Beginning this fall, many U.S. banking organizations will be conducting their first annual Dodd-Frank company-run stress tests. Today, the U.S. banking regulators (Federal Reserve, OCC and FDIC) proposed guidance setting forth supervisory expectations for stress tests conducted by national banks, state member and non-member banks, savings associations, bank holding companies and savings and loan holding companies with total consolidated assets of greater than $10 billion and less than $50 billion (collectively, “mid-sized firms”).
The proposed guidance is intended to help mid-sized firms conduct stress tests that are appropriately scaled to their size, complexity, risk profile, business mix and market footprint. The proposed guidance describes general supervisory expectations for Dodd-Frank stress tests, and, where appropriate, provides examples of practices that would be consistent with those expectations.
This blog post provides an introductory overview of the Dodd-Frank stress testing framework for mid-sized firms.
Introductory Overview of Dodd-Frank Stress Tests for Mid-Sized Firms
The Dodd-Frank Act requires all financial companies that have total consolidated assets of more than $10 billion and are regulated by a primary federal financial regulator to conduct annual company-run stress tests. A financial company must submit the results of its stress test to its primary federal financial regulator and publish a summary of the results.
The Dodd-Frank Act also requires the Federal Reserve to conduct annual supervisory stress tests of bank holding companies (BHCs) with $50 billion or more in total consolidated assets and systemically important nonbank financial companies. For BHCs with $50 billion or more in total consolidated assets, the Federal Reserve has integrated the Dodd-Frank stress test requirements and the capital plan submission requirement into its annual Comprehensive Capital Analysis and Review (CCAR). Currently, mid-sized BHCs are not subject to supervisory stress tests or CCAR.
What is a Stress Test? A stress test is a forward-looking process to quantitatively assess the potential impact of hypothetical, economic stress scenarios on the consolidated earnings, losses and regulatory capital ratios of a banking organization over a nine-quarter planning horizon.
What is a Stress Test Used For?
A mid-sized firm’s primary federal banking regulator will analyze the quality of the firm’s stress test processes and results. While there is no formal mechanism for a regulator to “pass” or “fail” a mid-sized firm’s Dodd-Frank stress test, regulators will likely consider a firm’s stress test processes and results when evaluating proposed actions that impact the firm’s capital, including but not limited to: M&A transactions; dividend payments; and redemptions of regulatory capital instruments.
A mid-sized firm’s board of directors and senior management must consider Dodd-Frank stress test results in the normal course of business, including capital planning, assessment of capital adequacy and risk management practices.
Public Disclosure: A mid-sized firm must publicly disclose summary results of its Dodd-Frank stress tests beginning in June 2015.
Senior Management Responsibilities for Dodd-Frank Stress Tests
Controls, oversight and documentation of stress testing processes: Senior management of a mid-sized firm must establish and maintain a system of controls, oversight, and documentation, including policies and procedures, that are designed to ensure that its stress testing processes are effective in meeting regulatory requirements. These policies and procedures must, at a minimum:
- Describe the mid-sized firm’s stress testing practices and methodologies as well as its processes for validating and updating those practices and methodologies consistent with applicable laws, regulations and supervisory guidance;
- Be comprehensive, ensure a consistent and repeatable process and provide transparency regarding the firm’s stress testing processes and practices for third parties;
- Provide a clear articulation of the manner in which Dodd-Frank stress tests should be conducted, roles and responsibilities of parties involved (including any external resources);
- Describe how stress test results are to be used by the firm; and
- Be integrated into the firm’s other policies and procedures.
Senior management should ensure compliance with its stress testing policies and procedures, assign competent staff, oversee stress test development and implementation, evaluate stress test results and review any findings related to the functioning of stress testing processes.
Understanding of stress testing processes and results: Senior management should ensure that weaknesses as well as key assumptions, limitations, and uncertainties in Dodd-Frank stress testing processes and results are identified, communicated appropriately within the organization and evaluated for the magnitude of impact, taking prompt remedial action where necessary. If a mid-sized firm is using vendor models, senior management is expected to demonstrate knowledge of the model’s design, intended use, applications, limitations and assumptions.
Senior management, directly and through relevant committees, should be responsible for regularly reporting to the board regarding Dodd-Frank stress test developments, including the process to design tests and augment or map supervisory scenarios, stress test results and compliance with a mid-sized firm’s stress testing policy.
Senior management should have an appropriate understanding of stress test models to provide summary information to the board of directors that allows directors to assess and question methodologies and results.
Use of stress test results: Senior management must receive a summary of the results of the Dodd-Frank stress test. Senior management must consider the results of the Dodd-Frank stress test in the normal course of business, including but not limited to, the mid-sized firm’s capital planning, assessment of capital adequacy and risk management practices. If stress test results are not aligned with the mid-sized firm’s internal capital goals, senior management should provide options that it and the board of directors would consider to bring them into alignment.
Board of Directors Responsibilities for Dodd-Frank Stress Tests
Controls, oversight and documentation of stress testing processes: A mid-sized firm’s board of directors is ultimately responsible for the mid-sized firm’s Dodd-Frank stress tests. The board of directors, or a committee thereof, must approve and review the policies and procedures of the stress testing processes as frequently as economic conditions or the condition of the mid-sized firm may warrant, but no less than annually.
Understanding of stress testing processes and results: The board of directors must receive a summary of information about Dodd-Frank stress testing and results. The board of directors or its designee should actively evaluate and discuss the summary information, ensuring that the stress tests appropriately reflect the mid-sized firm’s risk appetite, overall strategy and business plans, overall stress testing practices and contingency plans, directing changes where appropriate. The board of directors should ensure it remains informed about critical reviews of elements of Dodd-Frank stress tests conducted by senior management or others (such as internal audit), especially regarding key assumptions, uncertainties and limitations.
Use of stress test results: The board of directors must consider the results of the Dodd-Frank stress test in the normal course of business, including but not limited to, the firm’s capital planning, assessment of capital adequacy and risk management practices.
A mid-sized firm should document the manner in which stress tests are used for key decisions about capital adequacy, including capital actions and capital contingency plans. A mid-sized firm should indicate the extent to which Dodd-Frank stress tests are used in conjunction with other capital assessment tools, especially if the stress tests may not necessarily capture the firm’s full range of risks, exposures, activities and vulnerabilities that have the potential to affect capital adequacy.
If stress test results are not aligned with the mid-sized firm’s internal capital goals, the board of directors should consider options presented by senior management to bring them into alignment.
Federal Reserve, OCC and FDIC, Proposed Supervisory Guidance on Implementing Dodd-Frank Act Company-Run Stress Tests for Banking Organizations With Total Consolidated Assets of More Than $10 Billion But Less Than $50 Billion (July 30, 2013) available here: http://www.gpo.gov/fdsys/pkg/FR-2013-08-05/pdf/2013-18716.pdf