Alert October 23, 2012

OCC Issues Guidance Regarding Community Bank Stress Tests

The OCC issued guidance (the “Guidance”) to national banks and federal savings associations with total consolidated assets of less than $10 billion (collectively, “Community Banks”) on using stress tests to identify and quantify risk in loan portfolios and to help establish effective strategic planning processes and maintain adequate capital.  As discussed in the October 16, 2012 Financial Services Alert, the OCC, FDIC and FRB recently published final rules regarding stress tests for larger banks.

The OCC noted that it does not endorse a particular stress testing method for Community Banks; a Community Bank’s approach to stress testing should fit its unique loan portfolio strategy, size, loan types, composition, operations, and management.  Given the smaller scale and lesser complexity of most Community Banks, the OCC noted that assessing portfolio risk and capital vulnerability can be relatively simple and need not involve sophisticated analysis or third-party consultative support.  The OCC further stated, however, that an effective stress test will have the following elements: (1) asking plausible “what if” questions about key vulnerabilities; (2) making a reasonable determination of how much impact the stress event or factor might have on earnings and capital; and (3) incorporating the resulting analysis into the bank’s overall risk management process, asset/liability strategies, and strategic and capital planning processes.

The OCC advised that Community Banks engage in stress testing or sensitivity analysis of loan portfolios at least annually and use stress testing to establish and support reasonable risk appetite and tolerances, set concentration limits, adjust strategies, and appropriately plan for and maintain adequate capital levels. The OCC stated that it expects every bank, regardless of size or risk profile, to have an effective internal process to (1) assess its capital adequacy in relation to its overall risks, and (2) to plan for maintaining appropriate capital levels.  Bank management should mitigate identified risks and vulnerabilities through actions like increased portfolio monitoring, adjusted underwriting standards, selling or hedging assets, and increasing capital and should use the results of stress tests to establish appropriate action plans that address risks when the results are inconsistent with risk tolerance levels and the bank’s overall strategic and capital plans.

The Guidance sets forth certain potential methods and approaches to stress testing, including transaction stress testing, portfolio stress testing, enterprise level stress testing and reverse stress testing and noted that a Community Bank should primarily focus on concentrations of credit or loan portfolio segments that are significant to its overall business strategy.  The OCC stated that Community Banks can conduct stress tests on identified credit concentrations, on other loan portfolio segmentations, and at the individual loan level and that selecting the appropriate factors to stress test depends on the nature of the bank’s concentration risk.  The OCC noted that while problem credits are routinely the focus of risk management, the potential effects on credit concentrations or other portfolio segments are the focus of portfolio level stress testing and stated that the appropriate time frame for a stress test scenario should be at least a two-year projection because, in any given credit cycle, losses generally emerge over a two-year period following the downturn.

The OCC mentioned that it had created a new stress test tool, available along with other tools on the OCC’s BankNet website, for income-producing commercial real estate (“CRE”) loan portfolios for banks that exceed certain CRE concentration levels.

The OCC stated the both bank management and bank examiners should use the Guidance in conjunction with the following previously published guidance on stress testing objectives and methods: the “Concentrations of Credit” booklet in the OCC’s Comptroller’s Handbook series; OCC Bulletin 2012-16, “Guidance for Evaluating Capital Planning and Adequacy”; and the Interagency Final Guidance on “Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices.”