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.

Saving For The Perfect Storm

Some banking regulators are beginning to admit the errors made in the early part of this decade that have resulted in the extreme severity of the current economic downturn.  One area that is rearing its ugly head is the inadequacy of loan loss reserves by the largest financial institutions.  As loans were being made at a frenzied pace, the reserves for the inevitable losses associated with those loans were not increased.  The Wall Street Journal reported yesterday that John Dugan, the U.S. Comptroller of the Currency, made the following admission.

He noted that the record profits of the banking industry at the beginning of this decade weren't coupled with an appropriate increasing in reserving. Instead, Dugan said, the ratio of loan loss reserves to total loans actually fell even though bank executives had to know that record profits couldn't last forever.  "Stated differently, rather than being counter cyclical, loan-loss provisioning has become decidedly pro-cyclical, magnifying the impact of the downturn," Mr. Dugan said.

Like many American consumers, the banks themselves were guilty of spending freely by making bad loans and not saving for a rainy day - or, in today's case, saving for the perfect storm.