The Federal Reserve Board, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation jointly released guidance last week for depository institutions and holding companies with more than $10 billion in assets to assist them in conducting stress tests to detect weaknesses in their operations and on their balance sheets.

“The 2007-2009 financial crisis further underscored the need for banking organizations to incorporate stress testing into their risk management practices, demonstrating that banking organizations unprepared for stressful events and circumstances can suffer acute threats to their financial condition and viability,” the final supervisory guidance says.

The stress tests covered by the guidance are neither those conducted by the Federal Reserve to determine if large banks have enough capital to withstand financial and economic shocks nor those mandated by Section 165(i)(2) of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, 12 U.S.C. § 5365(i)(2). Nor are they the supplementary stress tests described in a proposed Federal Reserve rulemaking dealing with enhanced prudential standards for large banking institutions (over $50 billion in assets) and nonbank financial institutions of comparable significance.

Rather these guidelines are for internal stress tests conducted by the institutions themselves consistent with their individual businesses and risk profiles.

The multiple testing requirements faced by these institutions represent a regulatory burden that is considerable and threatens to be duplicative. The regulators have indicated, however, that they plan to coordinate all of the different stress tests and make sure they are consistent with one another.

According to the agencies, last week’s guidance is intended to provide general principles that medium and large depository institutions and their holding companies should follow in conducting forward-looking assessments of risks to improve their overall risk management strategies and better prepare them to be able to address a sufficiently broad range of adverse eventualities. An effective stress-testing framework should generally be conducted with a horizon of at least two years and should, among other things, “explore the potential for capital and liquidity problems to arise at the same time or exacerbate one another.”

To paraphrase these general principles: (1) Each institution‘s stress testing framework should emphasize activities and exercises that are tailored to and sufficiently capture its exposures, activities, and risks; (2) To be effective, a stress testing framework should employ multiple, conceptually sound stress testing activities and approaches; (3) Likewise, an effective stress testing framework should be forward-looking and flexible; and (4) Stress tests results should be clear, actionable, and well supported, and should inform future decision-making.

Small community banks justifiably fear that stress tests will eventually be mandated for them, which, in view of the relative simplicity of their operations when compared to their larger brethren, would be an onerous and wholly unnecessary regulatory burden. To allay these concerns, the regulators issued, contemporaneously with the guidance, a separate statement clarifying that the stress testing guidance does not apply to banks, thrifts, and their respective holding companies if they are below $10 billion in total consolidated assets.

That separate statement is cold comfort, however. First, it expressly recognizes, as does the guidance itself, that there are discrete areas of enterprise-wide stress testing that definitely do apply to smaller institutions. For example, pre-existing guidance on (A) interest rate risk management, (B) commercial real estate concentrations, and (C) funding and liquidity management continues to apply to all institutions, regardless of size.

Second, the agencies, even as they disclaim applicability to smaller institutions, continue to “emphasize that all banking organizations, regardless of size, should have the capacity to analyze the potential impact of adverse outcomes on their financial conditions . . . as part of sound risk management practices.” (Emphasis added).

Third, the Conference of State Bank Supervisors seems to be on board: Back in October 2010, CSBS issued a paper entitled “The Case for Stress Testing at Community Banks.”

Finally, both the American Bankers Association and the Independent Community Bankers have identified anecdotal evidence from their membership to the effect that federal bank examiners are already strongly encouraging those institutions to undertake the very kind of stress testing covered by last week’s guidance and suggesting that it represents “best practices” in the industry.

Thus, we believe it is not a question of whether—but of when—community banks and other small financial institutions will be, in no uncertain terms, required to shoulder this additional regulatory burden.

Ballard Spahr’s Consumer Financial Services Group and Bank Regulation and Supervision Group include experienced lawyers who regularly assist clients on regulatory compliance issues. For more information, please contact Keith R. Fisher in the Bank Regulation and Supervision Group at 202.661.2284 or fisherk@ballardspahr.com; CFS Group Practice Leader Alan S. Kaplinsky at 215.864.8544 or kaplinsky@ballardspahr.com; or CFS Group Practice Leader Jeremy T. Rosenblum, 215.864.8505 or rosenblum@ballardspahr.com. 


Copyright © 2012 by Ballard Spahr LLP.
www.ballardspahr.com
(No claim to original U.S. government material.)

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, including electronic, mechanical, photocopying, recording, or otherwise, without prior written permission of the author and publisher.

This alert is a periodic publication of Ballard Spahr LLP and is intended to notify recipients of new developments in the law. It should not be construed as legal advice or legal opinion on any specific facts or circumstances. The contents are intended for general informational purposes only, and you are urged to consult your own attorney concerning your situation and specific legal questions you have.