Twitter RSS

Capital and Prudential Standards Blog

Home Basel Committee Basel Committee Discusses Fundamental Elements of a Bank’s Capital Planning Process

Basel Committee Discusses Fundamental Elements of a Bank’s Capital Planning Process

Today, the Basel Committee published a paper that discusses four fundamental components of a sound capital planning process:  (1) internal control and governance; (2) capital policy and sufficient risk capture; (3) forward-looking view through stress testing; and (4) management framework for preserving capital.

The Basel Committee stated that its paper does not set forth new capital planning guidance.  Rather, it presents sound practices observed at some banks, which the Basel Committee believes can foster overall improvement in banks’ capital planning processes.  U.S. bank holding companies that are subject to the Federal Reserve’s Comprehensive Capital Analysis and Review (CCAR) would already be familiar with the principles and practices discussed in the paper.

This blog post provides a high-level overview of the fundamental components identified by the Basel Committee.  Our earlier blog post on the Federal Reserve’s August 2013 paper entitled Capital Planning at Large Bank Holding Companies: Supervisory Expectations and Range of Current Practice is available here.

The Basel Committee noted that its paper is also not intended to describe ideal practices, as banks’ practices and processes are expected to continue to improve and evolve.  Nor is the paper meant to outline a one-size-fits-all approach to capital planning, as it is understood that banks would need to adopt approaches that are tailored to their individual circumstances.

1.       Internal control and governance 

This component emphasizes the importance of a formalized capital planning process that is administered through an effective governance structure.

  • An internally consistent and coherent view of capital needs:  Irrespective of how a bank’s capital planning process is oriented, whether divided along functional lines or centralized, it should pursue the sound practice of producing an internally consistent and coherent view of a bank’s current and future capital needs.
  • Reflecting the input of different experts:  The Basel Committee noted the importance of a capital planning process that reflects the input of different experts from across a bank, including but not limited to staff from business, risk, finance and treasury departments, and reflects a strong link between the capital planning, budgeting and strategic planning processes within a bank.
  • Process to identify competing assumptions:  The Basel Committee observed that banks with sound capital planning practices have a formal process in place to identify situations where competing assumptions are made.  Differences in strategic planning and capital allocation across the bank are escalated for discussion and approval by senior executives.
  • Independent validation:  A sound practice observed at a number of banks involves subjecting capital plans and their underlying processes and models to regular independent validation.
  • Role of senior management and board of directors:  A sound practice typically involves a management committee or similar body that works under the auspices of a bank’s board of directors and guides and reviews efforts related to capital planning.  Usually, the board of directors sets forth the principles that underpin the capital planning process, including the forward strategy for the bank, an expression of risk appetite and a perspective on striking the right balance between reinvesting capital in the bank’s operations and providing returns to shareholders.
  • Board review, approval and consideration of results:  The Basel Committee noted that banks with stronger capital planning governance practices require the board of directors or one or more committees thereof to review and approve capital plans at least annually.


2.  Capital policy and sufficient risk capture 

This component relates to the role of a capital policy in codifying guidelines that senior management will rely upon in making decisions about capital deployment or preservation.  It also reiterates the importance of sufficient risk capture.

A.  Capital policy

  • According to the Basel Committee, a leading practice among banks is for a board of directors to hold a management team accountable for demonstrating that adherence to a capital policy will allow the bank to maintain ready access to funding, meet its obligations to creditors and other counterparties and continue to serve as a credit intermediary before, during and after a stressful scenario.  This means that a sound capital policy should also detail the range of strategies management is able to employ to address anticipated and unexpected capital shortfalls.
  • Metrics used in capital policy:  Typically, a capital policy will reference a suite of capital and performance related metrics against which management monitors the bank’s condition.  Regulatory capital measures feature prominently in banks’ capital policies.  Non-regulatory based metrics tend to focus on returns and include return on equity (ROE), return on risk-adjusted capital (RORAC), and risk-adjusted return on capital (RAROC).  Management teams employing sound capital planning practices seek to evaluate their capital adequacy from many different perspectives, including through the use of economic capital.
  • Thresholds, triggers and limits:  The Basel Committee observed that sound capital policies incorporate minimum thresholds that are monitored by managers.  Most banks identify triggers and limits for every metric specified in the capital policy.  It is important for a monitoring framework to be in place and complemented by a clear and transparent formal escalation protocol for those situations when a trigger or limit is approached or breached, at which point a timely decision needs to be taken.
  • Risk tolerance:  An important input to a capital policy is an expression of risk tolerance by management and the board of directors.  A risk tolerance statement directly informs the bank’s business strategy and capital management, including, for example, through the establishment of return targets, risk limits and incentive compensation frameworks at the group and business unit levels.

B.  Capturing material risks

  • According to the Basel Committee, banks with sound practices have a comprehensive process in place to regularly and systematically identify, and understand the limitations of, their risk quantification and measurement methods.  In addition, banks seek to capture in their capital plans those risks for which an explicit regulatory capital treatment is not present, such as, but not limited to, positions that result in concentrated exposures to a type of counterparty or industry, reputational risk and strategic risk.  The Basel Committee also noted the importance of establishing clear links between capital and liquidity monitoring, considerations that banks did not feature as prominently in past evaluations of capital adequacy.
  • Risk management gaps and responses:  Some banks have developed formal processes for determining the severity of risk management gaps and developing appropriate responses, including for monitoring and limiting the exposure in question and holding regulatory capital to serve as a buffer to absorb these risks, where warranted.  Sound practice includes the incorporation of those risk identification and mitigation efforts, together with an appraisal of their limitations, into the capital planning process.


3.  Forward-looking view through stress testing

According to the Basel Committee, stress testing should be an integral component of the capital planning process.  In many jurisdictions, reliance on stress testing has been driven by regulatory requirements.  While those requirements differ across countries, the Basel Committee identified some common themes.

  • No diversification effects:  Many banks that perform stress testing as part of the capital planning process do not incorporate diversification effects across risk dimensions or businesses.  By not incorporating a diversification assumption, a bank is presuming that the impact of a scenario is additive.  While conservative, this assumption leads to greater prudence in capital deployment decisions.
  • Assumed management actions:  In estimating the impact of a stress scenario, banks tend to incorporate actions that the management team could reasonably undertake to mitigate the impact of a modeled economic downturn.  It is important that senior executives are aware of and have approved such assumptions regarding potential management actions.  In particular, management should determine whether unrealistic assumptions are being made about its ability to react in a stressed environment, and question whether the assumed benefit of such actions is reasonably conservative.


4.  Management framework for preserving capital 

This component relates to the need for a formal management process to consider and prioritize a range of actions that could be taken to preserve capital.

  • Actions to preserve capital:  The Basel Committee noted that senior management and the board of directors should be responsible for prioritizing and quantifying the capital actions available to them to cushion against unexpected events.  It is critical that management teams assess the feasibility of the proposed contingent actions under stress, including potential benefits and long-term costs, and have a high degree of confidence that such actions can be executed as described.
  • Defining actions in advance:  It is important that actions to maintain capital are clearly defined in advance and that the management process allows for plans to be updated swiftly to enable better decision-making in changing circumstances.



Basel Committee, A Sound Capital Planning Process: Fundamental Elements (Jan. 23, 2014) available here:

Comments Off on Basel Committee Discusses Fundamental Elements of a Bank’s Capital Planning Process.