, President of France, Li Keqiang, Prime
Minister of the People’s Republic of China, Angela Merkel, Federal
Chancellor of Germany, John Kerry, US Secretary of State, Muhammad
Nawaz Sharif, Prime Minister of Pakistan, Matteo Renzi, Prime Minister of
Italy, Simonetta Sommaruga, President of the Swiss Confederation, and
Jacob Zuma, President of South Africa, will be among the key government
representatives present.
Participants also include more than 1,500 business leaders from the
Forum’s 1,000 Member companies, 300 public figures as well as recognized
leaders from other Forum communities, including Social Entrepreneurs,
Global Shapers, Young Global Leaders and Technology Pioneers.
Representatives from international organizations and civil society, as well
as religious leaders, cultural leaders, academia and the media will also
participate.
The full programme consists of over 280 sessions out of which over 100
sessions will be live webcast.
The themes include:
Crisis & Cooperation
Resolving geopolitical crises: With conflicts continuing to destabilize
Ukraine, the Middle East and other parts of the world, what can the
international community do to help bring about a lasting peace?
Registered participants include Abdel Fatah El Sisi, President of Egypt,
H.M. King Abdullah II Ibn Al Hussein, King of the Hashemite Kingdom of
Jordan, Haïdar Al Abadi, Prime Minister of Iraq, Masoud Barzani,
President of the Kurdistan Region, Iraq, Petro Poroshenko, President of
Ukraine.
Repercussions of climate change: As the world prepares for another round
of post-Kyoto climate negotiations, what are the chances for success at the
climate meeting in Paris?
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And how can the private sector contribute? Registered participants include
Christiana Figueres, Executive Secretary, United Nations Framework
Convention on Climate Change, Ollanta Moises Humala Tasso, President of
Peru, and Al Gore, Vice-President of the United States (1993-2001);
Chairman and Co-Founder, Generation Investment Management, USA
Pandemics and health: As the outbreak of Ebola has shown, combating the
spread of viruses is still a worldwide priority.
At the same time, non-communicable diseases such as diabetes are
becoming the world’s biggest silent killer.
What can the world do to ensure global health going forward?
Registered participants include Kofi Annan, Chairman, Kofi Annan
Foundation, Switzerland; Secretary-General, United Nations (1997-2006),
Margaret Chan, Director-General, World Health Organization (WHO),
Geneva, Alpha Condé, President of Guinea, Ibrahim Boubacar Keita,
President of the Republic of Mali, and Peter Piot, Director, London School
of Hygiene and Tropical Medicine; Executive Director, UNAIDS
(1994-2008).
Growth & Stability
Diverging growth and monetary policies: As expansionary monetary policy
in one part of the world comes to an end, central banks policies in other
parts of the world are further incentivizing the growth and employment,
with mixed results.
What will 2015 bring in terms of growth and monetary policies around the
world? Registered participants include Christine Lagarde, Managing
Director, International Monetary Fund (IMF), and the Governors of the
Central Banks of Brazil, Canada, England, France, Italy, Japan, Mexico and
Switzerland.
The new energy context: As energy prices are dropping to five-year lows,
what are the short- and long-term effects on the world?
What does it mean for growth in emerging economies and the impact on
climate change?
Registered participants include Khalid Al Falih, President and Chief
Executive Officer, Saudi Aramco, Mary Barra, Chief Executive Officer,
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General Motors Company, Abdalla Salem El Badri, Secretary-General,
Organization of the Petroleum Exporting Countries (OPEC), Emilio Lozoya,
Chief Executive Officer, Petroleos Mexicanos (PEMEX), and Patrick
Pouyanné, Chief Executive Officer and President of the Executive
Committee, Total, President and Chief Executive Officer.
Innovation & Industry
Future of technology: As technology expands to virtually all aspects of the
economy, how does it affect our lives?
What good can technology do for the world? And what is the right balance
between competition and innovation in the technology industry?
Registered participants include Jack Ma Yun, Executive Chairman, Alibaba
Group, Marissa Mayer, President and Chief Executive Officer, Yahoo, Satya
Nadella¸ Chief Executive Officer, Microsoft Corporation, Sheryl Sandberg,
Chief Operating Officer and Member of the Board, Facebook Inc., Eric
Schmidt, Executive Chairman, Google, USA, and Jimmy Wales, Founder
and Chair Emeritus, Board of Trustees, Wikimedia Foundation.
Society & Security
Income inequality and the development agenda: While many countries are
still struggling to reinvigorate growth, the discussion in other countries
revolves around the redistribution of wealth.
How can we incorporate the needs of developing nations, struggling
western economies, and the equality and parity questions?
Registered participants include Roberto Azevêdo, Director-General, World
Trade Organization (WTO), Bill Gates, Co-Chair, Bill & Melinda Gates
Foundation, Melinda Gates, Co-Chair, Bill & Melinda Gates Foundation,
Angel Gurría, Secretary-General, Organisation for Economic Co-Operation
and Development (OECD), Phumzile Mlambo-Ngcuka,
Undersecretary-General and Executive Director, United Nations Entity for
Gender Equality and the Empowerment of Women (UN WOMEN), and
Guy Ryder, Director-General, International Labour Organization (ILO).
The Co-Chairs of the Annual Meeting 2015 are: Hari S. Bhartia,
Co-Chairman and Founder, Jubilant Bhartia Group, India; Winnie
Byanyima, Executive Director, Oxfam International, United Kingdom;
Katherine Garrett-Cox , Chief Executive Officer and Chief Investment
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Officer, Alliance Trust, United Kingdom; Young Global Leader Alumnus;
Jim Yong Kim, President, The World Bank, Washington DC; Eric Schmidt,
Executive Chairman, Google, USA; and Roberto Egydio Setubal, Chief
Executive Officer and Vice-Chairman of the Board of Directors, Itaú
Unibanco, Brazil.
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Solvency II Overview – Frequently asked
questions
1. What is Solvency II?
The Solvency II regime introduces for the first time
a harmonised, sound and robust prudential framework for insurance firms
in the EU.
It is based on the risk profile of each individual insurance company in order
to promote comparability, transparency and competitiveness.
Solvency II (Directive 2009/138/EC) - as amended by Directive
2014/51/EU ('Omnibus II') - replaces 14 existing directives commonly
known as 'Solvency I'.
2. Why was Solvency II necessary?
Over its 40 years of existence, the 'Solvency I' regime showed structural
weaknesses.
It was not risk-sensitive, and a number of key risks, including market,
credit and operational risks were either not captured at all in capital
requirements or were not properly taken into account in the
one-model-fits-all approach.
This lack of risk sensitivity had the following consequences:

Owing to its simplistic model, Solvency I does not lead to an accurate
assessment of each insurer's risks;

It does not ensure accurate and timely intervention by supervisors;

It does not entail an optimal allocation of capital, i.e. an allocation which is
efficient in terms of risk and return for shareholders.
The Solvency II framework, like the Basel framework for banks, proposes to
remedy these shortcomings. It is divided into three 'pillars':
-
Pillar 1 sets out quantitative requirements, including the rules
to value assets and liabilities (in particular, technical
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provisions), to calculate capital requirements and to identify
eligible own funds to cover those requirements;
-
Pillar 2 sets out requirements for risk management,
governance, as well as the details of the supervisory process
with competent authorities; this will ensure that the regulatory
framework is combined with each undertaking's own
risk-management system and informs business decisions;
-
Pillar 3 addresses transparency, reporting to supervisory
authorities and disclosure to the public, thereby enhancing
market discipline and increasing comparability, leading to
more competition.
Capital requirements under Solvency II will be forward-looking and
economic, i.e. they will be tailored to the specific risks borne by each
insurer, allowing an optimal allocation of capital across the EU.
They will be defined along a two-step ladder, including the solvency capital
requirements (SCR) and the minimum capital requirements (MCR), in
order to trigger proportionate and timely supervisory intervention.
The new regime will also eliminate existing restrictions imposed by
Member States on the composition of insurers' investment portfolios.
Instead, insurers will be free to invest according to the 'prudent person
principle' and capital requirements will depend on the actual risk of
investments.
As for insurance groups, the same approach will be applied as for individual
insurers so that groups will be recognised and managed as economic
entities.
In capital requirements, diversification benefits will be recognised,
meaning that the total risks of a group are less than the sum of the risks of
its entities.
This will also contribute to a more efficient capital allocation for
shareholders.
The new regime will also promote greater cooperation between national
insurance supervisors that oversee the subsidiaries of any given group, with
a stronger role for the group supervisor.
The European Insurance and Occupational Pensions Authority (EIOPA) is
tasked with ensuring that the single rule book is applied consistently
throughout Europe.
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EIOPA also has mediating powers in case disagreements emerge between
national supervisory authorities when supervising cross-border groups.
3. What does the Delegated Act (implementing rules) add to the
Solvency II Directive?
The implementing rules contained in the delegated act which is due to enter
into force on the day following publication in the Official Journal, aim to set
out more detailed requirements for individual insurance undertakings as
well as for groups, based on the provisions set out in the Solvency II
Directive (see IP/14/1119).
They will make up the core of the single prudential rulebook for insurance
and reinsurance undertakings in the Union.
They are based on a total of 76 empowerments in the Solvency II Directive
and in particular cover the following areas:

rules for the market-consistent valuation of assets and liabilities, including
technical provisions; in particular, the rules set out technical details of the
so-called 'long-term guarantee measures' which were introduced by the
Omnibus II Directive to smooth out artificial volatility and ensure that
insurers can continue to provide long-term protection at an affordable
price;

rules for the eligibility of insurers' own fund items, covering capital
requirements to improve the risk sensitivity of the regime and allow timely
supervisory intervention;

the methodology and calibration of the Minimum Capital Requirement
(MCR) and of the standard formula for the calculation of the Solvency
Capital Requirement (SCR); this includes the calibration of market risks on
insurers' investments, taking into account the Commission’s long-term
financing agenda (see question 5);

for undertakings applying to use an internal model to calculate their SCR,
the implementing rules also specify standards that must be met as a
condition for authorisation;

the organisation of insurance and reinsurance undertakings' systems
of governance, in particular the role of the key functions defined in
the Directive (actuarial, risk management, compliance and internal
audit); the implementing rules also specify some aspects of the
supervisory review process and the elements to consider in deciding
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on an extension of the recovery period for undertakings that have
breached their SCR;

reporting and disclosure requirements, both to supervisors and to the
public; the increased comparability and harmonisation of
information is intended to improve the efficiency of supervision and
foster market discipline;

criteria for supervisory approval of the scope of the authorisation of
special purpose vehicles taking on reinsurance risk, and
requirements related to their operation;

rules related to insurance groups, such as the methods for calculating
the group solvency capital requirement, the operation of branches,
coordination within supervisory colleges, etc.; and

criteria to assess whether a solvency regime in a third country is
equivalent.
4. When will the new rules become applicable? Are there
transitional provisions?
The Solvency II Directive, along with the Omnibus II Directive
(see MEMO/13/992) that amended it, will have to be transposed by
Member States into national law before 31 March 2015.
On 1 April 2015, a number of early approval processes will start, such as the
approval process for insurers' internal models to calculate their Solvency
Capital Requirement.
The Solvency II regime will become fully applicable on 1 January 2016.
This timeline – in parallel with EIOPA's set of guidelines on preparing for
Solvency II – allows supervisors and undertakings to prepare for the
application of the new regime.
In addition, Solvency II includes a number of measures to ensure a smooth
transition from Solvency I, mostly:
 two measures on the valuation of technical provisions, helping the
transition to a market-consistent regime over 16 years;

tolerance for insurers breaching the Solvency Capital Requirement
within the first two years;

grandfathering of existing hybrid own-fund items that are eligible
under Solvency I, making it easier to meet the new capital
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requirements and giving the industry 10 years to adapt the
composition of its capital to Solvency II standards;

longer deadlines to report quarterly and annual information to
supervisors and to disclose reports to the public, decreasing
gradually from 20 weeks to 14 weeks after the close of the reporting
period over the first 3 financial years.
5. How do the implementing rules contribute to a proportionate
application of Solvency II, particularly for small and less complex
insurers?
The principle of proportionality is an integral part of the Solvency II regime,
meaning that a proportionate application of Solvency II should also apply
to small and less complex undertakings.
Solvency II will apply to almost all insurers and reinsurance undertakings
licensed in the EU.
Only the smallest undertakings (typically, undertakings that are not part of
a group and write less than EUR 5 million in premiums per year) will be
exempt from the new rules, although they may choose to apply them if they
wish.
Small insurance undertakings play an important role in the economic
environment and should not be subjected to unnecessary regulation.
Examples of proportionality lie mostly in the implementing measures
(delegated act) and include:

simplified methods for the calculation of technical provisions;

simplified methods for the calculation of the capital requirement;

asset-by-asset data is not required for collective investments; data
may be grouped under certain conditions;

exemptions are introduced from the use of International Financial
Reporting Standards (IFRS) in the valuation of assets and liabilities
for undertakings that do not already use IFRS for their financial
statements;

with respect to governance, key functions may be shared, including
the internal audit function, in certain circumstances;

with respect to reporting by smaller insurers:

quarterly reporting is of core data only;
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
supervisors can waive quarterly reporting partly or entirely, and
some of the annual reporting for smaller undertakings;

supervisors can decide to require narrative reporting only every three
years (though it would normally be annually).
6. What does Solvency II do to stimulate long-term investment by
insurers?
European insurers are the largest institutional investors in Europe’s
financial markets.
It is crucial that prudential regulation should not unduly restrain insurers’
appetite for long-term investments, while properly capturing the risks.
First, the capital requirements are designed to strongly incentivise insurers
to match the duration of assets and liabilities.
A perfect match in duration could reduce massively capital requirements.
Besides, on certain portfolios where cash-flows are matched and insurers
can hold fixed-income assets to maturity, they may use the 'matching
adjustment' which smoothes out artificial volatility on their balance sheet
and significantly reduces the capital requirement corresponding to the risk
of short-term spread fluctuations (see question 8).
Therefore, the design of the capital requirements will increase insurers'
appetite for long-term assets.
Second, Solvency II will repeal the investment limits imposed by Member
States regarding certain investments, in particular less liquid ones such as
infrastructure.
Instead, insurers will be free to invest according to the 'prudent person
principle' and capital requirements will depend on the actual risk of their
investments.
The standard formula for the calculation of market risk must be sufficiently
detailed to cater for different asset classes, featuring different risk profiles.
More tailored treatment of these assets has the added advantage of
increasing the risk-sensitivity of the capital requirements and thereby
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promoting good risk management and supporting the prudential
robustness of the overall regime.
The identification of a high-quality category of securitisation based on the
criteria set out in the European Insurance and Occupational Pensions
Authority (EIOPA)'s advice on high-quality securitisation from December
2013) is significant in this respect.
It will encourage insurers to invest in simpler securitisations, which are
more transparent and standardised, thereby reducing complexity and risk
and promoting sound securitisation markets which are needed in the EU
(see section below on securitisation).
Other specificities of the standard formula to stimulate long-term
investment by insurers include:

favourable treatment of certain types of investment fund that have
been created recently under EU legislation, such as European Social
Entrepreneurship Funds and European Venture Capital Funds.
(Note: the European Long-Term Investment Fund Regulation was
still under negotiation at the time of adoption of the Solvency II
delegated act. It was therefore legally impossible to cater explicitly
for ELTIF funds at the time of adoption of the implementing
measures);

similarly favourable treatment of investments in closed-ended,
unleveraged alternative investment funds, which captures in
particular other private equity funds and infrastructure funds other
than the European Funds mentioned above;

investment in infrastructure project bonds are treated as corporate
bonds, even when credit risk is tranched, instead of being treated as
securitisations. This is aligned with their treatment under banking
regulation (See recital (50) of Regulation (EU) No 575/2013 (the
Capital Requirements Regulation (EU) No 575/2013) on prudential
requirements for credit institutions and investment firms.);

several measures focused on unrated bonds and loans (targeting in
particular SMEs and infrastructure projects):

insurers investing in unrated bonds and loans can use proxy ratings
(e.g. using the rating of the issuer or of other debt instruments which
are part of the same or similar issuing programmes). The same
provisions exist in banking regulation (see article 139 of the Capital
Requirements Regulation (EU) No 575/2013) and help to reduce
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overreliance on ratings by avoiding punitive capital treatment for
unrated instruments;

where unrated debt instruments are guaranteed by collateral, the
risk-mitigating effect of the collateral on spread risk is recognised;

where debt instruments are fully guaranteed by multilateral
development banks, such as the European Investment Bank or the
European Investment Fund, they are exempted from any capital
requirement for spread and concentration risk, as is the case under
banking regulation (see articles 117 and 235 of the Capital
Requirements Regulation). The due diligence and credit
enhancement provided by these two European bodies considerably
reduce the risk of such investments.
7. What are the costs of implementing Solvency II?

In terms of implementation costs, the one-off net cost of
implementing Solvency II for the whole EU insurance industry has
been assessed to be around EUR 3 billion to EUR 4 billion, which is
relatively small compared to the annual turnover of the sector
(around EUR 1.1 trillion of written premiums).

In terms of capital requirements, taking into account the so-called
'long-term guarantees package' in the Omnibus II Directive, the
aggregate available surplus (free own funds above the capital
requirements of each insurer) is likely to be broadly identical to the
aggregate situation under Solvency I.
However, the distribution of capital requirements across
undertakings will reflect more accurately individual risks, leading to
a more efficient allocation of capital in the EU.
8. How is excessive volatility avoided in Solvency II?

Under Solvency II, insurers are incentivised to match cash-flows with
the long-term guarantees they offer using long-term assets available
in the market (see question 6).
This means they are less reliant on short-term price movements in
their assets, where these are unrelated to default.
It is therefore important to avoid artificial volatility in balance sheets,
i.e. volatility of technical provisions, capital resources or capital
requirements that does not reflect changes in the financial position or
risk exposure of the insurers.
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The so-called 'long-term guarantees' measures, introduced by Omnibus II,
will mitigate this artificial volatility by partially reflecting movements in
asset prices in the market-consistent valuation of the liabilities, thereby
reducing artificial balance sheet volatility.
By incorporating the long-term investment strategies of insurers in the
market-consistent valuation framework, the long-term ability of insurers to
meet their cash-flow needs is more accurately captured.
The measures contained in the package are essentially those proposed by
EIOPA in its long-term guarantee assessment report of June 2013, with
modifications to the detailed calibrations:

Volatility adjustment: a volatility adjustmentto the discount rates for
calculating technical provisions aiming to avoid pro-cyclical
investment behaviour of insurers when bond prices deteriorate
owing to low liquidity of bond markets or exceptional expansion of
credit spreads.
The adjustment has the effect of stabilising the capital resources of
insurers and will be calculated by EIOPA.

Matching adjustment: a matching adjustment will adjust the
discount rate applied in the valuation of predictable liabilities which
are cash-flow matched using fixed income assets.
The predictability of the portfolio means that matching assets can be
held to maturity and that the insurer is consequently not exposed to
price movements, only to the risk of default.
The matching adjustment is symmetrical – it can be positive in times
of high risk aversion in the markets and negative in times of low risk
aversion.

Extrapolation: Technical provisions are discounted with risk-free
interest rates. The rates are based on market observations.
For long maturities where no reliable market data are available the
risk-free interest rates need to be extrapolated.
The purpose of extrapolation is to ensure that the valuation of
technical provisions and the solvency postions of insurers are not
heavily distorted by strong fluctuations in the short-term interest
rate.

Two transitional measures: these allow insurers, over 16 years, to:
o calculate their technical provisions by using the Solvency I
discount rates, or
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o calculate technical provisions according to Solvency I rules.

The transitional measures will only apply to technical provisions for
insurance contracts concluded before the start of the Solvency II
regime.
The transitional measures are designed to phase out in a linear way
over the transitional period.
They are needed to smooth the transition to Solvency II for contracts
concluded under the previous solvency regime, which might
otherwise risk disturbing the insurance market.

Extension of the recovery period: in the event of exceptional adverse
situations, as determined by EIOPA, the supervisory authority may
extend the maximum recovery period in order to re-establish
compliance with the Solvency Capital Requirement.
Exceptional adverse situations include falls in financial markets,
persistently low interest rate environments and high-impact
catastrophic events.
The maximum extension is limited to 7 years.
The extension of the recovery period is an element of the so-called
'ladder of intervention' which provides for intensified intervention by
supervisors between the two levels of capital requirements – the
solvency capital requirements and (SCR) and the Minimum Capital
Requirement (MCR) – in order to ensure that corrective measures
are taken sufficiently early.
9. How do capital charges compare with those applicable to banks
under the Capital Requirements Regulation (CRR)/ Capital
Requirements Directive IV (CRDIV)?
It is important to ensure as much consistency as possible across the whole
financial sector to favour the development of a new and resilient investor
base while avoiding arbitrage opportunities.
First, it is desirable that definitions of asset classes are as consistent as
possible in different sectoral regulations.
For instance, the definition of simpler, more transparent securitisations in
Solvency II referred to in question 5 above is consistent with the definition
set out in the implementing rules on banks' Liquidity Coverage Ratio.
Second, it is desirable that relative capital requirements on different asset
classes are comparable across sectors, e.g. the relative ranking in terms of
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riskiness of equities versus corporate bonds should be as consistent as
possible.
However, a strict alignment of capital requirements in banks and insurance
would not be appropriate, as the risk measures are very different.
Indeed, a direct comparison of the capital calibrations for market and credit
risk is not meaningful for a number of reasons:

Under Solvency II, capital requirements are determined on the basis
of a 99.5% value-at-risk measure over one year, meaning that enough
capital must be held to cover the market-consistent losses that may
occur over the next year with a confidence level of 99.5%, resulting
from changes in market values of assets held by insurers.
By contrast, under CRR/CRDIV, the risk measure is a 99%
value-at-risk measure over 10 days for the trading book, while risk
weightings in the non-trading book capture credit risk, not
market-consistent price fluctuations. The different risk measures
applied mean that the resultant capital charges should in any event
not be identical.

In contrast to the risk weights applicable to the banking book, the
risk factors in Solvency II do not translate directly into capital
requirements.
Risk factors in Solvency II are applied as stress scenarios on asset
values, and the capital requirement is equal to the net impact on own
funds, taking into account the entire balance sheet.
Therefore:

capital requirements in Solvency II depend on diversification
between different sources of risk and the loss-absorbing effect of
discretionary benefits and deferred taxes.
These combined effects can reduce the capital charge resulting from
the stress factors by about half.

capital requirements in Solvency II depend on the liabilities of each
undertaking. The better the asset proceeds match the liabilities of an
undertaking in all the various stressed scenarios, the lower the final
capital charge will be.
An example of this is the interest rate stress, which is lowest when the
timing of future asset and liability cash-flows are matched and
remain matched under stress.
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11. How will Solvency II ensure that European insurers can
continue to be competitive abroad?
The Solvency II Directive includes equivalence provisions regarding third
countries.
When EU insurance groups calculate how their operations located in an
equivalent third country contribute to the group-wide Solvency Capital
Requirement, equivalence provisions allow them to use the third-country
local rules instead of Solvency II rules, under certain conditions.
The implementing rules flesh out certain criteria for equivalence and
elaborate on the choice of calculation methods for group solvency.
They ensure that future equivalence decisions by the Commission will bring
real benefits to EU insurance groups active abroad, maintaining a level
playing field with foreign competitors.
Any decision on the equivalence of specific third-country regimes would be
adopted later, in the form of further delegated acts, on the basis of detailed
analysis of third country regimes by EIOPA.
11. Will the Solvency II regime be reviewed?
The Omnibus II Directive includes a review clause (recital 60) inviting the
Comission to review the methods, assumptions and standard parameters
used when calculating the Solvency Capital Requirement (SCR) with the
standard formula within five years of application of the new regime (i.e. by
end 2021).
A recital in the delegated act brings this review forward to the end of 2018.
The review should make use of the experience gained in the first few years
of application of Solvency II.
Besides, the Directive (in Article 77f) mandates the Commission to report to
the co-legislators by the end of 2020 on the impact of the so-called
"long-term guarantees" package, in particular the functioning and stability
of European insurance markets; the extent to which insurance and
reinsurance undertakings continue to operate as long-term investors; and
the availability and pricing of long-term insurance products.
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12. What are the different pieces of legislation in the Solvency II
framework?
The Solvency II Directive (Directive 2009/138/EC), as amended by the
Omnibus II Directive (Direction 2014/51/EC) sets out the basic principles
of the regime.
The Directive lays down many empowerments for the Commission to adopt
delegated acts, and for the European Insurance and Occupation Pensions
Authority (EIOPA) to draft Regulatory Technical Standards (RTS) and
Implementing Technical Standards (ITS), in accordance with its founding
regulation (Regulation (EU) No 1094/2010).
However, the co-legislators have provided for a 'sunrise clause' whereby the
Commission is empowered, for two years following the entry into force of
Omnibus II, to adopt the Regulatory Technical Standards in accordance
with the procedure for the adoption of delegated acts, instead of the
procedure set out in the EIOPA founding Regulation (see Recital (16) of the
Omnibus II Directive and Article 308b).
Therefore, the main delegated act is based on a total of 76 empowerments
in the Solvency II Directive, including some which are in principle for
EIOPA to develop draft RTS but fall within the scope of the 'sunrise clause'.
Pursuant to Article 16 of its founding Regulation, EIOPA can also issue
guidelines with a view to establishing consistent, efficient and effective
supervisory practices, and to ensuring the common, uniform and consistent
application of EU law.
Such guidelines are addressed to supervisors and undertakings and are not
legally binding, but addressees not complying with them will have to
explain their reasons.
HIGH QUALITY SECURITISATION
13. What are the specific provisions in the Solvency II delegated
act?
Building on recommendations from the European Insurance and
Occupational Pensions Authority (EIOPA), the Commission delegated act
includes a detailed list of criteria to identify high-quality securitisation.
These criteria are mainly related to the structural features of transactions,
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i)
ii)
iii)
underlying assets’ characteristics,
transparency features and
underwriting processes.
Insurance undertakings investing in these instruments will be required to
hold less capital for market risk when they invest in securitisations that
feature a high degree of simplicity, transparency and credit quality.
This high-quality category would include the most senior tranches of
securitisations backed (under a "true sale" mechanism) by residential
mortgages, auto loans and leases, SME loans or consumer loans and credit
card receivables, but excluding re-securitisations and synthetic
securitisations.
Securitisation positions that meet the "high quality" requirements will
attract significantly lower capital requirements for insurers, compared to
other securitisation positions.
Their treatment under the standard formula follows a look-through
approach, whereby capital requirements on those positions cannot be
higher that capital requirements on the underlying securitised exposures if
they were held directly by insurers.
Securitised exposures would typically be treated as unrated loans,
attracting a 3%-per-year-of-duration stress in the standard formula.
Therefore, risk factors applicable to high-quality securitisation positions
are capped at 3%.
14. What is the prudential basis for the preferential treatment of
high-quality securitisations under Solvency II?
Only the most senior tranches may qualify for the favourable capital
treatment of high-quality securitisation positions.
These senior tranches provide credit enhancement, in other words, their
credit risk is lower than the credit risk in the entire pool of underlying
exposures.
It makes sense from an economic point of view that risk factors for
high-quality senior securitisation positions are no higher than those
applicable to the underlying securitised exposures if they were held directly
by insurers.
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15. What are the eligibility criteria in the Liquidity Coverage Ratio
(LCR) and Solvency II delegated acts?
The criteria to identify highly transparent, simple and sound securitisation
instruments set out in the Solvency II and LCR delegated acts are based on
recommendations from the European Insurance and Occupational
Pensions Authority (EIOPA) and a detailed analysis of the liquidity of
different instruments from the European Banking Authority (EBA).
In December 2013, the Commission received EIOPA's technical report on
the design and calibration of the Solvency II standard formula for certain
long-term investments.
This report proposed to single out high-quality securitisation and to apply a
differentiated prudential treatment to them.
In addition, the European Central Bank and the Bank of England supported
this differentiation objective in a joint statement released in April 2014 and
in a discussion paper published in May 2014.
The European Parliament, too, has expressed its support for the
development of high-quality securitisation instruments in its Resolution on
long-term financing.
The proposed criteria to identify high-quality securitisations do not include
any risk retention requirements (i.e. requirements that the originator,
sponsor or original lender should retain a material net economic interest in
the transaction).
This is because risk retention requirements are already implemented in EU
law and apply across the board, to all types of securitisation instruments
(whether high-quality or not) held by insurance undertakings and credit
institutions.
Most criteria on high-quality securitisation are common to the Solvency II
and LCR delegated acts.
However, as the purpose is different in each act – the Solvency II standard
formula concerns capital requirements, while the LCR delegated act
prescribes rules for the assets held by banks in their liquidity buffer – some
criteria are specific to the LCR delegated act, to ensure that high-quality
securitisation instruments are also highly liquid.
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15.1. General Requirements
15.1.1. Maximum seniority
The tranche must be the most senior in the securitisation transaction, and it
must remain so at all times, even after events that may impact the relative
seniority of tranches, such as the delivery of an enforcement or acceleration
notice.
This criterion ensures that the credit quality of the tranche is indeed
enhanced as compared to the credit quality of the entire pool of underlying
exposures.
Maximum seniority is among the more relevant features justifying a
prudential treatment that is aligned to the underlying exposures.
15.1.2. Homogeneous eligible underlying exposures
Homogeneity in the type of underlying exposures increases soundness,
simplicity and transparency (in particular, loan-level reporting is easier to
produce and interpret).
All underlying exposures must belong to only one of the following types:
Residential loans:
Securitisation positions may be backed by loans secured by a first-ranking
mortgage and/or by fully-guaranteed residential loans as referred to in
Article 129(1)(e) of the Capital Requirements Regulation.
In both cases, the pool of loans must feature on average a loan-to-value
ratio lower than or equal to 80%.
In the case of mortgage loans only, it is possible to derogate from this
loan-to-value requirement, provided that instead, the national law of the
Member State where the loans are originated provides for a maximum
loan-to-income ratio not higher than 45%, and each loan in the pool
complies with this limit.
The relevant national law must be communicated to the Commission, and
EBA and/or EIOPA.
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Loans, leases and credit facilities to undertakings, in particular
SMEs:
Securitisation positions may be backed by commercial loans, leases and
credit facilities to undertakings to finance capital expenditures or business
operations other than the acquisition or development of commercial real
estate, provided that at least 80% of the borrowers in the pool in terms of
amount are small and medium-sized enterprises at the time of issuance of
the securitisation.
Auto loans or leases:
Securitisation positions may be backed by loans or leases for the financing
of a broad range of vehicles. Such loans or leases may include ancillary
insurance and service products or additional vehicle parts, and in the case
of leases, the residual value of leased vehicles.
All loans and leases in the pool shall be secured with a first-ranking charge
or security over the vehicle or an appropriate guarantee in favour of the
securitisation special purpose vehicle.
Consumer loans and credit card receivables:
Securitisation positions may be backed by loans and credit facilities to
individuals for personal, family or household consumption purposes.
As a consequence of this closed list of eligible underlying exposures,
commercial mortgage backed securities (CMBS) and collateralised debt
obligations (CDOs) are excluded.
This is justified given their poorer performance, as shown in EIOPA's
advice and other studies of CMBS.
No re-securitisations, no synthetic securitisations
Re-securitisations are explicitly excluded, as they are typically complex and
less transparent structures, where the cascading of investor losses is very
difficult to understand due to re-tranching.
The same goes for synthetic securitisations, where the underlying
exposures are not transferred to the special purpose vehicle.
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Instead, the transfer of risk is achieved by the use of credit derivatives or
guarantees, while the exposures being securitised remain with the
originator.
The transfer of the assets to be securitised ensures that securitisation
investors have recourse to those assets should the Securitisation Special
Purpose Entity (SSPE) not fulfil its payment obligations.
Such recourse cannot be granted in synthetic transactions, due to the fact
that only the credit risk associated with the underlying assets, rather than
the ownership of such assets, is transferred to the SSPE.
Such a structure also adds counterparty risk on derivatives or guarantees,
and hampers investors' rights to the proceeds of the underlying exposures.
In addition, most synthetic structures add to the complexity of the
securitisation in terms of risk modelling.
15.1.3. Restricted use of derivatives and transferable financial
instruments
Derivatives can only be used for hedging currency and interest rate risk.
This also excludes the synthetic securitisations described in the above
paragraph.
The pool of underlying exposures must not include transferable financial
instruments (this effectively means CDOs are excluded), except financial
instruments issued by the securitisation special purpose entity itself, in
order to accommodate master trust structures.
15.1.4. 'True sale' and absence of severe 'claw back' provisions
The transfer of the underlying exposures to the securitisation special
purpose vehicle must be sufficiently certain from a legal point of view:

the transfer must be enforceable against any third party and the
underlying exposures be beyond the reach of the seller (originator,
sponsor or original lender) and its creditors, including in the event of
the seller's insolvency ('true sale' requirement);

the transfer of the underlying exposures to the SSPE may not be
subject to any severe clawback provisions in the jurisdiction where
the seller is incorporated because such provisions induce legal
insecurity on investors' rights.
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15.1.5. Continuity provisions for the replacement of servicers,
derivative counterparties and liquidity providers
The underlying exposures must have their administration governed by a
servicing agreement which includes servicing continuity provisions to
ensure, at a minimum, that a default or insolvency of the servicer does not
result in a termination of servicing.
Where applicable, the documentation governing the securitisation must
also include continuity provisions to ensure, at a minimum, the
replacement of derivative counterparties and liquidity providers upon their
default or insolvency.
The aim of these two criteria is to mitigate credit risk with different
counterparties involved in the securitisation transaction, whose default or
insolvency could jeopardise the smooth running of the transaction.
15.1.6. Absence of credit-impaired obligors
At the time of issuance of the securitisation or when incorporated in the
pool of underlying exposures at any time after issuance, the underlying
exposures must not include exposures to credit-impaired obligors (or where
applicable, credit-impaired guarantors).
The definition of credit-impaired obligors or guarantors is both
backward-looking (e.g. the obligor has declared bankruptcy, or has recently
agreed with his creditors to a debt dismissal or reschedule, or is on an
official registry of persons with adverse credit history) and forward-looking
(e.g. the obligor has a credit assessment by an external credit assessment
institution or has a credit score indicating a significant risk that
contractually agreed payments will not be made compared to the average
obligor for this type of loans in the relevant jurisdiction).
This criterion effectively excludes 'sub-prime' loans from the high-quality
securitisation category.
15.1.7. Absence of loans in default
At the time of issuance of the securitisation or when incorporated in the
pool of underlying exposures at any time after issuance, the underlying
exposures must not include exposures in default, as defined in the banking
prudential rules in Article 175 of Regulation (EU) No 575/2013.
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This criterion ensures that the securitisation does not contain loans or
leases already in default when the securitisation transaction begins or when
new exposures are transferred to the SSPE.
15.1.8. Reliance on the future sale of assets securing the
exposures
The repayment of the securitisation position must not be structured to
depend predominantly on the sale of assets securing the underlying
exposures; however, this shall not prevent such exposures from being
subsequently rolled over or refinanced.
The point of this criterion is to exclude transactions where the ability of the
SSPE to repay the securitisation notes is subject to an unacceptable level of
risk, due to overreliance on the proceeds of the sale of assets securing the
underlying exposures such as used cars when an auto lease securitisation
transaction matures.
While recognising that auto lease securitisations including residual values
may be eligible as high quality (see paragraph 15.1.2), the repayment of
those securitisations should not rely predominantly on the future
realisation of those residual values.
15.1.9. Pass-through requirement for non-revolving structures
Cash proceeds from the underlying exposures should flow in a simple and
transparent way to investors.
Structures where a significant amount of cash is retained within the SSPE
(for example, securitisations with bullet payments) would not comply with
this pass-through profile and, therefore, are excluded.
15.1.10. Early amortisation provisions for revolving structures
Where the securitisation has been set up with a revolving period, the
transaction documentation provides for appropriate early amortisation
events, which shall include at a minimum all of the following:

a deterioration in the credit quality of the underlying exposures;

a failure to generate sufficient new underlying exposures of at least
similar credit quality;
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
the occurrence of an insolvency-related event with regard to the
originator or the servicer.
High-quality securitisations should ensure that, in the presence of a
revolving period mechanism, investors are sufficiently protected from the
risk that principal amounts may not be fully repaid.
Sufficient protection should be ensured by the inclusion of provisions which
trigger amortisation of all payments at the occurrence of adverse events
such as those mentioned in the criterion.
15.1.11. At least one payment at the time of issuance
At the time of issuance of the securitisation, the borrowers (or, where
applicable, the guarantors) must have made at least one payment.
This is intended to exclude securitisation backed by newly-originated loans.
However, this requirement would not be proportionate in practice for the
securitisation of credit card receivables.
Hence there is a derogation for this type of securitisation.
15.1.12. Absence of self-certified loans
In the case of securitisations backed by residential loans, the pool of loans
must not include any loan that was marketed and underwritten on the
premise that the loan applicant or, where applicable, intermediaries, were
made aware that the information provided might not be verified by the
lender.
This requirement is essential to exclude loans where the applicant and,
where applicable, intermediaries, might be incentivised to misrepresent
essential information, e.g. to overstate their income.
This criterion also helps exclude 'sub-prime' lending.
15.1.13. Assessment of retail borrowers' creditworthiness
In the case of securitisations where the underlying exposures are residential
loans, auto loans or leases, consumer loans or credit facilities, the
creditworthiness of the borrowers must be assessed thoroughly, in
accordance with the Mortgage Credit Directive (Directive 2014/17/EU) or
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the Consumer Credit Directive (Directive 2008/48/EC) or equivalent rules
in third countries, where applicable.
This requirement effectively excludes flawed securitisation business
models, relying on unsound underwriting practices.
15.1.14. Transparency and disclosure of loan-level data
Where either the originator or sponsor of a securitisation is established in
the Union, they must comply with transparency requirements set out in the
Capital Requirement Regulation.
Furthermore, in accordance with Article 8b of Regulation (EU) No
1060/2009, the European Securities and Markets Authority (ESMA) will in
2017 set up a website centralising the publication of information regarding
structured finance instruments, i.e. securitisations.
Through this website, the issuer, originator or sponsor of the securitisation
will be able to publish information on the credit quality and performance of
the underlying assets of the structured finance instrument, the structure of
the securitisation transaction, the cash flows and any collateral supporting
a securitisation exposure as well as any information that is necessary for
investors to conduct comprehensive and well-informed stress tests on the
cash flows and collateral values supporting the underlying exposures.
Where neither the issuer, nor the originator, nor the sponsor of a
securitisation is established in the Union, comprehensive loan-level data in
compliance with standards generally accepted by market participants must
be made available to existing and potential investors and regulators at
issuance and on a regular basis.
15.1.15. Listing requirement
Both the Solvency II and LCR delegated acts require that high-quality
securitisation positions should be listed on a regulated market/recognised
exchange, or admitted to trading on another organised venue, with a robust
market infrastructure.
The drafting of this criterion could not be strictly aligned in the two acts
because of legal constraints stemming from differences in the
corresponding 'level 1' legislation.
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In addition, under the LCR delegated act, securitisation positions may be
deemed highly liquid if they are tradable on generally accepted repurchase
markets. This was not included in the Solvency II delegated act as
repurchase transactions to generate liquidity are not typical for insurers.
15.1.16. Credit quality
Both the Solvency II and LCR delegated acts require that high-quality
securitisation positions receive a minimum external credit assessment, on
issuance and at any time thereafter.
The minimum external credit assessment is one of the elements for
high-quality securitisation positions and does not constitute sole and
mechanistic reliance, in accordance with the principles of the Financial
Stability Board for reducing reliance on CRA ratings.
In Solvency II, the position should be investment grade, i.e. be assigned to
credit quality step 3 at least.
In order to ensure that the securitisation position is highly liquid, the LCR
delegated act requires that it is assigned to credit quality step 1.
The mappings of external credit assessments onto the respective scales of
credit quality steps applicable in banking and insurance legislation is
prepared by the Joint Committee of the European Supervisory Authorities.
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BIS Working Papers No 480
Trilemmas and trade-offs: living with financial
globalization
Maurice Obstfeld, comments by Otmar Issing and
Takatoshi Ito, Monetary and Economic Department
January 2015
This paper evaluates the capacity of emerging market economies
(EMEs) to moderate the domestic impact of global financial and monetary
forces through their own monetary policies.
I present a case that those EMEs that are able to exploit a flexible exchange
rate are far better positioned than those that devote monetary policy to
fixing the rate – a reflection of the classical monetary policy trilemma.
Indeed, this ability was critically important in EMEs’ widely successful
response to the global financial crisis (GFC) of 2007–09.
However, exchange rate changes alone do not insulate
economies from foreign financial and monetary developments.
While potentially a potent source of economic benefits, financial
globalisation does have a downside for economic management.
It worsens the trade-offs monetary policy faces in navigating
among multiple domestic objectives.
This drawback of globalisation raises the marginal value of
additional tools of macroeconomic and financial policy.
Unfortunately, the availability of such tools is constrained by a
financial policy trilemma that is distinct from the monetary
trilemma.
This second trilemma posits the incompatibility of national
responsibility for financial policy, international financial
integration and financial stability.
Therefore, national prudential policies cannot be effective when
capital markets are open to cross-border transactions.
My argument that independent monetary policy is feasible for
financially open EMEs, but limited in what it can achieve, takes
a middle ground between more extreme positions in the debate
about monetary independence in open economies.
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On one side, Woodford (2010, p 14) concludes: “I find it difficult
to construct scenarios under which globalization would interfere
in any substantial way with the ability of domestic monetary
policy to maintain control over the dynamics of inflation.”
His pre-GFC analysis, however, leaves aside financial market
imperfections and views inflation targeting as the only objective
of monetary control.
On the other side, Rey (2013) argues that the monetary
trilemma is really a dilemma, because EMEs can exercise no
monetary autonomy from US policy (or the global financial
cycle) unless they impose capital controls.
The outline of this paper is as follows.
First, I present an overview of the capital flow problem for
EMEs.
Then, I review mechanisms through which monetary policies
and the financial cycle in advanced economies, especially in the
United States, are transmitted to EMEs.
One potent mechanism works through interest rate linkages,
but financial conditions can also migrate through other
channels.
Thus, there is a global financial cycle that does not coincide with
global monetary policy shifts (Borio (2012), Bruno and Shin
(2013), Rey (2013)), and exchange rate changes alone do not
fully offset its effects.
The next section sets out empirical evidence on interest rate
independence in EMEs, adding to the existing literature by
analysing long-term interest rates.
The results leave no doubt that countries that do not peg their
exchange rates exercise considerable monetary autonomy at the
short end of the term structure, but long-term interest rates are
more highly correlated across countries irrespective of the
exchange rate regime.
In the penultimate section, I describe the relationship between policy
trilemmas and trade-offs in open economies.
I present my argument that the fundamental problem for open EMEs is not
ineffective monetary policy per se.
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The problem is a more difficult trade-off among multiple objectives, the
result of a shortage of reliable policy instruments for attaining those
objectives simultaneously.
A brief final section outlines future research directions and also describes
how some limited initiatives in international policy cooperation might
soften the harsh trade-offs thatEMEs now face.
To read more:
http://www.bis.org/publ/work480.pdf
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The rationale for discontinuing the
minimum exchange rate and
lowering interest rates
Introductory remarks by Mr Thomas
Jordan, Chairman of the Governing Board of the Swiss National Bank, at
the press conference of the Swiss National Bank, Zurich
Ladies and gentlemen
Thank you for once again accepting our invitation to this press conference
at such short notice.
Let me begin by explaining the rationale for discontinuing the minimum
exchange rate and lowering interest rates.
Afterwards, I shall be happy to answer your questions.
Discontinuation of the minimum exchange rate
The Swiss National Bank (SNB) has decided to discontinue the minimum
exchange rate of CHF 1.20 per euro with immediate effect and to cease
foreign currency purchases associated with enforcing it.
The minimum exchange rate was introduced during a period of exceptional
overvaluation of the Swiss franc and an extremely high level of uncertainty
on the financial markets.
This exceptional and temporary measure protected the Swiss economy
from serious harm.
While the Swiss franc is still high, the overvaluation has decreased as a
whole since the introduction of the minimum exchange rate.
The economy was able to take advantage of this phase to adjust to the new
situation.
Recently, divergences between the monetary policies of the major currency
areas have increased significantly - a trend that is likely to become even
more pronounced.
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The euro has depreciated substantially against the US dollar and this, in
turn, has caused the Swiss franc to weaken against the US dollar.
In these circumstances, the SNB has concluded that enforcing and
maintaining the minimum exchange rate for the Swiss franc against the
euro is no longer justified.
Interest rate lowered
At the same time as discontinuing the minimum exchange rate, the SNB
will be lowering the interest rate for balances held on sight deposit accounts
to -0.75% from 22 January.
The exemption thresholds remain unchanged.
Further lowering the interest rate makes Swiss-franc investments
considerably less attractive and will mitigate the effects of the decision to
discontinue the minimum exchange rate.
The target range for the three-month Libor is being lowered by 0.5
percentage points to between -1.25% and -0.25%.
Outlook for inflation and the economy
The inflation outlook for Switzerland is low.
In December we presented a conditional inflation forecast, which predicts
inflation of -0.1% for this year.
Since this forecast was published, the oil price has once again fallen
significantly, which will further dampen the inflation outlook for a time.
However, lower oil prices will stimulate growth globally, and this will
influence economic developments in Switzerland positively.
Swiss franc exchange rate movements also impact inflation and the
economic situation.
The SNB remains committed to its mandate of ensuring medium-term
price stability while taking account of economic developments.
In concluding, let me emphasise that the SNB will continue to take account
of the exchange rate situation in formulating its monetary policy in future.
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If necessary, it will therefore remain active in the foreign exchange market
to influence monetary conditions.
Thank you very much for your attention. I will now be happy to answer your
questions.
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Comprehensive Capital Analysis and Review
2015
Summary Instructions and Guidance
Part A - Introduction
The Federal Reserve’s annual Comprehensive Capital Analysis and Review
(CCAR) is an intensive assessment of the capital adequacy of large, complex
U.S. bank holding companies (BHCs) and of the practices these BHCs use
to assess their capital needs.
The Federal Reserve expects these BHCs to have sufficient capital to
withstand a highly stressful operating environment and be able to continue
operations, maintain ready access to funding, meet obligations to creditors
and counterparties, and serve as credit intermediaries.
About This Publication
These instructions set forth guidance and expectations for the stress testing
and capital planning cycle that begins on October 1, 2014, and the related
CCAR exercise (CCAR 2015).
Similar to the instructions in previous years, the instructions for CCAR
2015 provide information regarding the
• logistics for a BHC’s capital plan submissions;
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• expectations regarding the mandatory elements of a capital plan;
• qualitative assessment of a BHC’s capital plan;
• quantitative assessment of a BHC’s post-stress capital adequacy;
• response to capital plans and planned actions;
• limited adjustments a BHC may make to its planned capital distributions;
• planned supervisory disclosures at the end of the CCAR exercise; and
• common themes from CCAR 2014.
New Elements in CCAR 2015
The CCAR 2015 instructions include some new elements to enhance the
CCAR program, mainly in order to provide further guidance on supervisory
expectations around BHCs’ capital adequacy process and capital plan
submissions.
Specifically, they include:
• Supervisory expectations for reviews of BHCs’ regulatory reporting: A
BHC is expected to have a strong internal control framework that helps
govern its internal capital planning processes, including stress testing
performed under the CCAR program, and that framework should include
comprehensive documentation of the BHC’s policies and procedures.
To ensure that the BHC’s processes are sufficiently robust, the Federal
Reserve has requested each BHC make documentation available through
the supervisory process that outlines the BHC’s procedures used to ensure
the accuracy of the regulatory reports affecting CCAR, including the FR
Y-9C and FR Y-14.
This documentation should include any identified weaknesses in the BHC’s
internal controls around regulatory reporting and any plans to enhance the
control structure around regulatory reporting. (See “Data Supporting a
Capital Plan Submission” on page 9.)
• Organization of the capital plan submission: The instructions provide
examples of formats that BHCs may use to organize their capital plan
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submission to help ensure that the submission contains all required
information and to facilitate review by the Federal Reserve.
• Model inventory and risk-identification program documentation:
Pursuant to the recent revisions to the capital plan rule (capital plan rule
amendment), BHCs must provide a comprehensive inventory of the models
used in their capital plan projections.
The instructions clarify that the list of models should be organized around
the FR Y-14A line items.
In addition, a BHC is expected to provide documentation outlining the risk
identification process the BHC uses to support the BHC-wide stress testing
required in the capital plans.
• Incorporation of amendments to the capital plan and stress test rules: The
instructions provide additional details about how BHCs should implement
the capital plan rule amendment, including
(1) information on the transition to the new timeline for submitting capital
plans beginning in CCAR 2016;
(2) clarification of how BHCs that are subsidiaries of foreign banking
organizations should incorporate compliance with the intermediate holding
company rule2 into their capital plan projections;
(3) discussion of the evaluation of planned capital actions in the
“outquarters” of the planning horizon—projected 2016:Q3 and 2016:Q4 in
CCAR 2015 ; and
(4) the requirement that BHCs do not exceed the capital distributions
included in their capital plans on a gross or net basis.
Overview of CCAR Process
In November 2011, the Board of Governors of the Federal Reserve System
(Board) adopted the capital plan rule, which requires BHCs with
consolidated assets of $50 billion or more to submit annual capital plans to
the Federal Reserve for review.
Under the rule, a BHC’s capital plan must include detailed descriptions of
the BHC’s internal processes for assessing capital adequacy; the policies
governing capital actions; and the BHC’s planned capital actions over a
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nine-quarter planning horizon.
Further, a BHC must also report to the Federal Reserve the results of stress
tests conducted by the BHC under scenarios provided by the Federal
Reserve and under a stress scenario designed by the BHC (BHC stress
scenario).
These stress tests assess the sources and uses of capital under baseline and
stressed economic and financial market conditions.
Before a BHC submits its capital plan to the Federal Reserve, the capital
plan must be approved by the BHC’s board of directors, or a committee
thereof.
For CCAR 2015, capital plans should be submitted to the Federal Reserve
by no later than January 5, 2015.
Under the capital plan rule, the Federal Reserve assesses the overall
financial condition, risk profile, and capital adequacy on a forward-looking
basis and also assesses the strength of the BHC’s capital adequacy process,
including its capital policy (qualitative assessment).
In particular, the Federal Reserve seeks to ensure that large BHCs have
thorough and robust processes for managing their capital resources, and
that the processes are supported by effective firm-wide risk-identification,
risk-measurement, and risk-management practices.
The Federal Reserve expects that a BHC’s capital planning adequately
accounts for the potential for stressful outcomes and is supported by strong
internal control practices and close and effective oversight by the board of
directors and senior management.
The Federal Reserve’s quantitative assessment of capital plans is based on
supervisory and company run stress tests, conducted in part under the
Board’s rules implementing sections 165(i)(1) and (2) of the Dodd-Frank
Wall Street Reform and Consumer Protection Act (Dodd-Frank Act stress
test rules).
The supervisory review of a BHC’s capital plan includes an assessment of
the BHC’s ability to maintain capital levels above each minimum regulatory
capital ratio and above a tier 1 common ratio of 5 percent, after making all
capital actions included in their capital plans, under baseline and stressful
conditions throughout the nine-quarter planning horizon.
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Both quantitative and qualitative supervisory assessments are key inputs to
the Federal Reserve’s decision to object or not object to a BHC’s capital
plan.
The decisions for all 31 BHCs participating in CCAR 2015, including the
reasons for any objections to BHC capital plans will be published on or
before March 31, 2015.
In addition, the Federal Reserve will separately publish the results of its
supervisory stress test under both the supervisory severely adverse and
adverse scenarios.
Correspondence Related to CCAR
All questions from BHCs and communications from the Federal Reserve
concerning CCAR are handled through the secure CCAR Communications
mailbox.
BHCs will receive program updates via e-mail from the CCAR
Communications mailbox.
These updates include notifications about CCAR industry conference calls
hosted by the Federal Reserve and responses to frequently asked questions
(FAQ) submitted by participating BHCs about the CCAR process and
instructions.
The CCAR Communications mailbox serves as a BHC’s primary point of
contact for specific questions about the capital plan and stress test rule
requirements.
If a BHC seeks clarifications on CCAR and Dodd-Frank Act stress test
program elements, the BHC should submit its questions to the mailbox.
All questions and responses, other than BHC-specific questions, will be
made available to all CCAR BHCs through an FAQ document on a regular
basis.
BHC-specific questions will receive a direct response.
If needed, meetings may be scheduled to discuss submitted questions in
more detail; however, only those responses that come through the secure
mailbox will be considered official.
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Instructions for Submission of Capital Plans
Mandatory Elements of a Capital Plan
As noted earlier, a BHC must submit its capital plan and supporting
documentation to the Federal Reserve by January 5, 2015.
The capital plan rule specifies the four mandatory elements of a capital
plan:
1. An assessment of the expected uses and sources of capital over the
planning horizon that reflects the BHC’s size, complexity, risk profile, and
scope of operations, assuming both expected and stressful conditions,
including
a. Estimates of projected revenues, losses, reserves, and pro forma capital
levels—including any regulatory capital ratios (e.g., tier 1 leverage, common
equity tier 1 capital, tier 1 risk-based capital, and total risk-based capital
ratios) and any additional capital measures deemed relevant by the
BHC—over the planning horizon under baseline conditions and under a
range of stressed scenarios;these must include any scenarios provided by
the Federal Reserve and at least one stress scenario developed by the BHC
appropriate to its business model and portfolios.
b. The calculation of pro forma tier 1 common ratio over the planning
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horizon under baseline conditions and under a range of stressed scenarios,
inclusive of a discussion of how the company will maintain all minimum
regulatory capital ratios and a pro forma tier 1 common ratio above 5
percent under expected conditions and the stressed scenarios required.
c. A discussion of the results of the stress tests required by law or
regulation, and an explanation of how the capital plan takes these
results into account.
d. A description of all planned capital actions over the planning horizon.
2. A detailed description of the BHC’s process for assessing capital
adequacy.
3. A BHC’s capital policy.
4. A discussion of any baseline changes to the BHC’s business plan that are
likely to have a material impact on the BHC’s capital adequacy or liquidity.
In addition to these mandatory elements, the Federal Reserve also requires
a BHC to submit supporting information necessary to facilitate review of
the BHC’s capital plans under the Board’s capital plan rule and in
accordance with the FR Y-14 instructions.
The capital plan elements described in the CCAR 2015 instructions do not
replace the elements BHCs are required to provide in connection with the
FR Y-14, including appendix A to the FR Y-14A describing supporting
documentation.
The mandatory elements, particularly the first element, overlap with some
of the supporting documentation requirements.
Some information submitted by BHCs may satisfy both the capital plan rule
and the FR Y-14 requirements.
Organizing Capital Plan Submissions
The capital plan and any supporting information, including certain FR Y-14
schedules, must be submitted to the Federal Reserve through a secure
collaboration site.
In response to previous requests from BHCs for guidance on how to
organize a capital plan when submitting it via the collaboration site, the
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Federal Reserve is providing in this year’s instructions a suggested outline
for submissions.
The sections below provide greater detail regarding the suggested outline
for both the capital plan narrative and supporting documentation, as well
as define the submission components and map them to the mandatory
elements in the capital plan rule and the FR Y-14A instructions.
When submitting materials to the secure collaboration site, BHCs will be
able to categorize each component in order to ensure that supervisors can
easily identify and review relevant documentation.
Table 2 shows the categorization system that may be used for submissions
to the secure collaboration site.
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Capital Plan Narrative
This section outlines a potential organizational structure for a BHC’s capital
plan narrative.
• Capital plan: Provides a summary of the BHC’s capital plan and the pro
forma financial results under the different scenarios evaluated as part of
the capital adequacy process.
The document should summarize the BHC’s proposed capital actions, the
various scenarios, the key risks and drivers of financial performance under
each scenario, key assumptions, any process weaknesses or other
uncertainties that could affect results, and any mitigating controls.
The document should also summarize how certain risks that are not
captured in the stress scenario analysis are addressed in the capital
adequacy process.
• Capital policy: Provides the BHC’s standalone, written policy outlining the
principles and guidelines used for capital planning, capital issuance,
usage, and distributions (mandatory element 3).
• Planned capital actions: Provides
(1) a description of all planned capital actions over the planning horizon
and
(2) a summary of all capital actions by instrument in each quarter of the
nine-quarter planning horizon, which should align with the capitalactions
included in the FR Y-14A Summary and Regulatory Capital Instruments
schedules (mandatory element 1(d)).
• Capital adequacy process: Provides a detailed description of the BHC’s
process for assessing capital adequacy, including all assumptions,
limitations, weaknesses, and uncertainties that could potentially have a
material impact on consolidated results (mandatory element 2).
• Risk-identification program overview: Describes the risk-identification
process the BHC uses to support the BHC-wide stress testing required in
the capital plans and how and where these risks are captured in the BHC’s
capital adequacy process.
• BHC scenario design process overview: Describes the BHC’s process and
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approach to developing the BHC baseline and stress scenarios, including all
methodologies, variables, and key assumptions and how the BHC stress
scenarios address the BHC’s particular vulnerabilities.
• Material business plan changes: Provides a discussion of any expected
changes to the BHC’s business plan that are likely to have a material impact
on the BHC’s capital adequacy and funding profile (e.g., a proposed merger
or divestiture, changes in key business strategies, or significant
investments) (mandatory element 4).
• Summary of assumptions, limitations, and weaknesses: Describes all
assumptions, limitations, weaknesses, and uncertainties that could
potentially have a material impact on consolidated results or material loss
or revenue estimates.
• Governance framework: Describes internal governance around the
development of the BHC’s comprehensive capital plan.
Documentation should demonstrate that senior management has provided
the board of directors with sufficient information to facilitate the board’s
understanding of the stress testing used by the firm for capital planning
purposes.
• Summary of audit findings: Provides a summary of the most recent
findings and conclusions from a review of the BHC’s capital adequacy
process carried out by internal audit or an independent party.
In the discussion, the BHC should describe the scope of the audit work and
specifically identify any areas of the end-to-end capital adequacy process
that have not been independently reviewed by a third party.
If the BHC chooses to organize its capital plan narrative in the format set
forth above, the capital plan narrative elements may be submitted as one
large file, as individual files, or as several files that combine various
elements.
When uploading these documents to the secure collaboration site, a BHC
should follow these instructions:
1. For submission type, categorize all documents as “Capital plan narrative.”
2. For submission subtype, please choose the appropriate category from the
list below based on the descriptions above.
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• Submission subtype categories:
(1) Complete narrative,
(2) Capital plan,
(3) Capital policy,
(4) Planned capital actions,
(5) Capital adequacy process,
(6) Risk-identification program overview,
(7) BHC scenario design process overview,
(8)Material business plan changes,
(9) Assumptions – limitations – weaknesses,
(10) Governance framework,
(11) Summary of audit findings, and
(12) Other
• If the entire capital plan narrative (i.e., all elements above) is in one file,
please choose “Complete narrative.”
• If combining some of the elements above into one file, please choose
“Other” and provide a description of the document in the “Other – define”
field.
• If documentation does not fit one of the defined elements above, please
choose “Other” and provide a description of the document in the “Other –
define” field.
Capital Plan and FR Y-14A
Supporting Documentation
This section outlines a potential organizational structure for the required
documentation that each BHC must submit through the collaboration site
to support described below should be organized by the following topics:
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retail, wholesale, fair value option and held for sale loans, securities,
trading, counterparty,operational risk, pre-provision net revenue (PPNR),
mortgage-servicing rights (MSR), and regulatory capital transitions.
This supporting documentation also addresses mandatory element 1 under
the capital plan rule.
• Policies and procedures: All policies and procedures related to the capital
adequacy process, including the BHC’s model risk-management policy.
• Methodology and model inventory mapping to FR Y-14A: Provides an
inventory of all models and methodologies used to estimate losses,
revenues, expenses, balances, and risk-weighted assets (RWAs) and the
status of validation/independent review for each.
As required by the FR Y-14A instructions, documentation should also
include mapping that clearly conveys the methodology used for each FR
Y-14A product line under each stress scenario.
• Methodology documentation: Methodology documentation should
include, at a minimum, the following documents:
—Methodology and process overview: Describes key methodologies and
assumptions for performing stress testing on the BHC’s portfolios,
business, and exposures.
Documentation should clearly describe the model-development process,
the derivation of outcomes, validation procedures, and key assumptions.
Supporting documentation should clearly describe any known model
weaknesses and how such information is factored into the capital plan.
—Model technical documents: Includes thorough documentation of key
methodologies and assumptions for performing stress testing.
The documentation should include the design, theory, and logic underlying
the methodology and any available empirical support.
—Model validation: Includes model validation documentation on the
following elements: conceptual soundness, model robustness and
limitations, use of qualitative adjustments or other expert judgment,
exception reports, and outcomes analysis.
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In past CCAR exercises, many BHCs have provided audit reports and
documentation on results finalization and the challenge process as part of
their capital plan submissions.
BHCs submitting documentation similar to that described below should
use the following categories.
• Audit reports: Includes audit reports from a BHC’s audit of the capital
adequacy process, including reviews of the models and methodologies used
in the process.
• Results finalization and challenge materials: Provides any documentation
relating to the review, challenge, and aggregation processes and the
finalization of results used in a BHC’s capital planning processes to ensure
transparency and repeatability.
Data Supporting a Capital Plan
Submission
In conducting its assessment of a BHC’s capital plan, the Federal Reserve
relies on the completeness and accuracy of information provided by the
BHC.
As such, the BHC’s internal controls around data integrity are critical to the
Federal Reserve’s ability to conduct CCAR.
The Federal Reserve notes that CCAR BHCs are currently subject to
requirements relating to the accuracy of the “Capital Assessments and
Stress Testing” (FR Y-14A) and “Consolidated Financial Statements for
Holding Companies” (FR Y-9C) reporting forms.
Further, in Capital Planning at Large Bank Holding Companies:
Supervisory Expectations and Current Range of Practice, the Federal
Reserve clarifies that a BHC should have a strong internal control
framework that helps govern its internal capital planning processes,
including stress testing performed under the CCAR program, and that
framework should include comprehensive documentation of the BHC’s
policies and procedures.
A BHC is expected to have documentation outlining its procedures for
meeting the accuracy requirements of these reporting forms and its
evaluation of the results of such procedures.
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As a best practice, these procedures would take into consideration the
points in the data compilation and regulatory reporting systems and
processes where a material misstatement could occur, as well as controls in
place to mitigate those risks.
In addition, a BHC should have information about any identified
weaknesses in its controls around regulatory reporting and any plans to
enhance the control structure around regulatory reporting.
Stress Tests Conducted by BHCs
As noted previously, for the purposes of CCAR, each BHC is required to
submit the results of its stress tests based on three supervisory scenarios, at
least one stress scenario developed by the BHC, and a BHC baseline
scenario.
Specifically, a BHC must conduct its stress test for purposes of CCAR using
the following five scenarios:
• Supervisory baseline: a baseline scenario provided by the Board under the
Dodd-Frank Act stress test rules
• Supervisory adverse: an adverse scenario provided by the Board under the
Dodd-Frank Act stress test rules
• Supervisory severely adverse: a severely adverse scenario provided by the
Board under the Dodd- Frank Act stress test rules
• BHC baseline: a BHC defined baseline scenario
• BHC stress: at least one BHC defined stress scenario
A BHC’s estimates of its projected revenues, losses, reserves, and pro forma
capital levels must use data as of September 30, 2014; begin in the fourth
quarter of 2014; and conclude at the end of the fourth quarter of 2016.
The only exception to this planning horizon is with respect to the
Regulatory Capital Transitions schedule submission required under the FR
Y-14A.
The FR Y-14A Regulatory Capital Transitions schedule should be reported
as of September 30, 2014, with projections through December 31, 2019,
under the supervisory baseline scenario.
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In conducting its stress tests, a BHC must reflect the revised capital
framework that the Board adopted in connection with implementation of
the Basel III accord (revised regulatory capital framework), including the
framework’s minimum regulatory capital ratios and transition
arrangements, with one exception: a BHC that is subject to advanced
approaches and has exited parallel run is not required to incorporate the
advanced approach for calculating RWAs in CCAR 2015.
A BHC’s stress tests must also reflect the BHC’s tier 1 common ratio for
each quarter of the planning horizon.
Supervisory Scenarios
The supervisory scenarios in CCAR are also used in the Dodd-Frank Act
stress tests.
Under the Board’s Dodd-Frank Act stress test rules, the Board is required to
provide BHCs with a description of the supervisory macroeconomic
scenarios no later than November 15 of each calendar year.
This year, the Federal Reserve intends to provide the supervisory scenarios,
including the macroeconomic scenarios and the global market shock, as
soon as it is possible to incorporate the relevant data on economic and
financial conditions as of the end of the third quarter, but no later than
November 15, 2014.
It is important to note that the scenarios provided by the Federal Reserve
are not forecasts, but rather are hypothetical scenarios to be used to assess
the strength and resilience of BHC capital in baseline and stressed
economic and financial market environments.
While supervisory scenarios are generally applied to all BHCs that are part
of CCAR, the Federal Reserve can apply additional scenarios or scenario
components to a subset of BHCs.
One component, a global market shock, will be applied to six BHCs with
large trading operations in CCAR 2015, as required under the Dodd-Frank
Act stress test rules.
In addition, the Federal Reserve expects to require certain BHCs to apply a
closely related scenario component focusing on the default of a large
counterparty.
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Global Market Shock
BHCs with large trading operations will be required to include the global
market shock as part of their supervisory adverse and severely adverse
scenarios, and to conduct a stress test of their trading books, private-equity
positions, and counterparty exposures.
The global market shock will be applied to BHCs’ trading book and
private-equity positions, as of a point in time, resulting in instantaneous
loss and reduction of capital.
The as-of date for the global market shock is October 6, 2014.
The global market shock is an add-on component that is exogenous to the
macroeconomic and financial market environment specified in the
supervisory stress scenarios, and as a result, losses from the global market
shock should be viewed as an addition to the estimates of PPNR and losses
under the macroeconomic scenario.
BHCs should not assume a related decline in portfolio positions or RWAs
due to losses from the global market shock except in the case noted below.
If a BHC can demonstrate that its loss-estimation methodology stresses
identical positions under both the global market shock and the macro
scenario, the BHC may assume that the combined losses from such
positions do not exceed losses resulting from the higher of either the losses
stemming from the global market shock or those estimated under the
macro scenario.
However, the full effect of the global market shock must be taken through
net income in the first quarter of the planning horizon, which will include
the as-of date for the shock.
If a BHC makes any adjustment to account for identical positions, the BHC
must provide documentation demonstrating that the losses generated
under the macro scenario are on identical positions to those subject to the
global market shock, break out each of the adjustments as a separate
component of PPNR, and describe the rationale behind any such
adjustments.
Counterparty Default Scenario Component
Eight BHCs with substantial trading or custodial operations will be
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required to incorporate a counterparty default scenario component into
their supervisory adverse and severely adverse stress scenarios.
Like the global market shock, this component will only be applied to the
largest and most complex BHCs, in line with the Federal Reserve’s higher
expectations for those BHCs relative to the other BHCs participating in
CCAR.
In connection with the counterparty default scenario component, these
BHCs will be required to estimate and report the potential losses and
related effects on capital associated with the instantaneous and unexpected
default of the counterparty that would generate the largest losses across
their derivatives and securities financing activities, including securities
lending and repurchase or reverse repurchase agreement activities.
Each BHC’s largest counterparty will be determined by net stressed losses,
estimated by revaluing exposures and collateral using the global market
shock.
The as-of date for the counterparty default scenario component is October
6, 2014—the same date as the global market shock.
Similar to the global market shock, the counterparty default scenario
component is an add-on component to the macroeconomic and financial
market scenarios specified in the Board’s supervisory adverse and severely
adverse scenarios, and therefore, losses associated with this component
should be viewed as an addition to the estimates of PPNR and losses under
the macroeconomic scenario (see the description of global market shock).
BHC Scenarios
A central goal of the capital plan rule is to ensure that large BHCs have
robust internal practices and policies to determine the appropriate amount
and composition of their capital, given the BHC’s risk exposures and
corporate strategies and in line with supervisory expectations and
regulatory standards.
To gain a deeper understanding of a BHC’s unique vulnerabilities, the
capital plan rule requires each large BHC to design its own stress scenario
that is appropriate to the BHC’s business model and portfolios.
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For purposes of CCAR, each BHC will be required to submit the results of
its stress tests based on at least one stress scenario developed by the BHC,
and a BHC baseline scenario.
The BHC baseline scenario should reflect the BHC’s view of the expected
path of the economy over the planning horizon.
A BHC may use the same baseline scenario as the supervisory baseline
scenario if that BHC believes the supervisory baseline scenario
appropriately represents its view of the most likely outlook for the risk
factors salient to the BHC.
The BHC stress scenario must reflect the specific vulnerabilities of BHC’s
risk profile and operations, including those related to the company’s capital
adequacy and financial condition.
Specifically, the BHC stress scenario should be designed to significantly
stress factors that affect firm-wide material risk exposures and activities in
a coherent and consistent manner, including potential exposures from both
on- and off-balance sheet positions.
In addition, the forward-looking analysis required in the BHC stress
scenario should be relevant to and reflect the direction and strategy of the
firm as set by the BHC’s board of directors.
The BHC stress scenario should be designed to capture potential risks
stemming from a BHC’s idiosyncratic positions and activities and should be
severe enough to result in a substantial negative effect on capital.
A BHC should develop a BHC scenario of severity generally comparable to
the usual severity in the Board’s supervisory severely adverse scenario.
A BHC should demonstrate that the combined effect of its BHC stress
scenario on net income and other elements that affect capital results (i.e.,
other comprehensive income) in a BHC stress scenario are of severity
comparable to the severely adverse scenario.
A BHC stress scenario that produced regulatory capital and tier 1 common
capital ratios that were lower than those produced in company-run stress
tests under the Board’s severely adverse scenario, but that does not reflect
the BHC’s idiosyncratic positions and activities, would not be an
appropriate BHC stress scenario.
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Capital Action Assumptions
BHCs must incorporate assumptions about capital actions over the
planning horizon into their company-run stress tests.
The types of capital actions that BHCs must incorporate into their
projections under various scenarios are defined as follows:
• Planned capital actions: a BHC’s planned capital actions under the BHC
baseline scenario
• Alternative capital actions: a BHC’s assumed capital actions under the
BHC stress scenario
• Dodd-Frank Act stress test capital actions: capital action assumptions as
required under the Dodd-Frank Act stress test rules
Planned Capital Actions
As part of the CCAR capital plan submission, for all scenarios except the
BHC stress scenario, BHCs should calculate post-stress capital ratios using
their planned capital actions over the planning horizon under the BHC
baseline scenario.
With respect to the planned capital actions under theBHC baseline
scenario:
• For the initial quarter of the planning horizon, the BHC must take into
account the actual capital actions taken during that quarter.
• For the second quarter of the planning horizon (i.e., the first quarter of
2015), a BHC that received a non-objection to its 2014 capital plan should
include capital distributions consistent with those included in its 2014
capital plan.
If a BHC received an objection to its 2014 capital plan, its capital
distributions for the second quarter should be consistent with those
approved by the Federal Reserve for that quarter.
• For each of the third through ninth quarters of the planning horizon, the
BHC must include any capital actions proposed in its capital plan.
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The Federal Reserve will also conduct its post-stress capital analysis using
the BHC’s planned capital actions proposed in the BHC baseline scenario.
Alternative Capital Actions
In calculating post-stress capital ratios under the BHC stress scenario, a
BHC should use the capital actions it would expect to take if the stress
scenario were realized.
These alternative capital actions should be consistent with the BHC’s
established capital policy.
Dodd-Frank Act Stress Test
Capital Action Assumptions
For stressed projections under the Dodd-Frank Act stress test rule, a BHC
must use the following assumptions regarding its capital actions over the
planning horizon for the supervisory baseline scenario, the supervisory
adverse scenario, and the supervisory severely adverse scenario:
• For the first quarter of the planning horizon, the BHC must take into
account its actual capital actions taken throughout the quarter.
• For each of the second through ninth quarters of the planning horizon, the
BHC must include in the projections of capital
—common stock dividends equal to the quarterly average dollar amount of
common stock dividends that the company paid in the previous year (that
is, the first quarter of the planning horizon and the preceding three
calendar quarters);
—payments on any other instrument that is eligible for inclusion in the
numerator of a regulatory capital ratio equal to the stated dividend,
interest, or principal due on such instrument during the quarter;
—an assumption of no redemption or repurchase of any capital instrument
that is eligible for inclusion in the numerator of a regulatory capital
ratio; and
—an assumption of no issuances of common stock or preferred stock,
except for issuances related to expensed employee compensation.
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FR Y-14A Summary Schedule
Capital Worksheets
BHCs must complete capital worksheets on the FR Y-14A Summary
Schedule to report their projections of capital components, RWAs, and
capital ratios under each of the five scenarios.
With respect to a BHC’s projections under the supervisory scenarios, the
BHC must calculate two sets of pro forma capital ratios and complete
(1) the CCAR capital worksheet using the BHC’s planned capital
actions in the BHC baseline scenario, and
(2) the DFAST capital worksheet using the prescribed capital actions under
the Dodd-Frank Act stress test rule.
For the BHC-defined scenarios, a BHC should include only the CCAR
capital worksheet, and include projections using the BHC’s expected capital
actions as deemed appropriate by the BHC for that scenario and in
accordance with the BHC’s capital policy.
Table 3 illustrates the capital actions used for each scenario’s FR Y-14A
schedule.
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Supervisory Expectations for a Capital Adequacy Process
The description of a BHC’s process for assessing capital adequacy is an
important component of the BHC’s capital plan.
As discussed in supervisory guidance, a BHC’s capital adequacy process
should have as its foundation a full understanding of the risks arising from
its exposures and business activities, as well as stress testing analysis, to
ensure that it holds sufficient capital corresponding to those risks to
maintain operations across the planning horizon.
The detailed description of a company’s capital adequacy process should
include a discussion of how, under stressful conditions, the BHC will
maintain capital commensurate with its risks—above the minimum
regulatory capital ratios and the BHC’s internal capital goals—and serve as
a source of strength to its depository institution subsidiaries.
The full range of supervisory expectations, including governance and
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oversight expectations to complement the capital adequacy process aspects
mentioned above, are summarized in figure 1, “Seven principles of an
effective capital adequacy process.”
The remainder of this section provides additional detail on these elements.
BHCs should also refer to existing guidance for further information about
supervisory expectations for a BHC’s capital adequacy process, including
Capital Planning at Large Bank Holding Companies: Supervisory
Expectations and Current Range of Practice and the common themes
observed across BHCs that were provided with the CCAR 2014 feedback
letters.
Estimates of Projected Revenues, Losses, Reserves, and Pro
Forma Capital Levels
For the purposes of CCAR, each BHC is to submit its capital plan supported
by its internal capital adequacy process and include post-stress results
under various scenarios.
The Federal Reserve will be assessing the processes and practices each BHC
has in place to carry out this analysis, including the riskidentification,
risk-measurement, and riskmanagement practices supporting its analyses,
as well as the governance and internal controls around these practices.
A BHC should demonstrate that its results are consistent with the
environments specified in the scenarios being used, and that the various
components of its results are internally consistent.
For example, it would be generally inconsistent to project a shrinking
balance sheet or declining RWAs while also projectinglarge increases in net
income in a stress or baseline environment.
Hypothetical behavioral responses by BHC management should not be
considered as mitigating factors for the purposes of this analysis.
For example, hedges already in place should be accounted for as potential
mitigating factors, but not assumptions about potential future hedging
activities.
A BHC should clearly identify and document any aspects of its portfolios
and exposures that are not adequately captured in the FR Y-14 schedules
and that it believes are material to loss estimates for its portfolios, and
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explain the reason why the FR Y-14 is not accurately capturing such
exposures.
The BHC should also fully describe its estimate of the potential impact of
such items on financial performance and loss estimates under the baseline
and stress scenarios.
Some examples may include portfolios with contractual loss-mitigation
arrangements or contingent risks from intraday exposures.
Another example is pipeline risk associated with loan syndication,
securitization, or other activities that are particularly sensitive to market
conditions (such as loans to low-quality borrowers, including high-yield
corporate bonds and leveraged loans) and that may become more acute
during the period of stress.
In this context, pipeline risk should encompass more than just losses on
loans already in the pipeline at the start of the exercise and include the
possibility that the pipeline may grow during stress.
A BHC’s projections should reflect expectations of customer drawdowns on
unused credit commitments under each scenario.
The BHC should also consider in its projections the potential effect of any
assets and exposures that might be taken back on the balance sheet or
otherwise generate losses under stressful economic conditions (e.g., assets
held in asset-backed commercial paper conduits and other off-balance
sheet funding vehicles to which the BHC provides support).
Similarly, the BHC should consider unconsolidated entities to which the
BHC has potential exposure in its projections.
If non-contractual support may be provided during a stressful environment
for certain obligations or exposures of sponsored or third-party entities,
these should be included in a BHC’s analysis of contingent or potential
obligations, and all associated impacts should be captured.
A BHC’s projections must take into account all material risks to the BHC
regardless of whether those risks are explicitly covered by the information
requested in the FR Y-14 schedules.
The BHC is responsible for identifying all potential material sources of
losses from on{ and off{balance sheet positions in its post-stress
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projections, as well as any other events that have the potential to materially
affect capital in both baseline and stressful environments.
The Federal Reserve’s evaluation of a BHC’s capital plan will focus on
whether the BHC has an adequate process for identifying the full range of
relevant risks, given the BHC’s exposures and business mix, and whether
the BHC appropriately assesses the impact of those risks on the BHC’s
financial results and capital.
A BHC should incorporate and document any pertinent details that would
affect the production of its estimates.
Importantly, the BHC should discuss assumptions around accounting
treatment, anticipated changes in asset values or changes in customer
behavior, model or management overlays, and application of expert
judgment to provide support for the reasonableness of estimated losses.
Sensitivity analysis: Having an understanding of the sensitivity of
post-stress financial estimates to the various inputs and assumptions
developed to support the forecasting process is an important aspect of
developing sound estimates of projected losses, revenues, reserves, and
capital levels.
Sensitivity analysis is an important tool that tests the robustness of models
and enhances reporting for BHC management, the board of directors, and
the Federal Reserve.
BHCs should use sensitivity analysis to understand the range of potential
estimates based on changes to inputs and key assumptions as well as the
uncertainties associated with those estimates.
Examples of key assumptions that should be subject to sensitivity analysis
include projected market share, size of the mortgage market, cost and flow
of deposits, utilization rate of credit lines, discount rates, or level and
composition of trading assets.
Management should have a full understanding of key sensitivities in
estimates and highlight those to the board so that the board understands
the sensitivity of capital to alternative inputs and assumptions and can
make informed capital decisions.
Model risk management: For all models used in internal capital planning,
BHCs should follow existing supervisory expectations regarding model risk
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management, in particular the “Supervisory Guidance on Model
RiskManagement.”
Such expectations cover:
(1) model development, implementation, and use;
(2) independent review and validation; and
(3) model governance.
As part of validation, BHCs should conduct conceptual soundness reviews,
ongoing monitoring (including benchmarking), and outcomes analysis.
The Federal Reserve recognizes that BHCs may be challenged in conducting
full outcomes analysis for some of their stress test models,
given the lack of realized outcomes against which to test.
In such cases, BHCs should use sensitivity analysis, additional benchmarks,
or other means to help assess model performance.
They may also need to apply compensating controls to account for
additional model uncertainty that exists in such instances.
It is critical that BHCs assess the vulnerability of their models to error,
understand any other limitations, and consider the risk to the BHC should
estimates based on those models prove materially inaccurate.
All models should be evaluated for their intended use.
While use of existing risk-measurement models and processes for
producing stress loss estimates may be acceptable, BHCs should consider
whether these models and processes generate outputs that are relevant in
stressful conditions.
Use of such models may need to be supplemented with other data elements
and alternative methodologies.
BHCs may use expert judgment, such as management overlays to modeled
outputs, to compensate for model limitations, such as data limitations or
material changes in a BHC’s business.
When using such judgment-based approaches, as with any estimation
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methodology, BHCs should have a transparent, repeatable, well-supported
process that generates credible estimates that are consistent with assumed
scenario conditions.
Any model overrides or overlays— including those based solely on expert
judgment— should also be subject to oversight and review by an internal
validation group or other independent reviewers, with the recognition that
the work done to evaluate overlays to model output may be different than
the validation work to evaluate and test the model and model output.
BHCs should also ensure that any vendor or other third-party models are
used in accordance with expectations for model risk management.
Finally, the intensity and frequency of model risk management activities
should be a function of model materiality.
Loss Estimation
Loans held in accrual portfolios: Estimated losses on loans held in accrual
portfolios are generally credit losses due to failure to pay obligations (cash
flow losses), rather than discounts related to mark-to-market (MTM)
values.
In some cases, BHCs may have loans that are being held for sale or which
are subject to purchase-accounting adjustments.
In these cases, the analysis should anticipate the change in value of the
underlying asset, apply the appropriate accounting treatment, and
determine the incremental losses.
Fair value loans: BHCs may have loans that are held for sale or held for
investment, for which they have adopted fair value accounting (collectively,
fair value loans).
Losses on fair value loans should reflect both expected changes in fair value
of the loan and any losses that may result from an obligor default under a
given scenario.
BHCs should clearly document the method and key assumptions used to
compute losses on fair value loans.
Losses on available-for-sale (AFS) and held-to maturity (HTM) securities:
BHCs should provide projected other-than-temporary impairments (OTTI)
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for AFS and HTM securities.
OTTI projections should be based on September 30, 2014, positions and
should be consistent with specified macroeconomic assumptions and
standard accounting treatment.
If the BHC bifurcates credit losses from other losses, the method for
deriving the bifurcation should be provided in supporting documentation.
Trading and counterparty losses: Any BHC with material trading and
counterparty exposures should calculate potential losses from those
exposures under its BHC stress scenario.
The BHC should ensure that projected losses are consistent with the market
environment assumed in its stress scenario and clearly document the
method and key assumptions supporting the loss estimate.
There is no expectation that a BHC should use approaches similar to the
global market shock or counterparty default scenario components of the
supervisory stress scenarios to capture market or counterparty risk in its
internally constructed BHC stress scenario.
Allowance for loan losses: BHCs should estimate the portion of the current
allowance for loan losses available to absorb credit losses on the loan
portfolio for each quarter under each scenario while maintaining an
adequate allowance along the scenario path and at the end of the planning
horizon.
Loan-loss reserve adequacy should be assessed against the size,
composition, and risk characteristics of the loan portfolio projected over the
planning horizon under a given scenario in a manner that is consistent with
the BHC’s projections of losses in that scenario.
Pre-Provision Net Revenue Estimation
In general, BHCs are required to demonstrate that the approach used to
generate PPNR estimates is consistent with the economic and financial
environment specified in the relevant scenario.
BHCs must ensure that PPNR projections are explicitly based on,and
directly tied to, balance sheet and other exposure assumptions used for
related loss estimates.
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In addition, BHCs should apply assumptions consistent with the scenario
when projecting PPNR for feebased lines of business (e.g., asset
management) and ensure that the assumed business strategy is feasible
under the scenario.
In addition, BHCs should also ensure that expenses are appropriately
taking into account both the direct effects of the economic environment
(e.g., foreclosure costs) and projected revenues.
The models and business processes used to make projections should be
sufficiently documented so as to allow for supervisory assessment.
Trading revenues: All BHCs with trading activities and private-equity
investments should project the effect of various scenarios on their trading
revenue over the planning horizon.
In making these projections, BHCs should demonstrate that their historical
data selection and general approach is credible and applicable to the
assumed macroeconomic scenario.
BHCs should not assume that trading-related PPNR could never fall below
historical levels.
Mortgage servicing rights (MSR): All revenue and expenses related toMSRs
and the associated noninterest income and non-interest expense line items
must be reported on the PPNR schedules.
Residential mortgage representations and warranties: As part of PPNR,
BHCs must estimate losses associated with requests by mortgage investors,
including both government-sponsored enterprises and private label
securities holders, to repurchase loans deemed to have breached
representations and warranties, or with investor litigation that broadly
seeks compensation from BHCs for losses.
BHCs should consider not only how the macro scenarios could affect losses
from repurchased loans, but also a range of legal process outcomes,
including worse-than-expected resolutions of the various contract claims or
threatened or pending litigation against the BHC and against various
industry participants.
BHCs should provide appropriate support of the adverse litigation
expense-related outcomes considered in their analysis.
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Operational risk losses: Projections of losses arising from inadequate or
failed internal processes, people and systems, or from external events must
be reported by the BHC as operational risk losses, a component of PPNR. In
general, baseline projections are expected to match up reasonably with
historical, realized losses, taking into account any expected outcomes of
current ongoing or pending litigation or other operational events.
BHCs should use a conservative approach to project operational risk losses
for the stress scenario.
Specifically, operational risk losses under stress scenarios are expected to
be higher than the baseline projections regardless of whether the losses can
be directly linked to the stressed economic environment.
The Federal Reserve expects operational risk estimates in the BHC stress
scenario to capture bank-specific operational risks identified through
existing risk management tools such as risk assessments, key risk reports,
and scenario analysis.
BHCs should be able to demonstrate a detailed understanding of the
operational risks facing the organization and provide reasonable estimates
of potential operational risk losses.
The credibility of any empirical analysis relies on the relevance, accuracy,
comprehensiveness, appropriate classification, and internal consistency of
the underlying data.
The BHC should therefore give close attention to data issues that can affect
the credibility of the projected operational risk losses.
For example, the BHC should include all relevant historical data, including
legal reserves, in any analysis, and justify the exclusion of any historical
losses.
A BHC should generally use gross losses in its operational risk projections.
If the BHC uses losses net of recoveries, it should provide a strong
justification, as such recoveries may not occur during a stressed
environment.
The BHC should provide justification for the dates used in the analysis (e.g.,
accounting, discovery, or occurrence date) and provide analysis on how the
results would be affected by the use of specific dates.
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When available, the BHC should consider relevant external data, scenario
data, and business environment and internal control factors data in the
analysis, particularly when internal loss data is limited.
The process for selecting the data should be internally consistent,
well-reasoned, clearly documented, and understood by the banking
organization personnel responsible for its use.
The BHC should consider a variety of benchmarks in assessing the
reasonableness of its operational risk loss projections.
Some examples of such benchmarks might include average nine-quarter
cumulative operational risk losses and the most recent representative
nine-quarter cumulative operational risk losses to benchmark the baseline
scenario, and the worst historical nine-quarter cumulative operational risk
losses to benchmark the stressed scenarios.
As with loss estimates in other areas, the Federal Reserve expects BHCs to
estimate legal costs (including expenses, judgments, fines, and settlements)
that could occur under baseline and stressful environments.
When projecting legal costs in stress scenarios, a BHC should assume
unfavorable, stressed outcomes on current, pending, threatened, or
otherwise possible claims of all types.
Estimates of stressed legal losses and other costs and expenses should be
well supported by detailed underlying analysis.
Balance Sheet and Risk-Weighted Assets Projections
Balance sheet projections: Balances should be driven by the dynamic
interaction of various flows through the planning horizon and should
reconcile to projections for originations, pay-downs, drawdowns, and
losses under each scenario.
In stress scenarios, care should be taken to justify major changes in
portfolio composition based, for example, on assumptions about a BHC’s
strategic direction, including events such as material sales or purchases.
The losses used in producing balances should be the same as those
produced in internal loss-estimate modeling for the stress test.
Prepayment behavior should link to the relevant economic scenario and the
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maturity profile of the asset portfolio.
Any assumed reallocation of assets into securities or cash should recognize
the limits of portfolio transformation under stress due to market pressures
and current portfolio characteristics, including the likely state of interbank
lending markets and deposit levels.
To the extent that changes in the balance sheet are driven by a BHC’s
strategic direction, care should be taken to document underlying
assumptions, and the BHC should provide a detailed explanation
supporting the reasonableness of those assumptions in a stressed economic
and financial market environment.
For example, a BHC should specifically evaluate the implications of other
market participants possibly taking actions similar to its own in a stressed
environment.
For example, the possible positive outcomes that might be obtained if a
BHC were the only market participant taking such actions in a particular
market environment may not be fully realized if others are also attempting
to take similar actions.
RWA projections: Given that the as-of-date RWAs calculated for regulatory
reporting serves as the foundation for RWA projections in scenario
analysis, a BHC should ensure point-in-time RWA processes appropriately
capture all relevant on- and off-balance sheet exposures and are consistent
with the various risk-weighting frameworks to which the BHC is subject.
The BHC should provide detailed support for all assumptions used to derive
projections of RWAs, including assumptions related to components of
balance sheet projections (on- and off-balance sheet balances and
composition), income statement projections, and underlying risk attributes
of exposures.
It should document any known weakness in the translation of assumptions
into RWA estimates for each scenario and any compensating measures the
BHC took in response.
For example, a BHC should demonstrate how credit RWAs over the
planning horizon are related to projected loan growth under the
macroeconomic scenario, increased credit provisions or charge offs for loan
portfolios, and changing economic assumptions as well as how market
RWAs are related to market factors (e.g., volatility levels, equity index
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levels, bond spreads, etc.) and projected trading revenue.
Each BHC should demonstrate that these assumptions are clearly
conditioned on a given scenario and are consistent with stated internal and
external business strategies.
If BHC specific assumptions are used, the BHC should also describe these
assumptions and how they relate to reported RWA projections.
If the BHC’s models for projecting RWAs rely upon historical relationships,
the BHC should provide the historical data and clearly describe why these
relationships are expected to be maintained in each scenario.
Trading and counterparty RWAs: In general, all BHCs in the LISCC
portfolio as well as any BHCs subject to the market risk rule that report:
(1) trading assets and liabilities of greater than $10 billion or
(2) trading assets and liabilities of greater than 10 percent of total assets at
the as-of date for reporting should project market risk RWAs using a
quantitative methodology that captures both changes in exposures and
changes in volatility implied by stress conditions over time.
BHCs should document the rationale for any significant changes in risk
weighting assigned to the trading book, particularly in cases where
projections show the ratio of trading book RWAs-to-trading exposures and
trading asset balances declining over time or under stress conditions.
Additionally, any BHC subject to the market risk rule must use standard,
specific-risk charges for any positions or portfolios for which the BHC has
not received any required specific-risk-model approval, incremental
risk-model approval, or comprehensive risk-model approval for the
position or portfolio as of January 5, 2015.
In addition, if a BHC does not have an approved Stressed Value at Risk
(SVaR) model as of January 5, 2015, the BHC must specify this in writing.
Regulatory Capital Projections
BHCs are to provide data on the balances of regulatory capital instruments
under current U.S. capital adequacy guidelines and under the revised
regulatory capital framework for quarters of the planning horizon in which
they are subject to the revised regulatory capital framework, aggregated by
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instrument type based on actual balances as of September 30 of the current
calendar year and projected balances as of each quarter end through the
remaining planning horizon.
BHCs are to report information both on a notional basis and on the basis of
the dollar amount included in regulatory capital.
Other comprehensive income (OCI): Advanced approaches BHCs should
project the components of OCI, including unrealized gains and losses on
their AFS securities.
The accumulated components of OCI should be included in projections of
regulatory capital under each scenario, accounting for any transition
arrangements in the revised regulatory capital framework over the
nine-quarter planning horizon as appropriate.
Regulatory capital transitions: In the transition plan, a BHC must include
estimates of the composition and levels of regulatory capital, RWAs (based
on the standardized approach and advanced approaches, where applicable),
and leverage ratio exposures used to calculate regulatory capital ratios
under the supervisory baseline scenario.
Each BHC’s submission should include supporting documentation on all
material planned actions that the BHC intends to pursue in order to meet
the minimum regulatory capital ratios per the revised regulatory capital
framework, including, but not limited to, the run-off or sale of existing
portfolio(s), the issuance of regulatory capital instruments, and other
strategic corporate actions.
Supporting Documentation for Analyses Used in Capital Plans
Methodology and model inventory: BHCs are required to provide the
Federal Reserve with an inventory of all models and methodologies used to
estimate losses, revenues, expenses, balances, and RWAs in CCAR 2015.
The inventory should start with the FR Y-14A line items and provide the list
of models or methodologies used for each item under each scenario and
note the status of the validation or independent review each model or
methodology (e.g., completed, in progress).
The model inventory must include the name of the model, which should
then be consistently referred to in all technical documentation.
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Risk-identification program and mapping of material risks to capital plan:
One particular area of supervisory focus will be an assessment of the
comprehensiveness of a BHC’s process for identifying the full range of
relevant risks, given the BHC’s exposures and business mix.
Each capital plan submission should include documentation outlining the
risk identification process the BHC uses to support the BHC-wide stress
testing required in the capital plans.
The documentation should describe the BHC’s processes to identify all
known material risks, including emerging risks that the BHC may face in a
changing economic environment, given its size, activities, and risk
exposures and commitments, both on and off-balance sheet.
A BHC’s material risk identification process should be transparent and
repeatable, and translate efficiently into estimates of potential losses over a
range of scenarios and environments.
An assessment of the comprehensiveness of risk identification is a critical
aspect of the supervisory assessment of a BHC’s capital adequacy process.
The BHC should assess the data, infrastructure, and technology, including
the management information systems (MIS) that support the BHC’s
material risk identification process, for reliability and comprehensiveness.
Where weaknesses in capturing, aggregating, or measuring risk exposures
exist, the BHC should describe the processes and mitigating controls
employed to compensate for those deficiencies or weaknesses in the risk
identification process.
The board of directors should have a clear understanding of where the risk
identification and measurement process may be compromised.
Each BHC should develop and maintain a comprehensive inventory of risks
to which they are exposed, and refresh it as conditions warrant, such as
changes in the business mix and the operating environment.
The BHC should be able to demonstrate how its identified risks are
accounted for in its capital adequacy process and seek to capture all
applicable material risks in the enterprise-wide scenario analysis.
If certain risks are not explicitly incorporated into an enterprise-wide
scenario analysis, a BHC should note how all material risks are accounted
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for in other aspects of its capital planning process.
Best practice is to develop and maintain a detailed mapping of how and
where these risks are captured in the BHC’s capital adequacy process.
Documentation related to the BHC scenario: A BHC’s scenario design
process should result in a coherent, logical narrative of economic and
financial market factors and potential BHC-specific events that
appropriately stress the BHC’s firm-wide inventory of material risks.
Assumptions should remain constant across business lines and risk areas
for the chosen scenario, since the objective is to see how the BHC as a whole
will be affected by a common scenario that is consistently applied.
A BHC should consider the best manner in which to capture combinations
of stressful events and circumstances, including second-order and
“knock-on” effects that may result from the specified economic and
financial market environment or any potential BHC-specific event.
The use of expert judgment or management overlays is acceptable and
should be carefully explained and supported by empirical evidence.
Supervisors will focus particular attention on a BHC’s ability to adequately
support the approach and methodologies used for its BHC scenarios and
assess the impact to loss and PPNR estimates.
In addition, the BHC is required to provide a comprehensive listing of the
paths of all key variables used in each scenario in the FR Y-14A Scenario
schedule.
Within the supporting documentation, each BHC should discuss how the
BHC stress scenario stresses the specific vulnerabilities of the BHC’s risk
profile and operations.
Best practice is to clearly map the BHC’s identified material risks to the
elements incorporated within the BHC stress scenario to ensure that all
exposures are appropriately stressed and considered for full impact on
capital and discuss how material risks that are not explicitly incorporated
into the BHC scenario are considered and addressed as part of the BHC’s
capital adequacy process.
Documentation of internal stress testing methodologies and assumptions:
A BHC should include in its capital plan submissions thorough
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documentation of key methodologies and assumptions used in performing
stress testing.
Documentation should clearly describe the model-development process,
the derivation of outcomes, and validation procedures.
Supporting documentation should clearly describe any known data issues
or model weaknesses and how such information is factored into the capital
plan.
Senior management should provide its board of directors with sufficient
information to facilitate the board’s understanding of the stress testing
analysis used by the BHC for capital planning purposes, including any
identified weaknesses that increase uncertainty in the estimation process.
The BHC must provide credible support for BHC specific assumptions,
including any known weaknesses in the translation of assumptions into loss
and resource estimates.
For example, an overreliance on past patterns of credit migration (the basis
for roll rate and ratings transition models) may be a weakness when
considering stress scenarios, particularly when the available data do not
contain a period of significant stress.
The BHC should demonstrate that its approaches are clearly conditioned on
the scenarios being used.
While judgment is an essential part of risk measurement and risk
management, including for loss estimation purposes, a BHC should not be
overly reliant on judgment to prepare their loss estimates and should
provide documentation or evidence of transparency and discipline around
the process.
Any management judgment applied should be adequately supported and in
line with scenario conditions and should be consistently conservative in the
assumptions made to arrive at loss rates.
There should also be appropriate challenge of assumptions by senior
management.
Senior management should provide sufficient information to the board of
directors so that the board can understand the key assumptions, challenges
made by senior management, and any responses to those challenges and
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can effectively challenge reported results before making capital decisions.
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Comprehensive Capital Analysis and Review
2015
Part B
Description of All Capital Actions
Assumed over the Planning Horizon
As part of the quantitative assessment of a BHC’s capital plan, the Federal
Reserve considers the BHC’s description of all planned capital actions over
the planning horizon, including both capital issuances and capital
distributions, and relies on these descriptions of the planned capital actions
as a basis for its decisions about the BHC’s capital plan.
As detailed in the capital plan rule, a capital action is any issuance of a debt
or equity capital instrument, any capital distribution, and any similar action
that the Federal Reserve determines could impact a BHC’s consolidated
capital.
A capital distribution is a redemption or repurchase of any debt or equity
capital instrument, a payment of common or preferred stock dividends, a
payment that may be temporarily or permanently suspended by the issuer
on any instrument that is eligible for inclusion in the numerator of any
minimum regulatory capital ratio, and any similar transaction that the
Federal Reserve determines to be in substance a distribution of capital.
Organization of description of capital actions: BHCs must provide a
description of their planned capital actions.
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BHCs are also required to report their planned capital actions on the FR
Y-14A Summary schedule under the BHC baseline scenario and on the
FR Y-14A Regulatory Capital Instruments schedule.
BHCs should organize the description of the planned capital actions in their
capital plan in a manner that permits comparison with the schedules.
One method of organization would be a table, such as table 4, that presents
the capital actions by type of capital instrument over the quarterly path.
Planned capital actions in out-quarters of planning horizon: The Federal
Reserve has observed a practice whereby some BHCs have included
markedly reduced distributions in the final quarters of the planning
horizon (i.e., the quarters that are not subject to objection in the current
capital plan cycle, referred to as ‘‘out-quarters’’) relative to the
distributions in the preceding quarters of the capital plan where the
distributions are subject to possible objection in the current cycle.
A BHC should project its distributions in the final quarters of its capital
plan based on realistic assumptions about the future and in a manner
broadly consistent with previous quarters, unless the BHC is in fact
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planning to reduce its distributions.
The Federal Reserve will closely monitor a BHC’s planned capital actions to
the extent the distribution occurring in the out-quarters of capital plans are
lower than the distributions for the same quarters included in the BHC’s
capital plan for the next cycle.
If BHCs are unable to provide sufficient explanation for increases in
planned capital actions once the quarter is subject to review and possible
objection, the Federal Reserve may see that as an indication of
shortcomings in a BHC’s capital adequacy process or that the assumptions
and analyses underlying the capital plan, or the BHC’s methodologies for
reviewing the robustness of its capital adequacy process, are not reasonable
or appropriate.
Under the capital plan rule, the Federal Reserve may object to a capital plan
because the assumptions and analyses underlying the BHC’s capital plan
are not reasonable or appropriate, and the practice of reducing planned
capital distributions in the out-quarters therefore may form the basis for
objection to a BHC’s capital plan.
Expected Changes to Business Plans Affecting Capital Adequacy
or Funding
Each BHC should include in its capital plan a discussion of any expected
changes to the BHC’s business plan that are likely to have a material impact
on the BHC’s capital adequacy and liquidity.
Examples of changes to a business plan that may have a material impact
could include a proposed merger or divestiture, changes in key business
strategies, or significant investments.
However, a BHC should not include a divestiture that has not been
completed or contractually agreed prior to January 5, 2015, in its capital
plan submission.
In this discussion, the company should consider not just the impacts of
these expected changes, but also the potential adverse consequences should
the actions not result in the planned changes—e.g., a merger plan falls
through, a change in business strategy is not achieved, or there is a loss on
the planned significant investment.
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Subsidiaries of foreign banking organizations: For the purposes of CCAR
2015, a U.S. BHC that will be designated as the U.S. intermediate holding
company for a foreign banking organization’s U.S. operations will not to be
required to include the transfer of subsidiaries in accordance with the U.S.
intermediate holding company requirement in its capital plan projections.
The Federal Reserve recognizes that modelling the effects of this transfer
would require BHCs to adjust their management information and
accounting systems to take into account exposures across the entire U.S.
operations of a foreign banking organization, which may introduce
significant complexities into a BHC’s capital planning and stress testing.
The Federal Reserve will provide this onetime relief from including assets
transferred into the U.S. BHC in capital plan projections with the
expectation that, generally, the U.S. BHC subsidiary that will be designated
as the U.S. intermediate holding company will have a capital plan that
includes planned capital distributions (net of capital issuance) that are
equal to or lower than those included in the BHC’s capital plan for the
previous cycle.
The Federal Reserve expects that such U.S. BHCs will retain capital
compared with previous capital plans in preparation for compliance with
the U.S. intermediate holding company requirement.
Federal Reserve Assessment of BHC Capital Plans
To support its assessment of the capital plans, the Federal Reserve will
review the supporting analyses in a BHC’s capital plan, including the BHC’s
own stress test results, and will generate supervisory estimates of losses;
revenues; loan-loss reserves; balance sheet components and RWAs; and
post-stress capital ratios using internally developed supervisory models and
assumptions wherever possible.
The Federal Reserve has differing expectations for BHCs of different sizes,
scope of operations, activities, and systemic importance in various aspects
of capital planning.
In particular, the Federal Reserve has significantly heightened expectations
for BHCs that are subject to the Federal Reserve’s Large Institution
Supervision Coordinating Committee (LISCC) framework.
In assessing a BHC’s capital planning, capital positions, and overall capital
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adequacy, the Federal Reserve will have heightened expectations for the
LISCC BHCs.
These BHCs are expected to have the most sophisticated, comprehensive,
and robust capital adequacy processes.
Qualitative Assessments
Qualitative assessments are a critical component of the CCAR review.
Even if the supervisory stress test for a given BHC results in post-stress
capital ratios above the minimum requirements, the Federal Reserve could
nonetheless object to that BHC’s capital plan for other reasons.
These reasons include, but are not limited to, the following:
• There are material unresolved supervisory issues.
• The assumptions and analyses underlying the BHC’s capital plan are not
reasonable or appropriate.
• The BHC’s methodologies for reviewing the robustness of its capital
adequacy process are not reasonable or appropriate.
• The CCAR assessment results in a determination that a BHC’s capital
adequacy process or proposed capital distributions would otherwise
constitute an unsafe or unsound practice or would violate any law,
regulation, Board order, directive, or any condition imposed by, or written
agreement with, the Board.
As noted above, under the capital plan rule, the Federal Reserve may object
to a BHC’s capital plan if the assumptions and analyses underlying its
capital plan, or the BHC’s methodologies for reviewing the robustness of its
capital adequacy process, are not reasonable or appropriate.
The Federal Reserve assesses the strength of the risk-measurement and
risk-management practices supporting the capital adequacy process and
the governance and controls around these practices.
The Federal Reserve’s qualitative assessment places particular emphasis on
material risk identification; the BHC stress scenario; the translation of the
BHC stress scenario into projected losses, revenues, and post-stress capital
ratios; and the controls and governance around the capital adequacy
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process.
If the Federal Reserve identifies substantial weaknesses in a BHC’s capital
adequacy process, that finding on its own could justify an objection to a
BHC’s capital plan.
However, a non-objection to a BHC’s capital plan does not necessarily
mean that a BHC is considered to have fully satisfactory practices
supporting every element of its capital adequacy process.
Quantitative Assessments
The various types of quantitative assessments that the Federal Reserve
expects to consider are described in figure 2.
The Federal Reserve will evaluate the BHC’s post-stress capital ratios based
on the combination of stress performance measures (e.g., revenues, losses,
and reserves from the supervisory adverse and severely adverse scenarios)
and the BHC’s planned capital actions (e.g., planned dividends, issuances,
and repurchases as provided in the BHC baseline scenario) against each
minimum regulatory capital ratio and a 5 percent tier 1 common ratio in
each quarter of the planning horizon.
Supervisory Post-Stress Capital Analysis
In conducting its supervisory stress tests of BHCs under the Dodd-Frank
Act stress test rules, the Federal Reserve will use the same supervisory
scenarios and assumptions as the BHCs are required to use under the
Dodd-Frank Act stress test rules to project revenues, losses, net income,
and post-stress capital ratios.
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In addition, the Federal Reserve will independently project BHCs’ balance
sheet and RWAs over the nine-quarter planning horizon, using the same
supervisory macroeconomic scenarios.
Supervisory models and assumptions will be applied in a consistent manner
across all BHCs.
In connection with the annual CCAR exercise, the Federal Reserve will use
the data and information provided in the FR Y-14 regulatory reports as of
September 30, 2014 (except for trading and counterparty data).
BHCs should reference the instructions associated with each schedule to
determine the appropriate submission date for each regulatory report.
The Federal Reserve will apply conservative assumptions to any missing or
otherwise deficient FR Y-14 data in producing supervisory estimates if such
deficiencies are not remedied by December 31, 2014.
• Missing data or data deficiency: If a BHC’s submitted data quality is
deemed to be too deficient to produce a robust supervisory model estimate
for a particular portfolio, the Federal Reserve may assign a high loss rate
(e.g., 90th percentile) or a conservative PPNR rate (e.g., 10th percentile)
based on portfolio losses or PPNR estimated for other BHCs.
If data that are direct inputs to supervisory models are missing or reported
erroneously but the problem is isolated in a way that the existing
supervisory framework can still be used, a conservative value (e.g., 10th or
90th percentile) based on all available data will be assigned to the specific
data.
• Immaterial portfolio: Each BHC has the option to either submit or not
submit the relevant data schedule for a given portfolio that does not meet a
materiality threshold (as defined in FR Y-14Q and FR Y-14Minstructions).
If the BHC does not submit data on its immaterial portfolio(s), the Federal
Reserve will assign a conservative loss rate (e.g., 75th percentile), based on
the estimates for other BHCs.
Otherwise, the Federal Reserve will estimate losses using data submitted by
the BHC.
As part of CCAR, the Federal Reserve will conduct its post-stress capital
analysis 42 in the supervisory adverse and severely adverse scenarios using
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the BHCs’ planned capital actions in the BHC baseline scenario.
This assumption permits the Federal Reserve to assess whether a BHC
would be capable of continuing to meet minimum capital requirements
(the leverage, tier 1 risk-based, common equity tier 1 risk-based, and total
risk-based capital ratios) and a tier 1 common capital ratio of at least 5
percent throughout the planning horizon, even if adverse or severely
adverse stress conditions emerged and the BHC did not reduce planned
capital distributions.
Common Dividend Payouts
The appropriateness of planned capital actions will also be evaluated based
on the common dividend payout ratio (common dividends relative to net
income available to common shareholders) in the baseline scenario, and on
the BHC’s projected path to compliance with the revised regulatory capital
framework under the supervisory baseline scenario as the revised
regulatory capital framework is phased in.
The Federal Reserve expects that capital plans will reflect conservative
common dividend payout ratios.
Specifically, capital plans that imply common dividend payout ratios above
30 percent of projected after-tax net income available to common
shareholders in either the BHC baseline or supervisory baseline will receive
particularly close scrutiny.
Regulatory Capital Rule Transition Plans
As part of CCAR, the Federal Reserve evaluates whether a BHC’s proposed
capital actions are appropriate in light of the BHC’s plans to meet the
requirements of the revised regulatory capital framework after the
transition periods set forth in that rule.
As part of its capital plan submission, a BHC should provide a transition
plan that includes pro forma estimates under baseline conditions of the
BHC’s regulatory risk-based capital and leverage ratios under the revised
regulatory capital framework.
Generally, a BHC should maintain prudent earnings-retention policies with
a view toward meeting the conservation buffer under the time frame
described in the revised regulatory capital framework.
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Where applicable, a BHC’s regulatory capital transition plan should also
incorporate a plan to meet the higher loss absorbency requirements for
global systemically important banks as estimated by management or the
enhanced supplementary leverage ratio.
A BHC should, through its capital plan, demonstrate an ability to maintain
no less than steady progress along a path between its existing capital ratios
based upon the revised regulatory capital framework and the fully
phased-in requirements in 2019.
The Federal Reserve will closely scrutinize plans that fall short of this
supervisory expectation.
Some BHCs may exceed the transition targets over the near term, but not
yet meet the fully phased-in targets.
Those BHCs are expected to submit plans reflecting steady accretion of
capital at a sufficient pace to demonstrate continual progress toward full
compliance with the revised regulatory capital framework on a fully
phased-in basis.
The Federal Reserve expects that any BHC performance projections that
suggest that ratios would fall below the regulatory minimums at any point
over the projection period would be accompanied by proposed actions that
reflect affirmative steps to improve the BHC’s capital ratios, including
actions such as external capital raises, to provide great assurance that the
BHC will meet the minimum requirements of the revised regulatory capital
framework as they phase in.
Limited Adjustments to Planned Capital Actions
Upon completion of the quantitative and qualitative assessments of BHCs’
capital plans, but before the disclosure of the final CCAR results, the
Federal Reserve will provide each BHC with the results of the post-stress
capital analysis for its BHC, and each BHC will have an opportunity to make
a one-time adjustment to planned capital distributions.
The only adjustment that will be considered is a reduction in the common
stock distributions (e.g., common stock dividend and repurchases) relative
to those initially submitted in the BHC’s original capital plan.
The Federal Reserve’s final decision to object or not object will be informed
by the BHC adjusted capital distributions.
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The Federal Reserve has observed a practice where some BHCs have only
adjusted the out quarters of the planning horizon that are not subject to
objection in the current CCAR exercise (for CCAR 2015, those would be the
projected third and fourth quarters of 2016), while leaving the quarters
subject to objection unchanged.
Without explanation, this practice erodes the credibility of a BHC’s capital
plan.
Accordingly, a BHC that makes a one-time adjustment to its planned capital
distributions should not solely concentrate the adjustment in the quarters
not subject to objection in CCAR 2015.
Federal Reserve Responses to Planned Capital Actions
Based on the results of the qualitative and quantitative assessment, the
Federal Reserve determines whether to authorize a BHC to undertake its
planned capital actions during the next four quarters, covering the second
quarter of the current year through the first quarter of the following year
(the third through the sixth quarters of the CCAR 2015 planning horizon).
For CCAR 2015, the Federal Reserve’s authorization for capital
distributions will extend five quarters, through June 30, 2016, in order to
account for the shift in the capital plan cycle in 2016.
For purposes of CCAR 2015, if a BHC receives a non-objection to its capital
plan, the BHC generally may make the capital distributions included in its
capital plan submission beginning on April 1, 2015, through June 30, 2016,
without seeking prior approval from or providing prior notice to the Federal
Reserve.
If the BHC receives an objection to its capital plan, the BHC may not make
any capital distribution other than those capital distributions with respect
to which the Federal Reserve has indicated in writing its nonobjection.
In this instance, the Federal Reserve still may authorize the BHC to
undertake certain distributions set forth in its capital plan, consistent with
the quarterly path of authorized distributions, during this five-quarter
period.
The Federal Reserve at all times retains the ability to ultimately object to
capital distributions in future quarters if there is a material change in the
BHC’s risk profile (including a material change in its business strategy or
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any risk exposure), financial condition, or corporate structure, or if changes
in financial markets or the macroeconomic outlook that could have a
material impact on the BHC’s risk profile and financial condition require
the use of updated scenarios.
Disclosure of Supervisory Assessments
At the end of the CCAR process, the Federal Reserve intends to disclose
publicly its decision to object or not object to a BHC’s capital plan, along
with a summary of the Federal Reserve’s analyses of that company.
The Federal Reserve will publish a summary of the results of the Board’s
supervisory stress test of the company under the Dodd-Frank Act
supervisory stress tests.
The supervisory stress test disclosure will include results under both the
supervisory adverse and severely adverse scenarios.
The Federal Reserve will provide the detailed results of supervisory stress
tests for each BHC, including stressed losses and revenues, and the
post-stress capital ratios based on the capital action assumptions required
under the Dodd- Frank Act stress test rules, along with an overview of
methodologies used for supervisory stress tests. (See appendix B for the
format that will be used to publish these data.)
In its disclosure of the CCAR results, the Federal Reserve will also publish
the results of its post-stress capital analysis for each BHC, including BHC
specific post-stress regulatory capital ratios (leverage, common equity tier 1
risk-based, tier 1 risk-based, and total risk-based capital ratios) and the tier
1 common ratio estimated in the adverse and severely adverse scenarios.
These results will be derived using the planned capital actions as provided
under the BHC baseline scenario.
The disclosed information will include minimum values of these ratios over
the planning horizon, using the originally submitted planned capital actions
under the baseline scenario and any adjusted capital distributions in the
final capital plans, where applicable.
In addition to the information about its quantitative assessment of the
capital plans, the Federal Reserve will disclose the reasons for objections to
specific BHCs’ capital plans, including general information about the
capital planning weaknesses that led to an objection to the BHC’s capital
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plan for qualitative reasons.
Both sets of results, with the overview of methodologies and other
information related to supervisory stress tests and CCAR, are expected to be
published by March 31, 2015.
BHCs will be required to disclose the results of their company-run stress
tests within 15 days of the date the Board discloses the results of its
Dodd-Frank Act supervisory stress test.
Resubmissions
If a BHC receives an objection to its capital plan, it may choose to resubmit
its plan in advance of the next CCAR exercise in the following year.
As detailed in the capital plan rule, a BHC must update and resubmit its
capital plan if it determines there has been or will be a material change in
the BHC’s risk profile (including a material change in its business strategy
or any material-risk exposures), financial condition, or corporate structure
since the BHC adopted the capital plan.
Further, the Federal Reserve may direct a BHC to revise and resubmit its
capital plan for a number of reasons, including if a stress scenario
developed by a BHC is not appropriate to its business model and portfolios
or if changes in financial markets or the macroeconomic outlook that could
have a material impact on a BHC’s risk profile and financial condition
requires the use of updated scenarios.
Submissions that are late, incomplete, or otherwise unclear could result in
an objection to the resubmitted plan and a mandatory resubmission of a
new plan, which may not be reviewed until the following quarter.
Based on a review of a BHC’s capital plan, supporting information, and data
submissions, the Federal Reserve may require additional supporting
information or analysis from a BHC, or require it to revise and resubmit its
plan.
Any of these may also result in the delay of evaluation of capital actions
until a subsequent calendar quarter.
Execution of Capital Plan and Requests for Additional
Distributions
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The capital plan rule provides that a BHC generally must request prior
approval of a capital distribution if the dollar amount of the capital
distribution will exceed the amount described in the capital plan for which a
non-objection was issued (gross distribution limit).
In addition, a BHC generally must request the Board’s non-objection for
capital distributions included in the BHC’s capital plan if the BHC has
issued less capital of a given class of regulatory capital instrument (net of
distributions) than the BHC had included in its capital plan, measured
cumulatively, beginning with the third quarter of the planning horizon.
For example, if a shortfall in capital issuance occurred in the third quarter,
then the BHC may not make planned distributions in that quarter and
subsequent quarters unless and until it offsets the excess net distributions.
BHCs have the flexibility to credit excess issuances or lower distributions of
capital than the amounts included in the company’s capital plan for a given
class of regulatory capital instrument to subsequent quarters.
A BHC should notify the Federal Reserve as early as possible before
redeeming any capital instrument that counts as regulatory capital and that
was not included in its capital plan or if it has excess net distributions.
A BHC should use the CCAR Communications mailbox to submit any
requests for capital (gross or net) not included in its capital plan.
Any such requests should reflect the change in the BHC’s planned capital
issuances and any other relevant changes in the capital plan.
The BHC may be required to submit additional supporting information,
including a revised capital plan, the BHC’s forward-looking assessment of
its capital adequacy under revised scenarios, any supporting information,
and a description of any quantitative methods used that are different than
those used in its original capital plan.
The Federal Reserve will examine performance relative to the initial
projections and the rationale for the request.
Under the capital plan rule, the Federal Reserve may object to a BHC’s
capital plan if the assumptions and analysis underlying the capital plan, or
the BHC’s methodologies for reviewing the robustness of its capital
adequacy process, are not reasonable or appropriate.
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A BHC’s consistent failure to execute planned capital issuances may be
indicative of shortcomings in its capital planning processes and may
indicate that the assumptions and analysis underlying the BHC’s capital
plan, or the BHC’s methodologies for reviewing the robustness of its capital
adequacy process, are not reasonable or appropriate.
Accordingly, a consistent failure to execute capital issuances as indicated in
its capital plan may form the basis for objection if the BHC is unable to
explain the discrepancies between its planned and executed capital
issuances.
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Comprehensive Capital Analysis and Review
2015
Part C
Appendix A: Common Themes from CCAR
2014
Introduction
This appendix describes some of the common themes identified by
supervisors during CCAR 2014 that were broadly applicable to the bank
holding companies (BHCs) involved in the program.
The Federal Reserve provided these commonly observed themes to the
BHCs as part of the CCAR 2014 supervisory feedback communicated in
April 2014 to build upon expectations outlined in previous guidance and to
provide additional clarification in specific areas where BHCs continue to
experience challenges.
The topics covered here were all outlined in the Federal Reserve’s Capital
Planning at Large Bank Holding Companies: Supervisory Expectations and
Range of Current Practice, published in August 2013.
In subsequent communication, the Federal Reserve further clarified its
expectations for modelling changes in the fair value of available-for-sale
(AFS) securities to project other comprehensive income (OCI).
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In addition, certain information was updated regarding the threshold of
trading assets and liabilities that trigger specific expectations for projecting
market risk-weighted assets (RWAs).
The RWA Methodologies and AFS Fair Value OCI sections of this appendix
include those subsequent communications.
The following nine themes came out of the CCAR 2014 program and are
described further below:
(1) sensitivity analysis,
(2) assumptions management,
(3) model overlays,
(4) model risk management,
(5) capital policy,
(6) presentation of consolidated pro forma financial results,
(7) RWA projection methodologies,
(8) operational risk loss-estimation methodologies, and
(9) AFS Fair Value OCI.
Before discussing each of these themes in more detail, it is important to
reiterate one theme that is generally applicable to all of the issues below.
While supervisors generally expect that BHCs use independently validated
quantitative methods as the basis for their estimates, BHCs should not rely
on weak or poorly specified models.
Instead, qualitative approaches or adjustments to quantitative results
should be used, for example, to address data limitations, material changes
in a BHC’s business, or unique risks of a certain portfolio (including
fundamental changes to markets, products and businesses) that are not
well represented in reference data and therefore not well captured in a
model.
Most BHCs use some form of expert judgment—often as a management
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adjustment overlay to modelled outputs.
Supervisors prefer that BHCs use management overlays to compensate for
model limitations.
Regardless of the estimation methodology, BHCs should have a
transparent, repeatable, well-supported process that generates credible
estimates that are consistent with assumed scenario conditions.
1. Sensitivity Analysis
Having an understanding of the sensitivity of pro forma financial estimates
to the various inputs and assumptions developed to support the forecasting
process is an important aspect of developing sound stress scenario analysis
projections.
Sensitivity analysis is an important tool that tests the robustness of models
and enhances reporting for BHC management, the board of directors, and
supervisors.
Based on observations in CCAR 2014, there is a continued need for BHCs to
expand the use of sensitivity analysis to understand the range of potential
estimates based on changes to inputs and key assumptions as well as the
uncertainties associated with those estimates.
Most notably, BHCs did not conduct sufficient sensitivity analysis during
model development, and instead relied on the model validation function to
carry it out.
BHCs should expand the use of sensitivity analysis around both individual
loss, revenue, and balance sheet component estimates as well as aggregate
estimates at various levels of the consolidation process.
All key assumptions and input variables should be candidates for sensitivity
testing.
While not all assumptions and inputs will prove to have a material impact
on estimates, BHCs should conduct sensitivity analysis to determine which
inputs and assumptions can materially alter results.
Some foundational assumptions that are common to most BHCs and
should be subject to sensitivity analysis include projected market share, size
of the mortgage market, cost and flow of deposits, utilization rate of credit
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lines, discount rates, or level and composition oftrading assets.
However, this list is not exhaustive and conducting sensitivity testing only
on these assumptions will not be sufficient to meet supervisors’expectations
in this area.
Sensitivity testing can also be particularly helpful in understanding the
range of possible results of vendor-provided scenario forecasts and vendor
models with less transparent or proprietary elements.
Furthermore,sensitivity analysis can be an important tool to assess stress
testing models and the credibility of stress projections, given the inherent
challenges in conducting outcomes analysis of these models.
Overall, BHCs should ensure that model developers and model owners
conduct sensitivity analysis, in addition to the testing performed by the
model validation function.
BHCs should also conduct sensitivity analysis as part of the aggregation
process to understand the sensitivity of material components of the
consolidated pro forma financials, as well as the post-stress pro forma
capital ratios to material assumptions and inputs.
By understanding and documenting a range of potential outcomes, BHCs
can ensure there is a clear understanding of the inherent uncertainty and
imprecision around pro forma results.
Importantly, management should have a full understanding of key
sensitivities in estimates and highlight those to the board so that the
directors understand the sensitivity of capital to alternative inputs and
assumptions and can make informed capital decisions.
2. Assumptions Management
BHCs are expected to clearly document key assumptions used to estimate
losses, revenues, expenses, asset and liability balances, and RWA.
Documentation should provide the rationale and any empirical support for
assumptions and specifically address how they are consistent with scenario
conditions.
Assumptions should generally be conservative, particularly in areas of high
uncertainty, and should be well supported and subject to close oversight
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and scrutiny.
Given the significant number of assumptions required for capital planning
and stress testing, one of the most common issues across firms is unclear or
unsubstantiated assumptions.
While this issue spans all areas of capital planning, it was among the most
common issues for PPNR projections in CCAR 2013and again in CCAR
2014.
In particular, loan and deposit pricing assumptions were, in many
instances, not well documented nor adequately supported, and in some
cases they appeared inconsistent with the expected impact of scenario
conditions, shift in portfolio mix, or growth or decline in balances over the
planning horizon.
Similarly, in certain instances, assumptions were made that provided a
clear benefit to the BHC without consideration of strategic initiatives or
achievability under a given scenario.
Overall, assumptions that may materially affect capital estimates should be
consistent with scenario conditions, challenged across the enterprise, and
internally consistent within each scenario.
Where possible, assumptions should be supported by quantitative analysis
or empirical evidence, and as discussed in the preceding section,
augmented with sensitivity analysis to assess whether deviations from
assumed values could have a material impact on post-stress, pro forma
capital levels.
That said, assumptions do not have to be anchored in historical experience.
Historical experience may not be relevant if a BHC has gone through
significant structural changes, or if the economic environment changes
dramatically.
Assumptions not based in historical experience can be acceptable, if BHCs
provide sufficient support and rationale for why the assumptions are
plausible, internally consistent with assumed scenario conditions, and
conservative (i.e., they generate more losses or fewer revenues than strict
adherence to historical experience).
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3.Model Overlays
As noted, most BHCs use some form of expert judgment— often as a
management adjustment overlay to modeled outputs.
In developing management over-lays, BHCs should ensure that they have a
transparent and repeatable process; that assumptions are clearly outlined
and consistent with assumed scenario conditions; and that results are
provided with and without adjustments.
In general, the purpose and impact of specific management overlays should
be communicated in a way that facilitates a thorough understanding by the
BHC’s senior management.
Senior management should be able to independently assess the
reasonableness of using an overlay to capture a particular risk or
compensate for a known limitation.
Significant management overlays should receive a heightened level of
support and scrutiny, up to and including review by the board of directors
in instances where the impact to pro forma results is sufficiently material.
Extensive use of management overlays should also trigger discussion as to
whether new or improved modeling approaches are needed.
While improved support for management overlays was apparent during
CCAR 2014, some BHCs’ approach to overlays did not meet supervisory
expectations.
Specifically, a number of BHCs failed to tie management overlays to specific
model weaknesses or identified issues and used a general “catch-all”
adjustment to influence aggregate modeled losses in the interest of
conservatism.
In addition, several BHCs relied exclusively on a capital buffer and/or the
capital targets to account for model limitations, rather than using a specific
adjustment to model output, which directly impacts capital levels.
To the extent possible, BHCs should incorporate the impact of all risk
exposures into their projections of net income over the nine-quarter
planning horizon rather than trying to address certain risks and model
limitations by adding buffers on top of internally defined capital goals and
targets.
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In certain cases, BHCs made adjustments within the model (e.g., changes to
parameter estimates) that were independently reviewed as part of the
overall model validation process.
However, post-validation management overlays applied to model outcomes
to account for risks not captured by the model or to compensate for model
limitations often failed to receive an adequate level of independent review.
In addition to being clearly documented and well-supported, supervisors
expect all management overlays and adjustments to be reviewed in detail
and approved at the appropriate level given their materiality/impact to the
overall pro forma financial results.
4. Model RiskManagement
BHCs should ensure that they have sound model risk management,
including independent review and validation of all models used in internal
capital planning, consistent with existing supervisory guidance on model
risk management.
Most BHCs involved in CCAR 2014 have made progress in enhancing their
model risk management practices for models used in their capital planning
processes.
However, some BHCs still fell substantially short of supervisory
expectations, and all BHCs still have room for improvement, most notably
in the area of conducting more rigorous evaluations of the conceptual
soundness of modeling approaches applied to stress testing use.
Supervisors observed that validation activities conducted by some BHCs
were rigorous and appropriately resulted in required enhancements,
restrictions on use, or rejection.
However, there were numerous cases in which validation activities were not
in line with supervisory expectations or effective challenge was not
exercised.
For instance, some validation activities were only cursory in nature; did not
probe key assumptions or model sensitivities; and perhaps most critically,
did not evaluate models for their intended use (including vendor models).
Supervisors also expect that model overrides or overlays—including those
based solely on expert judgment—will be subject to oversight and review by
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validation staff or other independent reviewers, with the recognition that
the work done to evaluate overlays to model output may be different than
the validation work to evaluate and test the model and model output.
BHCs should also ensure that challenger or benchmark models used as part
of the capital planning processes are subject to validation, with the intensity
and frequency of validation work a function of the importance
of those models in generating estimates.
Supervisors recognize that not all validation activities can be conducted
before each model is used, especially certain types of outcomes analysis
given the lack of realized outcomes against which to assess projections
generated under stressful scenarios.
That said, at a minimum, BHCs should make every effort to conduct the
conceptual soundness evaluation of a model prior to its use.
An important aspect of model risk management governance is clearly
identifying whenever any validation activities are not able to be conducted
prior to use, making those shortcomings in validation transparent to users
of model output, developing remediation plans, and applying compensating
controls—such as conducting additional sensitivity analysis or using
benchmarks.
Any cases in which certain model risk management activities—not just
validation activities—are not completed could suggest high levels of model
uncertainty and call into question a model’s effectiveness.
BHCs should ensure that the output from models for which there are
model risk management shortcomings are treated with greater caution
(e.g., by applying compensating controls and conservative adjustments to
model results) than output from models for which all model risk
management activities have been conducted in line with supervisory
expectations.
5. Capital Policy
A BHC’s capital policy should be a distinct, comprehensive written
document that addresses the major components of the BHC’s capital
planning processes and links to and is supported by other policies.
The policy should provide details on how the board and senior management
manage, monitor, and make decisions regarding all aspects of capital
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planning and lay out expectations for the information included in the BHC’s
capital plan.
During CCAR 2014, supervisors observed many cases in which BHCs’
capital policies did not meet expectations.
For instance, at some BHCs, capital policies provided insufficient detail,
particularly as it pertained to the decision making process around the level
and composition of capital distributions.
Supervisors expect capital policies to include explicit limits on aggregate
capital distributions and to outline the type of analysis the BHC must
provide in its capital plan to support its proposed capital actions.
Many BHCs’ capital policies lacked a comprehensive suite of payout ratio
targets or limits; an explanation for how the BHC arrived at those targets or
limits; and, where they did exist, lacked defined response actions to be
taken in case of breaches of dividend and/or repurchase payout targets or
limits.
Some BHCs included general considerations for decision making, such as
review of capital ratios under stress scenarios, but offered no explanation of
how the BHC would arrive at planned distribution amounts or the form of
capital distributions.
During CCAR 2014, supervisors also observed that some BHCs did not
define and set capital goals and targets in a manner consistent with
supervisory expectations.
For example, some BHCs did not demonstrate that their internal capital
goals were aligned with the expectations of all relevant stakeholders
(including, but not limited to, shareholders, rating agencies, counterparties,
and creditors) to help ensure that the BHC could continue as a viable entity
during and after periods of stress.
Some BHCs did not consider or clearly incorporate the impact of stress test
results and uncertainty around those results in the determination of capital
targets.
In other cases, capital goals and targets did not incorporate expectations of
changes to regulatory standards (e.g., they were solely based on Basel I
metrics).
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Furthermore, some BHCs used a poorly defined capital buffer, ostensibly
to capture a range of additional risks or uncertainties, but without clear
attribution or sufficient analysis.
6. Presentation of Consolidated Pro Forma Results
BHCs should ensure that they have sound processes for review, challenge,
and aggregation of estimates used in their capital planning processes.
Based on supervisory evaluations from CCAR 2014, there is evidence that
processes for review, challenge, and aggregation contained significant
shortcomings at several BHCs and that all BHCs should continue to
enhance these processes.
In some cases, BHCs had satisfactory review and challenge processes for
some of their pro forma estimates, but not for others.
Satisfactory processes for review, challenge, and aggregation should
include:
• an effective internal review of processes used at both the line of
business/sub-aggregated and enterprise level, with final review and sign off
completed by an informed party not directly involved in those processes;
• policies and procedures documenting the process from end to end that
include a clear articulation of accountability for credibility of results at each
stage of the challenge process;
• evidence of clear communication among the different functions involved
in drawing together estimates from across the organization to promote
consistency and to ensure that those functions are operating under the
same guidelines and assumptions;
• set processes for aggregating and finalizing results, including appropriate
review and oversight of aggregate results to ensure coherence and
consistency of projected outcomes sourced from various forecast providers;
• clear identification and documentation of key assumptions, sensitivities,
limitations, and judgment applied at all levels of the processes used to
generate estimates, as well as communication of these items to relevant
senior management—and the board of directors, when necessary; and
• evidence of oversight and challenge to both processes and outcomes at the
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appropriate level of management, including documentation of actions
taken as a result of questions, issues, or requests that came up during such
review and discussions.
7. RWA Methodologies
Many BHCs faced challenges with their methodologies for projecting
RWAs.
Given that the as-of-date RWA calculated for regulatory reporting serves as
the foundation for RWA projections in scenario analysis, BHC management
should ensure, and provide evidence of, an independent review of RWA
regulatory reporting by either internal audit or another control function.
Independent reviews should ensure point-in-time RWA processes
appropriately capture all relevant on- and off-balance sheet exposures and
are consistent with the various risk-weighting frameworks to which the
BHC is subject.
For CCAR 2014, the level of independent review for point-in-time RWA
accuracy for many BHCs was not always evident, as reviews were either
dated, under the guise of general regulatory reporting audits that lacked
detail specific to RWA coverage, inferred as part of CCAR review process, or
nonexistent.
For BHCs subject to the Market Risk Capital Rule, supervisors expect
management to ensure that projections of market risk RWAs appropriately
reflect the level of risk in the BHC’s trading book and the contribution
market risk RWA makes to the firm’s total RWA.
BHCs should document the rationale for any significant changes in risk
weighting assigned to the trading book, particularly in cases where
projections show the ratio of trading book RWA-to-trading exposures
declining over time or under stress conditions.
All else equal, RWA per notional dollar of trading asset is generally
expected to increase over the projection horizon in response to the
heightened market volatility assumed in many firms’ stress scenarios, and
any deviations from that relationship should be well supported.
Although some BHCs subject to the Market Risk Capital Rule report market
risk RWAs that represent a relatively small proportion of total RWAs, all
BHCs should ensure that their reported projections of market risk RWAs
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sufficiently consider the impact of each scenario.
In general, all BHCs in the LISCC portfolio as well as any BHCs subject to
the Market Risk Capital Rule that report:
(1) trading assets and liabilities of greater than $10 billion or
(2) trading assets and liabilities of greater than 10 percent of total assets at
the as-of date for reporting should project market risk RWAs using a
quantitative methodology that captures both changes in exposures and
changes in volatility implied by stress conditions over time.
Providing overall support and documentation for RWA methodologies was
a shortcoming among BHCs in CCAR 2014.
BHCs should provide evidence for the appropriateness of assumptions
regarding the following:
• any aggregation of balance projections by exposure type or characteristic
(e.g., balances for exposures that do not distinguish between amounts that
are considered past due) for purposes of applying corresponding
risk weights
• any uses of average or effective risk weights based on the BHC’s as-of date
portfolio composition or historical trend (and evidence of the
appropriateness of basing RWA projections on historical trend,
given the potential for changes in portfolio composition over time and
under different stress conditions)
• support for any exposure types for which RWA is held constant over the
projection horizon
8. Operational Risk Loss Estimation
BHCs have found it challenging to identify meaningful relationships
between operational losses and macroeconomic factors.
Limited datasets and potential problems classifying and reporting events
contribute to the difficulties.
Specifically, the limited length of operational risk datasets makes finding
robust correlations to macroeconomic and financial variables difficult for
many firms.
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Compounding this problem, BHCs use extensive judgment to assign dates
to loss events that unfold over time, such as legal losses.
Given these challenges, correlation analysis can result in loss projections
that are unstable or invariant to scenario conditions, and are thus
inconsistent with the expectation that BHCs significantly stress their
operational risk exposures.
Given the challenges noted above, BHCs should not try to force the use of
unstable and/or unobservable correlations and should instead use a
conservative approach to project increased operational risk losses from
significant operational risk events that could plausibly occur during a
stressed economic and financial environment.
In other words, the use of scenario analysis may provide a more
conceptually sound basis for assessing potential operational losses under
stress.
The BHC stress scenario should capture significant operational risks that
could occur over the nine quarters of the BHC scenario and translate them
into loss estimates, regardless of whether or not they are directly linked to
the stressed economic environment.
The BHC stress scenario should be designed with the BHC’s particular
vulnerabilities in mind and include potential BHC-specific events such as
system failures, litigation related losses, or rogue trading.
BHCs internally identify operational risks using tools such as risk
assessments and key risk reports.
Material risks identified through these risk-management tools should be
considered and captured in the scenario analysis supporting stress test
estimates.
While operational risk events may not be caused by the economic
environment, firms should assume that they will occur during the
nine-quarter period for the purpose of stress testing.
Methodology Guidelines
Operational risk scenario analysis should cover a myriad of potential losses
characterized by differing event types and business lines, despite limited
historical data.
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Various techniques and methodologies can be used based on the particular
losses to be stressed, as long as they are logical, well supported, and
effectively stress material, inherent risks.
For example, a bank with limited internal data could supplement its
analysis through the use of external data, using such data in both
operational loss scenario analysis as well as other complementary
approaches to operational risk quantification.
BHCs are encouraged to explore multiple loss-projection techniques as long
as the overall methodology ultimately leads to reasonable, significant loss
projections.
In previous CCAR programs, four methodologies emerged: regression
analysis, loss-distribution approaches, historical averages, and scenario
analysis.
Regardless of the methodology or combination of methodologies a BHC
ultimately uses, it should justify its choice.
In addition, when using a given methodology, BHCs should adhere to the
supervisory expectations described below.
• When using a regression model, BHCs should have a clear understanding
of data and model limitations and make compensating adjustments that are
well supported and documented.
BHCs should also balance goodness of fit considerations with overfitting
and stability concerns in variable selection criteria.
• When using a loss-distribution approach, BHCs should provide reasoning
and justification for percentiles chosen as well as sensitivity analysis around
the percentiles.
• When using historical averages, BHCs should justify the date range
chosen through extensive sensitivity analysis, including exploring moving
averages, averages during stressed periods, rolling averages, and
worst-quarter results.
BHCs should also stress averages for both frequency and severity when
computing stressed operational risk loss estimates.
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• When using scenario analysis, BHCs should have a structured,
transparent, well-supported, and repeatable process subject to independent
validation and review.
BHCs should document and support the scenarios chosen and the resulting
loss estimates and describe reasons why some scenarios may have been
considered but then were rejected from the stress estimates.
Furthermore, BHCs should consider all large historical events the BHC
has experienced as well as external losses experienced by peer firms and
hypothetical events the BHC is exposed to but may have not yet
experienced.
Other Guidelines
The majority of operational risk shortcomings observed in CCAR 2014
related to data-capture, documentation, validation, and litigation-related
losses.
Data-capture issues typically included immature data-collection methods,
use of net losses, subjective exclusion of large historical losses, truncated
date ranges, and scaled-down internal losses BHCs should not assume that
if they have scaled down certain businesses, the associated operational
risk is necessarily eliminated and, thus, historical losses can be removed
from data used for operational risk projections.
Large historical events should not be excluded from a BHC’s dataset unless
soundly justified with evidence and analysis.
Date ranges used in any empirical analysis should be justified, and BHCs
should not selectively exclude time periods with relevant loss data.
Relatively recent data may be more representative of a bank’s current risk
profile, but larger datasets usually facilitate a more stable model.
BHCs should balance this trade off and conduct sensitivity analysis to
confirm any choices around date ranges.
In addition, the use of losses net of recoveries or insurance must be
particularly well supported (i.e., inclusive of an assessment of the likelihood
and timing of claims fulfillment), as such recoveries may not occur during a
stressed economic environment.
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Finally, many BHCs did not provide detailed and transparent information
on the process used to estimate legal losses and how these losses factor into
overall estimates of losses stemming from operational risks.
Some firms only considered settled losses and did not incorporate
forward-looking potential losses.
Supervisors expects firms to estimate legal costs (including expenses,
judgments, fines, and settlements) associated with the baseline and
stressful outcomes.
In baseline scenarios, firms should use expected litigation-related losses.
Under stress scenarios, firms should estimate potential losses by assuming
unfavorable, stressed outcomes on current, pending, threatened, or
otherwise possible claims of all types.
Estimates of stressed legal losses and other costs and expenses should be
well supported by detailed underlying analysis and, while considered as a
part of operational losses, should be broken out in their own subcategory, to
the extent possible.
9. AFS Fair Value OCI
As noted previously, this section on common themes identified by
supervisors in CCAR 2014 regarding BHC practices for AFS Fair Value OCI
was communicated to the BHCs subsequent to the other sections of this
appendix.
Under U.S. Generally Accepted Accounting Principles (GAAP), changes in
the fair value of AFS securities are reflected in changes in accumulated
other comprehensive income (AOCI); however, prior to issuance of the
revised capital framework, these changes were not reflected in the
calculation of regulatory capital.
In accordance with the revised capital framework, BHCs with total
consolidated assets of $250 billion or more or on-balance-sheet foreign
exposures of $10 billion or more (advanced approaches BHCs) must reflect
AOCI items in their regulatory capital beginning in the second quarter of
the planning horizon (the first quarter of 2014).
Under the transition provisions of the revised capital framework, regulatory
capital for advanced approaches BHCs must include 20 percent of eligible
AOCI in 2014, 40 percent in 2015, and 60 percent in 2016.
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This guidance applies only to advanced approaches BHCs; it does not apply
to BHCs with total consolidated assets of $50 billion or more that are not
advanced approaches BHCs.
Advanced approaches BHCs are expected to evaluate all AFS (and impaired
HTM) securities for changes in unrealized gains and losses that flow
through OCI under stress scenarios.
Stressing fair value is expected to reflect movements in projected spreads,
interest rates, foreign exchange rates, and any other relevant factors
specific to each asset class.
Historical spread and price data may be sourced externally or internally;
however, information utilized should be representative of the BHC’s
portfolio at a sufficiently granular level to capture the inherent risks of the
assets.
Additionally, the data utilized for projection is expected to span a sufficient
period of time that includes a period of vulnerability for that asset class.
Advanced approaches BHCs with weaker practices either chose historical
data from indices that did not represent the inherent risk in their portfolios
or evaluated a too limited a time frame of spread movements.
In order to appropriately capture the risks inherent in AFS agency
mortgage-backed securities (MBS), advanced approaches BHCs should
stress assets at a security level and substantially all risk be subject to
cashflow modeling.
The stress test should capture changes in prepayments, interest rates, and
spreads.
BHCs with better practices used cashflow models to project losses on every
asset in their portfolio, while BHCs with lagging practices utilized
sensitivity-based approaches (on a security and portfolio-level basis).
Changes in fair value of securities should be projected using
scenario-derived interest rates and spreads projected over the planning
horizon.
Advanced approaches BHCs should use the spreads that are consistent with
scenario conditions.
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Better practices reflected forecasting agencyMBS fair value changes
through a forward full revaluation, repricing at every quarter or at multiple
points in the time horizon.
There was limited variation across BHCs in approaches for stressing
Treasury securities.
Advanced approaches BHCs should explicitly link interest rate moves to
scenario conditions.
BHCs with better practices utilized full revaluation.
Lagging BHCs did not holistically capture future price changes and instead
projected price movements based only upon sensitivities.
For AFS credit sensitive assets, advanced approaches BHCs are expected to
project changes in fair value consistent with assumed scenario conditions.
Better practices included a projection of interest rate and spread changes
using cashflow modeling with explicit linkage to the projected scenario
horizon.
Advanced approaches BHCs are expected to support the appropriateness of
scenario variables specifically for each asset class.
For example, if a BHC utilizes the same key explanatory variable for every
asset class, there should be empirical support of a strong relationship
between the explanatory variable and each asset class.
The BHCs with the better practices utilized a regression-based methodology
that captured the risk characteristics of the portfolio at a granular level,
with clear documentation of key assumptions, limitations, and other
considerations.
If an advanced approaches BHC contemplates reinvestments, investments
should be clearly articulated with supporting rationale that is consistent
with scenario conditions.
New purchases and reallocations should also be subject to fair value
changes across the remaining time horizon.
BHCs with lagging practices did not contemplate any future changes in
unrealized gains and losses for new asset purchases.
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Consistent with expectations as laid out in Capital Planning at Large Bank
Holding Companies: Supervisory Expectations and Range of Current
Practice, all models utilized to project unrealized gains and losses should be
independently validated.
Any judgment used, including choice of data and key explanatory
variables, should be well supported and subject to independent challenge.
In order to transparently evaluate the full functionality of AFS fair value
OCI models, the Federal Reserve expects advanced approaches BHCs to
clearly document their key methodologies and assumptions used in
estimating unrealized gains and losses.
Documentation should concisely explain methodologies used for each asset
class, with relevant macroeconomic or other risk drivers, and demonstrate
relationships between these drivers and estimates.
The source and time frame of historical data utilized should also be clearly
detailed, including support for the dataset chosen relative to the
appropriate risk inherent in the portfolio.
Documentation should also be developed and maintained to detail how the
projections are consistent with the BHC’s scenario conditions.
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The rewards of an ethical culture
Remarks by Mr Thomas C Baxter, Executive Vice
President and General Counsel of the Federal Reserve
Bank of New York, at the Bank of England, London, 20
January 2015.
These remarks are personal and do not necessarily
represent the official position of the Federal Reserve Bank of New York, or
any other component of the Federal Reserve System.
Introduction
Let me begin by thanking Sir William Blair and the Bank of England for
inviting me to participate in this Project and at this Conference.
At the New York Fed, we have made ethical culture a priority for financial
services.
We have done this not as a formal part of a supervisory program, but more
as a call for reform. In the short time that I have this afternoon, I will speak
about the reasons why I believe reform is necessary, highlight some of the
important practical features of a strong ethical culture, and conclude by
setting out a few of the rewards that might result from it.
Bad behavior in the financial services industry prompted the New York
Fed's call for a stronger ethical culture in banking.
My list of the most serious transgressions is probably not much different
from anyone else's.
It includes the evasion of taxes and economic sanctions; conspiracy and
market manipulation with respect to LIBOR and foreign exchange rates;
and misselling financial products, including residential mortgages and
insurance, to people who should not have acquired them.
This list is only illustrative. It is not by any means exhaustive.
The traditional means to address bad behavior are enforcement actions
against the bad actors and the organizations where they worked.
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This traditional response, in my view, is appropriate and I strongly support
the actions that have been taken and that will continue to be taken.
All enforcement actions, though, are essentially retrospective.
Of course, we like to think that enforcement actions will not only punish but
also deter. But I wonder if this hope is really a prospective strategy.
We would better serve the public good if we could do something - anything more forward looking, and complementary to what our enforcement
colleagues are doing to deter future bad behavior.
Ethical culture
The new emphasis on an ethical culture within financial services firms
arises from the policy interest in preventing some of the bad behavior that
has been observed.
Now I use the phrase "some of the bad behavior" deliberately.
I fully embrace the goal of eliminating all bad behavior. But we cannot let
the goal of perfection become the enemy of progress. We need to start
making progress, so let us agree that perfection is probably not realistic.
Even an organization with the strongest ethical culture will have episodic
bad behavior.
Although culture is no panacea, I believe that the ethical culture of an
organization can improve the behavior of the people who work there.
Strengthening the ethical culture of financial services should therefore
reduce the volume of bad behavior we have been seeing.
Some of the skeptics say, "Prove it."
I confess that proof is hard to come by. Yet, I am not alone in the
fundamental belief that a strong ethical culture will lead to better behavior.
A 2010 Corporate Executive Board survey of more than 500,000
respondents shows a widespread view that corporations with strong ethical
cultures experience less misconduct.
This makes intuitive sense even in the absence of empirical proof.
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Further, the natural tendency to go with the intuitive is bolstered by the
potential benefit of a reduction in enforcement actions against financial
services firms, and by a healthy change in the public perception of the
financial services industry.
And, of course, there is ready evidence for the contrapositive view.
Few would disagree with the following: The bad behavior that contributed
to the Financial Crisis was evidence of a culture that was not strongly
ethical.
Let me also pose a challenge to those who are skeptical about the benefits of
a strong ethical culture: If this is not a suitable method to prevent bad
behavior by bankers, what alternative proposal do you advocate? The status
quo is not acceptable.
As a wise man once said, "Plan beats no plan."
The components of a strong ethical culture
So what are the key components of a strong ethical culture?
It is said that lawyers love a metaphor, and this lawyer is no exception.
I like to think about ethical culture as if it were a package.
The culture that we will have is derivative of what we put into the package,
and there are clear choices to be made.
The contents depend upon the type of organization, the kinds of people, and
the nature of the skills needed to conduct the organization's activities.
Time will not permit me to cover this thoroughly, so let me cover a few
items with a very broad brush.
What goes in
For starters, the conduct of the people in any organization will be strongly
influenced by incentives.
Let me mention the "big three."
Bankers, like lawyers, want to do quality work, with people they like and
respect, and receive fair recognition in return.
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I will touch on all three but will focus on two species of recognition:
compensation and promotion.
Each should be tied to ethical considerations.
If the only consideration with respect to compensation and promotion is
how much money the individual made for the firm, then that communicates
a message that is inhospitable to a strong ethical culture.
A second key component is what I call "character at the top."
The usual expression is "tone at the top," and it refers to the message from
the people who occupy the upper most positions in any organization (the
board of directors and the "C" Suite).
My worry with the typical expression is that it tends to focus on words,
rather than conduct.
The implication is that if you sing the right notes in the right key then all
will be fine.
I do not believe this.
Employees will be influenced by the actions of key management, and not
merely by the songs they sing.
If those actions are in harmony with stated mores, then the combination
should foster a strong ethical culture.
But if the observed actions are not congruent with the words (or, worse,
conflict with the words), then employees will follow suit: They may say the
right things, but they will not behave the right way.
Worse still, they will sense that they work for a firm lacking in integrity.
This has long-term, deleterious consequences.
Recall that one of the key attractions in working for a particular
organization is association with people who are liked and respected.
Do people like and respect leaders who lack integrity? Good luck attracting
top talent in that kind of organization.
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A third key component in a strong ethical culture is values. Most firms
elaborate rules of proper behavior, often in well-crafted codes of conduct.
In some large, complex organizations, the rules can be difficult and tedious,
like the rules for conflicting interests and for avoiding trading on insider
information. In better run firms, the rules are built on a foundation of the
shared and well-understood values of the institution.
These values reflect a bank's public function as a financial intermediary and
recognize the privileges that come with a banking charter.
In other firms, however, compliance rules can be undermined by the values
of the organization, resulting in an unhealthy dissonance.
For example, if there are elaborate rules for complying with the tax laws of a
particular jurisdiction, but the organizational value is to facilitate flight
capital, a mixed message may be sent that tax compliance rules are just
technicalities.
Similarly, in the area of economic sanctions, if the sanction is perceived as
something technical and implicating only a single currency, the bank might
be sending an unintended message - that we comply with the sanction only
because it represents a mandatory but silly rule of a single sovereign issuing
a specific currency, and not because the sanction seeks to address a
problem that all should find abhorrent, like financing a jurisdiction
engaged in genocide.
What to leave out
Thinking about culture like a package, there are some things that I would
leave out.
Again, without being exhaustive, here are three examples.
First, I would leave out any depiction of the persons that an organization
does business with as "counterparties."
If you went to your doctor and overheard her refer to you in conversation
with office personnel as a "counterparty," rather than as a "patient," would
you worry?
I would.
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Similarly, if you went to your personal lawyer and overheard him refer to
you in conversation with his associate as a "counterparty," rather than as a
"client," would you worry?
You should.
My point here is not that banking is a profession like medicine or law.
My point is about how you see your customer and the service provided to
that customer.
A counterparty is not someone needing your help; "it" represents a profit
opportunity - something to be exploited.
Their loss is your gain.
A customer, by contrast, is someone to be served.
It is right to charge a fee to a customer, client, or patient, but the
transaction is driven by the other person's needs.
Many financial services firms, however, refer to the people they do business
with as counterparties.
This is no accident.
It characterizes the way in which the organization views the person it is
facing in its businesses.
Viewing customers as profit opportunities is inconsistent with a strong
ethical culture.
In my experience, firms that consider their operational model as service
provider tend to have a better culture than those firms that consider their
operational model as money maker.
The second item that I would leave out is a conception of a bank as a money
making machine.
This is not to say that I would ignore profitability; that would be foolish and
would destine a firm to a short life.
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But a bank's goal should be to provide service to its customers through
financial intermediation, as Mark Carney has explained so eloquently.
Christine Lagarde sees this as a question of animating purpose - of "telos" and I agree.
Similarly, the Archbishop of Canterbury, Justin Welby, has called for
financial institutions to reset to the first principle of service, playing a role
in the world that contributes to "human flourishing."
If you don't believe me, listen to the Archbishop: It is possible to do good
and do well at the same time.
And remember one of attributes that attracts the best and the brightest to
an organization is the prospect of quality work.
Having a work force that feels they are contributing to the greater good
should benefit the organization in its effort to recruit the best minds, but
also in the effort to recruit those with the best hearts (who presumably will
be less likely to become malefactors).
The last item that I will leave out is "short termism."
Permit me to describe the concept.
With increasing frequency, people working in a financial services firm have
no loyalty to their employer because they do not intend to work there long.
Instead, the idea is to get some experience and a decent bonus and then
move to the next employer - or, if the bonus is large enough, to work for
oneself.
Given the specialization that tends to accompany various financial services,
people with near-term career horizons tend to develop loyalty to the special
group of individuals with whom they transact business and who might
provide the next job opportunity.
These specialized bankers or traders increasingly resemble independent
contractors or freelancers - careerists with no institutional loyalty.
In foreign exchange, for example, we saw people orchestrating a
manipulative scheme across a network of individuals at many institutions.
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This is all rational and understandable - specialists need the long-term
allegiance of their network to continue to ply their trade, and this allegiance
is far more consequential than loyalty to the organization currently
employing them.
So, when in conflict, career trumps institution.
Some of this is simply generational; there is more employment mobility
now than thirty years ago.
But compensation plans bear some degree of responsibility as well.
Annual bonuses that reward immediate book value without reflecting tail
risk to the organization reinforce short termism.
Changing the time horizon for compensation will be a significant feature of
meaningful cultural reform.
Conclusion
The principal benefit to a financial services firm in having a strong ethical
culture is the avoidance of bad banker behavior.
Bad banker behavior often leads to enforcement actions that can carry
significant monetary fines, that can inflict destructive damage to the
organization's reputation, and in the worst case, that can cause the death of
a franchise (recalling that all financial services firms depend upon public
confidence to survive).
A strong ethical culture also attracts the best and the brightest personnel,
who will seek out the bank as the place to build a career doing high quality
work, for fair compensation, with people they like and respect.
As for those with whom the bank does business, they may come to see the
organization as customer focused, looking to serve them well, and not
turning them into the next "profit opportunity."
Finally, from the perspective of the supervisory community, an industry
comprising personnel who have a strong ethical culture will be a safer and
sounder industry, certainly safer and sounder than an industry full of
miscreants.
This could be a powerful factor toward financial stability.
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Thank you for your kind attention.
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Comments on the Fair and Effective
Markets Review
Speech by Mr Jerome H Powell, Member of the
Board of Governors of the Federal Reserve System,
at "Making Markets Fair and Effective for All",
sponsored by The Brookings Institution,
Washington DC, 20 January 2015.
The views expressed here are my own and are not necessarily shared by
other members of the Federal Reserve Board or the Federal Open Market
Committee.
I want to thank the Brookings Institution for inviting me to comment today
on Martin Wheatley's presentation on the Fair and Effective Markets
Review (Review).
The Review is an ambitious and important initiative.
Although London is perhaps the leading center for many fixed-income,
currency, and commodities (FICC) markets, these markets are global, and
the United States and the largest U.S. firms play key roles in them.
So the Review addresses issues that affect our markets as well.
The Review looks to identify further steps that should be taken to restore
public confidence in FICC markets in the wake of the depressingly
numerous instances of serious misconduct in these markets in recent years.
That misconduct has been, and will continue to be, addressed through
substantial fines and criminal prosecution of the firms and individuals
involved.
The Federal Reserve continues to take part in these enforcement actions in
cooperation with other U.S. agencies.
The design of the Review is not only to advance the enforcement process,
but also to look carefully at markets and firms and ask whether there are
structural vulnerabilities or incentives for bad conduct that have not been
well addressed by reforms to date.
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I will offer comments on a few specific areas and discuss some of our
parallel efforts here in the United States.
First, as the Review notes, there is a perception that FICC markets and their
participants are highly sophisticated and do not need protection.
While that may be generally true, the perspective is too narrow, because the
importance of these markets extends far beyond the largest participants in
them.
The market mechanism allocates credit and determines the borrowing costs
of households, companies and governments.
Proper market functioning is really a public good that relies on confidence
and trust among market participants and the public.
Bad conduct, weak internal firm governance, misaligned incentives, and
flawed market structure can all place this trust at risk.
One of the ways we have to influence incentives is through compensation
practices at supervised institutions.
Many have argued that pre-crisis compensation practices at the largest
financial firms allowed or created misaligned incentives.
In response, many firms have changed their compensation practices since
the crisis to better align incentives between individuals and firms,
particularly through enhanced deferral of incentive compensation, with
delayed vesting and the possibility of more robust forfeiture in a broader set
of circumstances.
We have strongly encouraged these reforms in our supervision of these
institutions.
In my view, the reforms are both essential and generally on target.
The U.S. financial regulators, including the Federal Reserve, are also
preparing for public comment a proposed new rule on incentive
compensation that will codify and strengthen these initiatives.
As the Review notes, greater transparency can also help curb market abuses
and strengthen competition.
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In the United States, we have had over a decade of experience with the
Trade Reporting and Compliance Engine (TRACE) in over-the-counter
corporate bond, MBS and ABS markets.
The Municipal Securities Rulemaking Board provides similar data for
municipal bonds.
The Dodd-Frank Act also imposed rules requiring greater transparency in
over-the-counter derivatives markets through the use of central clearing,
trade repositories, and swap execution facilities. Given the issues around
OTC derivatives during the recent crisis, these clearly are important
initiatives.
But despite significant progress, there are still a number of impediments to
sharing trade report data across regulatory agencies and jurisdictions,
leaving us with only a piecemeal picture of the overall market rather than
the full transparency that we desire.
The issues around foreign exchange (FX) benchmarks serve to illustrate
one of the important challenges discussed in the Review - the difficulty of
managing the potential conflicts of interest associated with the traditional
market-maker model.
In FX markets, a wide range of end users seek to guarantee trade execution
at the WM Reuters fixing at 4:00 p.m. U.K. time each day.
This practice results in dealers having advance information about flows,
and at the same time places them at some risk, as they are agreeing to
execute these orders at an unknown future price.
This advance information can create a perception that dealers are trading
ahead of their clients, and it certainly created incentives to attempt to
influence the fixing price.
The recent Financial Stability Board (FSB) report on foreign exchange
benchmarks made a number of recommendations designed to address
these issues in this specific market, including use of trading platforms to
maximize the netting of fixing orders, encouraging dealers to charge a
transparent bid-asked spread or other fee to compensate them for the risk
they take, and strengthening dealers' internal systems and controls to
better manage potential conflicts of interest.
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Of course, similar challenges exist with market-making in other FICC
markets.
Many firms have taken up these challenges with their own reforms, and
their efforts serve to emphasize how complicated these issues can be.
Dealers must communicate with other firms, within their own firms and
with their clients, and must execute their clients' trades.
The challenge is to identify and preserve the legitimate benefits of such
communication and trading while safeguarding against improper uses of
information.
It may be that these challenges can be addressed through coordinated
private efforts; for example, through such bodies as the Foreign Exchange
Committee and the Treasury Market Practices Group, sponsored by the
Federal Reserve Bank of New York.
These groups are actively working on industry best practices in their
markets and have often played a constructive role on market practices that
enhance market functioning.
It may also be that further supervisory or regulatory action is needed.
Turning to our work on interest rate benchmark reform, it is worth recalling
that, before the scandal broke, the London interbank offered rate (LIBOR)
was not regulated. U.K. authorities have now addressed this shortcoming
by making both the submission and administration of LIBOR regulated
activities.
The process by which firms make their LIBOR submissions is now subject
to careful monitoring.
The new LIBOR administrator, ICE Benchmark Administration, now
regulated by the Financial Conduct Authority, is evaluating changes to
LIBOR so that it can be based as much as possible on actual arm's-length
transactions from a broader base of funding transactions.
With surveillance and penalties in place, and a new administrator, one
might be excused for thinking that there is nothing more to be done. In fact,
some people do think that.
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That is emphatically not the view of the FSB Official Sector Steering Group
that I now co-chair with Martin, which concluded that it is essential to
develop one or more risk free (or near risk free) alternatives to LIBOR for
use in financial contracts such as interest rate derivatives.
The reasons are related to the structure of both LIBOR and the market that
underlies it.
Unsecured interbank borrowing has been in a secular decline for some
time, and there is a scarcity, or outright absence in longer tenors, of actual
transactions that banks can use to estimate their daily submission to LIBOR
or that can be used by others to verify those submissions.
LIBOR is huge - there are roughly $300 trillion in gross notional contracts
that reference it - so the incentives to manipulate it still remain in place.
And the structural problems go much further than the incentives for
manipulation.
Markets need to be fair, effective, and also safe.
If the publication of LIBOR were to become untenable because the number
of transactions that underlie it declined further, then untangling the
outstanding LIBOR contracts would entail a legal mess that could endanger
our financial stability.
For these reasons, the Federal Reserve has convened a group of the largest
global dealers to form the Alternative Reference Rates Committee.
We have asked them to work with us in promoting alternatives to U.S.
dollar LIBOR that better reflect the current structure of funding markets.
As the Review's consultation document notes, issues of this kind are really
global in nature; U.S. dollar LIBOR contracts are traded throughout the
world, not simply in the United States. For this reason we are working in
close consultation with our foreign regulatory counterparts in this
endeavor.
One of the reasons that I emphasize structural issues such as the
market-maker model or the secular decline in unsecured interbank
borrowing is that FICC markets are undergoing rapid changes that seem
likely to have far-ranging consequences.
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Issues that a few years ago concerned equity markets now arise in FICC
markets as well.
As the consultation document notes, broker-dealers are curtailing some of
their market-making activities and their appetite for providing liquidity in
response to regulatory changes and their own assessment of the risks and
returns of these activities.
At the same time, other players such as mutual funds, exchange traded
funds, algorithmic and high-frequency traders, and electronic exchanges
are taking more prominent roles.
These changes will affect market liquidity and functioning in ways that are
difficult to foresee.
It is possible that some of these factors played a role in the sharp swing in
Treasury yields last October 15, and we are working with other regulators to
understand exactly what happened that day and to determine whether
there are implications for regulatory or supervisory policy.
The Review raises the right questions in considering the troubling patterns
of market abuse, and also in considering the structural changes that we are
now seeing.
It is important that market participants, end users, and regulators
collectively take a step back and consider, as the Review invites us to do,
whether the changing structure of FICC markets will result in markets that
are fair, effective, and safe.
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An overview of the financial
landscape in Barbados
Speech by Dr DeLisle Worrell, Governor of the Central Bank of Barbados, at
the Domestic Financial Institutions Conference, Bridgetown
Barbados has a sound and sophisticated financial system which provides
an adequate range and variety of financial services for businesses and
households, but there are a few gaps still to be filled.
The main impact of the global recession on our financial system has been to
reduce profitability among commercial banks, and to arrest the growth of
insurance business.
The financial landscape is changing largely because of changes in the way
that large companies manage their regional and international finance and
payments arrangements.
My remarks this morning will address these 3 issues.
The main financial providers in Barbados are the banks- by far the largest
segment, insurance companies, credit unions and finance companies.
Between them, they provide adequately for the needs of households.
Banks provide mortgages, short term consumer credit and payments
services.
Many people hold savings with commercial banks, even though savings
bonds and credit union shares are more remunerative alternatives.
Banks also provide for the working capital needs of established businesses,
and contribute to the funding of projects for larger firms.
All banks operating in Barbados are part of international banks
headquartered in Canada and Trinidad.
They therefore have strong backing.
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Banks' profitability has declined, but loan write-offs are only a tiny
percentage of their credit and have not contributed much to the fall in
profitability.
Credit unions are the banks' competition.
Because of their mutual ownership, they are able to offer lower interest
spreads than the banks, between what members earn on their shares, and
the interest they pay on borrowings.
Credit unions currently offer most of the services banks offer, and there are
no barriers in principle to prevent those credit unions which qualify from
providing the remaining services in which they have expressed an interest.
Insurance and pension funds cover the remainder of the financial services
most businesses and households need.
The insurance industry contracted with the exit of Clico, and there has been
little recovery since then.
Insurance and pension funds look for investment that will yield a good
return over the long run, and they are therefore a potential source of
funding for capital formation.
The weakness of this segment is the limits on the supply of long term
finance.
What makes matters worse is a preference for investment in marketable
securities rather than equity participation in projects.
In Barbados there is a scarcity of marketable corporate instruments
available for purchase and sale on an ongoing basis.
All in all, our financial system provides a range of services that pretty much
satisfies the needs of Barbadian households and large and well established
businesses.
However, venture capital is in short supply, and the fixed investment needs
of small and medium sized enterprise continue to be a challenge for us.
Our session this afternoon will explore this conundrum.
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Impact of the crisis
The global recession which is dated from the September 15 2008 Lehman
bankruptcy, had little effect on the Barbadian financial system, with the one
important exception of Clico.
As might have been expected, the weakness of the Barbadian economy
resulted in late and incomplete debt service by some firms and households,
but in the typical case a workout arrangement was put in place.
On the other hand, Government maintained its perfect service record, both
for domestic and foreign debt.
Changes in business finance
The most noticeable changes in financial transactions in recent times have
been on the foreign exchange market.
The interbank market is now inactive, in contrast to the situation up to a
decade ago, when daily interbank transactions of a modest size were the
norm.
Large customers of the banks have corporate treasuries which manage their
transactions and exposures in several currencies, matching exposures by
currency so as to minimise net exposure in foreign exchange, and reduce
the transactions costs of currency conversion.
We have looked into this phenomenon at this conference in years past, and
when we meet with banks we invariably discuss how the market is evolving.
Some businesses appear to have achieved a degree of independence of their
bankers, with respect to foreign currency receipts and payments.
In so far as this facilitates payment of imports out of private firms' foreign
earnings, there is no problem with that arrangement.
Our programme today includes an update on the financial system, a
presentation on cyber security, investment options for insurance
companies, the view from the credit union sector, a new look at banking
subsidiaries, and a panel on equity finance.
It is a varied menu, and one that is certain to be instructive.
We expect to have a productive day.
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