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Will Banks Be Ready for Expanded Stress-Test Rules?

Now that the financial regulatory agencies, including the Office of the Comptroller of the Currency and Federal Deposit Insurance Corp., have released the highly anticipated economic scenarios that will be used by banks to produce their company-run supervisory stress tests for 2014, the race is on to become compliant—and beyond.

While the over-arching goal of a company-run stress test is to ensure that banking institutions have adequate, forward-looking capital planning processes, uncertainty remains about the convergence of stress testing and capital planning.

Because the released economic scenarios are so broad, they substantially fail to directly support internal capital decision-making without adequate alignment. Also, the scenarios lack a significant correlative relationship to a bank's unique activities composition, unless a bank's exposures and revenues are perfectly correlated to Consumer Price Index inflation or the 10-year U.S. Treasury yield. So a bank, whether covered today or expected to be covered tomorrow, should move toward stress testing and capital-planning calibration on its own initiative.

Stress testing, within the context of a supervisory release, generally seeks to analyze systemic adequacy, or a macro perspective. This macro view is significantly distinct when compared with the fundamental objectives of a bank's internal capital adequacy assessment process (ICAAP). For example, ICAAP seeks to identify and measure only material influences which set and assess internal capital adequacy goals that relate to certain activity-based risks. Summarily, ICAAP is process-focused and includes issues such as articulating risk appetite and reconciling capital planning, together with activities segmentation.

Broad-Based Business Imperative

For banks of all sizes, stress testing has emerged as a critical business requirement. This is true because for covered institutions, regulatory sanctions for inadequacy encompass limitations on dividends, mergers, stock repurchase, and in some instances compensation. These "capital action" limitations exist as part of the early remediation framework and impose mandatory restrictions on growth and capital distributions if a bank is not adequately capitalized under stressed conditions.

The early remediation framework envisions a living will under Section 165(d) of the Dodd-Frank Act. The living-will component of the remediation plan describes divestiture or, under extreme conditions, a comprehensive wind-up in a way that mitigates systemic effects. As a result, a regulatory agency may take restrictive action if it is not satisfied that capital is adequate—arguably a subjective standard. Therefore, determining whether a bank is adequately capitalized is more complicated and individually deterministic than most banks understand or are prepared for.

For non-covered institutions, regulatory oversight can and may be extended at any time for almost any articulable reason. This supervisory discretionary determination is supported by, among other provisions, 12 CFR Section 46.4, which determines causation on a case-by-case basis.

Notwithstanding the broader applicability based on the discretionary reservation of authority, taken together, supervisory scenarios distributed to banks invoking the production of company-run stress tests such as DFAST (Dodd-Frank Act stress tests) are generally independently insufficient to reconcile a bank's internal risk profile under ICAAP, nor are they comprehensive to satisfy the macro or systemic perspective of DFAST.

Because the supervisory-distributed economic scenarios are systemic and generically disconnected from internal analyses such as ICAAP, which will vary from bank to bank, it is logical that the prompt corrective action (PCA), early-remediation framework and applicable data, can, if properly configured, connect the disparity between systemic DFAST and ICAAP.

Innovation and Best Practice

Because the regulators purposely provide generic and ambiguous economic scenarios such as nominal GDP growth and disposable income growth, which is non-correlative, they therefore seek innovation and best practice development, which will be pushed onto the rest of the banks, including smaller and less specialized banks.

It is this underlying scheme to inspire innovation that will ultimately be imposed on most, if not all, banking institutions. This is true because supervisory guidance explicitly states that the purpose of the consolidation between stress testing and capital planning is to require a reasonable determination of impact on earnings and capital, and most significantly, to inform the bank of the overall risk management process. This simply means that as banks further develop their correlations and risk practices, the regulators will likely enhance the mandates accordingly, together with an expanding population of covered institutions.

If there was ever a time to embrace the convergence of stress testing and capital-planning best practices, or to jump in front of the industry, this is it. Alternatively, other banks' best practices will necessarily determine future requirements.



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