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.

Added Stress in the United Kingdom

Last week, the Wall Street Journal reported that financial institutions in the UK are being subjected to even more stringent stress testing requirements than their US counterparts. The Financial Services Authority (FSA) is requiring the largest financial institutions to conduct what it calls "reverse stress testing". These tests are designed to determine what an institution will need to recover from a catastrophic operational risk event such as a natural disaster or pandemic. Evidently, the UK bankers are none too pleased with the request according to the following report.

Bankers call it the latest example of regulatory overkill. Executives protest that they are wasting countless hours dreaming up outlandish doomsday scenarios. The chief executive of a major U.K. bank said the tests are predicated on "a massive confluence [of] absurd scenarios" in which executives passively watch events unfold rather than trying to stabilize the situation. Bankers are especially worried that the process could result in them being forced to hold more capital. The FSA said in a planning document that the tests "may result indirectly in changes to the levels of capital held by firms" if the exercise "identifies business model vulnerabilities that have not previously been considered."

An FSA spokeswoman defended the exercise. "It might seem outlandish to them, but the point is that it pushes the business model to the point it collapses," the spokeswoman said. She said the banks also should be evaluating relatively mundane situations like what they would do in the event of a major internal fraud.

What is somewhat surprising by this report is the fact that these financial institutions should have already conducted similar scenario planning and testing as part of the Basel II Capital Accord requirements. However, since the Basel II requirements were largely self-regulated, it appears that the banks did not do their homework the first time around. For those bankers in the US who did not do their homework as well, you might want to get started before the teacher asks for it.