Stress testing regulations you should know
Financial institutions make tough lending choices that can help determine which clients get the funding they need to succeed—they act as an important arbiter. At the same time, financial institutions of all sizes are facing an increased push by federal regulators to go beyond historical risk-management efforts. Here is a rundown of some of the regulations you should know.
Bank-related stress testing gained widespread attention in 2009 as regulators required the 19 largest U.S. bank holding companies to undergo stress tests as part of the The Supervisory Capital Assessment Program (SCAP) demonstrating their ability to maintain minimum capital requirements, even in the event of extreme economic conditions.
But even before that, the FDIC outlined guidance in 2006 for institutions to conduct stress tests if 100 percent of their total capital was in loans tied to construction, development and other land deals, or if they had commercial real estate loans representing 300 percent or more of their risk-based capital. It reiterated that guidance in 2008 in the wake of the housing market’s tumble and the U.S. financial crisis.
Under the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act, FDIC-regulated institutions with more than $10 billion in assets are required to perform stress testing. More recently, the Federal Reserve appended this, specifying that bank holding companies and financial institutions between $10 billion and $50 billion in assets must conduct stress tests annually and disclose their results between June 15th and June 30th of each year.
Additional regulations have been released that further define who must stress test and how to perform these stress tests, especially for community banks under $10 billion in assets. Regulations outline that some type of stress test or sensitivity analysis is a key element of sound risk management, even at smaller institutions.
The OCC’s October 2012 Supervisory Guidance expands which financial institutions need to stress test their portfolio. It also provides more transparency for community banks on how to perform these stress tests, emphasizing that community banks should begin with a simple top down stress test conducted annually, along with “bottom up” stress testing at the concentration and loan level, especially for concentrations of concern such as commercial real estate (CRE). Other examples of concentrations in the loan portfolio that could be considered for stress testing are loans dependent on a type of agribusiness, loans with construction-related risk, long-term fixed rate municipal securities and residential mortgage loans.
Basel III regulations, which have yet to be finalized, require financial institutions to assess their current risk levels and run stress tests on different time intervals to assess future losses and plan capital requirements accordingly.
“Regulators are essentially telling bankers, ‘You need to be on top of your portfolio and, in some way or another, be able to forecast the impact on the institution’s financial statements if things change economically or if things change in one sector,’” says Tim McPeak, a director at Sageworks. “For example, in commercial real estate, if the valuations change for the worse, if the vacancy rates increase, if interest rates change, you need to be able to attempt to quantify what the impact is going to be on your institution – or really, what the impact will be on your capital levels.”
To learn more about stress testing expectations, download this new whitepaper, Stress Testing: Who, What, When and Why.