Overview of Global Prudential and Risk Management

CCAR – Comprehensive Capital Analysis and Review

Definition
The U.S. Federal Reserve (Fed) introduced a regulatory framework to promote a safer and more stable financial system in the aftermath of the financial crisis of 2008. The Fed assesses whether large banks and financial institutions, referred to as Bank Holding Companies (BHC), have enough capital to absorb losses during stressful conditions, as well as whether they have an effective capital planning process. The Fed has set up an annual Comprehensive Capital Analysis and Review (CCAR) framework to perform the assessment of BHCs’ capital adequacy and capital planning.

Capital adequacy, capital planning and capital distribution arrangements are evaluated within the CCAR.

Failing the assessment will not only prevent the BHC from carrying out planned capital distributions without Fed approval, but the BHC will also be required to undergo changes to their business strategies or their organizational structure.

The CCAR process involves:

  • A detailed description of the bank’s internal processes and controls for assessing capital adequacy.
  • A detailed description of planned capital actions over a nine-quarter planning horizon.
  • Reporting the results of stress tests undertaken under scenarios provided by the Federal Reserve along with scenarios designed by the BHC.
  • Explicit approval by the Board of the processes and controls in relation to capital planning.

The number of supporting documents to be provided is extensive. These documents include policies and procedures related to the capital planning process, methodology documentation that describes the models and their validation, the key methodologies and assumptions for performing stress testing.

Main Challenges

  • Completeness of the risk inventory: Firms are required to prove that their risk identification process is exhaustive, transparent, repeatable and consistent with the firm’s scenario generation and capital adequacy processes. This includes establishing policies, procedures, systems and controls to ensure the infrastructure used to support risk identification, such as the generation of data and metrics, are robust. In some case, BHCs have various risk capture systems working concurrently due to takeovers or the development of new line of businesses. This makes the completeness of the risk inventory even more difficult.
  • Model validation: Risk, capital management and valuation models are required to be independently validated. Further, the firm’s methodology and model inventory should be mapped to each FR Y-14 line item and scenario. BHCs may uses sophisticated model that cannot be validated internally because of the specific skills it requires.
  • Advanced approach: Implementation of advanced approached calculation methodologies to calculate risk-based capital requirements for credit and operational risk. For instance, the quantification of operational uses complex statistical techniques and the scope of modelling can be quite extensive.
DFAST – Dodd-Frank Act Supervisory Stress Testing

Overview 
The Dodd-Frank Act Supervisory Stress Testing (DFAST) process is a forward-looking quantitative evaluation of the impact of stressful economic and financial market conditions on various balance sheet indicators and other financial metrics. Through this process, the Fed assesses changes in the BHC’s capital ratio under a hypothetical set of stressful economic conditions established by the Federal Reserve.

The evaluation involves projecting the firm’s balance sheet, Risk-Weighted Assets (RWA) and net income over a nine-quarter planning horizon. These projections, along with capital action assumptions, allow the firm to predict changes in capital. “The approach followed take into account U.S. generally accepted accounting principles (GAAP) and regulatory capital rules.” 

Main Challenges

  • Data validation: DFAST is quite data intensive, in terms of volume and quality. It requires the validation and calibration of parameters, market data, assumptions used for interpolating or extrapolating data. Managing data infrastructure of that magnitude requires adequate human resources, data governance processes and data management processes.
  • Risk models: Each year the Fed will provide BHCs with models in order to produce the supervisory stress tests. Although, those models seem to mature and become more predictable, BHCs need to maintain a flexible stress testing framework to cope efficiently with any changes in those models. Maintaining a framework that complies with changing and increasingly severe supervisory requirements can be challenging. It requires the adequate personnel’s expertise or external assistance. The changes implemented in the models used to evaluate operational risk or market RWAs or capital has a great impact on capital ratios.
  • Stress Testing:
     o  Application of regulatory stress tests and scenarios.
     o  Development of firm specific localized stress and scenario impacts.
     o  Calculation of portfolio specific impacts of applied stress tests across all balance sheet items.
     o  Development of recovery and resolution scenarios
ICAAP - Internal Capital Adequacy Assessment Process

Definition
The Internal Capital Adequacy Assessment Process (ICAAP) is part of the Basel II Accord, which aimed to improve risk management within banks. It is a framework that assesses whether the level of capital held by the firm adequately covers all material risks to which the institution is exposed. Therefore, as part of the process, firms must understand their inherent risk profile and identify and quantify all material risks.
 
Main Challenges

  • Risk identification and quantification:
    Where the firm opts for more risk-sensitive methodologies, such as the Internal Ratings-Based (IRB) approach for credit risk or the Internal Models Approach (IMA) for market risk, risk quantification may require the use of sophisticated models. Although such risk solutions are relatively well known and fairly standardized in the industry, the models typically require sophisticated technology, robust controls and framework that mobilize large human and financial resources for firms. 

    Further, quantification of Pillar 2A risks, such as conduct risk or strategic risk, for which there are relatively less well established standards within the industry, can be a complex exercise. In practice a qualitative capital cushion is applied, after the application of an in-house methodology with assumptions to try and quantify the impact.
  • Reporting and monitoring process:
    Defining the adequate granularity for each risk type, the appropriate reporting template, frequency and more generally defining the framework for the fully automated reporting is one of the other challenges facing the bank. These processes should be configured to ensure that a continuous assessment of the risks associated with efficient controls and workflow. These processes should allow a continuous monitoring of underlying risks.

    In addition, the effectiveness of the reporting process should be tested continuously, which implies defining test plans for instance.
  • Capital planning:
    As part of the risk governance, senior management and the Board of directors must define the risk appetite of the firm, and in accordance to this risk profile reconcile the capital and strategic planning. The challenge is to maintain consistent through the actual risk profile, regulatory requirements and capital management
  • Stress Testing:
    The European Central Bank defines Stress Tests in the ICAAP context as follows: “Internal stress tests scenarios have to be tailored towards the institution’s individual key vulnerabilities, resulting from its business model and operating environment in the context of stressed macroeconomic and financial conditions. The application of severe, but plausible macro assumptions plus the focus on the key vulnerabilities is expected to result in a material impact on the institution’s internal and regulatory capital ratios.” As for DFAST, stress tests require the adequate expertise and resources to comply with supervisory requirements.

Duff & Phelps Offering
Duff & Phelps is an award-winning provider of compliance, regulatory consulting, risk management and valuation services focused on the financial services industry. We help clients build, manage and protect their businesses. Our global team of 300 professionals operates seamlessly across borders to provide clients with cross-jurisdictional advice and integrated expertise.

Based in key financial centers, we are closely connected with regulators and industry associations so that our clients have the best available information on regulatory requirements and trends.

The Duff & Phelps Prudential and Risk Management Consulting practice comprises a global team of former regulators, experienced consultants, risk and portfolio managers and front office quantitative analysts. They are industry practitioners with financial engineering, quantitative modelling, risk, regulatory and capital management expertise. 

We have built and invested in best in class, and audit compliant, proprietary and industry standard risk analytic, capital risk management, regulatory finance and valuation tools, that are portable across various use cases (e.g., predictive credit risk models that can be used within an ICAAP and IFRS9 framework) and provide our clients cost-effective solutions.

Risk Analytic Solutions
Our Risk Analytic Solutions include credit, market, operational and other risk models that can be easily deployed or leveraged. Examples include:

  • Computation of VaR and ETL for client portfolios using historical and Monte Carlo simulations.
  • Significant loss and scenario assessment modelling, sensitivity reporting.
  • Estimation of PD, LGD and EAD for all categories of asset types.
  • Computation of PFE and EPE.
  • Valuation of KVA, CVA, DVA charges and sensitivities.
  • Risk mitigation and hedge strategies for CVA and DVA, FX, rates, credit, commodity exposures.

ICAAP and Liquidity Risk Management Advisory
A capital risk management framework that supports adequate capital ratios, ensures liquidity adequacy, and articulates a well-defined recovery and resolution plan, is an integral part of a Prudential Risk Framework. Our capital and liquidity risk management services help our clients anticipate and optimize capital requirements, adapt to regulatory changes and assess capital impacts on financial forecasting and analysis, recovery and resolution planning, and within business development models. We provide clients various strategies to identify, measure and manage capital and liquidity risk.

Capital and Liquidity Analytics

  • Estimation of Capital Ratios, Pillar 1 and 2 charges linked to key risk indicators and enterprise risks. 
  • Estimation of baseline and expected capital requirements, stressed capital requirements.
  • Automated RWA and capital charge estimations, predictive economic and regulatory capital models.
  • Targeted liquidity ratio estimations for baseline and stress scenarios, liquidity forecasting tools.

Stress Testing Analytics

  • Customized stress test integrated to parameters provided by regulators, vendor-based forecasts.
  • Development of optimal capital allocation strategies and evaluation of risk-adjusted returns.
  • Development of stressed credit rate, market risk metrics and measures.
  • Stressed portfolio valuation impacts to various risk factors and assumptions.

Recovery and Resolution Planning

  • Assisting with approach and analysis, including designing stress tests, reverse stress tests, recovery indicators, early warning indicators, recovery options and scenario analysis.
  • Assessing the credibility of recovery options, viability of stressed portfolio sales, losses and gains.

Regulatory Reporting

  • Assistance with reviewing, completing regulatory filings for ICAAP, CCAR, and DFAST.
  • Review of reporting controls, completeness and accuracy of past returns.
  • Development of automated tools to capture key return metrics.
  • Leverage integrated analytics to estimating all enterprise risk impacts, metrics across multiple regulatory jurisdictions (COREP/FINREP, GABRIEL, FR Y forms).

Integrated Finance Analytic Solutions
The continuing evolution of capital standards globally, combined with the augmentation and convergence of finance and accounting regulation has meant that financial institutions need versatile and adaptable analytical solutions. Tools developed should be cross functional and leverageable across finance, risk and accounting, as the use cases dictate. Duff & Phelps’ Prudential Risk Management team has the ability to consult and deploy the following financial analytic solutions:

Portfolio Valuation Tools

  • Valuations of vanilla and exotic derivatives for all fixed income, FX, commodity and equity products.
  • Portfolio loan valuations.
  • Illiquid long-dated private placement bonds, corporate loans, credit contingent payoffs, credit indices, Total Return Swap and Credit Linked Notes.
  • CDO/CLO valuations.

Portfolio Optimization and Risk Management Tools

  • Portfolio and loan-level risks modelling, including expected and unexpected loss modelling.
  • Distribution of values, losses and capital. 
  • Concentration analysis by industry, region, asset type and counterparty.
  • What-if analysis, stress testing and reverse stress testing to determine losses and assess capital adequacy under various economic conditions.
  • Origination and underwriting analytics.

IFRS9 Credit Risk Modelling

  • Predictive and Probabilistic ECL Modelling
  • Lifetime and point-in-time PD, LGD modelling, with requisite scenario assessments.
  • Econometric forecasting tools for the development of various baseline and stress forecasts.
  • PFE, EAD and EL modelling and reporting.
  • Credit ratings modelling and migration under various scenarios.
  • Recovery rate modelling.
  • Calibration and updating of existing credit risk management analytics to support IFRS 9 enhancements.

List of abbreviations

COREP

Common Reporting

GABRIEL

FCA online system to collect and store regulatory data from firms

FINREP

Financial Reporting

FR Y forms

Federal Reserve reporting forms

IFRS

International Financial Reporting Standards

VaR

Value At Risk

ETL

Expected Tail Loss

PD

Probability of Default

LGD

Loss Given Default

EAD

Exposure At Default

PFE

Potential Future Exposure

EPE

Expected Positive Exposure

KVA

Valuation Adjustment for regulatory capital

CVA

Credit valuation adjustment

DVA

Debit Valuation Adjustment

FX

Foreign Exchange

Sources:
1 Federal Reserve Board, “Dodd-Frank Act Stress Test 2016: Supervisory Stress Test Methodology and Results” June 2016

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