Last week, the FDIC, Federal Reserve, and OCC issued the final guidance on Stress Testing for Banking Organizations Over $10 Billion in Assets, which will go into effect on July 23, 2012. This guidance does not implement the stress testing requirements imposed under Dodd-Frank, that are being implemented through separate notices of proposed rulemaking by the respective agencies. The guidance notes that the agencies believe that the principles contained in this document will be useful when conducting the stress tests required by the Act.
Issued concurrently were bulletins by the agencies clarifying that compliance with the guidance is not required by community banks. As soon as I read these bulletins, I realized that many bankers probably read only the first paragraph of this document and misinterpreted the message to be that stress testing is not required or recommended for any institution under the $10 billion threshold. That is not the case. Let me repeat, that is not the case.
The last paragraph of this document, as well as page four of the large bank stress testing guidance, reiterate that the previously issued supervisory guidance, including commercial real estate (CRE) concentrations, liquidity risk, and interest-rate risk management, remains in force as it should be.
The 2006 Interagency CRE guidance requires portfolio level stress testing for banks that exceed 100% and 300% of CRE assets to total risk-based capital. This guidance has been in place for quite a while now but, unfortunately, has not been successfully implemented by the regulators for various reasons according to the General Account Office's report issued on May 2011. In December 2011, the OCC's Concentrations of Credit Handbook was updated. It directs examiners to include a page in each Report of Examination that lists concentrations that pose a challenge and the risk management process in place to mitigate the potential negative impact on the institution. So beware. There is ample existing regulatory guidance that examiners can cite to enforce stress testing practices are in place at community banks.
I expect to see more enforcement of this guidance as banks emerge from the crisis. Once bankers move troubled assets off their books and have less conversations about ORE, nonaccruals, and TDR's during regulatory examinations, then examiners can focus on bank's efforts to proactively manage concentration risk.
With that said, even though I primarily work with community banks, I took the time to thoroughly read and absorb the large bank stress testing guidance. I strongly recommend that every banker working in lending, operations, and senior management of a financial institution do the same. The guidance is very well written and in a general format so that every bank, regardless of their size, can benefit from the information contained in the principles, approaches, and applications.
The guidance states: "All banking organizations should have the capacity to understand fully understand their risks and potential impact of stressful events and circumstances on their financial condition. The 2007-2009 financial crisis further underscored the need for banking organizations to incorporate stress testing into their risk management, as banking organizations unprepared for stressful events and circumstances can suffer acute threats to their financial condition and viability."
Regulators have highlighted the use of stress testing as a means to better understand the range of potential risk exposures. The guidance states that the stress testing framework should supplement other quantitative risk management practices, such as those that rely primarily on statistical estimates of risk or loss based on historical data, as well as qualitative practices. In this manner, stress testing can assist in revealing unidentified or under-assessed risk concentrations and interrelationships and their potential impact on the banking organizations during times of stress."
The guidance outlined five key stress testing principles:
- The framework should include activities and exercises that are tailored to and sufficiently capture the organization's material exposures, activities and risks.
- An effective stress testing framework employs multiple conceptually sound stress testing activities and approaches
- An effective stress testing framework is forward-looking and flexible
- Stress test results should be clear, actionable, well supported, and inform decision-making.
- Strong governance and effective internal controls help ensure that the framework contains core elements, from clearly defined stress testing objectives to recommended ones.
- Scenario Analysis: a technique where you apply a historical or hypothetical scenario to assess the impact of various events and circumstances, including the most extreme situations. Examples include sever recession, failure of a major counterparty, loss of major clients, localized economic downturn, or a sudden change in interest rates brought about by unfavorable inflation developments.
- Scenario analysis can obviously be a very involved exercise because a recession or local economic downturn (such as the closing of a plant that is a major base of employment for a small town) will have an enormous impact on the bank's entire operation. However, for a community bank that typically specializes in CRE lending, the scenario can involve stress testing for accelerated loss default estimates or, in the case of rising interest rates, the CRE portfolio can be stress tested to determine if borrowers cash flow will be enough to absorb the higher debt payment once interest rates rise. A banker should be able to isolate the CRE loans that have a variable-rate feature as well as those loans that will mature in the short term to analyze the payment shock and recalculate the DSCR.
- Sensitivity Analysis: refers to assessment of risk when certain variables, parameters, and inputs are "stressed" or "shocked." Unlike scenario analysis, this is performed without an explicit underlying reason or narrative in order to explore what occurs under a range of inputs and at extreme or highly adverse levels. The guidance state: "It can help to assess a combined impact on several variables, parameters, factors, or drivers. For example, an organization could better understand the impact on its credit losses from a combined increase in default rates and a decrease in collateral values....An organization can also explore the impact of highly adverse capitalization rates, declines in net operating income, and reductions in collateral when evaluating risk from CRE exposure."
- This is clearly the most valuable type of stress testing for a community bank with CRE exposures. Imagine how important this information would have been if credit and risk officers were able to assess the impact of the bank's loan loss reserve and capital base when the recession first hit and collateral values declined so dramatically while default rates increased sharply.
The guidance also discusses stress testing for capital and liquidity and the governance and control expectations for an institution's stress testing framework. In conclusion, the guidance states, "Stress testing may be particularly valuable during benign periods when other measures may not indicate emerging risks."