Final Stress Test Guidance Issued for Medium-Sized Banks

Bank regulators have issued final guidance detailing their expectations for required stress tests conducted by medium-sized financial companies.

The guidance from the Federal Reserve Board, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency applies to banks with total consolidated assets of between $10 billion and $50 billion. In October 2012, bank regulators issued final rules requiring annual, company-run stress tests in accordance with the Dodd-Frank Act. The first stress tests must be conducted by March 31, 2014.

Under those rules, banks must assess the potential impact of a minimum of three macroeconomic scenarios—baseline, adverse, and severely adverse—on their consolidated losses, revenues, balance sheet (including risk-weighted assets), and capital. Covered institutions should apply each supervisory scenario across all business lines and risk areas.

If a financial institution does not currently have sufficient internal data to conduct a stress test, it is permitted to use an alternative data source as a proxy for its own risk profile and exposures. The guidance notes, however, that they would be expected to develop strategies to accumulate sufficient data to improve their stress test estimation processes over time. Banks must also demonstrate that the proxy data is relevant to their own exposures and appropriate for the estimation, and that they are actively collecting internal data.

Banks should ensure their risk management policies and practices generally apply to the use of vendor and third-party products, the guidance says. It does not, however, prescribe which vendors should be used, or provide the specific directions for vetting vendors.

Credit losses associated with loan portfolios and securities holdings should be estimated directly and separately, whereas other types of losses can be incorporated into estimated net revenue. Larger, more sophisticated companies should consider more advanced loss estimation practices that identify the key drivers of losses for a given portfolio, segment, or loan; determine how those drivers would be affected in supervisory scenarios; and estimate resulting losses.

Banks are expected to maintain an adequate loan-loss reserve through a none-quarter horizon, consistent with accounting standards and internal practices.

Medium-sized financial institutions are not required to meet or maintain any specific post-stress capital ratios or targets. However, the final guidance does set an expectation that they determine whether their post-stress results are aligned with their own internal capital goals and risk appetite. When this is not the case, senior management would be expected to provide options that senior management and the board would consider for bringing them into alignment.

The stress rest rules do not require medium-sized banks to create capital action plans or submit a capital plan to regulators. The agencies have existing supervisory expectations regarding appropriate capital planning practices.

Policies and procedures for stress tests should be comprehensive, ensure a consistent and repeatable process, and provide transparency for third parties. Recognizing the “sensitive nature” of public disclosure, it is only required for stress tests conducted under the severely adverse scenario.

Community banks with less than $10 billion in assets are not subject to Dodd-Frank stress tests. The OCC's expectations for stress testing by community banks are outlined in earlier bulletins, “Community Bank Stress Testing” (Oct. 18, 2012), and “Guidance for Evaluating Capital Planning and Adequacy” (June 7, 2012). Savings and loan holding companies are not subject to Dodd-Frank stress testing until the next calendar year, after they are subject to regulatory capital requirements. This will be in the stress test cycle that begins Oct. 1, 2016.