Why CEOs Must Pay Attention to Regulatory Capital Silos: A Strategic Planning Primer

No matter who –or what department—at your bank handles regulatory capital testing, the outcome will ultimately reflect on the CEO. And that means regulators are going to pay attention to the entire process.

“Every CEO must recognize that a capital adequacy exercise is ultimately an evaluation of a bank’s executive management’s ability to guide the bank through a range of economic circumstances, taking into consideration the bank’s existing financial strength and operating performance within its geographic footprint,” said Invictus Consulting Group Chairman Kamal Mustafa.

Most banks have completely separate stress testing, capital planning and strategic planning functions. Unless these units operate together, using the same methodology and data, the capital adequacy analysis will be useless, and maybe even wrong.  And that will reflect on the CEO, not the risk officer or risk department. “History has shown that, whether it be a failure of strategy or a failure of analytics, the CEO and executive management is always held responsible,” Mustafa said.

CEOs are faced with competing interests when evaluating regulatory capital adequacy. After all, regulatory capital adequacy is focused on risk. Reward (profitability) is of relatively lower importance to regulators beyond the fact that it contributes toward the accumulation of the bank’s capital cushion. The CEO’s obligation to shareholders is primarily maximizing reward (profitability) within acceptable levels of risk. This is essentially a reversal in prioritization to the regulatory approach.

CEOs must walk a tightrope, making sure that they integrate both the risk and the reward parts of their mandate, using consistent data and a cohesive process and methodology. Absence of this total integration is obvious to regulators and inevitably reflects poorly on the bank and its CEO/executive management.

The symbiosis between strategic planning, capital planning and stress testing is vital, yet banks often make these common mistakes:

• Separation of management responsibility and accountability between the functions.
• Differentiation of methodologies between the functions.
• Use of legacy analytics that have little or no relevance to the present-day banking environment.
• Lack of consistency in the use of data and information between the functions.
• No alternative scenarios linking the functions.
• Macro (national) focus rather than regional (bank geographic footprint) focus.
• Parallel approach to each step rather than progressive steps leading from strategic planning to capital planning to stress testing.

These are the recommended steps in the post-recession strategic planning process:

Step 1: Development of an operating strategic plan. That is the prime directive for all CEOs/executive management. It is the optimization of short and long-term risk/reward scenarios. The strategic planning process cannot be based on a “crystal-ball” approach, but must evaluate a range of likely scenarios to help define a primary operating strategic plan with appropriate contingencies.

Step 2:  Generation of a capital plan designed to support and fund the operating strategic plan. Regulators want to know the capital impact of contemplated strategic options.

Step 3:  Stress testing of the strategic/capital plan based on extreme scenarios defined by regulators (CCAR, Dodd-Frank).

Step 4: Identification, quantification, and analysis of capital shortfalls, if any, identified in the stress testing process.

Step 5:  Back to Step 1 if any capital shortfalls are identified in the stress testing process.

Step 6:  Constant monitoring of real-world performance against strategic plan with appropriate ongoing adjustments.

Thanks to the successive CCAR exercises, regulators have developed considerable expertise in analyzing bank stress tests. With even a cursory review, they can instantly identify banks that have followed the “intent of the law” versus banks that attempt to meet the “letter of the law”. Volume and detail are not any replacement for substance.