Regulatory scrutiny has shifted directly to capital this year, and every community bank must produce a capital plan that is thorough and realistic. Regulators are specifically looking at minimum capital targets. They do not want to see regulatory minimums. They want to see minimums set that are in line with the bank's unique risk profile.
There are key elements that bank management teams and board members should infuse into the planning process. Above all, the capital planning and its resulting document must involve information and education at the board level. A best practice after assessing and quantifying a bank's risk profile is to set current minimums and strategic long-term minimums.
Information
Every capital plan should be driven by and connected to the institution’s strategic plan. Forward strategic modeling will unveil where your capital adequacy is currently, but also into the future. Communication of the results of this exercise is critical as it will answer questions such as “What is our current capital position?” and “What will the future capital position be?” Determining your current capital position should be ratio driven. Components should include equity to assets, risk-based capital, and the Tier 1 leverage ratio. There should also be comparisons to national and state peer groups. The forward strategic planning model illustrates the dollar value of capital and all pertinent ratios projected out over time.
Based on the information that is garnered from your modeling, the board must then discuss risk and its implications to capital adequacy. The board must set minimum capital targets with the guidance of the management team and information gleaned from the forward modeling. This in turn begets a review and potential changes to the bank’s capital policy. Credit risk has a direct impact on capital and must be assessed and monitored. This should include an overview of the bank’s historical and current credit performance as well as comparisons to national and state peer groups.
Education
Managing capital adequacy now and into the future, and assessing the risks associated with it, is complex. The board must have confidence in the tools and information that they will use to monitor it. Credit shock capital and spend time absorbing what it is telling you.
This credit shock will illuminate for the directors how capital will hold up under a worst-case scenario. Educate further by illustrating the impact to capital based on the level of net charge-offs. The board should be clear on all factors that would result in the bank being undercapitalized.
Taking it Further
- Review the bank’s economic value of equity (EVE). This should include a breakdown of what drives the bank’s EVE, such as the bank’s level of cash-type deposits (checking, savings, and money markets).
- Interest rate shock and interest rate simulations effect on capital. This should not only shock EVE +/- 200 for regulatory purposes, but should also reflect at least two yield curve simulations and their impact to EVE.
- What are the bank's earnings at risk? Though earnings at risk are a component of EVE, there should be a historical review of the bank’s interest rate risk management.
- What is the bank’s liquidity risk? The financial crisis of 2008/2009 has placed new emphasis on contingency liquidity planning and its relationship to capital strength. What is the impact of a liquidity shock on the bank? Will the bank have sufficient capital in a liquidity situation?
- Develop a contingency capital plan. This should include all the methods and possibilities of raising capital.
Capital planning is the leader of the pack under regulatory scrutiny. Developing a capital plan that is thorough, realistic, and part of the boardroom dialogue is critical. Take action to ensure your capital plan has the components needed.