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From Banking and Finance Law Daily, October 25, 2013

OCC describes how annual bank stress test scenarios will be developed, distributed

By Richard A. Roth, J.D.

The Office of the Comptroller of the Currency has adopted a policy statement outlining how it will build the three scenarios that national banks will use in their mandatory annual stress tests. The scenarios will be distributed to banks by November 15 of each year, and banks ordinarily will conduct their tests using their financial data as of September 30 of that year.

According to the OCC, a stress test is “a process to assess the potential impact of stressful scenarios on the consolidated earnings, losses, and capital of a covered institution over the planning horizon, taking into account the covered institution’s current condition, risks, exposures, strategies, and activities” (12 C.F.R. §46.2). The Dodd-Frank Act requires larger banks, thrifts, and holding companies, as well as designated nonbank financial companies, to conduct periodic stress tests (12 U.S.C. §5365). The OCC’s policy statement applies to the annual tests to be carried out by national banks and federal thrifts with assets of more than $10 billion.

Scenarios. A scenario is the set of assumptions about economic conditions that institutions are to use for their stress tests. For each of the nine quarters in the stress test horizon, the scenario will provide variables that include the growth rate of gross domestic product, the unemployment rate, the inflation rate, asset prices, and financial market conditions.

The OCC notes that the level and rate of change of the unemployment rate are expected to be a key variable expressing the severity of the economic stress being tested.

Each stress test will require the use of three scenarios:

  • baseline—a scenario based on the economic conditions that are expected to occur over the test horizon;

  • adverse—a scenario based on conditions that would be characteristic of a mild to moderate recession;

  • severely adverse—a scenario based on conditions that would be found in a severe recession.

Examples included in the policy statement hypothesize unemployment rate increases of more than 4 percent in the severely adverse scenario.

While a stress test generally will have a nine-quarter horizon, the OCC intends to publish scenarios that extend for an additional year. This is intended to help institutions estimate continued levels of loan losses so they can determine what level of loan loss reserves would be adequate.

Not all institutions will need to consider all of the variables included in a given scenario, the policy statement notes. On the other hand, some institutions may need to use the variables provided by the OCC to generate estimates of other variables they need to consider. Specific institutions, such as those that engage in significant trading activities, also may be required to consider additional factors, the agency says.

Developing scenarios. In developing its scenarios, the OCC will consult with the Federal Reserve Board and Federal Deposit Insurance Corporation and also with private sources of information from outside the agencies. The scenarios used by the three regulatory agencies generally will be comparable, if not identical, but the OCC says that its scenarios occasionally may be different if differences are necessary to reflect its concerns.

Scenarios will be adjusted each year, the OCC says. However, due to the expenses this could impose on banks and thrifts, the agency says it will attempt to minimize changes.

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