A Brief Supervisory Perspective on Banks’ Internal Assessments of Capital Adequacy David Palmer Federal Reserve Board April 2009

2 U.S. Supervisors and Capital Adequacy Supervisors have long emphasized the importance of strong capital levels at all banking institutions  Lots of effort expended to improve regulatory measures Banking institutions should also conduct an internal assessment of capital adequacy  Regulatory capital measures are useful, but have limitations  Example: CRE concentrations at small banks  Responsibility for assessing capital lies first with the bank Some institutions, because of their size and complexity, may need a more rigorous and sophisticated process  Difference of degree, not kind  Federal Reserve’s SR is a reflection of this view  Similar approach being taken under Pillar 2 of Basel II

3 Key Concepts in Internal Assessments For assessments of capital adequacy, supervisors are more interested in capital attribution (determining the size of the capital “pie”), as opposed to capital allocation (how to divide an existing capital “pie”) Economic capital (EC) relates to methods or practices that financial institutions use to attribute capital to absorb losses from risk-taking activities for various time horizons and confidence levels  But using EC does not automatically mean a bank has a robust and credible process to assess capital adequacy Internal assessments of capital adequacy are comprehensive processes that allow institutions to ensure that their capital levels are adequate

4 Key Challenge: Risk Infrastructure Meaningful and accurate capital adequacy assessments depend on a credible risk management foundation Process requires fundamental risk management infrastructure  For example, ability to accurately rate credit exposures  Problems here generally indicate core issues needing attention  Fix these issues before moving forward Also need advanced risk measurement and quantification  For example, ability to assign PDs and LGDs to credit exposures  Focus on the ability to produce credible inputs to capital attributions  Must be addressed before capital attributions make sense Qualitative approaches are an important complement to quantitative tools, even for the best modeling Validation is vitally important at all levels

5 Key Challenge: Capital Coverage

6 Key Challenge: Stress Testing Stress tests allow banks to look at their assessment of capital adequacy in different ways  Allows them to “tweak” assumptions in existing models  Allows them to look beyond existing models (such as EC) Should tests be “plausible”? Ex ante probabilities often wrong  Even if an event seems quite unrealistic, check its severity Need to keep updating stress tests and their assumptions  Structural changes in markets or economies may make some tests less meaningful  Consider conditional/intermediate probabilities and severities Probably the most difficult challenge is to assess combination of risks and the losses they produce  It is particularly difficult to assess spillover or “knock-on” effects Need to run a range of stress tests, not just rely on one or two  Important to identify and isolate key assumptions in each test

7 Stepping Back… All assessments of capital adequacy are subject to uncertainty that will never fully disappear  Inherent data challenges and modeling challenges Each assessment tool has assumptions and limitations  Firms should not rely on just models or on just stress testing  Good to use several complementary tools But even the use of many tools leaves an element of uncertainty in assessments  Assessments are “estimates” – do not fully represent reality  For example, some interrelationships and amplification effects will not be known in advance  Banks need strong capital buffers given uncertainties  Maintain a sense of humility about what one really understands