Financial institutions should be prepared to increase their emphasis on documentation to avoid running afoul of federal regulatory authorities. Last week the OCC, Federal Reserve and FDIC issued proposed joint supervisory guidance for company-run stress testing under the Dodd-Frank Act (DFA).[1] Section 165(i)(2) of the DFA mandates annual internally run stress testing for financial companies with consolidated assets exceeding $10 billion. In October 2012, the three federal banking agencies issued regulations implementing section 165(i)(2) stress testing. The guidance proposed last week provides additional supervisory guidance to banking institutions with assets between $10 and $50 billion. On the whole, the proposed guidance sets the agencies’ expectations and suggests possible methodologies without explicitly requiring any particular practice save one: documentation.

Under the DFA regulations promulgated last October,[2] companies are required to run a minimum of three stress tests based on economic scenarios provided by regulators (called supervisory scenarios). Although the proposed guidance addresses a number of issues, it focuses on a few key areas for testing under these scenarios. First, the guidance suggests methodologies by which companies can segment their portfolios into categories based on common risk characteristics. Second, the guidance provides a number of examples to illustrate possible methodologies for estimating losses in each scenario. Likewise, it suggests several methods deemed appropriate for estimating the company’s pre-provision net revenue. Finally, the guidance recommends several approaches for completing balance sheet and risk-weighted asset projections.

Documentation requirements underpin the relative flexibility companies enjoy under the regulations and guidance. While the proposed guidance suggests certain methodologies, it generally encourages companies to use appropriate alternatives. For example, companies are not required to use all the variables outlined in a supervisory scenario if inappropriate for the company’s line of business. Moreover, companies are free to employ additional variables beyond those provided in the scenario. Such deviations are permissible so long as they are “well supported and documented.” 

Documentation requirements extend beyond stress testing itself to management’s use of the results. DFA regulations require management to incorporate stress test results in the company’s planning and operations. The guidance offers little in the way of substantive suggestions for incorporation, but rather emphasizes that the company “should document the manner in which DFA stress tests are used for key decisions.” At bottom, the proposed guidance indicates that banking agencies will permit companies to exercise wide latitude in conducting stress testing. Whether the agencies will be so flexible in practice, however, remains to be seen.