Alert May 22, 2012

Federal Banking Regulators Issue Final Guidance on Bank Stress Testing Framework for Large Banks

The FRB, FDIC and the OCC (collectively, the “Agencies”) released final guidance (the “Final Guidance”) on stress testing for banking organizations with more than $10 billion in assets.  The Final Guidance is substantially similar to the proposed version of the guidance circulated for comment by the Agencies in June 2011 (see the June 14, 2011 Financial Services Alert).  The Agencies state that the Final Guidance builds upon the Agencies’ previously issued supervisory guidance covering the uses and merits of stress testing in specific areas of risk management.  The Final Guidance clarifies particular aspects of the proposed version of this guidance based on the comments received by the Agencies and fully adopts the principles in the proposed version of the guidance with only “minor additional refinements.”  For example, the Agencies noted that the Final Guidance clarifies that portions of the guidance may not apply, or may apply differently, to foreign banking organizations with U.S. branches and emphasizes the importance of reverse stress testing.

The Agencies state that the Final Guidance does not implement the stress testing requirements required under the Dodd-Frank Act.  Rulemaking that will set forth stress test requirements imposed under the Dodd-Frank Act will be provided in the future by each of the Agencies.

The Final Guidance reiterates the four general principles to be applied by banks in implementing an effective stress testing framework and adds a fifth principle:

(1) An effective stress testing framework should have activities and exercises tailored to, and that sufficiently capture, the bank’s exposure, activities and risks;

(2) An effective stress testing framework should employ multiple conceptually sound stress testing activities;

(3) An effective stress testing framework should be forward-looking and flexible;

(4) Stress testing results should be clear, actionable, well supported and inform decision-making; and

(5) An effective stress testing framework should include strong governance and effective internal controls.

The Agencies provide clarification in the Final Guidance concerning the approaches and applications to be used in a bank’s stress testing framework, which may include: scenarios analysis, sensitivity analysis, enterprise-wide testing, and reverse stress testing.  The Final Guidance provides that the stress testing framework should be designed to address the adequacy of capital and liquidity.  In particular, the Agencies state, the framework should include an evaluation of the interaction between capital and liquidity and the potential for simultaneous impairment.

Finally, the Final Guidance elaborates on the fifth principle, strong internal governance and controls. According to the Final Guidance, strong governance and effective internal controls is key to an effective stress testing framework. Such internal controls and governance should include monitoring third party vendors for appropriate controls, and overseeing stress test development and implementation.  Further, the Final Guidance provides that a bank should “establish a comprehensive, integrated and effective stress testing framework that fits into the broader risk management of the banking organization.”  For example, senior management and the board should objectively review stress testing activities and results with a “critical eye” and the results should be taken into consideration for capital and liquidity adequacy planning.