A bank’s board of directors has the role of fundamental oversight in stress testing. The most recent guidelines released for the Federal Reserve’s Comprehensive Capital Analysis and Review (CCAR 2014) under the Dodd-Frank Act include several directives for bank boards. Although the guidelines are mandated for banks with between $10 billion and $50 billion in assets, stress testing will likely be broadened, making current guidance a good foundation for banks below $10 billion in assets. Looking to get started? Here are some key takeaways for board members as they prepare for future stress testing compliance.
The buck stops… with you.
Perhaps the most significant expectation for boards of directors is that they are “ultimately responsible” for the bank’s stress tests. Board members should be receiving summary information from their stress tests, including results from each scenario. Beyond this awareness, the board should also be evaluating the results to ensure they appropriately reflect the company’s risk appetite and overall strategy.
It’s a framework, not the SATs.
The goal of capital adequacy stress testing is not just to pass a test, but rather to ensure that the bank could withstand major challenges to its viability—and having enough capital is a major factor. For larger banks, the board “must consider the results of the stress test in the normal course of business, including, but not limited to, the company’s capital planning, assessment of capital adequacy, and risk management practices.” Stress testing should be an integral part of the bank’s business planning process, and direct involvement of senior management and the board are essential. The role of the board in responding to existing challenges is similarly important, and incorporating stress testing into business planning demonstrates that the board is doing its part in disaster preparedness.
Get and stay involved.
While it is management’s responsibility to design and implement stress testing, the board needs to be involved in order to ask the necessary questions to provide an effective challenge process. In doing so, board members should always be in a position “to assess and question methodologies and results,” including model assumptions, limitations, and uncertainties, all of which should be sufficiently documented.
Keep up with the times.
The board “must approve and review the policies and procedures for DFA stress tests to ensure that policies and procedures remain current, relevant, and consistent with existing regulatory and accounting requirements and expectations.” While this mandate is rather open-ended, there are a few things to bear in mind about the newer Dodd-Frank-mandated stress testing for capital adequacy. Stress testing results should be produced for a minimum of the three required scenarios. Board members should not be hesitant to request additional scenarios. Capital adequacy stress testing goes well beyond stressing certain loan segments, which is the most common form of stress testing already in place at many banks. Rather, capital adequacy stress testing is comprehensive and involves impacts throughout the income statement and balance sheet exposures. Impacts (such as losses) should be estimated by drawing relationships between economic factors (like GDP growth) and the line items being projected. Current practice at many firms typically assumes that stressed losses would be a multiple (e.g., 2x) of historical losses, but these results are arbitrary.
Get it in writing.
The board should examine documentation annually (at a minimum) to confirm that it is adequate and shows that the bank has a robust process for producing and evaluating results. At banks with more than $10 billion in assets, the board or a board committee “must approve and review the policies and procedures of the stress testing processes as frequently as economic conditions or the condition of the company may warrant, but no less than annually.” With that said, thorough documentation is essential.
Make it add up.
For the purpose of consistency with the bank’s strategy as well as the board’s history, projected capital actions should coincide with the scenarios and internal practices in the bank’s stress tests. For example, dividend policy in each scenario should be consistent with any corporate restrictions and the board’s decisions in historical stress periods.
While these directives can be easily delegated to members of management, bank regulators have made it clear that the bank’s board of directors is accountable for successful stress testing implementation, results, and integration into future planning. As stress testing becomes more frequent and rigorous, the process should already be in the forefront of board members’ minds and corporate agenda. Eventually, stress testing results will become public. Banks that score well and do so cost-effectively will be rewarded in the marketplace.