Agencies Finalize Stress Test Guidance For Banks With More Than $10 Billion in Assets; Guidance Not Applicable to Smaller Banks

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The Federal Reserve Board, the Office of the Comptroller of the Currency (OCC), and the Federal Deposit Insurance Corporation (FDIC, and together, the agencies) on February 14 issued final supervisory guidance regarding stress-testing practices at "banking organizations" with total consolidated assets of more than $10 billion. (The term banking organization means national banks, federal savings associations, and federal branches and agencies supervised by the OCC; state member banks, bank holding companies, savings and loan holding companies, and all other institutions for which the Federal Reserve Board is the primary federal supervisor; and state nonmember banks, and all other institutions for which the FDIC is the primary federal supervisor.) The agencies noted that supervisors will examine firms’ stress testing methodologies through the supervisory process.

The proposed guidance identified and included a discussion of four key principles for a banking organization’s stress testing framework and related stress test results, namely that: (i) a banking organization’s stress testing framework should include activities and exercises that are tailored to and sufficiently capture the banking organization’s exposures, activities, and risks; (ii) an effective stress testing framework employs multiple conceptually sound stress testing activities and approaches; (iii) an effective stress testing framework is forward-looking and flexible; and (iv) stress test results should be clear, actionable, well supported, and inform decision-making. In the final guidance, the agencies have incorporated a fifth principle specifying that an organization’s stress testing framework should include strong governance and effective internal controls. The elements of the fifth principle had been set forth in section VI of the proposed guidance, and the fifth principle does not expand on this aspect of the proposed guidance. Rather, the agencies reorganized this discussion into a fifth principle "in order to underscore the importance of governance and controls as a key element in a banking organization’s stress testing framework."

The agencies have modified the final guidance to clarify that senior management, not the board of directors, should have the primary responsibility for stress testing implementation and technical design. "However, the agencies emphasize that a banking organization’s board of directors should be provided with information from senior management on stress testing developments (including the process to design tests and develop scenarios) and on stress testing results (including from individual tests, where material). As a general matter, the board of directors is also responsible for monitoring effectiveness of the overall framework, and using the results to inform their decision making process."

The guidance "highlights the importance of stress testing at banking organizations as an ongoing risk management practice that supports a banking organization's forward-looking assessment of its risks and better equips it to address a range of adverse outcomes…, and builds upon previously issued supervisory guidance that discusses the uses and merits of stress testing in specific areas of risk management." The guidance also "outlines general principles for a satisfactory stress testing framework and describes various stress testing approaches and how stress testing should be used at various levels within an organization…and also discusses the importance of stress testing in capital and liquidity planning and the importance of strong internal governance and controls as part of an effective stress-testing framework."

According to the agencies, "the guidance does not implement the stress testing requirements in the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act) or in the Federal Reserve Board's capital plan rule that apply to certain companies, as those requirements have been or are being implemented through separate proposals by the respective agencies." Nonetheless, "the agencies expect that banking organizations with total consolidated assets of more than $10 billion would follow the principles set forth in the guidance--as well as other relevant supervisory guidance--when conducting stress testing in accordance with the Dodd-Frank Act, the capital plan rule, and other statutory or regulatory requirements."

In their Statement to Clarify Supervisory Expectations for Stress Testing by Community Banks, also issued on May 14, the agencies stated that "community banks are not required or expected to conduct the types of stress testing specifically articulated in the initiatives noted above, which are directed at larger organizations.” In particular, "community banks are not required or expected to conduct the enterprise-wide stress tests required of larger organizations under the capital plan rule, the proposed rules implementing Dodd-Frank Act stress testing requirements, or as described in the stress testing guidance for organizations with more than $10 billion in total consolidated assets." The agencies continue to emphasize, however, that "all banking organizations, regardless of size, should have the capacity to analyze the potential impact of adverse outcomes on their financial condition." The agencies noted that "certain portions of existing interagency guidance applicable to all banking organizations discuss addressing potential adverse outcomes as part of sound risk management practices" and that "such existing guidance, including that covering interest rate risk management, commercial real estate concentrations, and funding and liquidity management (among others), continues to apply."

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