Fed Details Flaws in Big Banks' Capital Planning

WASHINGTON — Large bank holding companies that underwent stress-testing by the Federal Reserve Board have improved their capital planning since the financial crisis, but several deficiencies remain that need to be corrected soon, the agency warned Monday.

"There is still considerable room for advancement across a number of dimensions," the Fed said in a paper intended to detail best practices for bank holding companies.

The largest 18 U.S. banks were tested by the Fed earlier this year to gauge their capital adequacy in the event of a severe economic downturn. Twelve more institutions will be added to next year's evaluation.

Banks that were part of the process this year "made substantial improvements" in capital planning, but the central bank detected several common flaws, according to the paper.

Among them was an inability to show how all risks were accounted for during the capital-planning process. Banks also used stress-test scenarios and modeling techniques that did not address distinct vulnerabilities of their business model, the Fed said.

The paper recognized that some risks, including reputational, strategic and compliance risks, are difficult to incorporate into a plan but faulted banks that failed to address those issues at all.

"Many BHCs [bank holding companies] used internal capital targets to account for such risks, putting in place an incremental cushion above their targets to allow for difficult-to-quantify risks and the inherent uncertainty represented by any forward-looking capital planning process," the paper says. Companies "with lagging practices did not even attempt to account for other risks in their capital planning process."

The Fed said that to "the extent possible" banks should incorporate these risks into their planning over nine quarters and "articulate and support" any relevant assumptions. But it warned that using "a simple rule (such as a percent of capital)" without such analysis "is a lagging practice."

The central bank also raised concerns about loss, revenue and expense projections that "were not robust, transparent and/or repeatable, or that did not fully capture the impact of stressed conditions."

It said some capital policies did not clearly outline a firm's goals and targets or provide analytical support for how such goals are appropriate. The Fed said some plans need to be more comprehensive in scope, and others need to be more detailed.

Finally, the Fed said that banking companies must have strong governance and controls tied to the capital-planning process, including the ability to identify, measure and manage risks.

Companies "should have a systematic and repeatable process to identify all risk and consider the potential impact to capital from these risks," the Fed paper said.

It said banks should establish standardized processes that senior management regularly updates.

Companies "should be able to demonstrate how their identified risks are accounted for in their capital planning processes," the paper said.

Stronger banks , the Fed said, had boards of directors that were informed of, and generally understood, the risks a firm was taking, as well as their exposures and vulnerabilities.

In contrast firms with "weaker practices provided insufficient information to the board." For example, some capital distribution recommendations did not include relevant supporting information and were based on optimistic expectations, the Fed said.