The Conference of State Bank Supervisors (CSBS) is recommending that community banks use stress testing to evaluate the potential impact of key risk factors. The recommendation announced on October 20 is described in a white paper entitled The Case for Stress Testing at Community Banks; Enhancing the Risk Management Framework to Ensure Economic Viability. The white paper calls for stress testing to be an industry-driven initiative and not a regulatory exercise. The CSBS said that conducting stress tests would help bank managers to better understand their institution’s risk profile and vulnerabilities, and should be accompanied by standards and best practices to define risk parameters, appropriate applications, and limitations. The white paper suggests that stress tests be integrated into the risk management framework of a bank and that banks should work to develop the standards and best practices with reasonable parameters and limitations. The CSBS said that it believes technology and the existing availability of data should not make stress testing an excessive burden or cost to community banks. According to the CSBS, simple stress tests can be conducted based on public data for banks with well defined risks and core deposit funding, but banks with more concentrated or high-risk asset structures would require more specialized stress testing to incorporate loan and other relevant data.

Nutter Notes: The CSBS said that it developed the white paper to spark dialogue among industry participants, policymakers and regulators on the benefits that may be achieved from conducting stress tests at community banks. The white paper recommends that stress testing should not be conducted by bank regulators, but that state and federal regulators should review the assumptions used by management to ensure that a bank is taking a realistic view of its potential risks. It also recommends that regulators evaluate the results of stress tests and review bank management’s plans for mitigating risks identified by stress testing. The CSBS suggested that a bank’s management should be evaluated on its risk mitigation efforts. However, CSBS said that a bank should not be subject to regulatory criticism as a result of identifying vulnerabilities through stress testing because it would create incentives for banks to conduct less effective stress tests. The white paper points out that the Dodd-Frank Act contains several provisions that require stress testing for systemically significant bank holding companies and other financial institutions. While the Dodd-Frank Act does not require community banks to undergo stress tests, the white paper suggests that regulators will become accustomed to seeing stress testing as part of the risk management framework and an important part of the supervisory process. The CSBS said that “bank management will find it difficult to demonstrate sufficient risk management processes without incorporating an element of stress testing.”