On August 5, 2013, the Federal Reserve Board (the "FRB"), the Federal Deposit Insurance Corporation (the "FDIC"), and the Office of the Comptroller of the Currency (the "OCC") published in the Federal Register proposed supervisory guidance on implementing section 165(i)(2) of the Dodd-Frank Act regarding annual company-run stress tests.1 Stress tests are an important part of a banking organization’s risk management practice, supporting a company’s forward looking assessment of its risk and helping to ensure that the company has sufficient capital to support its operations through periods of stress.

In October 2012, the FRB, FDIC, and OCC published final rules implementing stress testing requirements for companies with more than $10 billion in total assets but less than $50 billion in total assets.2 In April 2013, the agencies also published notices of proposed rulemaking regarding reporting requirements in order to meet the Dodd-Frank Act stress test requirements.3 The stress test rules apply 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 consolidated assets. Although the stress test rules do not currently apply to foreign banking organizations, the FRB anticipates issuing separate proposals for enhanced prudential standards, including stress test requirements, for foreign banking organizations at a later date.

This alert summarizes the stress test rules and the proposed supervisory expectations for conducting annual company-run stress tests. The stress test rules 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.

Stress Test Timelines

A company is required to conduct a stress test that extends over a nine-quarter planning horizon based on data as-of September 30 of the preceding calendar year. Therefore, a stress test beginning in the fall of 2013 would have an as-of date of September 30 and include quarterly projections beginning with December 31, 2013 and ending on December 31, 2015.

Results of the stress test must be reported to the banking organization’s primary supervisor and to the FRB by March 31. The reported results must include: a description of the types of risks included, a description of the methodologies used, an explanation of the most significant causes for the changes in capital ratios, and any other information required by the supervisors. In addition, the banking organization must disclose a summary of the stress test results to the public in the period between June 15 and June 30. The first stress test-related public disclosure is not required until June 15 – 30, 2015 for a stress test based on data as-of September 30, 2014.

Stress Test Scenarios

The stress test rules require a banking organization to assess the potential impact on the company’s capital under at least three different macroeconomic scenarios. Each scenario is based on a set of conditions that affect the U.S. economy or the financial condition of the company. The baseline scenario reflects the consensus or general views on the economic and financial outlook. The adverse scenario includes a set of conditions that are more adverse than those associated with the baseline scenario, and the severely adverse scenario includes a set of conditions that are more severe than those associated with the adverse scenario. For banking organizations with significant trading activities, additional trading and counterparty risk components may be included under the adverse and severely adverse scenarios to ensure that the stress tests provide a meaningful identification of downside risks and assessment of the potential impact of adverse outcomes on the company’s capital. Typically, the components would include market price and rate "shocks" consistent with historical and hypothetical adverse market events.

These scenarios are not economic forecasts but rather are hypothetical scenarios used to assess a company’s capital strength in stressed conditions. Each scenario should be applied across all business lines and risk areas in order to assess the effect of the scenarios on the entire enterprise. The FRB, FDIC, and OCC will provide a general description of each scenario no later than November 15 of each year. A company is not required to use all of the variables provided in each scenario, if those variables are not applicable to the company’s business. The company may also add its own variables, but is not required to do so.

Stress Test Methodologies and Practices

When conducting a stress test a banking organization must estimate the following for each required scenario: losses, pre-provision net revenue, provision for loan and lease losses, and net income. The supervisors expect the estimation process to capture the relationship between the scenarios and the impact on the company, and understand that the methods used by companies to the produce such estimates will vary. The supervisors also expect banking organizations to continually enhance their risk management practices and stress testing practices. When making projections, a banking organization should use conservative assumptions about management responses to the conditions in the scenarios, and should include only those responses for which there is strong support.

Estimating the Impact on Capital

Stress testing requires a banking organization to estimate the potential impact of the scenarios on its regulatory capital levels and capital ratios, while incorporating the effects of any capital actions over the stress test horizon. The supervisors expect that the capital levels and ratios will be reduced under the adverse and severely adverse scenarios.

As part of the stress test, a banking organization must make the following assumptions regarding its capital actions:

  • For the first quarter, the company must take into account its actual capital actions as of the end of that quarter.
  • For quarters two through nine, the banking organization must include the following in the projections of capital:
    • Common stock dividends equal to the quarterly average dollar amount of common stock dividends that the company paid in the previous year;
    • Payments on any other instrument that is included in the numerator of a regulatory capital ratio equal to the stated dividend, interest, or principal due on such instrument during the quarter; and
    • An assumption of no redemption or repurchase of any capital instrument that is included in the numerator of a regulatory capital ratio.

A bank holding company should assume it will not issue any new common stock, preferred stock, or other instrument that would count towards regulatory capital in quarters two through nine, except for any routine issuance related to employee compensation. Although bank holding companies are required to use specific capital action assumptions, banks and thrifts should use capital actions that are consistent with the three different scenarios and its internal practices.

Controls, Oversight, and Documentation

A banking organization must maintain a system of controls, oversight, and documentation, including policies and procedures, that will ensure the company is meeting the requirements of the stress test rule. The system of controls, oversight, and documentation should be comprehensive and provide a consistent and repeatable process. In addition, senior management should ensure that the stress testing process and practices are transparent for third parties. The board of directors must review the policies and procedures at least on an annual basis to ensure that they are current, relevant, and consistent with existing regulatory requirements.

What Banking Organizations Should Do

While the stress test guidance is currently in the proposal stage, it would be prudent for banking organizations with more than $10 billion but less than $50 billion in consolidated assets to begin to consider implementing the following practices in preparation of its stress tests.

  • Develop specific strategies to accumulate the data necessary to improve the estimation and projection practices over time.
  • Look beyond just historical data and challenge conventional assumptions to ensure that the company’s stress test is not constrained by its own past experiences.
  • Develop policies and procedures related to stress testing that provide a clear description of the manner in which a stress test should be conducted, the roles and responsibilities of the parties involved, and how a stress test is to be used.
  • Establish an integral role for senior management in overseeing the stress test, evaluating the stress test results, addressing weaknesses that are identified, and communicating any developments with the board of directors.
  • Provide for the board of directors involvement by actively evaluating the stress test results and ensuring that it appropriately reflects the company’s risk appetite, overall strategy, and business plans.

Comments on the proposed guidance are due to the OCC and FDIC by September 25, 2013 and to the FRB by September 30, 2013.