On March 5, 2014, the Federal Reserve Board (the “FRB”), the Federal Deposit Insurance Corporation (the “FDIC”) and the Office of the Comptroller of the Currency (the “OCC”) issued final supervisory guidance implementing the provisions of section 165(i) (2) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) regarding annual company-run stress tests for mid-sized banking organizations. The final supervisory   guidance applies to all bank and savings and loan holding companies, national banks, state member banks, state non-member banks, federal savings associations, and state chartered savings associations with more than $10 billion but less than $50 billion in total consolidated assets. Banking organizations with less than $10 billion in total consolidated assets are not subject to the stress testing requirements. The effective date of the final supervisory guidance is March 31, 2014 for banking organizations regulated by the FDIC and OCC and April 1, 2014 for banking organizations regulated by the FRB.

The final supervisory guidance is substantially similar to the proposed supervisory guidance issued by the FRB, FDIC and OCC in August 2013. For a summary of the proposed supervisory guidance, please refer to our August 2013 alert. Consistent with the proposed supervisory guidance, the final stress test guidelines require a company to  assess the potential impact of a minimum of three macroeconomic scenarios on its consolidated losses, revenues, balance sheet, and capital. The three scenarios include a baseline scenario, an adverse scenario, and a severely adverse scenario.

This alert summarizes the material differences between the proposed and final supervisory guidance issued by the FRB, FDIC and OCC and provides additional guidance on the implementation of an effective stress testing framework.

Material Differences Between the Proposed and Final Supervisory Guidance

Although it is similar to the proposed FRB, FDIC and OCC guidance issued in August 2013, the final supervisory guidance materially modifies the proposed guidance as follows:

  • The final supervisory guidance clarifies that a banking organization subject to the stress testing guidelines is not subject to: (1) the FRB’s capital plan rule set forth in 12 C.F.R. section 225.8; (2) the FRB’s annual Comprehensive Capital Analysis and Review set forth in 12 C.F.R. Part 252, subparts E and F; or (3) supervisory stress tests for capital adequacy and the related data collections supporting supervisory stress tests provided for in the FRB’s Form FR Y-14Q, FR Y-14M and FR Y-14A.
  • The final supervisory guidance reiterates that, in projecting quarterly stress test provisions, a banking organization should estimate an adequate level of allowance for loan and lease losses (“ALLL”). However, unlike the proposed guidance, which required ALLL estimates to be consistent with Generally Accepted Accounting Principles, the final guidance specifies that the ALLL projections should generally be consistent with a banking organization’s internal ALLL approach. In addition, the final supervisory guidance provides that: (1) the ALLL at the beginning of the stress test planning horizon must include any losses projected beyond the required nine-quarter horizon; and (2) management should ensure that the banking organization’s projected ALLL is sufficient to cover remaining losses under the scenario for each quarter of the planning horizon, including the last quarter.
  • The proposed and final supervisory guidance both permit banking organizations to use additional stress test variables beyond those provided by the supervisors, so long as the additional variables are consistent with the general economic environment assumed in the supervisory scenarios. The final supervisory guidance makes clear, however, that it is inappropriate for a banking organization to use a regional or local variable that exhibits limited stress compared to variables in the supervisors’ macroeconomic scenarios if the approach for deriving the regional or local variable is based on benign conditions.
  • The proposed and final supervisory guidance both require a banking organization with limited internal data to accumulate the data necessary to improve its stress testing estimates over time. In the final supervisory guidance, the FRB, FDIC and OCC acknowledge that some banking organizations may not initially possess internal data with respect to certain portfolios and must therefore rely on proxy data for a period of time. The final supervisory guidance permits such reliance provided that the banking organization demonstrates that  the proxy data is relevant to its own exposures and is appropriate for a particular estimate, and that the banking organization is actively engaged in collecting internal data.
  • The final supervisory guidance acknowledges that a banking organization may not be able to validate all of  its stress testing models before its stress test results are submitted to its supervisor. In these cases, the final supervisory guidance specifies that the use of non-validated models is appropriate if the banking  organization has: (1) attempted to identify models based on materiality and highest risk, and has prioritized validation activities accordingly; (2) applied controls to ensure the output from non-validated models is not treated the same as the output from fully validated models; and (3) clearly documented models that have not been validated and identified them in reports to model users, senior management and other applicable parties. The final supervisory guidance also requires a banking organization to have an explicit exception process and validation timeline for stress testing models that have not been validated.
  • The proposed and final supervisory guidance both permit a banking organization to utilize a simpler   approach for stress test balance sheet and risk-weighted asset projections. The final supervisory guidance specifically allows a banking organization to use static balance sheet and static risk-weighted assets over the stress test planning horizon, but requires a banking organization to consider the appropriateness of such an approach if it has a more volatile balance sheet as a result of mergers, acquisitions or organic growth.
  • The proposed and final supervisory guidance both provide that, beginning in June 2015, a banking organization must annually publicly disclose a summary of its stress test results in the period between June 15 and June 30. However, the final supervisory guidance clarifies that an FRB state member bank with $10 to $50 billion in total consolidated assets that is a subsidiary of a bank or savings and loan holding company with average total consolidated assets of $50 billion or more must annually publicly disclose a summary of its stress test results in the period between March 15 and March 31.

Implementing an Effective Stress Testing Framework

The final supervisory guidance reaffirms that stress tests are an important component within a banking organization’s risk management framework and serve as a useful tool to assist a banking organization in understanding the range of potential risks it faces. Consistent with FRB, FDIC and OCC guidance, an effective stress testing regime should:

  • Include activities and exercises that are tailored to, and sufficiently capture, the exposures, activities and risks faced by a banking organization
  • Employ multiple conceptually sound stress testing activities and approaches
  • Be forward-looking and flexible
  • Ensure that results are clear, actionable, well supported and inform future decision-making
  • Include strong governance and effective internal controls

An effective stress testing framework should also clearly establish an integral role for senior management in overseeing stress testing, evaluating stress test results, addressing any identified weaknesses and communicating developments to the banking organization’s board of directors. In addition, the board of directors should actively evaluate stress test results to verify that they adequately reflect the company’s risk appetite, overall strategy and business plans. To eliminate safety and soundness concerns, a banking organization should also continually enhance its risk management practices to ensure that its stress testing framework evolves as necessary over time.

The FRB, FDIC and OCC have made clear, however, that company-run stress tests should only be one component   of broader risk management activities conducted by a mid-size banking organization. Because stress tests yield hypothetical results, and are not designed to forecast likely outcomes, they may not appropriately reflect a company’s full range of risks with respect to capital adequacy. For example, the final supervisory guidance notes that stress  tests required under the Dodd-Frank Act may not always account for certain factors, such as regional concentrations or a natural disaster,that could result in additional risk to a banking organization’s regulatory capital levels. Accordingly, a banking organization should evaluate the results of its company-run stress test along with other capital assessment tools to make certain that all material risks and vulnerabilities are considered in its overall capital adequacy assessment.