Alert June 14, 2011

Federal Banking Agencies Propose Guidance on Stress Testing for Large Banking Firms

On June 9, 2011, the FRB, FDIC and OCC (the “Agencies”) jointly proposed new guidelines on the structure, content and governance of stress-testing for banks with more than $10 billion in assets (the “Guidelines”).  The Guidelines are distinct and separate from new stress-testing requirements promulgated under the Dodd-Frank Wall Street Reform and Consumer Protection Act. 

The Agencies state that an effective stress test would be conducted at least annually and be designed to identify vulnerabilities at the institutions, assess capital adequacy and assist with recovery planning.  Stress tests should include activities and exercises tailored to the banking organization’s exposures, activities and risks.  The Agencies emphasize that the stress test must be conceptually sound and be approached as part of a forward-looking and flexible framework.  Stress tests should produce results that are clear, actionable and well supported.  The Agencies emphasize that capital and liquidity requirements should be a special focus of all stress testing.

The Agencies recommend four stress testing approaches.  These are:

  • Scenario Analysis - a type of stress testing in which a banking organization applies historical or hypothetical scenarios to assess the impact of various events and circumstances, including extreme ones.  Scenarios usually involve some kind of coherent, logical narrative or “story” as to why certain events and circumstances are occurring
  • Sensitivity Analysis - a banking organization’s assessment of its exposures, activities, and risks when certain variables, parameters, and inputs are “stressed” or “shocked” without a specific underlying reason.
  • Enterprise-Wide Stress Testing - assessing the impact of certain specified scenarios on the banking organization as a whole, particularly on capital and liquidity.
  • Reverse Stress Testing - a tool that allows a banking organization to assume a known adverse outcome, such as suffering a credit loss that breaches regulatory capital ratios or suffering severe liquidity constraints making it unable to meet its obligations, and then deduce the types of events that could lead to such an outcome.

The Agencies have requested comments by July 29, 2011 on all of the Guidelines.