Agencies Adopt Stress Test Guidance for Large Banks, Community Banks

By Richard Roth, J.D., Editor, the CCH Federal Banking Law Reporter, CCH Bank Compliance Guide, Bank Digest; co-author, Dodd-Frank Wall Street Reform and Consumer Protection Act—Law, Explanation and Analysis

The Federal Reserve Board, Federal Deposit Insurance Corp. and Office of the Comptroller of the Currency have adopted interagency guidance on stress test requirements for large banking organizations—those with $10 billion or more in total consolidated assets. At the same time, the agencies issued a statement intended to allay fears of community banks that they would be subject to comparable requirements.

The guidance does not implement the Dodd-Frank Act’s stress test requirement, nor does it fall under the Fed’s capital plan rule  that applies to holding companies with consolidated assets of $50 billion or more, the agencies said. Separate proposals will apply to those provisions. However, institutions subject to stress test requirements under those two provisions should follow the guidance issued May 14, 2012, in complying with those provisions.

The guidance was described as stating broad principles for a stress-testing framework and describing how stress testing should be used on different levels, including on an enterprise-wide basis, for both risk management and capital and liquidity planning. It is not intended to provide detailed instructions for testing any particular risk or business area, the agencies said.

Stress Test Frameworks.—The agencies defined stress testing as “exercises used to conduct a forward looking assessment of the potential impact of various adverse events and circumstances on a banking organization.” A bank’s stress test framework should be appropriate for its size, complexity, activities and overall risk profile. The framework should include “clearly defined objectives, well-designed scenarios tailored to the banking organization’s business and risks, well-documented assumptions, sound methodologies to assess potential impact on the banking organization’s financial condition, informative management reports, ongoing and effective review of stress testing processes, and recommended actions based on stress test results,” the guidance said.

The guidance set out specific principles that should be used in establishing a stress test framework:

 

• An institution’s framework should include activities and exercises that are intended and able to capture the banking organization’s exposures, activities and risks.
• The framework should use multiple conceptually sound stress testing activities and approaches.
• The framework should be forward-looking and flexible.
• Results should be clear, actionable and well supported, and should inform the  institution’s decision making.

Approaches and Applications.—The approaches and applications used by an institution should be appropriate for the purpose and scope of the specific test, according to the guidance. As a result, an institution should first define the purpose and focus of a test and then select the proper technique, considering its size, exposures, activities, risks and whether the test applies to the entire enterprise or a lower level within the enterprise. The guidance described several specific approaches: 

• Scenario analysis—a type of stress testing in which the institution applies historical or hypothetical scenarios to assess the impact of various events and circumstances.
• Sensitivity analysis—the analysis of the institution’s exposures, activities and risks when certain variables, parameters and inputs are “stressed” or “shocked.”
• Enterprise-wide stress testing—a test that involves assessing the impact of certain specified scenarios on the institution as a whole, particularly with regard to the institution’s capital and liquidity.
• Reverse stress testing—a test in which the institution assumes a known adverse outcome, such as a credit loss that breaches regulatory capital ratios, and then deduces the types of events that could lead to such an outcome.

The guidance also calls for periodic stress testing of an institution’s capital and liquidity adequacy.

Community Banks.—In a separate joint statement, the agencies took pains to make clear that neither the interagency guidance issued on May 14 nor the stress test requirements under Dodd-Frank and the capital plan rule apply to community banks. “[C]ommunity banks are not required or expected to conduct the enterprise-wide stress tests required of larger organizations under the capital plan rule, the proposed rules implementing Dodd-Frank Act stress testing requirements, or as described in the stress testing guidance for organizations with more than $10 billion in total consolidated assets,” the statement said. However, all institutions must have the ability to analyze the effect that adverse economic conditions could have on their financial condition, the agencies said, and community banks remain subject to existing guidance on the subject.

The inapplicability of the interagency guidance to institutions with less than $10 billion in total consolidated assets also was explicitly stated in the guidance.