Corporate Practice
NOVEMBER 2012
BEIJING CHARLOTTE CHICAGO GENEVA HONG KONG HOUSTON LONDON LOS ANGELES MOSCOW NEW YORK NEWARK PARIS
Federal Banking Agencies Issue Final Stress Tests Rules For Banking Organizations with Assets of Between $10 Billion$50 Billion On October 9, the federal banking agencies announced adoption of final rules1 implementing a requirement in the Dodd-Frank Act2 that banking organizations, including savings and loan holding companies3, with total consolidated assets of more than $10 billion but less than $50 billion4, conduct annual stress tests, report the results to their principle federal regulator and the Federal Reserve Board, and publish a summary of the results. Because many banking organizations subject to these rules have not previously participated in agency-mandated stress testing programs5 and thus will need time to build systems, implementation of these rules will be delayed. A $10 billion to $50 billion banking organization must conduct its first stress test under the regulations using financial statement data as of September 30, 2013 and report the results by March 31, 2014. The publication requirement for such firms will first apply to the 2014 stress test using data as of September 30, 2014, results of which would not be disclosed until June 15- 30, 20156. However, a bank that is part of a holding company with $50 billion or more in total consolidated assets may choose to follow a stricter time schedule if it chooses to do so. The new rules define the term “stress test,” establish methodologies to conduct stress tests with at least three sets of conditions (baseline7, adverse8, and severely adverse9), establish the form of report to be submitted, and require publication of a summary of results.
SAN FRANCISCO This was not a joint inter-agency rulemaking, and each agency’s stress testing regulations are not identical to those of the others, although they do reflect an effort
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SHANGHAI
to coordinate on most substantive points. Section 165(i) of the Dodd-Frank Wall Street Reform and Consumer Protection Act.
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WASHINGTON, D.C.
Savings and loan holding companies would not be subject to the stress testing requirement until they are subject to minimum risk-based capital and leverage
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www.winston.com
requirements. Banking organizations with total consolidated assets of $50 billion or more will be subject to more burdensome rules.
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Most banks with consolidated assets of $50 billion or more have been involved in agency-sponsored stress testing programs, such as the 2009 Supervisory Capital
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Assessment Program (SCAP), the Federal Reserve Board’s Comprehensive Capital Analysis and Review (CCAR), and Capital Plan Review (CapPR) stress tests. Under the new rules, these banks will be required to conduct their first annual stress tests as of September 30, 2012 subject to case-by-case delay for non-SCAP, non-CCAR banking organizations with total consolidated assets of $50 billion or more. They are to report stress test results by January 5, 2013. A banking organization with total consolidated assets of $50 billion or more would be required to publish a summary of results between March 15 and March 31.
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A “baseline scenario” is a set of conditions that affect the U. S. economy or the financial condition of a covered bank that reflects the consensus views of the
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economic and financial outlook. It will reflect the views of professional forecasters, government agencies, and other public-sector organizations as of the beginning of the annual stress-test cycle. An “adverse scenario” is a set of conditions that affect the U. S. economy or the financial condition of a covered bank that are more adverse than those associated
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with the baseline scenario and may include trading or other additional components. At a minimum, its variables will be consistent with mild to moderate recessions. A “severely adverse scenario” is a set of conditions that affect the U. S. economy or the financial condition of a covered bank that overall are more severe than those
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associated with the adverse scenario and may include trading or other additional components. It will be generally consistent with severe post-war U. S. recessions, but the Federal Reserve Board expects to take into account salient risks that may not be observed in a typical severe recession. News media report that the severely adverse scenario in the stress test that the Federal Reserve Board imposed on MetLife assumes an unemployment rate of 13% and an 8% contraction in GDP.
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Purpose Stress testing is merely a process to assess the potential impact of different scenarios on a banking organization’s earnings, losses, and capital over a fixed period of time considering the organization’s condition, risks, exposures, strategies, and activities. Stress tests provide the regulators forward-looking information to assist in their overall assessment of a bank’s capital adequacy and in identifying downside risks and the potential impact of adverse outcomes. Stress tests also should help a banking organization with its internal capital planning. Earlier this year, the agencies issued formal guidance on stress testing for banking organizations with more than $10 billion in total consolidated assets,10 which explains how broader stress testing activities should address the impact of potential adverse outcomes of various risks and may affect aspects of a bank’s financial condition beyond capital adequacy. Where a bank with more than $10 billion in assets is part of a shell holding company, the bank’s principal regulator and the Federal Reserve Board, as regulator of the holding company, will coordinate efforts and communicate with both the bank and the holding company on how to address stress testing requirements while avoiding duplication.
Agency Coordination The agencies have coordinated with one another to achieve consistency and comparability of stress test results in the areas of scope of application, scenarios, data collection, reporting, and disclosure. The agencies also will coordinate on the development of scenarios and will seek comment on the procedures to be used to do so.
Scenario Development Normally, the banking organization would conduct an annual stress test using its financial data as of September 30 of that year. The stress test is to assess the potential impact of different scenarios on capital and related items over a nine-quarter planning horizon. The agencies will distribute at least three economic scenarios (baseline, adverse, and severely adverse) to all covered banks by November 15 each year. Each scenario will include the paths 10
See 77 FR 29458 (May 17, 2012).
of a number of economic variables, such as real Gross Domestic Product, the unemployment rate, and equity and property prices; each banking organization may use all or a subset of the variables and may even extrapolate other variables, such as local economic variables, from the paths of the economic variables provided by regulators. Banking organizations with $50 billion or more in total consolidated assets will have seven weeks to report the results of the annual stress test, but smaller banking organizations with more than $10 billion in consolidated assets will have until March 31, 2014 to do so. The agencies will also coordinate on the development of scenarios and seek comment on the procedures to be used to do so. To ensure comparability, the agencies will not permit banks to use their own internally generated scenarios, but will normally require all covered banks to use the same scenarios.
Stress Test Methodologies and Practices Each covered banking organization will be required to calculate for each of the nine-quarter quarter ends: (1) estimates of losses, (2) pre-provision net revenues, (3) net income, and (4) provision for loan and lease losses, resulting from the conditions specified in each scenario, as well as the potential impact on (5) capital levels and (6) capital ratios, taking into account the payment of dividends, planned capital infusions, and any other expected capital actions. Each banking organization is to adopt policies and procedures that outline its stress testing practices and methodologies, as well as processes for validating and updating those practices. The board of directors or one of its committees must review and approve these policies and procedures at least annually, and the board and senior management is to receive a summary of the annual stress test results. The board and senior management are to consider the stress test results in the normal course of business, including, but not limited to, capital planning, assessment of capital adequacy, and risk management practices. The Federal Reserve Board plans to issue supervisory guidance to banking organizations with more than $10 billion in assets, providing more detail describing supervisory expectations for company-run stress tests.
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Reporting
Public Disclosure of Stress Test Results
The covered banking organization is to report stress test results to both its primary federal regulator and to the Federal Reserve Board by March 31, 2014 if its total consolidated assets exceed $10 billion, but are less than $50 billion. If its total consolidated assets are $50 billion or more, the report is due by January 5, 2013.
Normally, a banking organization would be required to publish the summary of stress test results on its website.
The information to be reported includes (1) a description of the types of risks included in the severely adverse scenario stress test; (2) a summary of methodologies used; (3) estimates of (a) aggregate losses, (b) pre-provision net income, (c) net income, (d) provision for loan and lease losses, and (e) capital ratios; and (4) an explanation of the most significant causes for changes in regulatory capital ratios (e.g. the amount of losses attributable to a particular portfolio). The agencies have proposed reporting templates for banking organizations with $50 billion or more in consolidated assets, but will propose more simplified separate reporting templates for smaller banking organizations with more than $10 billion in assets. The FDIC and Federal Reserve Board rules provide that the confidentiality of the reports will be governed by the Freedom of Information Act. However, the OCC rule provides that reports are non-public information and property of the OCC, unauthorized disclosure of which is generally prohibited. A banking organization will file its report with both its primary federal regulator and the Federal Reserve Board, and thus, it is theoretically possible that the confidentiality of the reports could be different for different banking organizations and even be different for the same banking organization between its primary federal regulator and the Board. The regulators will analyze the quality of each covered banking organization’s stress test processes and results and provide feedback during the supervisory process. The agencies vary in their estimates of the average number of hours required by institutions to prepare the annual report, with the FDIC estimating 1,040, but the Federal Reserve Board estimating only 80 hours after initial setup. The OCC determined that its final rule will not result in expenditures by the private sector of more than $100 million in one year.
The information to be disclosed closely tracks the information to be reported to the agencies. In adopting the final regulations, the banking agencies removed a proposed requirement that covered banking organizations publicly disclose stress test results under baseline and adverse scenarios. However, any such public disclosures could have been considered long-term earnings forecasts and created securities law problems for the disclosing banking organizations, and so, the agencies dropped that aspect of the proposal. A covered bank that is a consolidated subsidiary of a holding company may publish abbreviated disclosures (a summary of changes in capital ratios with an explanation of the most significant causes) with the parent’s disclosures and on the same timeline as the parent.
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Disclaimer The final rules are complex and this Client Briefing summarizes them as a general matter. Clients that have additional questions or wish to discuss issues raised in this briefing should contact the authors. Chicago (312) 558-5600 Jerry Loeser Christine Edwards
These materials have been prepared by Winston & Strawn LLP for informational purposes only. These materials do not constitute legal advice and cannot be relied upon by any taxpayer for the purpose of avoiding penalties imposed under the Internal Revenue Code. Receipt of this information does not create an attorney-client relationship. No reproduction or redistribution without written permission of Winston & Strawn LLP. © 2012 Winston & Strawn LLP
