March 7, 2014

Section 165(i)(2) of Dodd-Frank requires banking organizations with more than $10 billion in total assets to conduct annual stress tests. It also mandates that the FRB, FDIC and OCC (together, the “Federal Agencies”) adopt rules that (i) define the term ‘‘stress test’’; (ii) establish methodologies for stress testing at least three different sets of conditions, including baseline, adverse and severely adverse; (iii) establish the form and content of reports to the appropriate Federal Agencies; and (iv) require public disclosure of stress test results. In furtherance of Dodd-Frank requirements, the Federal Agencies adopted final rules regarding annual company-run stress tests (“Final Rules”) for Medium-Size Banks in October 2012. After issuing those Final Rules, the Federal Agencies then sought comment on proposed supervisory guidance that would supplement the Final Rules. The Federal Agencies also discussed expectations for stress test practices and offered additional details regarding methodologies that should be employed by Medium-Size Banks. Specifically, the proposed guidance sets forth five principles for an effective stress-testing regime, as follows:

  • Stress-testing framework should include activities and exercises that are tailored to and sufficiently capture a Medium-Size Bank’s exposures, activities and risks;
  • An effective stress-testing framework should employ multiple conceptually sound stress-testing activities and approaches;
  • An effective stress-testing framework should be forward-looking and flexible;
  • Stress test results should be clear, actionable, well supported and inform decision-making; and
  • Stress-testing framework should include strong governance and effective internal controls.

Consistent with the proposed guidance, the Federal Agencies’ final Guidance published on March 4, 2014, retains the overall structure and content of the proposed guidance and provides additional detail about certain methodologies and key practices required under Dodd-Frank. The final Guidance for Medium-Size Banks is outlined as follows:

  • Stress Test Timelines : Stress test projections are based on exposures with an as-of date of Sept. 30 of the preceding calendar year and extend over a nine-quarter planning horizon that begins in the quarter ending Dec. 31 of the same year and ends with the quarter ending Dec. 31 two years later. For example, a stress test beginning in the fall of 2013 would use an as-of date of Sept. 30, 2013, and involve quarterly projections of losses; pre-provision net revenue (PPNR); balance sheet, risk-weighted assets; and capital beginning on Dec. 31, 2013, of that year and ending on Dec. 31, 2015.
  • Scenarios for Stress Tests : Medium-Size Banks must assess the potential impact of baseline, adverse and severely adverse scenarios (in addition to other scenarios provided annually by Federal Agencies) to assess the potential impact of the scenarios on their consolidated earnings, losses and capital. The Federal Agencies will provide a description of any additional scenarios no later than Nov. 15 each calendar year.
  • Stress Test Methodologies and Practices : In conducting a stress test, Medium-Size Banks must estimate loss projections, PPNR, balance sheet and risk-weighted asset projections, estimates for immaterial portfolios, projections for quarterly provisions and ending allowance for loans and lease losses, and projections for quarterly net income for each scenario. Stress test methodologies and key practices should be commensurate with the bank’s size, complexity and sophistication. Key practices for stress tests include the appropriate use of data sources, data segmentation and model risk management. Medium-Size Banks may use partially validated risk models, provided that such banks have (1) made an effort to identify models based on materiality and highest risk and to prioritize validation activities accordingly; (2) applied compensating controls so that the output from models that are not validated or are only partially validated are not treated the same as the output from fully validated models; and (3) clearly documented such cases and made them transparent in reports to model users, senior management and other relevant parties.
  • Estimating the Potential Impact on Regulatory Capital Levels and Capital Ratios : In conducting a stress test, for each quarter of the planning horizon Medium-Size Banks must estimate the potential impact on regulatory capital levels and capital ratios (including regulatory capital ratios specified by the Federal Agencies), incorporate the effects of any capital actions over the planning horizon, and maintain an allowance for loan losses appropriate for credit exposures throughout the planning horizon. Estimates should account for any actual and projected capital actions during the planning horizon such as dividends, payments on capital instruments and redemptions or repurchases.
  • Controls, Oversight and Documentation : Senior management must establish and maintain a system of controls, oversight and documentation, including policies and procedures designed to ensure that its stress-testing processes comply with Dodd-Frank requirements. These policies and procedures must describe the Medium-Size Bank’s stress-testing practices and methodologies, and document the processes for validating and updating practices and methodologies consistent with applicable laws, regulations and supervisory guidance. The board of directors, or a committee thereof, must review and approve the stress-testing policies and procedures processes as frequently as macro-economic conditions or the bank’s condition may warrant, but no less than annually. In addition, the board of directors and senior management must receive a summary of the results of the stress test. The board of directors and senior management must consider the results of the stress test in the normal course of business and as part of the bank’s ongoing capital planning, assessment of capital adequacy and risk management practices.
  • Report to Supervisors : Medium-Size Banks must report the results of the stress test to the appropriate Federal Agencies by March 31 of each year. The stress test report must include a description of the types of risks included in the stress test, a description of the methodologies used in the stress test and an explanation of the most significant causes for the changes in regulatory capital ratios under each scenario, as well as other information required by the Federal Agencies.
  • Public Disclosure of Stress Tests : Medium-Size Banks must publicly disclose a summary of the results of the stress test in the period beginning on June 15 and ending on June 30 of each year. The first such public disclosure shall be between June 15 and June 30, 2015, using Sept. 30, 2014, financial statement data. A bank’s stress test public disclosure may be included in its parent company’s public disclosure (on the same timeline). A summary of the stress test results should also be included on the bank’s website.

Medium-Size Banks must complete their first stress test under the final stress test rules before March 31, 2014. A link to the Final Rules is available here. A link to the Guidance for Medium-Size Banks is available here.

The Final Rules and Guidance are not applicable to community banks with less than $10 billion in total assets. The OCC’s final supervisory guidance for community bank stress testing is available here.