Despite widespread speculation about repeal of the Dodd-Frank Act, the new Congress is more likely to focus on softening key aspects of the financial-reform law, rather than make wholesale changes to it. Among the areas mentioned for revision are consumer protections, restrictions on trading in derivatives, and the regulatory demands banks incur when they cross key asset-size thresholds, including requirements for capital stress testing. If legislators do focus on stress testing, it’s possible they may modify and increase the size thresholds for the Federal Reserve’s Comprehensive Capital Analysis and Review and maybe even for the Dodd-Frank Act stress tests.
If it happens, this would appear to be a full reprieve for banks with assets under $10 billion — and perhaps even for those between $10 billion and $50 billion. But stress testing as a risk management tool is unlikely to go away, and banks will still be required to demonstrate stress-testing capabilities across the enterprise, although firms may see relief from requirements for implementing a DFAST regulatory-reporting framework and public-disclosure process.
Banks should also remember that while stress testing has taken center stage due to its inclusion in Dodd-Frank, it has a long history in regulatory and supervisory communication. In fact, stress testing is required through a variety of other regulations and supervisory guidance that are unlikely to be modified or repealed. The other regulation and supervisory guidance include:
And while DFAST is perhaps the most prescriptive regime, these other regulations and guidance require stress testing across a variety of banks’ businesses, with specific stress testing that focuses on:
- Credit losses on individual positions and portfolios
- Loans in the pipeline and at the point of underwriting
- Positions that lead to interest-rate risk
- Liquidity positions
- Operational vulnerabilities
- Key metrics that support risk appetite statements
Most banks recognize the enduring importance of stress testing and will continue to enhance their overall stress-testing capabilities and ensure their frameworks do more than simply meet regulatory requirements. They perform stress testing — not as a regulatory exercise or risk management mandate — but as a broad-based contingency-planning activity that will help improve a bank’s long-term performance.
A Broader Stress Testing Program
Designing and establishing a stress-testing framework that goes well beyond regulatory requirements will give banks an opportunity to include meaningful elements and metrics that improve risk management and risk-based decision-making and help develop detailed risk appetites, as shown in the diagram below.
Click here to view larger version of graphic.
Well-designed and -executed stress tests provide essential information to management and the board and help them make critical determinations, such as estimating the impact of an acquisition target and measuring and managing credit concentrations.
Banks that view stress testing as a core risk management tool can derive exceptional value from the exercise by:
- Applying results to a wide range of business and strategic decisions, including mergers and acquisitions, the potential addition of new business lines and products, portfolio positioning, and even pricing and hedging
- Making stress testing a core element of the risk appetite of the bank
- Incorporating stress testing into risk-based decision-making
Banks of all sizes can implement broad-based stress testing by expanding and enhancing their current frameworks. Key areas to consider include:
- The full range of analysis stress testing can provide
- Comprehensive, accurate, and timely data
- Robust risk identification
- Appropriate models and platforms
- Well-documented procedures
The regulation and guidance around stress testing suggest that many current requirements will likely endure. Midsize banks can continue to expand and find new uses for their stress-testing frameworks. Even banks below the $10 billion threshold will derive strategic advantages by implementing a stress-testing framework and defining their long-term goals for key uses of stress testing. Smaller firms can achieve significant benefits by first meeting regulatory requirements (e.g., performing credit-portfolio risk analysis), and then assigning key capabilities to a manager and implementing a time frame that supports near-term, internal decision-making.
How Promontory Can Help
Promontory, an IBM Company, has extensive knowledge of best practices for stress testing at institutions of all sizes and complexities. We are uniquely qualified in helping banks implement stress testing that goes beyond regulatory requirements, and provide unparalleled insight into how firms can make extensive use of their stress-testing frameworks.
Our subject-matter experts have previously advised a wide range of banks on expanding their stress testing to enhance risk management, risk-based decision-making, and risk-informed planning, at all levels of the organization. Promontory helps banks of all sizes ensure that their frameworks comply with the relevant regulation and guidance — such as SR 12-7, the interagency guidance on leveraged lending and CRE concentrations, and the rules governing DFAST.
Our solutions correspond to the size and complexity of the institution, and include:
- Designing and developing sector-specific stress-testing programs (e.g., for CRE portfolios)
- Defining the stress-testing culture and creating statements of intended uses
- Advising on organizational structure and developing governance and control frameworks
- Establishing processes that underpin risk identification and comprehensive risk appetite statements
- Developing phased road maps and implementation plans
- Developing suites of stress-testing models at the right level of granularity and informed by risk-materiality assessments
- Designing and producing stress-testing reports
- Designing and implementing programs for data aggregation and governance
- Defining key data sets and sources
- Designing and implementing programs for model risk management and internal audit
We welcome your questions about how to get the most out of your stress-testing framework. Please contact Promontory to discuss how we can help you design and implement stress-testing programs that go beyond regulatory expectations and give your firm a strong competitive advantage.
+1 212 542 6776
+1 202 370 0408