5 Areas that Major U.S. Banks Should Leverage between CCAR & Basel III

In July of 2013, the Federal Reserve Board (FRB) approved a final rule for the implementation of Basel III1 regulatory capital reforms into its annual stress protocol. For the major U.S. Bank Holding Companies (MUSBHCs) that are required to comply with the Comprehensive Capital Analysis and Review (CCAR)2 program, this measure made it more difficult to continually meet the minimum capital requirements ratios set forth by the FRB. Most notably, the revision introduced a common equity tier one ratio, and mandated a steady increase in the quantity and quality of required capital holdings for MUSBHCs—to be phased in up until 2019.

The substantial regulatory burden placed on MUSBHCs since the global credit crisis of 2008-09 has been welldocumented, and the Basel III final rule is yet another method of forcing these companies to forgo profits in order to maintain capital requirements and reduce risk. But a less well-known impact of the Basel III final rule is that it provides MUSBHCs with opportunities to step back and more efficiently organize their compliance activities. While achieving CCAR and Basel III compliance are not entirely seamless propositions, there are a large number of overlapping regulatory requirements between the two programs. The following two organizational structures are predominant for MUSBHCs when it comes to compliance: A representative from one of the MUSBHCs highlights the advantages to standing up two separate model development teams for CCAR and Basel III:
“Basel models are fundamentally simple, with a dominant emphasis on following very specific regulations. The CCAR models can be much more complex…[they seek to] capture behavior over many time periods, and need to replicate business processes. [CCAR and Basel] each has its own documentation requirements and production support requirements.”
A representative from another MUSBHC prefers to keep CCAR and Basel professionals working in a single, integrated team for each core area, citing this structure as one that “creates clarity and consistency on how to deal with all issues around capital preservation and regulatory requirements”.

When comparing the separated vs. single team approaches for satisfying the regulatory requirements of CCAR and Basel III, it is clear that each offers its own advantages and disadvantages, and that the required level of collaboration differs between MUSCBHCs. However, if executives and compliance directors from MUSBHCs are able to focus on the aspects where the CCAR and Basel III programs overlap, efficiencies can be found and exploited.

As shown in figure 1, MUSBHCs can streamline operations and thereby cut compliance costs by re-thinking how they manage the following 5 core areas of CCAR and Basel III:
Data Processing and Management
The reference data sets required are similar in most aspects for CCAR and Basel stress testing. Managers of data processing and management at MUSBHCs must be cognizant, however, that CCAR and Basel are different in terms of 1) historical timeframe requirements and 2) securities classification. Basel requires MUSBHCs to include 5 years of historical data in their reference data sets. CCAR does not specify a numerical historical timeframe requirement, mandating instead that BHCs include a full economic cycle when selecting reference data. In addition, certain classifications of securities— such as the definition of losses for loans—differ between CCAR and Basel. MUSBHC project managers who are in charge of data teams must take these differences into account when processing and organizing data to be used the by the organization during preparation for CCAR and Basel compliance.

Both CCAR and Basel III regulations nonetheless require efficient data infrastructure to compile, clean, and consolidate data from risk and finance systems. Reliable, comprehensive data processing and control systems are critical to support risk identification, risk aggregation, quantitative modeling, stress-testing and reporting exercises.

A group of well-organized and highly collaborative CCAR and Basel III professionals should work to accomplish the following data-related tasks at MUSBHCs:
  • Collate and organize historical data to capture a full economic and business cycle; ideally at both the account and monthly level
  • Forecast accurate economic loss data—including loss amount and loss date for each resolution type (charge off, REO sale, and NPL sale)
  • Facilitate well-justified treatment of bank mergers, records of management actions, government intervention, portfolio liquidation, and other disruptive events
  • Build a warehouse that efficiently stores and sorts the following data elements: market risk, counter-party credit risk, liquidation risk, operational risk, economic capital and risk-weighted assets (RWAs)
Model Development
MUSBHCs are required to develop their quantitative models in a manner that closely integrates business strategy across assets classes and at each line of business into the capital framework. These models’ development and implementation therefore become paramount in building an “initial line of defense” for supporting the reporting deliverables required to satisfy both CCAR and Basel III. Many MUSBHCs currently build models to satisfy both CCAR and Basel III regulations that have the following shared characteristics:
  • The quantitative methodologies fall into one of two categories: loss estimation and Pre-Provision Net Revenue (PPNR) projection.
  • Parametric modeling methods (such as discrete choice, survival analysis, linear regression, and time series) are widely used for credit loss estimation and revenue projection. Non-parametric approaches (classification tree and regression tree) are complementary to derive Probability of Default (PD), Loss Given Default (LGD), and Exposure at Default (EAD) metrics.
  • Market risk exposure: the Value at Risk (VaR) metric employs variance/covariance matrices and historical/ Monte Carlo simulation.
  • Variable selection is dependent on information ranking, pattern discovery, clustering, and population validation.
CCAR allows for a more flexible framework in terms of model development and implementation. This flexibility, however, sometimes leads to the construction of CCAR models that utilize more advanced modeling methods than corresponding Basel models. The high number of similarities between the two frameworks still allow for CCAR and Basel models to be streamlined among a consolidated group of professionals—with the optionality of building separate CCAR models when necessary.
Model Validation
MUSBHCs should have a transparent, repeatable, and well-supported validation framework to evaluate:
  • Conceptual soundness with developmental evidence
  • Ongoing monitoring of implemented models
  • Outcome analysis from back testing
Conservative assumptions for loss forecasting and revenue estimation are expected to be applied throughout the stress testing process to ensure the appropriateness of each test.
Highly segmented, independentlyworking model validation teams for CCAR and Basel often add significant costs for major U.S. BHCs.
Collaboration between these teams allows MUSBHCs to operate more efficiently because of the ability to share code libraries and hire contract employees that have the niche skills required to complete the necessary model validation procedures in a timely manner.
Internal Audit and Control
The internal audit and control process is known as the third line, or “last line,” of defense for the MUSBHCs among industry insiders. These teams evaluate the entire capital planning process and ensure the integrity of each assessment metric and deliverable before they are probed and tested by regulatory authorities. MUSBHCs often combine their CCAR and Basel III internal audit and control teams into one without significantly increasing operational risk. Most MUSBHCs require many rounds of reconciliation and crosschecking between business lines and project teams throughout the internal audit and control process. When the internal audit and control teams work independently, this creates more work for all parties involved, as personnel are often asked to deliver the same deliverables twice or more. The act of streamlining the internal audit and control process for both CCAR and Basel III addresses the requirements from both sets of regulations, and can substantially improve the efficiency of a MUSBHC’s capital planning process.
Reporting
The regulatory reports necessary for CCAR submission are similar to Basel III in several aspects. In fact, Basel III reports are generally included within CCAR submission reporting packages (FRY – 14 reports, e.g.). Reports are presented in a wide range of templates and frequency requirements (ranging from monthly to annually). Most are complex and time consuming, with thousands of line items and metrics included in each.

Given the similarities between CCAR and Basel III reporting requirements, MUSBHCs that silo the two project teams in charge of each will inevitably waste resources by forcing their teams to complete the same work twice. With a project manager that can properly ensure that the team understands the differences between CCAR and Basel III reporting requirements while at the same time exploiting the similarities to reduce time and resource expenditure, MUSBHCs will benefit from streamlining their CCAR and Basel III reporting teams as much as possible.
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1“Internal regulatory framework for banks (Basel III).” http://www.bis.org/bcbs/basel3.htm. Last visited on August 4, 2015.

2Board of Governors of the Federal Reserve System. “Comprehensive Capital Analysis and Review 2015 – Summary Instructions and Guidance.” http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20141017a1.pdf. October 2014.