[Federal Register Volume 79, Number 49 (Thursday, March 13, 2014)]
[Rules and Regulations]
[Pages 14153-14169]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2014-05518]
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Rules and Regulations
Federal Register
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Federal Register / Vol. 79, No. 49 / Thursday, March 13, 2014 / Rules
and Regulations
[[Page 14153]]
DEPARTMENT OF THE TREASURY
Office of the Comptroller of the Currency
12 CFR Part 46
[Docket No. OCC-2013-0013]
FEDERAL RESERVE SYSTEM
12 CFR Part 252
[Docket No. OP-1485]
FEDERAL DEPOSIT INSURANCE CORPORATION
12 CFR Part 325
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
AGENCY: Board of Governors of the Federal Reserve System (Board or
Federal Reserve); Federal Deposit Insurance Corporation (FDIC); Office
of the Comptroller of the Currency, Treasury (OCC).
ACTION: Final supervisory guidance.
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SUMMARY: The Board, FDIC, and OCC, (collectively, the agencies) are
issuing this guidance, which outlines principles for implementation of
the stress tests required under section 165(i)(2) of the Dodd-Frank
Wall Street Reform and Consumer Protection Act (Dodd-Frank Act or DFA
stress tests), applicable to all bank and savings and loan holding
companies, national banks, state member banks, state nonmember banks,
Federal savings associations, and state-chartered savings associations
with more than $10 billion but less than $50 billion in total
consolidated assets (collectively, the $10-50 billion companies). The
guidance discusses supervisory expectations for DFA stress test
practices and offers additional details about methodologies that should
be employed by these companies.
DATES: Effective dates are as follows:
For the Board: April 1, 2014.
For the FDIC: March 31, 2014.
For the OCC: March 31, 2014.
FOR FURTHER INFORMATION CONTACT:
Board: David Palmer, Senior Supervisory Financial Analyst, (202)
452-2904; Joseph Cox, Financial Analyst, (202) 452-3216; Keith
Coughlin, Manager, (202) 452-2056; Benjamin McDonough, Senior Counsel,
(202) 452-2036; or Christine Graham, Senior Attorney, (202) 452-3005,
Board of Governors of the Federal Reserve System, 20th and C Streets
NW., Washington, DC 20551.
FDIC: Ryan Sheller, Section Chief, (202) 412-4861; Alisha
Riemenschneider, Senior Financial Institutions Specialist, (712) 212-
3280; Mark Flanigan, Counsel, (202) 898-7427; or Jason Fincke, Senior
Attorney, (202) 898-3659, Federal Deposit Insurance Corporation, 550
17th Street NW., Washington, DC 20429.
OCC: Kari Falkenborg, Financial Analyst, (202) 649-6831; Harry
Glenos, Senior Financial Advisor, (202) 649-6409; Ron Shimabukuro,
Senior Counsel, or Henry Barkhausen, Attorney, Legislative and
Regulatory Affairs Division, (202) 649-5490, Office of the Comptroller
of the Currency, 400 7th Street SW., Washington, DC 20219.
SUPPLEMENTARY INFORMATION:
I. Background
In October 2012, the agencies issued final rules implementing
stress testing requirements for companies \1\ with over $10 billion in
total assets pursuant to section 165(i)(2) of the Dodd-Frank Wall
Street Reform and Consumer Protection Act (DFA stress test rules).\2\
At that time, the agencies also indicated that they intended to publish
supervisory guidance to accompany the final rules and assist companies
in meeting rule requirements, including separate guidance for companies
with between $10 billion and $50 billion in total assets. To supplement
these rules, on July 30, 2013, the agencies sought public comment on
proposed supervisory guidance (``proposed guidance'') that discussed
supervisory expectations regarding the conduct of the DFA stress tests
and offered additional details about methodologies that should be
employed by these companies.\3\
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\1\ For the OCC, the term ``company'' is used in this guidance
to refer to national banks and Federal savings associations that
qualify as ``covered institutions'' under the OCC Annual Stress Test
Rule. 12 CFR 46.2. For the Board, the term ``company'' is used in
this guidance to refer to state member banks, bank holding
companies, and savings and loan holding companies. See 12 CFR
252.13. For the FDIC, the term ``company'' is used in this guidance
to refer to insured state nonmember banks and insured state savings
associations that qualify as a ``covered bank'' under the FDIC
Annual Stress Test Rule. 12 CFR 325.202.
\2\ See 77 FR 61238 (October 9, 2012) (OCC final rule), 77 FR
62378 (October 12, 2012) (Board final rule), and 77 FR 62417
(October 15, 2012) (FDIC final rule).
\3\ See 78 FR 47217 (August 5, 2013).
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The proposed guidance was organized around the DFA stress test rule
requirements. In the proposed guidance, the agencies indicated that
they would expect $10-50 billion companies to follow the DFA stress
test rule requirements, other relevant supervisory guidance, and the
expectations from the proposed guidance when conducting DFA stress
tests. The final guidance is organized in a similar manner.
Consistent with the proposal, other relevant guidance includes
``Supervisory Guidance on Stress Testing for Banking Organizations With
More Than $10 Billion in Total Consolidated Assets'' issued by the
agencies in May 2012 (``May 2012 guidance'').\4\ The May 2012 guidance
sets forth broad principles for a satisfactory stress testing framework
for banking organizations with total assets of more than $10 billion,
including principles related to governance, controls, and use of
results.
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\4\ See 77 Federal Register 29458 (May 17, 2012).
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However, it is important to note that other guidance relevant for
the $10-50 billion companies does not include, and these firms are not
subject to, other requirements and expectations applicable to bank
holding companies with assets of at least $50 billion, including the
Federal Reserve's capital plan rule, annual Comprehensive Capital
Analysis and Review, supervisory stress tests for capital adequacy, or
the related data collections supporting the supervisory stress test.\5\
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\5\ See 12 CFR 225.8 (capital plan rule); Supervisory and
Company-Run Stress Test Requirements for Covered Companies, 12 CFR
part 252, subparts E and F; and the Capital Assessment and Stress
Testing information collection (FR Y-14Q, FR Y-14M, and FR Y-14A).
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[[Page 14154]]
II. Summary of Comments
The agencies received 13 comments on the guidance from trade
organizations, industry participants, vendors, and individuals. In
addition to the comments, the agencies held a series of discussions
with trade groups, state banking supervisors, and the banking
organizations to raise awareness about the proposed guidance and
solicit feedback. Some commenters expressed support for the proposed
guidance. However, several commenters recommended changes to, or
clarification of, certain provisions of the proposed guidance, as
discussed below. In response to these comments, the agencies have
clarified the principles set forth in the guidance and modified the
proposed guidance in certain respects as described in this section of
the SUPPLEMENTARY INFORMATION.
A. Overall Comments on the Proposed Guidance
Commenters provided several suggestions for clarifying or modifying
the proposed guidance. Commenters requested additional clarity around
what practices are commensurate with a company's size and complexity
and what constitutes a larger or more sophisticated company. Some
commenters requested that the agencies provide additional tailoring of
expectations based on the size and complexity of companies, and on each
company's familiarity with stress testing. Other commenters argued that
the guidance adopted an approach that was too prescriptive and should
provide each company with flexibility to focus its stress test on the
company's assessment of its idiosyncratic risks. Commenters also
recommended that the agencies consider requiring other types of stress
testing besides scenario analysis and that a more comprehensive set of
risks should be addressed in the guidance.
The final guidance retains the overall structure and content of the
proposal. In addition, the final guidance provides additional detail
about certain key requirements already established in the DFA stress
testing rules. The proposed guidance emphasized that the expectations
regarding stress testing for $10-50 billion companies would generally
be reduced compared to expectations for companies with $50 billion or
more in assets. In order to underscore that point, the final guidance
provides additional examples of certain tailored expectations for $10-
50 billion companies. In addition, the final guidance provides
information on the circumstances under which a $10-50 billion company
should use the more advanced practices described in the guidance.
Several commenters opposed stress testing for $10-50 billion
companies. The commenters argued that conducting the stress tests would
be expensive, time-consuming, and of limited benefit. One commenter
suggested that the stress tests would distract key personnel from
conducting other types of risk management. Commenters requested that
$10-50 billion companies be exempt from stress testing requirements
under certain circumstances, such as if the company was well
capitalized, or be allowed to use an alternative simplified stress
test, such as assuming certain loss rates or conducting a local market
and concentration analysis.
Stress testing for companies with more than $10 billion but less
than $50 billion in total consolidated assets is a requirement of the
Dodd-Frank Act. The agencies are not exempting a company based on its
pre-stress capital ratios or allowing companies to conduct a simplified
stress test that is not based on the supervisory scenarios provided by
each agency, as those practices may not address the possibility of
losses under stressful circumstances. However, as noted above, the
agencies have sought to tailor the stress testing requirements and
expectations for $10-50 billion companies. For example, the
expectations for data sources, data segmentation, sophistication of
estimation practices approaches, reporting and public disclosure are
elevated for larger and more complex organizations than for $10-50
billion companies.
Commenters requested that the agencies modify the timing of the
stress tests to reduce the regulatory reports that need to be completed
at or shortly after year-end. Commenters noted that companies were
required to file many other regulatory reports at the end of a year and
that other regulatory changes are implemented at the beginning of a
year. One commenter's request was to allow companies to conduct their
stress tests with an as of date of December 31 and a due date of June
30. The agencies note that the DFA stress test rules do not require
$10-50 billion companies to file regulatory reports by year-end.
Compared to larger banking organizations, the DFA stress test rules for
$10-50 billion companies provide these companies with additional time
to conduct their stress tests each year, with the report due by March
31, rather than the reporting deadline of January 5 that is required
for companies with $50 billion or more in assets. The agencies
recognize that some companies may still face resource constraints based
on the timeline of the annual stress tests, but the timeline was
codified in the DFA stress test rules. Thus, modification of that
timeline is outside of the scope of the final guidance.
Some commenters were appreciative of the agencies' communication
regarding the guidance and one commenter requested that the agencies
set up a dedicated electronic mailbox for companies to use to submit
questions to the agencies about the stress tests. The agencies
recognize that additional clarification about the stress tests may be
necessary and are evaluating additional tools to assist in this regard.
In the meantime, companies should direct questions regarding the
guidance to their examination staff or to the contacts identified in
the guidance.
B. Scenarios for DFA Stress Tests
Under the stress test rules required by the Dodd-Frank Act, $10-50
billion companies must assess the potential impact of a minimum of
three macroeconomic scenarios--baseline, adverse, and severely
adverse--on their consolidated losses, revenues, balance sheet
(including risk-weighted assets), and capital. The proposed guidance
indicated that $10-50 billion companies should apply each supervisory
scenario across all business lines and risk areas so that they can
assess the effect of a common scenario on the entire enterprise, though
the effect of the given scenario on different business lines and risk
areas may vary.
Some commenters opposed requiring $10-50 billion companies to use
the supervisory scenarios in their DFA stress tests, arguing that the
national variables would not be useful or relevant for many companies,
that the agencies do not have a strong record of identifying emerging
risks in the past, and that the scenario variables were not
sufficiently plausible to be useful as a risk management tool. Other
commenters argued that translating scenario variables into projections
of losses, revenues, the balance sheet, risk-weighted assets, and
capital would be time-consuming, complicated, and without sufficient
benefit to justify the cost. The commenters stated that $10-50 billion
companies do not have the staff or expertise to perform the
quantitative analysis necessary to properly translate the scenarios in
the stress tests.
The use of common supervisory scenarios by all companies subject to
annual company-run stress tests is a key feature of the stress test
rules required
[[Page 14155]]
by the Dodd-Frank Act. However, the proposed guidance indicated that
$10-50 billion companies are not required to use all of the variables
in the supervisory scenarios. In addition, the proposed guidance stated
that $10-50 billion companies could, but would not be required to,
include additional variables or additional quarters to improve the
robustness of their company-run stress tests. However, the proposed
guidance indicated that the paths of any additional regional or local
variables that a company used would be expected to be consistent with
the path of the national variables in the supervisory scenarios. The
agencies believe that the final guidance allows for substantial
flexibility in translating scenario variables and are retaining these
principles. Thus, consistent with the final guidance, a company is not
required to use all the variables in the supervisory scenarios but
could use additional variables or quarters to improve their company-run
stress tests.
Commenters requested further clarification regarding the
translation of the supervisory scenarios into projections of losses and
revenues. One commenter questioned whether idiosyncratic risks should
be addressed in relation to the supervisory scenarios or through the
use of alternative scenarios that might not be consistent with the
supervisory scenarios. Consistent with principles articulated in the
May 2012 stress testing guidance, the final guidance reiterates that no
single stress test can accurately estimate the effect of all stressful
events and circumstances. Accordingly, the final guidance clarifies
that while additional variables may be used to better link the scenario
variables in the supervisory scenarios with companies' projections, the
DFA stress tests may not capture the effects of all of a company's
risks and vulnerabilities.
The agencies received several comments regarding the translation of
national variables in the supervisory scenarios to regional variables.
Commenters requested additional flexibility in the use of regional
variables and in projecting regional variables in cases where data on
local conditions may be less readily available. Commenters suggested
that $10-50 billion companies will have to rely on vendors for
intermediate variables as they lack the expertise to create those
variables internally. For these reasons, some commenters suggested that
the agencies assist companies in developing regional variables, either
by directly providing local variables or by approving of specific
third-party provided variables or specific vendors who provide scenario
variables.
The agencies believe that the guidance provides sufficient
flexibility regarding the use of regional variables. The guidance does
not require a $10-50 billion company to project regional variables, and
to the extent that a $10-50 billion company decides to project one or
more regional variables, the guidance simply provides that the paths of
the regional variables should be consistent with the paths of the
national variables. For example, it would be inappropriate to use a
regional or local variable that exhibited limited stress compared to
variables in the macroeconomic scenarios provided by the agencies
because the approach for deriving that additional variable would be
based on relatively benign conditions. The agencies do not currently
plan to include regional variables in the supervisory scenarios as it
would be difficult to provide a single set of regional variables that
would be appropriate and stressful for every company subject to DFA
stress tests. The agencies do not supervise third-party vendors or
consultants and do not endorse any vendor products, including those
relating to scenario variables for use in the DFA stress tests. The
final guidance retains the expectation that each company should ensure
that they understand any vendor-supplied variables they use and confirm
that such variables are relevant for and relate to company-specific
characteristics.
C. Data Sources and Segmentation
The proposed guidance indicated that if a company does not
currently have sufficient internal data to conduct a stress test, it
would be permitted to use an alternative data source as a proxy for its
own risk profile and exposures. However, the proposed guidance noted
that companies with limited data would be expected to develop
strategies to accumulate sufficient data to improve their stress test
estimation processes over time.
While one commenter appreciated the proposed guidance's caution
regarding the use of historical data, several commenters requested
further clarification on expectations for data sources. Commenters
believed that compiling internal historical data would be cost
prohibitive and suggested that companies should be able to make
reasonable assumptions to address limitations of the history or
applicability of data. Other commenters requested that the agencies
specify what factors are most relevant to determining whether proxy
data are appropriate and another commenter requested that the agencies
specifically instruct companies about which historical periods from
which to collect data. Other commenters requested that the agencies
clarify the expected timeline for improving the quality of internal
data and circumstances where use of proxy data would be appropriate on
a continuing basis.
Developing high-quality internal data is a crucial project for
improving a company's stress testing estimation practices. However, in
response to comments, the final guidance states that in some cases
where a company may initially lack internal data on certain portfolios
it may need to rely on proxy data for some time. Such practices may be
acceptable provided that the company demonstrates that proxy data are
relevant to the company's own exposures and appropriate for the
estimation being conducted, and that the company is actively collecting
internal data.
D. Model Risk Management
The proposed guidance indicated that companies should have in place
effective model risk management practices, including validation, for
all models used in DFA stress tests, consistent with existing
supervisory guidance.\6\ Commenters requested additional guidance on
the use of benchmarking and challenger models and on whether models
needed to be validated before the stress test results are submitted to
the agencies.
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\6\ ``Supervisory Guidance on Model Risk Management,'' OCC 2011-
12 and ``Guidance on Model Risk Management,'' Federal Reserve SR
letter 11-7.
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In response, the agencies have clarified that, consistent with
existing supervisory guidance on model risk management, in some cases,
companies may not be able to validate all the models used in their DFA
stress tests prior to submission. The final guidance indicates that the
use of such models may be appropriate provided that companies made an
effort to identify and prioritize validation for models based on
materiality and highest risk; applied compensating controls so that the
output from models that have not been validated or have only been
partially validated is not treated the same as the output from fully
validated models; and documented clearly such cases and made them
transparent in reports to model users, senior management, and other
relevant parties. The final guidance also notes that companies should
have timelines with explicit plans for conducting the remaining areas
of validation for such
[[Page 14156]]
models and recognize that any provisional use of models without
validation is temporary. Furthermore, the final guidance does not
contain any expectations regarding the use of challenger or
benchmarking models.
The proposed guidance indicated that companies should ensure that
their model risk management policies and practices generally apply to
the use of vendor and third-party products as well. While some
commenters stated that the expectations regarding the use of vendor
models from the proposed guidance seemed fairly straightforward, other
commenters requested modifications. One suggestion was that the
agencies encourage companies to take ownership of stress tests rather
than relying on vendors. One commenter suggested that $10-50 billion
companies be provided discretion to select and utilize vendor products
and services as long as the companies, with the help of the vendors,
conduct their stress tests in accordance with the rules and supervisory
guidance.
Other commenters requested clarification on the validation of
vendor models. Some noted that it would be burdensome to require
independent parties to validate vendor models and duplicative for each
company to independently validate models from the same vendor. The
commenters requested that the agencies evaluate and approve the use of
certain products and services from vendors that meet stress testing
guidelines. Alternatively, commenters suggested the agencies should put
out specific guidelines for vendors to follow and allow a company to
rely on vendor certification that it follows these guidelines.
Regarding vendor models, similar to the existing supervisory
guidance on model risk management, the final guidance does not indicate
whether $10-50 billion companies should or should not use vendor models
and does not prescribe which vendors should be used. The guidance does
indicate that existing supervisory guidance provides guidelines for
companies regarding model risk management for vendors, and states that
vendor models should be validated in a manner similar to internal
models. Because model risk management, including validation of vendor
models, is the responsibility of individual companies, it would not be
appropriate for the agencies to provide the specific assistance
suggested by commenters, such as vetting vendors. Consistent with their
past practice, the agencies plan to use the normal supervisory process
to work with individual companies regarding expectations for
appropriate model risk management for vendor products and services.
E. Loss Estimation
The proposed guidance clarified that credit losses associated with
loan portfolios and securities holdings should be estimated directly
and separately, whereas other types of losses should be incorporated
into estimated pre-provision net revenue (``PPNR''). The proposed
guidance stated that larger or more sophisticated companies should
consider more advanced loss estimation practices that identify the key
drivers of losses for a given portfolio, segment, or loan; determine
how those drivers would be affected in supervisory scenarios; and
estimate resulting losses. Loss estimation practices should be
commensurate with the materiality of the risks measured and well
supported by sound, empirical analysis.
Commenters requested that the agencies provide additional
information about credit loss estimation, as this is by far the most
material risk to $10-50 billion companies. Some commenters suggested
that the agencies provide explicit instructions for how to calculate
loan losses under the stress tests. The final guidance retains the
substantial flexibility regarding loss estimation practices, including
for credit losses, provided in the proposed guidance. Notwithstanding
some commenters' request for additional specificity, the agencies
believe it is important for the guidance to provide this flexibility in
light of evolving loss estimation techniques and the different levels
of complexity at different companies.
Another commenter requested clarification regarding when it would
be appropriate to use the simpler estimation approaches described in
the guidance, especially because in some cases simpler approaches may
be superior or more robust than sophisticated quantitative approaches
for estimating loan losses. Similarly, one commenter requested that the
agencies state that they did not have a preference for bottom-up stress
testing for $10-50 billion companies. The final guidance provides some
additional information on when a $10-50 billion company should use the
more advanced practices described in the guidance. For example, the
final guidance notes that each company's loss estimation practices
should be commensurate with the materiality of the risks measured and
that $10-50 billion companies should consider using more than just the
minimum expectations for the exposures and activities that present the
highest risk. However, the final guidance does not categorically
preclude any specific estimation approach, including bottom-up stress
testing.
The proposed guidance stated that companies could use different
processes for the baseline scenario than for the adverse and severely
adverse scenarios in order to better capture the loss potential under
stressful conditions, including using their budgeting process if it was
conditioned on the supervisory scenario. While some commenters
supported the potential use of the budgeting process for projections
under the baseline scenario, one commenter noted that companies will be
challenged to use their internal budgeting processes if the internal
process must be conditioned on the supervisory baseline scenario. The
use of scenarios provided by each agency is a requirement of the Dodd-
Frank Act that was codified in the DFA stress test rules. While a
company may use its budgeting process for the DFA stress tests
conducted under the baseline scenario, provided that the company can
link the budgeting process to the supervisory baseline scenario,
companies are not required or expected to use the supervisory baseline
scenario for any of their budgeting processes.
F. Pre-Provision Net Revenue Estimation
With respect to PPNR, commenters requested that $10-50 billion
companies be allowed to focus on projecting net-interest margin rather
than on projecting expenses or revenue from fees unless there were
material risks uncovered as part of the stress tests. The proposed
guidance indicated that in some cases it may be appropriate for
companies to use simpler approaches for projecting PPNR. For example,
companies could project each of three main components of PPNR (net
interest income, non-interest income, and non-interest expense) on an
aggregate level for the entire company or by business line based on
internal or industry historical experience. The agencies agree that
net-interest margin is an important component of projecting PPNR and
that, where fees are not a material source of revenue, a company would
not be expected to use the same level of sophistication in estimating
fee income as it used in estimating the company's net interest margin.
Some commenters requested additional information about the
expectations for addressing operational risk in the stress tests. One
commenter noted that operational risk is central to managing the key
risks to banking organizations because operational risk directly
affects the implementation of a business model, and its execution
affects market, liquidity, and credit risk.
[[Page 14157]]
However, the commenter argued it would be a mistake to apply credit
risk models to strategic or operational risk modeling. Another
commenter noted that a company's operational risk may not be directly
related to the scenarios, and requested additional clarification about
estimating operational risk losses in DFA stress testing.
The proposed guidance did not prescribe the use of any specific
type of operational risk modeling and indicated that losses from
operational risk events would need to be estimated only if such events
are related to the supervisory scenarios provided, or if there are
pending related issues, such as ongoing litigation, that could affect
losses or revenues over the planning horizon. The final guidance
follows a similar approach and clarifies there may be certain aspects
of operational risk that a company is not required to address in its
DFA stress tests; however, the company should consider those other
aspects of operational risk as part of broader stress testing described
in the May 2012 stress testing guidance.
G. Balance Sheet and Risk-Weighted Assets
Under the proposed guidance, a company would have been expected to
ensure that projected balance sheet and risk-weighted assets remain
consistent with regulatory and accounting changes, are applied
consistently across the company, and are consistent with the scenario
and the company's past history of managing through different business
environments. The guidance noted that in certain cases, it may be
appropriate for a company to use simpler approaches for balance sheet
and risk-weighted asset projections, such as a constant portfolio
assumption.
One commenter asked for examples of circumstances where it would be
appropriate to assume a constant portfolio. In response, the final
guidance states that $10-50 billion companies may be able to use an
assumption of a static balance sheet and static risk-weighted assets
over the planning horizon; however, companies should consider whether
such an approach is appropriate if the company has more volatile
balance sheets and risk-weighted assets, such as from mergers and
acquisitions or internal growth. In addition, the final guidance
clarifies that cases in which balance sheet and risk-weighted asset
projections decline over the planning horizon, and thus positively
affect capital ratios, should be very well supported by analysis and
documentation.
H. Projections for Quarterly Provisions and Ending Allowance for Loan
and Lease Losses (ALLL)
The proposed guidance stated that companies are expected to
maintain an adequate loan-loss reserve through the planning horizon,
consistent with supervisory guidance, accounting standards, and a
company's internal practice. The proposed guidance noted that the ALLL
at the end of the planning horizon should be consistent with generally
accepted accounting principles (GAAP), including any losses projected
beyond the nine-quarter horizon.
While some commenters said that the guidance was clear on
projecting ALLL, other commenters requested that the agencies clarify
expectations regarding consistency between projections of the ALLL and
GAAP. One commenter argued that determining the credit impairment of a
loan in accordance with GAAP required loan-level examination of credit
quality. Another commenter requested that the agencies clarify the
interaction between the supervisory scenarios and GAAP requirements for
the appropriate level of the ALLL.
In response to comments, the final guidance clarifies that, because
loss projections for the stress tests can in some cases be conducted at
a portfolio level, the ALLL projections may also be conducted at a
similar level, provided that they are not inconsistent with the
company's existing methodologies to calculate ALLL for other regulatory
purposes and for current financial statements. The key supervisory
expectation in this regard is that management ensures that the
company's projected ALLL is sufficient to cover remaining loan losses
under the scenario for each quarter of the planning horizon, including
the last quarter.
I. Estimating the Potential Impact on Regulatory Capital Levels and
Capital Ratios
The proposed guidance stated that projected capital levels and
ratios should reflect applicable regulations and accounting standards
for each quarter of the planning horizon. In particular, the proposed
guidance noted that, in July 2013, the Board and the OCC issued a final
rule and the FDIC issued an interim final rule regarding regulatory
capital requirements for banking organizations (revised capital
framework). Except for the stress testing cycle that began on October
1, 2013, $10-50 billion companies must measure their regulatory capital
levels and regulatory capital ratios for each quarter of the planning
horizon in accordance with the rules that would be in effect during
that quarter, including the transition arrangements set forth in the
revised capital framework.\7\
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\7\ Each of the agencies is providing a one-year transition
period for the vast majority of $10-50 billion companies where the
companies would not be required to reflect the revised regulatory
capital framework in their DFA stress tests. For the stress test
cycle that began on October 1, 2013, $10-50 billion companies should
calculate their regulatory capital ratios using the regulatory
capital framework in effect as of September 30, 2013. See 12 CFR
252.12(n) (Board); 12 CFR 46.6 (OCC); 12 CFR 325.205 (FDIC).
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The proposed guidance indicated an expectation that post-stress
capital ratios under the adverse and severely adverse scenarios will be
lower than under the baseline scenario. Commenters believed that
expecting capital to be lower under stress scenarios may not be
appropriate for $10-50 billion companies. Commenters argued that other
factors, such as slower originations, higher paydowns, and accelerated
charge-offs could result in improved credit quality and higher capital
ratios in the adverse and severely adverse scenarios. Another commenter
noted that it was difficult to get scenario-based forecasts of asset
balances to match up with circumstances that lead to declining ratios
and requested additional information about assumptions that would
necessarily lead to lower capital ratios in stressful conditions than
in baseline scenarios.
While there could be rare cases in which capital ratios are higher
under the adverse and severely adverse scenarios, any such case should
be very well supported by a $10-50 billion company with analysis and
documentation. Since the stress tests are intended to assess the
hypothetical negative impact on companies' capital positions from
stressful conditions, the agencies generally expect companies' post-
stress capital ratios under the adverse and severely adverse scenarios
to be lower than under the baseline scenario.
One commenter requested clarification regarding what constitutes a
reasonable and conservative management response. Another commenter
suggested that dynamic hedging should not be anticipated as a risk-
mitigation technique under stress scenarios. In response, the agencies
note that companies should make conservative assumptions about
management responses in the stress tests, and should include only those
responses for which there is substantial support. Any assumptions that
materially mitigate losses should be well justified. For example, as
discussed
[[Page 14158]]
in the proposed guidance, projecting changes in balances that mitigate
losses are expected to also reduce revenues.
The proposed guidance noted that while holding companies are
required to use specified capital action assumptions, there are no
specified capital actions for banks and thrifts. The proposed guidance
indicated that a bank or thrift should use capital actions that are
consistent with the scenarios and the company's internal practices in
their DFA stress tests. Additionally, the proposed guidance noted that
holding companies should consider that the Board's DFA stress test
rules require the use of certain capital assumptions in the DFA stress
tests, which may not be the same as the assumptions used by the holding
company's subsidiary depository institutions.
The agencies recognize that the consistency between the capital
action assumptions at the holding company level and at the subsidiary
depository institution level is a complicated aspect of the DFA stress
test requirements. The key supervisory expectation is that if the
stress test submissions for the bank or thrift and its holding company
differ in terms of projected capital actions as a result of the
different requirements of the DFA stress test rules, the companies
should address such differences in the narrative portion of their
submissions to their primary regulators and the Board. For example, if
a bank assumed that it would curtail dividends to a bank holding
company, the bank holding company should discuss how it would fund any
capital distributions in a stressed environment.
Some commenters appreciated the flexibility that the guidance
affords regarding capital actions in stress tests. However, others
stated that the capital action assumptions at the holding company level
are unrealistic. One commenter noted that while the capital action
differences are clearly articulated, there was no guidance on how to
reconcile those differences. Another commenter requested additional
flexibility for holding company capital actions as that would enhance
the usefulness of the stress tests as a business planning tool and make
it more actionable. In response, the agencies note that the capital
action assumptions specified for holding companies are a requirement of
the Board's DFA stress test rules and that modifying those assumptions
is outside of the scope of this guidance.
J. Controls, Oversight, and Documentation
The proposed guidance indicated that, as required by the DFA stress
test rules, a company's policies and procedures for DFA stress tests
should be comprehensive, ensure a consistent and repeatable process,
and provide transparency regarding a company's stress testing processes
and practices for third parties. In addition, the guidance provided
additional detail on responsibilities for senior management and boards
of directors relating to the DFA stress test. Commenters requested that
the agencies modify the guidance to further embed risk oversight and
management into daily business decisions and activities. One commenter
suggested that companies should be able to reconcile how final outcomes
compare to expected outcomes.
Certain requirements for controls and oversight are codified in the
DFA stress test rules. Moreover, the agencies believe that the
expectations in the final guidance are appropriate and sufficient, and
to a large degree, are already contained in the May 2012 stress testing
guidance. Specifically, there is no need for additional guidance on
controls and oversight, including on reconciling final and expected
outcomes of the stress tests, since the proposed guidance, as well as
related guidance, indicated the importance of evaluating stress test
outcomes and the practices that produce those outcomes.
Some commenters requested that the agencies clarify their
expectations for the boards of directors. Specific clarification was
requested on the level of detail that the senior management should
report to the board of directors regarding methodologies used in the
stress tests. Another commenter suggested it was inappropriate for a
board to review and approve the stress testing framework and policies.
One suggestion was that the agencies hold training programs for boards
that reflect stress testing obligations. Another requested that the
agencies communicate to the board of directors the relative importance
of the DFA stress tests as a supervisory matter. Another commenter
stated that there were too many requirements for boards and that the
stress testing requirements would be burdensome.
Certain requirements for boards of directors are codified in the
DFA stress test final rules. These requirements will help ensure that
boards of directors provide proper oversight of DFA stress tests,
thereby enhancing the tests' integrity and credibility. The agencies
believe that the proposed guidance and the May 2012 stress testing
guidance sufficiently convey the expectations for boards of directors,
by indicating that they should play an oversight role and be advised
and educated about key stress testing information, but they do not need
to be intimately involved in every detail of the stress testing
process. For example, the proposed guidance noted that boards should
receive ``summary information'' and allowed boards to have designees to
evaluate such information. In addition, the proposed guidance
articulated the different expectations for boards of directors versus
the expectations for senior management, with the expectation that
senior management should be more involved in the details of the
company's stress testing activities. These expectations have been
retained in the final guidance.
The proposed guidance indicated that a $10-50 billion company would
be expected to ensure that its post-stress capital results are aligned
with its internal capital goals and risk appetite. For cases in which
post-stress capital results were not aligned with a company's internal
capital goals, senior management would be expected to provide options
that senior management and the board would consider to bring them into
alignment. One commenter suggested that management should not be
required to create action plans to enhance the level and composition of
capital in response to stress tests, and that stress tests are just one
of many relevant factors for evaluating capital adequacy.
The agencies' stress test rules do not require $10-50 billion
companies to create capital action plans; furthermore, the DFA stress
test rules do not require companies to submit a capital plan to the
agencies. The agencies have existing supervisory expectations for $10-
50 billion companies regarding appropriate capital planning practices
that incorporate new information about their capital positions,
including from capital stress tests. However, $10-50 billion companies
are not subject to the Board's capital plan rule, which includes
specific capital planning and assessment requirements beyond those
specified in the DFA stress test rules. In addition, the agencies' DFA
stress test rules do not require $10-50 billion companies to meet or
maintain any specific post-stress capital ratios or targets. However,
the final guidance does retain the expectation that companies determine
whether their post-stress results are aligned with their own internal
capital goals. The final guidance also retains the expectation that in
cases in which post-stress capital results are not aligned with a
company's internal capital goals, the company should provide options it
would consider to bring them into alignment.
[[Page 14159]]
K. Report to Supervisors and Public Disclosure of Stress Test Results
The proposed guidance indicated that companies must report the
results of their DFA company-run stress tests on the $10-50 billion
reporting form.\8\ One commenter requested clarification on whether a
company must submit two reports even if the subsidiary bank or thrift
is 98 percent of the holding company. Under the stress test rules
required by the Dodd-Frank Act, all companies subject to DFA stress
testing, including holding companies and subsidiary banks and thrifts,
must conduct stress tests and report information to the agencies. If
the holding company's assets are substantially held in the subsidiary
bank or thrift the agencies expect that the report will not be
significantly different at the bank and at the holding company. In
addition, the agencies note that they closely coordinated on the
creation of the $10-50 billion reporting form and it is generally
identical for all $10-50 billion companies.
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\8\ For purposes of this guidance, the term ``$10-50 billion
reporting form'' refers to the relevant reporting form a $10-50
billion company will use to report the results of its DFA stress
tests to its primary Federal financial regulatory agency.
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Regarding public disclosure, the proposed guidance stated that $10-
50 billion companies would need to follow the requirements of the
stress test rules required by the Dodd-Frank Act. One commenter
expressed concern that the public disclosure of the stress tests could
provide fodder for short sellers and requested that the agencies
explain the hypothetical nature of the stress test results to the
public. The agencies recognize the sensitive nature of public
disclosure of stress testing results and have designed the disclosure
requirements to reflect that sensitivity--for example, public
disclosure is only required for stress tests conducted under the
severely adverse scenario. However, public disclosure of the results of
the stress tests is a requirement of the Dodd-Frank Act. The agencies
have sought to tailor the disclosure requirement for $10-50 billion
companies both in the stress testing rules required under the Dodd
Frank Act and through the expectations in this guidance. The agencies
have frequently communicated the hypothetical nature of the stress
tests, but, in response to the commenter request, the agencies have
added that clarification to the final guidance.
L. Stress Testing at Savings and Loan Holding Companies (SLHCs)
The agencies received several comments regarding the application of
the guidance to SLHCs. Commenters generally stated that the guidance
did not reflect the unique concerns of SLHCs that are substantially
engaged in either insurance underwriting or commercial activities and
requested further tailoring of the supervisory expectations for
conducting DFA stress tests at nonbank SLHCs. Commenters noted the
fundamental differences in the nonbank business and insurance risk and
the banking risks in the proposed guidance. For these reasons, the
commenters requested delaying the implementation for excluded SLHCs,
tailoring expectations for SLHCs with substantial nonbank businesses,
and providing a general exemption from stress testing for SLHCs with
thrift subsidiaries with less than $10 billion in assets.
The Board's rules implementing the Dodd-Frank Act stress tests
provide that an SLHC that meets the asset threshold on or before the
date on which it is subject to minimum regulatory capital requirements
must comply with the requirements of that subpart beginning with the
stress test cycle that commences in the calendar year after the year in
which the company becomes subject to the Board's minimum regulatory
capital requirements, unless the Board accelerates or extends the
compliance date. On July 2, 2013, the Board approved a final rule that
would implement regulatory capital requirements for SLHCs, other than
those that are substantially engaged in insurance underwriting or
commercial activities. As discussed in the preamble to that rule, the
Board excluded SLHCs that are substantially engaged in insurance
underwriting or commercial activities in order to consider further
development of appropriate capital requirements of these companies, and
is exploring further whether and how the proposed rule should be
modified for these companies in a manner consistent with section 171 of
the Dodd-Frank Act and safety and soundness expectations. That preamble
indicated that the Board expects to implement a framework for SLHCs
that are not subject to the final rule by the time covered SLHCs must
comply with the final rule in 2015.
SLHCs that are substantially engaged in insurance underwriting or
commercial activities will become subject to DFA stress testing in the
stress test cycle that commences in the calendar year after the year in
which those companies become subject to the Board's minimum regulatory
capital requirements, unless the Board accelerates or extends the
compliance date. As such, the Board does not anticipate that
supervisors will assess the extent to which SLHCs that are
substantially engaged in insurance underwriting and commercial
activities are meeting the expectations in this guidance until such
SLHCs are subject to the requirements of the stress test rules required
under the Dodd-Frank Act. The Board may further tailor the application
of DFA stress testing as it implements the stress test requirements for
these SLHCs.
III. Administrative Law Matters
A. Paperwork Reduction Act Analysis
This guidance references currently approved collections of
information under the Paperwork Reduction Act (44 U.S.C. 3501-3520)
provided for in the DFA stress test rules.\9\ This guidance does not
introduce any new collections of information nor does it substantively
modify the collections of information that the Office of Management and
Budget (OMB) has approved. Therefore, no Paperwork Reduction Act
submissions to OMB are required.
---------------------------------------------------------------------------
\9\ See OMB Control Nos. 1557-0311 and 1557-0312 (OCC); 3064-
0186 and 3064-0187 (FDIC); and 7100-0348 and 7100-0350 (Board).
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B. Regulatory Flexibility Act Analysis
Board:
While the guidance is not being adopted as a rule, the Board has
considered the potential impact of the guidance on small companies in
accordance with the Regulatory Flexibility Act (5 U.S.C. 603(b)). Based
on its analysis and for the reasons stated below, the Board believes
that the guidance will not have a significant economic impact on a
substantial number of small entities. Nevertheless, the Board is
publishing a regulatory flexibility analysis.
For the reason discussed in the SUPPLEMENTARY INFORMATION above,
the Board is issuing this guidance to provide additional details
regarding the supervisory expectations for the DFA stress tests
conducted by $10-50 billion companies. Under regulations issued by the
Small Business Administration (SBA), a small entity includes a
depository institution, bank holding company, or SLHCs with total
assets of $500 million or less (a small banking organization).\10\ The
guidance would apply to companies supervised by the agencies with more
than $10 billion but
[[Page 14160]]
less than $50 billion in total consolidated assets, including state
member banks, bank holding companies, and SLHCs. Companies that would
be subject to the guidance therefore substantially exceed the $500
million total asset threshold at which a company is considered a small
company under SBA regulations. In light of the foregoing, the Board
does not believe that the guidance would have a significant economic
impact on a substantial number of small entities.
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\10\ Effective July 22, 2013, the SBA revised the size standards
for small banking organizations to $500 million in assets from $175
million in assets. 78 FR 37409 (June 20, 2013).
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IV. Supervisory Guidance
The text of the supervisory guidance is as follows:
Office of the Comptroller of the Currency
Federal Reserve System
Federal Deposit Insurance Corporation
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
I. Introduction
In October 2012, the U.S. Federal banking agencies (``agencies'')
issued the Dodd-Frank Act stress test rules \1\ requiring companies
with total consolidated assets of more than $10 billion to conduct
annual company-run stress tests pursuant to section 165(i)(2) of the
Dodd-Frank Wall Street Reform and Consumer Protection Act (``DFA'').\2\
This guidance outlines key supervisory expectations for companies with
total consolidated assets of more than $10 billion but less than $50
billion that are required to conduct DFA stress tests (collectively
``companies'' or ``$10-50 billion companies'').\3\ As discussed further
below, it builds upon the interagency stress testing guidance issued in
May 2012 for companies with more than $10 billion in total consolidated
assets (``May 2012 stress testing guidance''), that set forth general
principles for a satisfactory stress testing framework.\4\
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\1\ See 77 FR 61238 (October 9, 2012) (OCC), 77 FR 62396
(October 12, 2012) (Board: Annual Company-Run Stress Test
Requirements for Banking Organizations with Total Consolidated
Assets over $10 Billion Other than Covered Companies), and 77 FR
62417 (October 15, 2012) (FDIC).
\2\ Public Law 111-203, 124 Stat. 1376 (2010). Each entity that
meets the applicability criteria must conduct a separate stress test
and provide a separate submission. For example, both a bank holding
company between $10-50 billion in assets and its subsidiary bank
with between $10-50 billion in assets must conduct a separate stress
test; however, if a subsidiary bank of a $10-50 billion bank holding
company has $10 billion or less in assets then it does not need to
conduct a DFA stress test.
\3\ For the OCC, the term ``company'' is used in this guidance
to refer to a banking organization that qualifies as a ``covered
institution'' under the OCC Annual Stress Test Rule. 12 CFR 46.2.
For the Board, the term ``company'' is used in this guidance to
refer to state member banks, bank holding companies, and savings and
loan holding companies. 12 CFR 252.13. For the FDIC, the term
``company'' is used in this guidance to refer to insured state
nonmember banks and insured state savings associations that qualify
as a ``covered bank'' under the FDIC Annual Stress Test Rule. 12 CFR
325.202.
\4\ See 77 FR 29458, ``Supervisory Guidance on Stress Testing
for Banking Organizations With More Than $10 Billion in Total
Consolidated Assets,'' (May 17, 2012).
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The supervisory expectations described in this guidance are
tailored to the $10-50 billion companies, similar to the manner in
which the requirements in the stress test rules required under the
Dodd-Frank Act were tailored for this set of companies.\5\ The
additional information provided in this guidance should assist
companies in complying with the stress test rules required under the
Dodd-Frank Act and conducting DFA stress tests that are appropriate for
their risk profile, size, complexity, business mix, and market
footprint. The DFA stress test rules allow flexibility to accommodate
different practices across organizations, for example by not specifying
specific methodological practices. Consistent with this approach, this
guidance sets general supervisory expectations for stress tests, and
provides, where appropriate, some examples of possible practices that
would be consistent with those expectations.\6\
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\5\ For example, expectations for data sources, data
segmentation, sophistication of estimation practices, reports and
public disclosure are generally reduced compared to the expectations
for larger organizations. Consistent with the approach taken in the
DFA stress test final rules, in general the expectations for Dodd-
Frank stress testing practices among companies with at least $50
billion are elevated compared to $10-50 billion companies.
\6\ Companies subject to this guidance are not subject to the
Federal Reserve's capital plan rule, the Federal Reserve's annual
Comprehensive Capital Analysis and Review, supervisory stress tests
for capital adequacy, or the related data collections supporting the
supervisory stress test. 12 CFR 225.8 (capital plan rule);
Supervisory and Company-Run Stress Test Requirements for Covered
Companies 12 CFR part 252, subparts E and F; and the Capital
Assessment and Stress Testing information collection (FR Y-14Q, FR
Y-14M, and FR Y-14A).
---------------------------------------------------------------------------
This guidance does not represent a comprehensive list of potential
practices, and companies are not required to use any specific
methodological practices for their stress tests. Companies may use
various practices to project their losses, revenues, and capital that
are appropriate for their risk profile, size, complexity, business mix,
market footprint and the materiality of a given portfolio.
II. Background
Stress tests are an important part of a company's risk management
practices, and the agencies have previously highlighted that importance
as a means for companies to better understand the range of potential
risks facing them. Specifically, the May 2012 stress testing guidance
sets forth the following five principles for an effective stress
testing regime:
1. A company's stress testing framework should include activities
and exercises that are tailored to and sufficiently capture the
company's exposures, activities, and risks;
2. An effective stress testing framework should employ multiple
conceptually sound stress testing activities and approaches;
3. An effective stress testing framework should be forward-looking
and flexible;
4. Stress test results should be clear, actionable, well supported,
and inform decision-making; and
5. A company's stress testing framework should include strong
governance and effective internal controls.
This DFA stress test guidance builds upon the May 2012 stress
testing guidance, sets forth the supervisory expectations regarding
each requirement of the DFA stress test rules, and provides
illustrative examples of satisfactory practices. The guidance indicates
where different requirements apply to banks, thrifts, and holding
companies. The guidance is structured as follows:
A. DFA Stress Test Timelines
B. Scenarios for DFA Stress Tests
C. DFA Stress Test Methodologies and Practices
D. Estimating the Potential Impact on Regulatory Capital Levels and
Capital Ratios
E. Controls, Oversight, and Documentation
F. Report to Supervisors, and
G. Public Disclosure of DFA Stress Tests
The agencies expect that the annual company-run stress tests
required by the Dodd-Frank Act and the agencies' stress test rules will
be one component of the broader stress testing activities conducted by
$10-50 billion companies. Notably, the DFA stress tests produce
projections of hypothetical results and are not intended to be
forecasts of expected or most likely outcomes. The DFA stress tests may
not necessarily capture a company's full range of risks, exposures,
activities, and vulnerabilities that have a potential effect on capital
adequacy. For example, DFA stress tests may not account for regional
[[Page 14161]]
concentrations and unique business models and they may not fully cover
the potential capital effects of interest rate risk or an operational
risk event such as a regional natural disaster.\7\ Consistent with the
May 2012 stress testing guidance, a company is expected to consider the
results of DFA stress testing together with other capital assessment
activities to ensure that the company's material risks and
vulnerabilities are appropriately considered in its overall assessment
of capital adequacy. Finally, the DFA stress tests assess the impact of
stressful outcomes on capital adequacy, and are not intended to measure
the adequacy of a company's liquidity in the stress scenarios.
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\7\ For purposes of this guidance, the term ``concentrations''
refers to groups of exposures and/or activities that have the
potential to produce losses large enough to bring about a material
change in a banking organization's risk profile or financial
condition.
---------------------------------------------------------------------------
III. Annual Tests Conducted by Companies
A. DFA Stress Test Timelines
Rule Requirement: A company must conduct a stress test over a nine-
quarter planning horizon based on data as of September 30 of the
preceding calendar year.\8\
---------------------------------------------------------------------------
\8\ 12 CFR 46.5 (OCC); 12 CFR 252.14 (Board); 12 CFR 325.204
(FDIC).
---------------------------------------------------------------------------
Under the DFA stress test rules, stress test projections are based
on exposures with the as-of date of September 30 and extend over a
nine-quarter planning horizon that begins in the quarter ending
December 31 of the same year and ends with the quarter ending December
31 two years later.\9\ For example, a stress test beginning in the fall
of 2013 would use an as-of date of September 30, 2013, and involve
quarterly projections of losses, pre-provision net revenue (``PPNR''),
balance sheet, risk-weighted assets, and capital beginning on December
31, 2013 of that year and ending on December 31, 2015. In order to
project quarterly provisions, a company should estimate the adequate
level of the allowance for loan and lease losses (``ALLL'') to support
remaining credit risk at the end of each quarter. The ALLL estimation
should include the final quarter of the planning horizon, which may
require additional projections of credit losses beyond 2015. The ALLL
projections for DFA stress testing should be generally consistent with
a company's internal ALLL approach; however, some modifications might
be necessary, as discussed in more detail below.
---------------------------------------------------------------------------
\9\ Planning horizon means the period of at least nine quarters,
beginning with the quarter ending December 31, over which the
relevant stress test projections extend.
---------------------------------------------------------------------------
B. Scenarios for DFA Stress Tests
Rule Requirement: A company must use the scenarios provided
annually by its primary Federal financial regulatory agency to assess
the potential impact of the scenarios on its consolidated earnings,
losses, and capital.\10\
---------------------------------------------------------------------------
\10\ 12 CFR 46.6 (OCC); 12 CFR 252.14 (Board); 12 CFR 325.204
(FDIC).
---------------------------------------------------------------------------
Under the stress test rules implementing Dodd-Frank Act
requirements, $10-50 billion companies must assess the potential impact
of a minimum of three macroeconomic scenarios--baseline, adverse, and
severely adverse--provided by their primary supervisor on their
consolidated losses, revenues, balance sheet (including risk-weighted
assets), and capital. The rules defines the three scenarios as follows:
Baseline scenario means a set of conditions that affect
the U.S. economy or the financial condition of a company that reflect
the consensus views of the economic and financial outlook.
Adverse scenario means a set of conditions that affect the
U.S. economy or the financial condition of a company that are more
adverse than those associated with the baseline scenario and may
include trading or other additional components.
Severely adverse scenario means a set of conditions that
affect the U.S. economy or the financial condition of a company that
overall are more severe than those associated with the adverse scenario
and may include trading or other additional components.
Each agency will provide a description of the supervisory scenarios
to companies no later than November 15 each calendar year. The
scenarios provided by each agency are not forecasts but rather are
hypothetical scenarios that companies will use to assess their capital
strength in baseline and stressed economic and financial conditions.
Companies should apply each scenario across all business lines and risk
areas so that they can assess the effect of a common scenario on the
entire enterprise, though the effect of the given scenario on different
business lines and risks may vary.
The agencies believe that a uniform set of supervisory scenarios is
necessary to provide a basis for comparison across companies. However,
a company is not required to use all of the variables provided in the
scenario, if those variables are not relevant or appropriate to the
company's line of business. In addition, a company may, but is not
required to, use additional variables beyond those provided by the
agencies. For example, a company may decide to use a regional
unemployment rate to improve the robustness of its stress test
projections.\11\ When using additional variables, companies should
ensure that the paths of such variables (including their timing) are
consistent with the general economic environment assumed in the
supervisory scenarios. More specifically, it would be inappropriate to
use a regional or local variable that exhibited limited stress compared
to variables in the macroeconomic scenarios provided by the agencies,
such as if the approach for deriving that additional variable was based
on relatively benign conditions. Any use of additional variables should
be well supported and documented.
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\11\ The use of additional variables may be used by companies to
better link the DFA stress test scenario variables in the
supervisory scenarios with a company's unique portfolios and risks.
However, consistent with the May 2012 stress testing guidance, no
single stress test can capture all possible effects on capital,
meaning that the DFA stress tests may not capture the effects of all
of a company's risks and vulnerabilities and may need to be
supplemented by other stress testing activities.
---------------------------------------------------------------------------
In addition, a company may choose to project the paths of variables
beyond the timeframe of the supervisory scenarios, if a longer horizon
is necessary for the company's stress testing methodology. For example,
a company may project the unemployment rate for additional quarters in
order to calculate inputs to its end-of-horizon ALLL or to estimate the
projected value of certain types of securities under the scenario.
Companies may use third-party vendors to assist in the development
of additional variables based on the supervisory stress scenarios. In
such instances, consistent with existing supervisory expectations,\12\
companies should understand the third-party analysis used to develop
additional variables, including the potential limitations of such
analysis as it relates to stress tests, and be able to challenge key
assumptions. Companies should also ensure that vendor-supplied
variables they use are relevant for and relate to company-specific
characteristics.
---------------------------------------------------------------------------
\12\ ``Supervisory Guidance on Model Risk Management,'' OCC
2011-12, or ``Guidance on Model Risk Management,'' Federal Reserve
SR 11-7, April 4, 2011.
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C. DFA Stress Test Methodologies and Practices
Rule Requirement: In conducting a stress test, for each quarter of
the planning horizon, a company must estimate the following for each
required
[[Page 14162]]
scenario: Losses, PPNR, provision for loan and lease losses, and net
income.\13\
---------------------------------------------------------------------------
\13\ 12 CFR 46.6 (OCC); 12 CFR 252.15(a)(1) (Board); 12 CFR
325.205(a)(1) (FDIC).
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As noted above, companies must identify and determine the impact on
capital from the supervisory scenarios, as represented through the
supervisory scenario variables and any additional variables chosen by
the company. A company's estimation processes should reasonably capture
the relationship between the assumed scenario conditions and the
projected impacts and outcomes to the company.\14\ The agencies expect
that the specific methodological practices used by companies to produce
the estimates may vary across organizations.
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\14\ Additionally, companies' methodologies should be
sufficiently documented and transparent so that limitations and
areas of uncertainty are clearly identified for users of stress test
results and other stakeholders.
---------------------------------------------------------------------------
Supervisors generally expect that all banking organizations, as
part of overall safety and soundness, will continue to enhance their
risk management practices. Accordingly, a $10-50 billion company's DFA
stress testing practices should evolve over time. In addition, DFA
stress testing practices for $10-50 billon companies should be
commensurate with each company's size, complexity, and sophistication.
This means that, generally, larger or more sophisticated companies
should consider employing not just the minimum expectations, but the
more advanced practices described in this guidance. In addition, $10-50
billion companies should consider using more than just the minimum
expectations for the exposures and activities of highest impact and
that present the highest risk.
The remainder of this section outlines key practices that all $10-
50 billion companies should incorporate into their methodologies for
estimating losses, PPNR, provision for loan and lease losses
(``PLLL''), and net income. It begins with general expectations that
apply across various types of estimation methodologies, and then
provides additional expectations for specific areas, such as loss
estimation, revenue estimation, and balance sheet projections. In
making projections, companies should make conservative assumptions
about management responses in the stress tests, and should include only
those responses for which there is substantial support. For example,
companies may account for hedges that are already in place as potential
mitigating factors against losses but should be conservative in making
assumptions about potential future hedging activities and not
necessarily anticipate that actions taken in the past could be taken
under the supervisory scenarios.
1. Data Sources
Companies are expected to have appropriate management information
systems and data processes that enable them to collect, sort,
aggregate, and update data and other information efficiently and
reliably within business lines and across the company for use in DFA
stress tests. Data used for DFA stress tests should be reliable and
generally consistent across time.
In cases where a company may not currently have a full cycle of
historical data or data in sufficient granularity on which to base its
analyses, it may use an alternative data source, such as a data history
drawn from other organizations of comparable market presence,
concentrations, and risk profile (for example, regulatory reporting or
vendor-supplied data), as a proxy for its own risk profile and
exposures. Companies with limited internal data should develop
strategies to accumulate the data necessary to improve their estimation
practices over time, as having internal data relevant to current
exposures generally improves loss projections and provides a better
basis for assessment of those projections. The agencies recognize that
in some cases companies may not initially have internal data on certain
portfolios and thus may rely on proxy data for some time. Such
practices may be acceptable provided that the company demonstrates that
proxy data are relevant to the company's own exposures and appropriate
for the estimation being conducted, and that the company is actively
collecting internal data.
Over the long term, companies may continue to use proxy data to
benchmark the estimates produced using internal data or to augment any
gaps in internal data (for example, if a company is moving into a new
business area). However, companies should use proxy data cautiously, as
these data may not adequately represent a company's own exposures,
business activities, underwriting, and risk characteristics.
Even when a company has extensive historical data, it should look
beyond the assumptions based on or embedded in those historical data.
Companies should challenge conventional assumptions to ensure that a
company's stress test is not constrained by its own past experience.
This is particularly important when historical data does not contain
stressful periods or if the specific characteristics of the scenarios
are unlike the conditions in the available historical data.
2. Data Segmentation
To account for differences in risk profiles across various
exposures and activities, companies should segment their portfolios and
business activities into categories based on common or related risk
characteristics. The company should select the appropriate level of
segmentation based on the size, materiality, and risk of a given
portfolio, provided there are sufficiently granular historical data
available to allow for the desired segmentation. The minimum
expectation is that companies will segment their portfolios and
business activities using the categories listed in the $10-50 billion
reporting form.\15\ A company may use more granular segmentation than
the $10-50 billion reporting form categories, particularly for more
material, concentrated, or relatively riskier portfolios. For instance,
a company could have a commercial loan portfolio containing loans to
different industries with varying sensitivities to the scenario
variables.
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\15\ For purposes of this guidance, the term ``$10-50 billion
reporting form'' refers to the relevant reporting form a $10-50
billion company will use to report the results of its DFA stress
tests to its primary Federal financial regulatory agency.
---------------------------------------------------------------------------
More advanced portfolio segmentation can take several forms, such
as by product (construction versus income-producing real estate),
industry, loan size, credit quality, collateral type, geography,
vintage, maturity, debt service coverage, or loan-to-value (LTV) ratio.
The company may also pool exposures with common or correlated risk
characteristics, such as segmenting loans to businesses related to
automobile production. Companies may also segment the portfolio
according to geography, if they engage in activities in geographic
areas with differing economic and financial characteristics. Such
segmentation may be particularly valuable in situations where
geographic areas show varying sensitivity to national economic and
financial changes or where different scenario variables are necessary
to capture key risks (such as projecting wholesale loan losses for
regions with different industrial concentrations). For any type of
segmentation that is more granular than the categories in the $10-50
billion reporting form, a company should maintain a map of internally
defined segments to the $10-50 billion reporting form categories for
accurate reporting.
Some companies' business line or risk assessment functions may
segment data with more granularity, that is, beyond
[[Page 14163]]
the $10-50 billion reporting form categories, which would support their
DFA stress tests. Enhanced data details on borrower and loan
characteristics may identify distinct and separate credit risks within
a reporting category more effectively, and therefore yield a more
accurate risk assessment than simply analyzing the larger aggregate
portfolio. Greater segmentation, particularly for larger or riskier
portfolios, may prove especially useful in estimating the risks to a
portfolio under the adverse or severely adverse scenarios, because
aggregated or less segmented portfolios may mask or distort the effect
of potentially more stressful conditions on sub-portfolios. While $10-
50 billion reporting form categories represent the minimum acceptable
segmentation, larger or more sophisticated $10-50 billion companies
should consider whether that level of segmentation is sufficient for
the risk in their portfolios.
3. Model Risk Management
Companies should have in place effective model risk management
practices, including validation, for all models used in DFA stress
tests, consistent with existing supervisory guidance.\16\ This includes
ensuring that DFA stress test models are subject to appropriate
standards for model development, implementation and use, model
validation, and model governance. Companies should ensure an effective
challenge process by unbiased, competent, and qualified parties is in
place for all models. There should also be sufficient documentation of
all models, including model assumptions, limitations, and
uncertainties. Senior management should have appropriate understanding
of DFA stress test models to provide summary information to the
company's board of directors that allows directors to assess and
question methodologies and results. In some cases, companies may not be
able to validate all the models used in their DFA stress tests prior to
submission; this may be appropriate provided that companies have (1)
made an effort to identify models based on materiality and highest risk
and prioritize validation activities accordingly, (2) applied
compensating controls so that the output from models that are not
validated or are only partially validated is not treated the same as
the output from fully validated models, and (3) clearly documented such
cases and made them transparent in reports to model users, senior
management, and other relevant parties. Companies should have an
explicit exception process when models are put into production without
validation, with heightened levels of management approval for more
material models. There should also be timelines with explicit plans for
conducting the remaining areas of validation for such models and
recognition that any provisional use without validation is temporary.
---------------------------------------------------------------------------
\16\ OCC 2011-12 and FR SR 11-7.
---------------------------------------------------------------------------
Companies should ensure that their model risk management policies
and practices generally apply to the use of vendor and third-party
products as well. This includes all the standards and expectations
outlined above and in existing supervisory guidance. If a company is
using vendor models, senior management is expected to demonstrate
knowledge of the model's design, intended use, applications,
limitations and assumptions. For cases in which knowledge about a
vendor or third-party model is limited for proprietary or other
reasons, companies should take additional steps to ensure that they
have an understanding of the model and can confirm it is functioning as
intended. For example, companies may need to conduct more sensitivity
analysis and benchmarking if information about a vendor model is
limited for proprietary or other reasons. Additionally, a company
should have as much internal knowledge as possible and contingency
plans to prepare for the possibility of vendor contract termination or
other situations in which a vendor model is no longer available.
In cases where there are noted weaknesses or limitations in models
or data used for stress tests, a company may choose to apply
qualitative adjustments to the model or its output that are expert
judgment-based. In most cases, however, estimation solely based or
heavily reliant on qualitative adjustments should not be the main
component of final loss estimates. Where qualitative adjustments are
made, they should be consistently determined and applied, and subject
to a well-defined process that includes a well-supported rationale,
methodology, proper controls, and strong documentation. When expert
judgment is used on an ongoing basis, the estimates generated by such
judgment should be subject to outcomes analysis, to assess performance
equivalent to that used to evaluate a quantitative model. Large
qualitative adjustments to the stress test results, especially on a
repeated basis, may be indicative of a flawed process.
4. Loss Estimation
For their DFA stress tests, companies are expected to have credible
loss estimation practices that capture the risks associated with their
portfolios, business lines, and activities. Credit losses associated
with loan portfolios and securities holdings should be estimated
directly and separately (as described in this section), whereas other
types of losses should be incorporated into estimated PPNR (as
described in the next section). Processes for loss estimation should be
consistent, repeatable, transparent, and well documented. Companies
should have a transparent and consistent approach for aggregating loss
estimates across the enterprise. For example, inputs from all parts of
the company should rely on common assumptions and map to specific loss
categories of the $10-50 billion reporting form. A company should
ensure that all enterprise loss estimation approaches reflect
reasonably sufficient rigor and conservatism, and that, for loss
estimation, the scenarios are applied consistently across the company.
Each company's loss estimation practices should be commensurate
with the materiality of the risks measured and well supported by sound,
empirical analysis. The practices may vary in complexity, depending on
data availability and the materiality of a given portfolio. In general,
loss estimation practices for credit risk are expected to be more
advanced than other elements of the stress test, given that credit risk
usually represents the largest potential risk to capital adequacy among
$10-50 billion companies.
Companies should be aware that the credit performance in a benign
economic environment could differ markedly from that during more
stressful periods, and the differences could become greater as the
severity of stress increases. For example, companies that experienced
low losses on their construction loans during a benign economic
environment, due to the presence of interest reserves or other risk-
mitigating factors, may experience a sharp and rapid rise in losses in
a scenario where market conditions deteriorate for a prolonged period.
A company's decision whether to use consistent or different loss
estimation processes for various supervisory scenarios should depend on
the sensitivity of a company's loss estimation process to a given
scenario.
A company may use a consistent process for loss estimation for all
scenarios if that process is sufficiently sensitive to the severity of
each scenario. Alternately, a company may use different loss estimation
processes for different scenarios if the process it uses for the
baseline scenario does not
[[Page 14164]]
adequately capture the sensitivity of loss estimates to adverse and
severely adverse scenarios. For example, a company may use its
budgeting process for its baseline loss projections, if appropriate,
but it should use a different process for the adverse and severely
adverse scenarios if its budgeting process does not capture the
potential for sharply elevated losses during stressful conditions.
Whatever processes a company chooses should be conditioned on each of
the three macroeconomic scenarios provided by supervisors.
Companies may choose loss estimation processes from a range of
available methods, techniques, and levels of granularity, depending on
the type and materiality of a portfolio, and the type and quality of
data available. For instance, some companies may choose to base their
stress loss estimates on industry historical loss experience, provided
that those estimates are consistent with the conditions in the
supervisory scenarios. Companies should choose a method that best
serves the structure of their credit portfolios, and they may choose
different methods for different portfolios (for example, wholesale
versus retail). Furthermore, companies may use multiple methods to
estimate losses on any given credit portfolio, and investigate
different methods before settling on a particular approach or
approaches. Regardless of whether a company uses historical loss
experience or a more sophisticated modeling technique to estimate
losses in a given scenario, the company should verify that resulting
loss estimates are appropriately conditioned on the scenario, and any
assumptions used are well understood and documented.
In estimating losses based on historical experiences, companies
should ensure that historical loss experience contains at least one
period when losses were substantially elevated and revenues
substantially reduced, such as the downturn of a credit cycle. In
addition, companies should ensure that any historical loss data used
are consistent with the company's current exposures and condition. This
could occur, for instance, if a company has shifted the proportion of
its commercial lending from large corporations to smaller businesses,
and the shift is not appropriately reflected in its historical loss
data. If neither a company's own data history nor industry loss data
include periods of stress comparable to the supervisory adverse or
severely adverse scenario, the company should make reasonable,
conservative assumptions based on available data.
Companies may choose to estimate credit losses at an aggregate
level, at a loan-segment level, or at a loan-by-loan level. Aggregate
approaches generally involve estimating loan losses for portfolios of
loans, such as the $10-50 billion reporting form categories or more
granular categories. Loan segmentation approaches group individual
loans into segments or pools of obligors with similar risk
characteristics to estimate losses. For example, individual 30-year
fixed-rate mortgage loans may be pooled into one segment, and 5-year
adjustable-rate mortgages (ARMs) into another segment, each to be
modeled separately based on the balance, loss, and default history in
that loan segment. Loan segments can also be determined based on
additional risk characteristics, such as credit score, LTV ratio,
borrower location, and payment status. Finally, loan-level approaches
estimate losses for each loan or borrower and aggregate those estimates
to arrive at portfolio-level losses.
Some of the more commonly used modeling techniques for estimating
loan losses include net charge-off models, roll-rate models, and
transition matrices. Net charge-off models typically estimate the net
charge-off rate for a given portfolio, based on the historical
relationship between the net charge offs and relevant risk factors,
including macroeconomic variables. Roll-rate models generally estimate
the rate at which loans that are current or delinquent in a given
quarter roll into delinquent or default status in the next quarter,
conditioning such estimates on relevant risk factors. Transition
matrices estimate the probability that risk ratings on loans could
change from quarter to quarter and observe how transition rates differ
in stressful periods compared with less stressful or baseline periods.
Some companies may also use an approach where the probability of
default, loss given default, and exposure at default are estimated for
individual loans, conditioning such estimates on each loan or portfolio
risk characteristics and the economic scenario. Companies can benefit
from exploring different modeling approaches, giving due consideration
to cost effectiveness and with the understanding that more
sophisticated methodologies will not necessarily prove more practicable
or robust.
Loss estimation practices should be commensurate with the overall
size, complexity, and sophistication of the company, as well as with
individual portfolios, to ensure they fully capture a company's risk
profile. Accordingly, smaller, less sophisticated $10-50 billion
companies may employ simpler loss estimation practices that rely on
industry historical loss experience at a higher level of aggregation.
On the other hand, larger or more sophisticated $10-50 billion
companies, including those with more complex portfolios, should
consider more advanced loss estimation practices that identify the key
drivers of losses for a given portfolio, segment, or loan, determine
how those drivers would be affected in supervisory scenarios, and
estimate resulting losses.
Loss estimates should include projections of other-than-temporary
impairments (OTTI) for securities both held for sale and held to
maturity. OTTI projections should be based on positions as of September
30 and should be consistent with the supervisory scenarios and standard
accounting treatment. Companies should ensure that their securities
loss estimation practices, including definitions of loss used, remain
current with regulatory and accounting changes.
5. Pre-Provision Net Revenue Estimation
The projection of potential revenues is a key element of a stress
test. For the DFA stress test, companies are required to project PPNR
over the planning horizon for each supervisory scenario.\17\ Companies
should estimate PPNR at a level at least as granular as the components
outlined in the $10-50 billion reporting form. Companies should be
mindful that revenue patterns could differ markedly in baseline versus
stress periods, and should therefore not make assumptions that revenue
streams will remain the same or follow similar paths across all
scenarios. In estimating PPNR, companies should consider, among other
things, how potentially higher nonaccruals, increased collection costs,
and changes in funding sources during the adverse and severely adverse
scenarios could affect PPNR. Companies should ensure that PPNR
projections are generally consistent with projections of losses, the
balance sheet, and risk-weighted assets. For example, if a company
projects that loan losses would be reduced because of declining loan
balances under a severely adverse scenario, PPNR would also be expected
to decline under the same scenario due to the decline in interest
income. Companies should ensure transparency and appropriate
documentation of all material assumptions related to PPNR.
---------------------------------------------------------------------------
\17\ The DFA stress test rules define PPNR as net interest
income plus non-interest income less non-interest expense. Non-
operational or non-recurring income and expense items should be
excluded.
---------------------------------------------------------------------------
There are various ways to estimate PPNR under stress scenarios and
companies are not required to use any
[[Page 14165]]
specific method. For example, companies may project each of the three
main components of PPNR (net interest income, non-interest income, and
non-interest expense) or sub-components of PPNR (e.g., interest income
or fee income), on an aggregate level for the entire company or by
business line. Companies may base their PPNR estimates on internal or
industry historical experience, or use a more sophisticated model-based
approach to project PPNR. For example, some companies may project PPNR
based on a historical relationship between PPNR or broad components of
PPNR and macroeconomic variables. In those instances, companies may use
the level of PPNR or the ratio of PPNR to a relevant balance sheet
measure, such as assets or loans. Some companies may use a more
granular breakout of PPNR (for example, interest income on loans),
identify relevant economic variables (for example, interest rates), and
employ models based on historical data to project PPNR. Some companies
may use their asset-liability management models to project some
components of PPNR, such as net-interest income.
A company may estimate the stressed components of PPNR based on its
own or industry-wide historical income and expense experience,
particularly during the early development of a company's stress testing
practices. When using its own history, a company should ensure that the
data include at least one stressful period; when using industry data, a
company should ensure that such data are relevant to its portfolios and
businesses and appropriately reflect potential PPNR under each
supervisory scenario. If neither its own data nor industry data include
the period of stress that is comparable to the supervisory adverse or
severely adverse scenario, a company should make conservative
assumptions, based on available data, and appropriately adjust its
historical PPNR data downward in its stressed estimate. A company that
has been experiencing merger activity, rapid growth, volatile revenues,
or changing business models should rely less on its own historical
experience, and generally make conservative assumptions.
It may be appropriate for smaller or less sophisticated $10-50
billion companies to employ PPNR estimation approaches that project the
three main components of PPNR at the aggregate, company-wide level
based on industry experience. Larger or more sophisticated $10-50
billion companies should consider PPNR estimation practices that more
fully capture potential risks to their business and strategy by
collecting internal revenue data, estimating revenues within specific
business lines, exploring more advanced techniques that identify the
specific drivers of revenue, and analyzing how the supervisory
scenarios affect those revenue drivers. Whatever process a company
chooses to employ, projected revenues and expenses should be credible
and reflect a reasonable translation of expected outcomes consistent
with the key scenario variables.
In addition to the credit losses associated with loan portfolios
and securities holdings, described in the previous section, that should
be estimated directly and separately, companies may determine that
other types of losses could arise under the supervisory scenarios.
These other types of losses should be included in projections of PPNR
to the extent they would arise under the specified scenario conditions.
For example, any trading losses arising from the scenario conditions
should be included in the non-interest income component of PPNR. As
another example, companies should estimate under the non-interest
expense component of PPNR any losses associated with requests by
mortgage investors--including both government-sponsored enterprises as
well as private-label securities holders--to repurchase loans deemed to
have breached representations and warranties, or with investor
litigation that broadly seeks damages from companies for losses.
Companies with material representation and warranty risk may
consider a range of legal process outcomes, including worse than
expected resolutions of the various contract claims or threatened or
pending litigation against a company and against various industry
participants. Additionally, in estimating non-interest income,
companies with significant mortgage servicing operations should
consider the effect of the supervisory scenarios on revenue and
expenses related to mortgage servicing rights and the associated impact
to regulatory capital.
PPNR estimates should also include any operational losses that a
company estimates based on the supervisory scenarios provided.
Companies should address operational risk in their PPNR projections if
such events are related to the supervisory scenarios provided, or if
there are pending related issues, such as ongoing litigation, that
could affect losses or revenues over the planning horizon.\18\
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\18\ As noted above, there may be certain aspects of operational
risk that a company is not expected to address in DFA stress tests;
however, the company should consider those other aspects of
operational risk as part of broader stress testing described in the
May 2012 stress testing guidance.
---------------------------------------------------------------------------
6. Balance Sheet and Risk-Weighted Asset Projections
A company is expected to project its balance sheet and risk-
weighted assets for each of the supervisory scenarios. In doing so,
these projections should be consistent with scenario conditions and the
company's prior history of managing through the different business
environments, especially stressful ones. For example, a company that
has reduced its business activity and balance sheet during past periods
of stress or that has contingent exposures should take these factors
into consideration. The projections of the balance sheet and risk-
weighted assets should be consistent with other aspects of stress test
projections, such as losses and PPNR. In addition, balance sheet and
risk-weighted asset projections should remain current with regulatory
and accounting changes.
Companies may use a variety of methods to project balance sheet and
risk-weighted assets. In certain cases, it may be appropriate for a
company to use simpler approaches for balance sheet and risk-weighted
asset projections, such as a static balance sheet and static risk-
weighted assets over the planning horizon; however, companies should
consider whether such an approach is appropriate if they have more
volatile balance sheets and risk-weighted assets, such as from mergers,
acquisitions, or organic growth. Alternatively, a company may rely on
estimates of changes in balance sheet and risk-weighted assets based on
their own or industry-wide historical experience, provided that the
internal or external historical balance sheet and risk-weighted asset
experience contains stressful periods. As in the case of loss
estimation and PPNR, using industry-wide data might be more appropriate
when internal data lack sufficient history, granularity, or
observations from stressful periods; however, companies should take
caution when using the industry data and provide appropriate
documentation for all material assumptions.
Some companies may choose to employ more advanced, model-based
approaches to project balance sheet and risk-weighted assets. For
example, a company may project outstanding balances for assets and
liabilities based on the historical relationship between those balances
and macroeconomic variables. In other cases, a company could project
certain components of the
[[Page 14166]]
balance sheet, for example, based on projections for originations,
paydowns, drawdowns, and losses for its loan portfolios under each
scenario. Estimated prepayment behavior conditioned on the relevant
scenario and the maturity profile of the asset portfolio could inform
balance sheet projections.
In stress scenarios, companies should justify major changes in the
composition of risk-weighted assets, for example, based on assumptions
about a company's strategic direction, including events such as
material sales, purchases, or acquisitions. Furthermore, companies
should be mindful that any assumptions about reductions in business
activity that would reduce their balance sheets and risk-weighted
assets over the planning horizon (such as tightened underwriting) are
also likely to reduce PPNR. Such assumptions should also be reasonable
in that they do not substantially alter the company's core businesses
and earnings capacity. Any case in which balance sheet and risk-
weighted asset projections decline over the period, and therefore
positively affect capital ratios, should be well supported by analysis
and data.
7. Estimates for Immaterial Portfolios
Although stress testing should be applied to all exposures as
described above, the same level of rigor and analysis may not be
necessary for lower-risk, immaterial, portfolios. Portfolios considered
immaterial are those that would not represent a consequential effect on
capital adequacy under any of the scenarios provided. For such
portfolios, it may be appropriate for a company to use a less
sophisticated approach for its stress test projections, provided that
the results of that approach are conservative and well documented. For
example, estimating losses under the supervisory scenarios for a small
portfolio of municipal securities may not involve the same
sophistication as a larger portfolio of commercial mortgages.
8. Projections for Quarterly Provisions and Ending Allowance for Loan
and Lease Losses
The DFA stress test rules require companies to project quarterly
PLLL.\19\ Companies are expected to project PLLL based on projections
of quarterly loan and lease losses and the appropriate ALLL balance at
each quarter-end for each scenario. In projecting PLLL, companies are
expected to maintain an adequate loan-loss reserve through the planning
horizon, consistent with supervisory guidance, accounting standards,
and a company's internal practice. Estimated provisions should
recognize the potential need for higher reserve levels in the adverse
and severely adverse scenarios, since economic stress leads to poorer
loan performance.
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\19\ 12 CFR 46.6(a)(1) (OCC); 12 CFR 252.15(a)(1) (Board); 12
CFR 325.206(b) (FDIC).
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The ALLL at the end of the planning horizon should include any
losses projected beyond the nine-quarter horizon. Given that loss
projections for the stress tests can in some cases be conducted at a
portfolio level, the ALLL projections may also be conducted at a
similar level, provided that they are consistent with the company's
existing methodologies to calculate ALLL. Management should ensure that
the company's projected ALLL is sufficient to cover remaining loan
losses under the scenario for each quarter of the planning horizon,
including the last quarter.
9. Projections for Quarterly Net Income
Under the DFA stress test rules, companies must estimate projected
quarterly net income for each scenario. Net income projections should
be based on loss, revenue, and expense projections described above.
Companies should also ensure that tax estimates, including deferred
taxes and tax assets, are consistent with relevant balance sheet and
income (loss) assumptions and reflect appropriate accounting, tax, and
regulatory changes.
D. Estimating the Potential Impact on Regulatory Capital Levels and
Capital Ratios
Rule Requirement: In conducting a stress test, for each quarter of
the planning horizon a company must estimate: the potential impact on
regulatory capital levels and capital ratios (including regulatory
capital ratios and any other capital ratios specified by the primary
supervisor), incorporating the effects of any capital actions over the
planning horizon and maintenance of an allowance for loan losses
appropriate for credit exposures throughout the planning horizon.\20\
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\20\ 12 CFR 46.6(a)(2) (OCC); 12 CFR 252.15(a)(2) (Board); 12
CFR 325.205(a)(2) (FDIC).
---------------------------------------------------------------------------
In the DFA stress test rules, companies are required to estimate
the impact of supervisory scenarios on capital levels and ratios, based
on the estimates of losses, PPNR, loan and lease provisions, and net
income, as well as projections of the balance sheet and risk-weighted
assets. Companies must estimate projected quarterly regulatory capital
levels and regulatory capital ratios for each scenario. Stress tests
are intended to assess the negative impact on companies' capital
positions from hypothetical stress conditions; as such, the agencies
expect companies' post-stress capital ratios under the adverse and
severely adverse scenarios to be lower than under the baseline
scenario. Any rare cases in which ratios are higher under the adverse
and severely adverse scenarios should be very well supported by
analysis and documentation. Projected capital levels and ratios should
reflect applicable regulations and accounting standards for each
quarter of the planning horizon.
Rule Requirement: A bank holding company or savings and loan
holding company is required to make the following assumptions regarding
its capital actions over the planning horizon:
1. For the first quarter of the planning horizon, the bank holding
company or savings and loan holding company must take into account its
actual capital actions as of the end of that quarter.
2. For each of the second through ninth quarters of the planning
horizon, the bank holding company or savings and loan holding company
must include in the projections of capital:
(a) Common stock dividends equal to the quarterly average dollar
amount of common stock dividends that the company paid in the previous
year (that is, the first quarter of the planning horizon and the
preceding three calendar quarters);
(b) Payments on any other instrument that is eligible for inclusion
in the numerator of a regulatory capital ratio equal to the stated
dividend, interest, or principal due on such instrument during the
quarter; and
(c) An assumption of no redemption or repurchase of any capital
instrument that is eligible for inclusion in the numerator of a
regulatory capital ratio.\21\
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\21\ 12 CFR 252.15(b).
---------------------------------------------------------------------------
In their DFA stress tests, bank holding companies and savings and
loan holding companies are required to calculate pro forma capital
ratios using a set of capital action assumptions based on historical
distributions, contracted payments, and a general assumption of no
redemptions, repurchases, or issuances of capital instruments. A
holding company should also assume it will not issue any new common
stock, preferred stock, or other instrument that would count in
regulatory capital in the second through ninth quarters of the planning
horizon, except for any common issuances related to expensed employee
compensation.
While holding companies are required to use specified capital
action
[[Page 14167]]
assumptions, there are no specified capital actions for banks and
thrifts. A bank or thrift should use capital actions that are
consistent with the scenarios and the company's internal practices in
their DFA stress tests. For banks and thrifts, projections of dividends
that represent a significant change from practice in recent quarters,
for example to conserve capital in a stress scenario, should be
evaluated in the context of corporate restrictions and board decisions
in historical stress periods. Additionally, a holding company should
consider that it is required to use certain capital assumptions that
may not be the same as the assumptions used by its bank subsidiaries.
Finally, any assumptions about mergers or acquisitions, and other
strategic actions should be well documented and should be consistent
with past practices of management and the board during stressed
economic periods. Should the stress-test submissions for the bank or
thrift and its holding company differ in terms of projected capital
actions (e.g., different dividend payout assumptions during the stress
test horizon for the bank versus the holding company) as a result of
the different requirements of the DFA stress test rules, the
institution should address such differences in the narrative portion of
their submissions.
E. Controls, Oversight, and Documentation
Rule requirement: Senior management 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 the requirements of the DFA stress
test rule. These policies and procedures must, at a minimum, describe
the company's stress testing practices and methodologies, and describe
the processes for validating and updating practices and methodologies
consistent with applicable laws, regulations, and supervisory guidance.
The board of directors, or a committee thereof, of a company 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.\22\
---------------------------------------------------------------------------
\22\ 12 CFR 46.5(d) (OCC); 12 CFR 252.15(c) (Board); 12 CFR
325.205(b) (FDIC).
---------------------------------------------------------------------------
Pursuant to the DFA stress test requirement, a company must
establish and maintain a system of controls, oversight, and
documentation, including policies and procedures that apply to all of
its DFA stress test components. This system of controls, oversight, and
documentation should be consistent with the May 2012 stress testing
guidance. Policies and procedures for DFA stress tests should be
comprehensive, ensure a consistent and repeatable process, and provide
transparency regarding a company's stress testing processes and
practices for third parties. The policies and procedures should provide
a clear articulation of the manner in which DFA stress tests should be
conducted, roles and responsibilities of parties involved (including
any external resources), and describe how DFA stress test results are
to be used. These policies and procedures also should be integrated
into other policies and procedures for the company. The board (or a
committee thereof) 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 as frequently as economic
conditions or the condition of the company may warrant, but no less
than annually.
Senior management must establish policies and procedures for DFA
stress tests and should ensure compliance with those 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. Senior
management should ensure that weaknesses--as well as key assumptions,
limitations and uncertainties--in DFA 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. Senior management, directly and
through relevant committees, should also be responsible for regularly
reporting to the board regarding DFA stress test developments
(including the process to design tests and augment or map supervisory
scenarios), DFA stress test results, and compliance with a company's
stress testing policy.
A company's system of documentation should include the
methodologies used, data types, key assumptions, and results, as well
as coverage of the DFA stress tests (including risks and exposures
included). For any models used, documentation should include sufficient
detail about design, inputs, assumptions, specifications, limitations,
testing, and output. In general, documentation on methodologies used
should be consistent with existing supervisory guidance.
Companies should ensure that other aspects of governance over
methodologies used for DFA stress tests are appropriate, consistent
with the May 2012 stress testing guidance. Specifically, companies
should have policies, procedures, and standards for any models used.
Effective governance should include validation and effective challenge
for any assumptions or models used, and a description of any remedial
steps in cases where models are not validated or validation identifies
substantial issues. A company should ensure that internal audit
evaluates model risk management activities related to DFA stress tests,
which should include a review of whether practices align with policies,
as well as how deficiencies are identified, monitored, and addressed.
Rule requirements: The board of directors and senior management of
the company must receive a summary of the results of the stress test.
The board of directors and senior management of a company 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.\23\
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\23\ 12 CFR 46.5(d) and 46.6(c)(2) (OCC); 12 CFR 252.15(c)(3)
(Board); 12 CFR 325.205(b)(2) and (3) (FDIC).
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A company's board of directors is ultimately responsible for the
company's DFA stress tests. Board members must receive summary
information about DFA stress tests, including results from each
scenario. The board or its designee should appropriately evaluate and
discuss this information, ensuring that the DFA stress tests are
consistent with the company's risk appetite and overall business
strategy. The board should ensure it remains informed about critical
review of elements of the DFA stress tests conducted by senior
management or others (such as internal audit), especially regarding key
assumptions, uncertainties, and limitations. In addition, the board of
directors and senior management of a $10-50 billion company must
consider the role of stress testing results in normal business
including in the capital planning, assessment of capital adequacy, and
risk management practices of the company. A company should
appropriately document the manner in which DFA stress tests are used
for key decisions about capital adequacy, including capital actions and
capital contingency plans. The company
[[Page 14168]]
should indicate the extent to which DFA stress tests are used in
conjunction with other capital assessment tools, especially if the DFA
stress tests may not necessarily capture a company's full range of
risks, exposures, activities, and vulnerabilities that have the
potential to affect capital adequacy. In addition, a company should
determine whether its post-stress capital results are aligned with its
internal capital goals. For cases in which post-stress capital results
are not aligned with a company's internal capital goals, senior
management should provide options it and the board would consider to
bring them into alignment.
F. Report to Supervisors
Rule Requirement: A company must report the results of the stress
test to its primary supervisor and to the Board of Governors by March
31, in the manner and form prescribed by the agency.\24\
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\24\ 12 CFR 46.7 (OCC); 12 CFR 252.16 (Board); 12 CFR 325.206
(FDIC).
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All $10-50 billion companies must report the results of their DFA
company-run stress tests on the $10-50 billion reporting form. This
report will include a company's quantitative projections of losses,
PPNR, balance sheet, risk-weighted assets, ALLL, and capital on a
quarterly basis over the duration of the scenario and planning horizon.
In addition to the quantitative projections, companies are required to
submit qualitative information supporting their projections. The report
of the stress test results must include, under each scenario: a
description of the types of risks included in the stress test, a
description of the methodologies used in the stress test, an
explanation of the most significant causes for the changes in
regulatory capital ratios, and any other information required by the
agencies. In addition, the agencies may request supplemental
information, as needed.
If significant errors or omissions are identified subsequent to
filing, a company must file an amended report. For additional
information, see the instructions provided with the reporting
templates.
G. Public Disclosure of DFA Test Results
Rule Requirement: A company must disclose a summary of the results
of the stress test in the period beginning on June 15 and ending on
June 30.\25\
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\25\ 12 CFR 46.8 (OCC); 12 CFR 252.17 (Board); 12 CFR 325.207
(FDIC).
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Under the DFA stress test rules, a company must make its first DFA
stress test-related public disclosure between June 15 and June 30,
2015, by disclosing summary results of its annual DFA stress test,
using September 30, 2014, financial statement data.\26\ The regulation
requires holding companies to include in their public disclosure a
summary of the results of the stress tests conducted by any
subsidiaries subject to DFA stress testing.\27\ A bank can satisfy this
public disclosure requirement by including a summary of the results of
its stress test in its parent company's public disclosure (on the same
timeline); however the agencies can require a separate disclosure if
the parent company's public disclosure does not adequately capture the
impact of the scenarios on the bank.
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\26\ The exception is any $10-50 billion state member bank that
is a subsidiary of a bank holding company or a savings and loan
holding company with average total consolidated assets of $50
billion or more; in that case, the state member bank subsidiary must
disclose a summary of the results of the stress test in the period
beginning on March 15 and ending on March 31.
\27\ 12 CFR 252.17(b).
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The summary of the results of the stress test, including both
quantitative and qualitative information, should be included in a
single release on a company's Web site, or in any other forum that is
reasonably accessible to the public.
Each bank or thrift must publish a summary of its stress tests
results separate from the results of stress tests conducted at the
consolidated level of its parent holding company, but the company may
include this summary with its holding company's public disclosure.
Thus, a bank or thrift with a parent holding company that is required
to conduct a company-run DFA stress test under the Federal Reserve
Board's DFA stress test rules will have satisfied its public
disclosures requirement when the parent holding company discloses
summary results of its subsidiary's annual stress test in satisfaction
of the requirements of the applicable regulations of the company's
primary Federal regulator, unless the company's primary Federal
regulator determines that the disclosures at the holding company level
does not adequately capture the potential impact of the scenarios on
the capital of the companies.
A company must disclose, at a minimum, the following information
regarding the severely adverse scenario:
a. A description of the types of risks included in the stress test;
b. A summary description of the methodologies used in the stress
test;
c. Estimates of--
Aggregate losses;
PPNR;
PLLL;
Net income; and
Pro forma regulatory capital ratios and any other capital ratios
specified by the primary Federal regulator;
d. An explanation of the most significant causes for the changes in
regulatory capital ratios; and
e. For bank holding companies and savings and loan holding
companies: For a stress test conducted by an insured depository
institution subsidiary of the bank holding company or savings and loan
holding company pursuant to section 165(i)(2) of the Dodd-Frank Act,
changes in regulatory capital ratios and any other capital ratios
specified by the primary Federal regulator of the depository
institution subsidiary over the planning horizon, including an
explanation of the most significant causes for the changes in
regulatory capital ratios.
It should be clear in the company's public disclosure that the
results are conditioned on the supervisory scenarios. Items to be
publicly disclosed should follow the same definitions as those provided
in the confidential report to supervisors. Companies should disclose
all of the required items in a single public release, as it is
difficult to interpret the quantitative results without the qualitative
supporting information.
Differences in DFA Stress Test Requirements for Holding Companies Versus
Banks and Thrifts
------------------------------------------------------------------------
Bank holding
companies and
savings and loan Banks and thrifts
holding companies
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Capital actions used for Capital actions No prescribed
company-run stress tests. prescribed in capital actions.
Federal Reserve Banks and thrifts
Board's DFA stress should use capital
tests rules. actions consistent
Generally based on with the scenario
historical and their internal
dividends, business practices.
contracted
payments, and no
repurchases or
issuances.
[[Page 14169]]
Public disclosure of company- Disclosure must Disclosure
run stress tests. include information requirement met
on stress tests when parent company
conducted by disclosure includes
subsidiaries the required
subject to DFA information on the
stress tests. bank or thrift's
stress test
results, unless the
company's primary
regulator
determines that the
disclosure at the
holding company
level does not
adequately capture
the potential
impact of the
scenarios on the
capital of the
company.
------------------------------------------------------------------------
Dated: February 19, 2014.
Thomas J. Curry,
Comptroller of the Currency.
By order of the Board of Governors of the Federal Reserve
System, March 5, 2014.
Robert deV. Frierson,
Secretary of the Board.
Dated at Washington, DC, this 5th day of March, 2014.
Federal Deposit Insurance Corporation.
Robert E. Feldman,
Executive Secretary.
[FR Doc. 2014-05518 Filed 3-12-14; 8:45 am]
BILLING CODE 4810-33-P; 6714-01-P; 6210-01-P