New Proposed Guidance on Stress Testing for Banks

Yesterday, the Office for the Comptroller of the Currency (”OCC”), the Federal Reserve and the Federal Deposit Insurance Corporation (”FDIC”) issued proposed guidance for banking institutions to create a robust stress testing framework to adequately assess potential risks. The largest financial institutions have been subject to direct stress testing during the financial crisis in association with the administration of the Troubled Asset Relief Program (”TARP”). This new guidance formally outlines requirements for a broader population of institutions, specifically those with $10 billion or more in assets. According to the guidance, all banks of this size should structure their framework in the following manner.

“….. a banking organization’s stress testing framework should include, but are not limited to, augmenting risk identification and measurement; estimating business line revenues and losses and informing business line strategies; identifying vulnerabilities and assessing their potential impact; assessing capital adequacy and enhancing capital planning; assessing liquidity adequacy and informing contingency funding plans; contributing to strategic planning; enabling senior management to better integrate strategy, risk management, and capital and liquidity planning decisions; and assisting with recovery planning.”

While this guidance does not explicitly meet the requirements of section 165(i) of the Dodd-Frank Wall Street Reform and Consumer Protection Act for non-bank companies, the OCC, Federal Reserve and FDIC plan to issue rules consistent with this guidance for those companies. So, this serves as a preview of what is to come. Public commentary on this proposed guidance is requested by June 29, 2011.

FDIC Calls for Risk Management Improvements

This week, the Federal Deposit Insurance Corporation (”FDIC”) released a special edition of its Supervisory Insights publication focusing on the recent foreclosure crisis in mortgage banking. In the report, the FDIC provides additional perspective on the deficiencies in internal processes, staffing and control that resulted in a foreclosure moratorium by several of the largest mortgage servicing institutions in late 2010. The FDIC worked with the lead regulatory agencies of the fourteen largest mortgage servicers in the United States to conduct extensive reviews of current foreclosure practices.

The reviews uncovered many common issues among the mortgage servicers. The FDIC noted the following, “concerns included lax foreclosure documentation, ineffective controls over foreclosure procedures, and deficient loss mitigation procedures and controls. Many institutions failed to commit resources sufficient to manage responsibly the rapidly growing volume of mortgage loans in default or at risk of default. Weak governance and controls increased legal, reputational, operational, and financial risks while creating unnecessary confusion for borrowers.”

While the report focuses specifically on the foreclosure shortcomings, it can also serve as a reminder of the value of strong internal controls and risk management practices. As our business processes grow to be more complex and interconnected, the risks inherent in the processes grow exponentially. Unchecked, these risks can quickly propel a business into a full-blown crisis.

Incentive Pay & Risk Back in the Spotlight

Yesterday, the Federal Deposit Insurance Corporation (FDIC) approved a proposal to limit excessive risk taking that is tied to incentive programs at large financial institution. The proposed rules are a result of the Dodd-Frank Act of 2010. Here is a summary of the new rules from the FDIC's website.

The Board of Directors of the Federal Deposit Insurance Corporation (FDIC) today approved a joint proposed rulemaking to implement Section 956 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Section 956 prohibits incentive-based compensation arrangements that encourage inappropriate risk taking by covered financial institutions and are deemed to be excessive, or that may lead to material losses.

Consistent with Dodd-Frank, the proposed rule does not apply to banks with total consolidated assets of less than $1 billion, and contains heightened standards for institutions with $50 billion or more in total consolidated assets. For these larger institutions, the rule requires that at least 50 percent of incentive-based payments be deferred for a minimum of three years for designated executives. Moreover, boards of directors of these larger institutions must identify employees who individually have the ability to expose the institution to substantial risk, and must determine that the incentive compensation for these employees appropriately balances risk and rewards according to enumerated standards.

Chairman Bair said "This proposed rule will help address a key safety and soundness issue which contributed to the recent financial crisis – that poorly designed compensation structures can misalign incentives and induce excessive risk-taking within financial organizations. Importantly, we believe the rule will accomplish its objectives in a way that appropriately reflects the size and complexity of individual institutions. Importantly, this inter-agency proposal will apply across all types of US financial institutions, limiting the opportunity for regulatory arbitrage. Similarly, it will better align US compensation standards with those which have been adopted internationally under the framework approved by the Financial Stability Board in 2009."

Public comment will be accepted for 45 days prior to final approval. In addition, the rules are a joint effort of the Federal Financial Institutions Examination Council (FFIEC), the Securities & Exchange Commission (SEC) and the Federal Housing Finance Agency (FHFA) who each must also approve the rules. These rules are a step in the right direction for those more interested in long-term results, but they will certainly be the subject of intense debate.