Friday, May 18, 2012

U.S. Finalizes Stress Test Guidance for Largest Banks

The Federal Reserve Board, Federal Deposit Insurance Corporation, and the Office of the Comptroller of Currency have issued definitive guidance on supervisory expectations for stress testing by banking organizations with more than $10 billion in total consolidated assets.  This set of interpretations is a final version of initial guidance issued June 15, 2011, and provides high-level principles for stress testing practices required of big banks and depository institutions.  Overall, it “highlights the importance of stress testing as an ongoing risk management practice that supports a banking organization’s forward-looking assessment of its risks and better equips the organization to address a range of adverse outcomes.”

The regulators expect covered entities to implement an effective stress testing framework providing integrated, and forward-looking set of activities for a banking organization to employ in order to
assist in the identification and measurement of its material risks and vulnerabilities.  Banks are directed to tailor their stress testing to their particular size, complexity, business activities, and overall risk profile.  In doing so, the guidance provides five broad stress testing principles organizations should take into consideration in the development and implementation of a stress testing framework:

  • Principle 1: A banking organization’s stress testing framework should include activities and exercises that are tailored to and sufficiently capture the banking organization’s exposures, activities, and risks.

  • Principle 2: An effective stress testing framework employs multiple conceptually sound stress testing activities and approaches.

  • Principle 3: An effective stress testing framework is forward-looking and flexible.

  • Principle 4: Stress testing results should be clear, actionable, well supported, and inform decision-making.

  • Principle 5: An organization’s stress testing framework should include strong governance and effective internal controls.
The guidance also describes several approaches and applications that banking organizations should consider using, such as 
  1. scenario analysis, 
  2. sensitivity analysis, 
  3. enterprisewide stress testing, and 
  4. reverse stress testing.

The release also discusses four different stress test components and how they can be applied to a banking organization’s stress testing framework.
  1. Scenario analysis 
  2. Sensitivity analysis
  3. Enterprise-wide stress testing
  4. Reverse stress testing
Given the importance of capital and liquidity to a banking organization’s viability, the guidance also emphasizes the use of stress testing in these two areas in particular, including an evaluation of the interaction between capital and liquidity, and the potential for both to become impaired at the same time. Stress testing for capital and liquidity adequacy should be conducted in coordination with a banking organization’s overall strategy and annual planning cycles.  Again, results should be refreshed in the event of major strategic decisions, or other decisions that can materially affect capital or liquidity.

Recognizing that stress testing approaches will evolve over time, the guidance stresses that organizations should strive for robust stress testing systems, and should revisit testing principles, design, and practices to keep up with changing conditions.