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Community Banks in the Stress-Test Net

Financial regulatory agencies, including the Office of the Comptroller of the Currency (OCC) and the Federal Deposit Insurance Corporation (FDIC), have released the highly anticipated economic scenarios that will be used by banks with greater than $10 billion in total assets to produce their 2014 company-run stress tests, but community banks with less than $10 billion in total assets should start paying close attention, too.

This is true because the stress test requirement for community banks is currently limited to identifying risks and quantifying exposures in loan portfolios. This narrowly focused application clearly makes any stress testing regime more palatable, less costly and allows for the establishment of initial risk tolerances. So from an initiation perspective, community banks should be grateful that this phase-in approach is limited in application.

However, the intricacies of the regulatory guidance and historical expansion of scope suggest that a narrowly focused perspective may be only a start. For instance, the list of Comprehensive Capital Analysis and Review (CCAR) banks grew from 19 to 30 – almost immediately.

For Tier 2 and community banks, the difficulty, complication and cost will likely appear later (but could come quickly) with a similar expansion, requiring smaller banks to leverage their stress test programs to support enterprise risk appetite setting and risk identification, including liquidity, legal, and operation risks that have not previously been measured. This expansion of scope will necessarily extend beyond quantifying limited exposures subject to the loan portfolio. In addition to the tracking of enterprise risks, the loan portfolio application will need enhancement to incorporate the newer risk perspectives.

As a result, this more onerous standard will become similar to the identification, monitoring, and reporting exercises that plague larger banks that are subject to CCAR.

Generally, a stress test should be capable of assessing the potential impact on the consolidated earnings, losses, and capital of a covered financial institution over the planning horizon by considering an enterprise view of the risks, exposures, strategies and activities. Today, the regulators are asking only a fraction of the textual definition – until they require more.

Unlike the systemic implications that are primary considerations for larger and more complex banks, smaller banks should realize early that relying on the narrowly focused inclusion of credit concentration, interest rate sensitivity and a scaled view of pre-provision net revenue must be expanded to account for complexities, interconnectedness and new risk categories, such as legal, enhanced operational and liquidity.

So the question becomes, if regulatory expansion becomes reality and the expectation of more sophisticated modeling becomes necessity, how do Tier 2 and community banks intend to build models, processes and strategies to account for adequate regulatory mandated scalability?

It is this underlying question that should and likely will inspire innovation that provokes Tier 2 and community banks to develop informative decision support systems that provide for a reasonable determination of impact on earnings and capital from an enterprise perspective.

If there was ever a time for smaller banks to pay close attention to the evolution of stress testing and capital planning imposed onto the larger banks as a predictive determination, this is it.


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