Three Dos and Don'ts of Capital Planning
- John Demeritt
- 6 hours ago
- 5 min read
Capital plans can look very different from institution to institution. In the community bank and credit union space, it’s not uncommon to see a “capital plan” that consists of a simple, spreadsheet-based budget forecast (i.e., static). On the other end of the spectrum, some institutions maintain a detailed three-year projection that includes adverse scenarios/stress tests, relief or contingency scenarios, and a supporting narrative (i.e., dynamic).
Capital planning doesn’t have to be complicated to be effective. The goal is to build a repeatable process that looks beyond the annual budget, considers what could change, and outlines what management would do if capital were to come under pressure.
With a few practical steps – extending the forecast horizon, adding meaningful stress scenarios, and mapping realistic response options – a capital plan can transform into a tool that may add meaningful insight to strategic decision-making.
Do:
1) Extend your capital forecast horizon (one-year is good; three-year is better!)
Many institutions produce a twelve-month capital forecast once per year based on budget assumptions. One drawback of a one-year forecast is that it can potentially mask longer-term exposures (like earnings-at-risk simulations that stop at 12 months). After all, capital typically only changes gradually unless there is outsized growth or a significant stress event.
Extending the horizon to three years may help reveal the longer-term impact of the strategic plan and highlight potential capital pressure before it becomes urgent. If capital adequacy is at risk in years two or three, that’s extremely valuable to know now.
2) Include adverse scenarios (economic, liquidity, IRR, credit impacts, etc.)
DCG has reviewed hundreds of capital plans. Of all of them, the most common pitfall is to model a static budget and stop there. The implicit assumption in a static budget is that it will play out exactly as planned… but experience often reveals otherwise.
Since 2020, how many institutions have been on-plan with budget each year? How many unexpected events have occurred in just the past few years? No one has a crystal ball, which is exactly why dynamic budgeting that includes “what if-ing” and stress testing is essential.
A prudent capital plan starts with a baseline forecast, but it shouldn’t end there. Understanding how moderate and severe downturns could affect capital is fundamental. If GDP were to decline and unemployment rose to 6%, how severe could loan losses become? What would these projected losses mean for capital through reduced interest income and higher future provisioning? What if unemployment were to rise to 10%? Do you know whether your institution’s capital would withstand the pressures?
And credit stress rarely happens in isolation. What if the downturn were to coincide with deposit outflows in a rising-rate environment where outflows must be replaced with higher-cost funding? Institutions should test the resulting margin compression to understand the full impact on earnings and capital to determine an optimal response.
3) Develop a hierarchy of relief scenarios
Relief scenario game planning is where practitioners prioritize and document strategies to address different types of capital stress. Remediation options might include deleveraging, shifting asset mix (to reduce risk-weighted assets), asset sales, dividend and growth adjustments, or, even in some cases, a capital raise.
Other options may be limited to earnings enhancement strategies that take time, which reinforces why capital planning is most effective when done proactively, not in the middle of a stress event.
For each potential strategy, it’s important to quantify and document three items:
Estimated time to execute
Immediate impact on capital ratios
Ongoing annualized earnings impact on capital ratios
This is where many institutions find the most value from the process: having a practical, quantified catalog of actions that may be deployed if conditions deteriorate. Trying to design relief strategies during a stress event can lead to suboptimal decisions; stress changes how we think, and it compresses timelines.
Don’t:
1) Don’t let perfection become the enemy of progress
No forecast is perfect, and no stress test will predict exactly what will happen. The goal is directional clarity: what could happen over time and how might a capital position respond.
Avoid getting so detailed that the process stalls, or become overly-sensitive to assumptions that don’t materially change outcomes. It’s not necessary to pinpoint loan growth to the basis point! Remember, the goal is to understand the trajectory and its implications for capital adequacy vs an accounting exercise requiring more precision.
2) Don’t set it and forget it
Standardized stress assumptions may offer some insight and could be a good place to start. From there, tailor scenarios to the institution’s balance sheet complexity and business model. For example, if a loan portfolio is concentrated in a specific collateral type (e.g., multifamily in certain geographies) or higher-risk segments, it’s important to understand how much capital may be required to absorb losses in those areas specifically.
Conditions also change throughout the year as local and national economic trends, competition, interest rates, and regulatory expectations evolve. Capital planning is a constant work in progress and should include periodic check-ins to confirm whether assumptions and scenarios still reflect reality.
3) Don’t assume it’s a check-the-box exercise
“Capital planning and stress testing are just regulatory appeasement” is unrealistic at best and reckless at worst.
The reality is that understanding how much capital is truly needed or “at risk” in a stressful event can unlock opportunity today. If institutions set capital ratio minimums arbitrarily high based on “gut feel,” they may unnecessarily carry excess capital that limits opportunities to improve earnings.
Turning capital planning into a decision tool
A strong capital plan is not just a forecast; it’s a decision-support tool. When institutions extend the horizon, test adverse scenarios, and document practical relief actions, capital planning becomes a source of confidence rather than a compliance exercise.
Done well, it helps leadership anticipate pressure points early, evaluate tradeoffs clearly, and act decisively, protecting resilience in stress while still enabling smart growth in normal times.
Could your capital plan use a tune-up?
If you’re unsure about the right capital level or the opportunity cost of operating with overly conservative targets, DCG can help. Contact DCG to quantify capital at risk, evaluate practical stress scenarios, and help determine a prudent capital range that supports resilience without leaving earnings on the table.
ABOUT THE AUTHOR
John Demeritt is a Managing Director at Darling Consulting Group. In this capacity, he works directly with financial institution executives to improve the effectiveness of their asset/liability management (ALM) process, providing insight and education on managing interest rate risk, liquidity risk, credit risk, and capital. He also advises on regulatory compliance, stress testing, and contingency planning.
John began his career with DCG in 2006 as a financial analyst and currently manages DCG’s Risk Analyzer Plus product and Loan Credit Loss Model solution. He is a graduate of the University of Massachusetts with a degree in finance and marketing.
Contact John Demeritt at jdemeritt@darlingconsulting.com or 978-499-8144.
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