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From Banking and Finance Law Daily, March 6, 2014

Regulators issue stress test guidance for mid-size institutions

By Andrew A. Turner, J.D.

The Federal Reserve Board, Office of the Comptroller of the Currency, and Federal Deposit Insurance Corporation have issued final guidance describing supervisory expectations for stress tests to be conducted by financial companies with total consolidated assets of between $10 billion and $50 billion (OCC 2014-5). These companies are required by the Dodd-Frank Act to carry out annual company-run stress tests. The first round of tests must be completed by March 31, 2014.

The guidance outlines the principles behind Dodd-Frank stress test practices and offers additional details about methodologies that should be employed by these companies. The guidance also underscores the importance of stress testing as an ongoing risk management practice that supports a company’s forward-looking assessment of its risks and better equips the company to address a range of macroeconomic and financial outcomes. Supervisory expectations regarding each requirement of the Dodd-Frank stress test rules and illustrative examples of satisfactory practices are included.

Structure of guidance. The guidance addresses:

  • the use of supervisory scenarios;

  • segmentation of portfolios and data;

  • model risk management and loss estimation practices;

  • projections for pre-provision net revenue (PPNR), balance sheets, and risk-weighting of assets;

  • projections for quarterly provisions and ending allowance for loan and lease losses (ALLL);

  • estimating the potential impact on regulatory capital levels and capital rations;

  • sound practices regarding the controls, oversight, and documentation required by the agencies’ stress test rules;

  • reporting of stress test results; and

  • stress testing at savings and loan holding companies.

Supervisory expectations. The guidance provides examples of tailored expectations for $10-50 billion companies. The expectations for data sources, data segmentation, sophistication of estimation practices approaches, reporting and public disclosure are elevated for larger and more complex organizations than for $10-50 billion companies. Information is provided on the circumstances under which a $10-50 billion company should use the more advanced practices described in the guidance.

The guidance sets general supervisory expectations for stress tests, and provides, where appropriate, some examples of possible practices that would be consistent with those expectations. It does not represent a comprehensive list of potential practices, and companies are not required to use any specific methodological practices for their stress tests. Companies may use various practices to project their losses, revenues, and capital that are appropriate for their risk profile, size, complexity, business mix, market footprint, and the materiality of a given portfolio.

Timelines. Stress test projections are based on exposures with the as-of date of September 30 and extend over a nine-quarter planning horizon that begins in the quarter ending December 31 of the same year and ends with the quarter ending December 31 two years later. For example, a stress test beginning in the fall of 2013 would use an as-of date of Sept. 30, 2013, and involve quarterly projections of losses, pre-provision net revenue, balance sheet, risk-weighted assets, and capital beginning on Dec. 31, 2013, of that year and ending on Dec. 31, 2015. In order to project quarterly provisions, a company should estimate the adequate level of the allowance for loan and lease losses to support remaining credit risk at the end of each quarter. The ALLL estimation should include the final quarter of the planning horizon, which may require additional projections of credit losses beyond 2015.

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