Deadlines are looming for implementation of the stress tests required under the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank). The Office of the Comptroller of the Currency (OCC) has issued its final details on stress testing for banks, which went into effect on Oct. 9, 2012.
Executives should make sure that their board members have a thorough understanding of the organization’s compliance effort and the bank’s resulting additional responsibilities. Boards should also understand the potential benefits of getting implementation right.
Understanding What Stress Testing Entails
All banks with assets between $10 billion and $100 billion will need to put in place strong methods for producing forecasts for credit risk management and capital planning. However, the level of detail and reporting schedules will vary by asset category. Financial institutions with assets between $10 billion and $50 billion must submit their initial results in March 2014. While banks might feel as though they have plenty of time, implementing a stress-testing framework will take five to six months.
An effective framework should define how various levels of the organization—segments, business lines, and risk types—will work together to accomplish the following objectives:
- Produce credible outcomes based on high-quality input data and information
- Identify concentrations of exposures and risks
- Reflect a bank’s unique vulnerabilities to economic factors that affect exposures and risks
- Assess and forecast capital and liquidity adequacy at various quarterly horizons
- Capture “interplay” among different exposures and risks and their combined effects
Managing the Increased Complexity of Stress Tests
The Dodd-Frank stress test is far more complex than the forecasts, loan-loss statements, and other reports that institutions currently must produce. To estimate a bank’s overall health, the stress-test provision mandates the use of prescribed economic scenarios issued by the federal government as well as a bank-defined scenario. These forecasts must cover rolling nine-quarter time horizons, beginning with position information as of Sept. 30 of each year.
The submission package includes the following components:
- Capital plan, including risk appetite
- Risk register
- Risk assessment
- Portfolio assessment and scoping
- Stress-testing methodology approach and documentation
- Fiscal year 2014 submission documentation and data templates
Instructions and templates can be found on the OCC website.
The OCC will assess the processes and practices banks use to analyze and assess capital adequacy, along with processes for risk identification and measurement and management practices supporting its analysis of a bank’s overall health.
Preparing the Board for Effective Oversight
The regulations stipulate that the stress test should adequately and effectively estimate how the bank’s portfolio may respond to prescribed shock scenarios. These estimates and measures need to include each exposure, expected losses, and capital demands throughout the multiyear horizon. These stress tests will become a key component of the bank’s ever-increasing capital planning and compliance requirements. The entire production, from data extracts through board review and approval, must have strong controls, documentation, and audit trails. Therefore, board members should be prepared to verify that their institution’s framework meets this baseline for effective procedures and that the stress-testing production provides effective and actionable information. The board should have an active oversight of both the stress-testing implementation project and the ongoing production.
Executives can help their board members by sharing quarterly updates and making sure board members are familiar with the institution’s credit portfolio, the different scenarios, understanding and interpreting stress-test results, and integrating and “harmonizing” stress-testing views with other existing and future forecasting and asset liability management functions.
Building on Initial Successes
Complying with the stress-testing provision will require a multiyear commitment on the part of institutions and their boards. Banks have the opportunity to both meet their initial regulatory obligations and advance and improve the sophistication of their bank’s risk management operations. In the first year, many banks will struggle to implement a foundational framework and basic processes. Over time, though, executives can develop additional capabilities to enhance the organization’s view of its risk. To support this progression, executives should present board members with a comprehensive strategy for implementation as well as a multiyear road map.
In the coming months, financial institutions will have to undertake an ambitious effort to put the necessary controls and systems in place to support stress testing. As this endeavor will involve a substantial enterprise-wide investment, executives should confirm that their board members have a full understanding of and commitment to the requirements and potential benefits of effective stress tests. With a unified approach, a bank will be well-positioned to both meet the regulatory compliance objectives and enhance its organization’s risk management capabilities.