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Supervision and Regulation Letters

SR 14-3

Supervisory Guidance on Dodd-Frank Act Company-Run Stress Testing for Banking Organizations with Total Consolidated Assets of More Than $10 Billion but Less Than $50 Billion

March 6, 2014

Seal of the Board of Governors of the Federal Reserve System
BOARD OF GOVERNORS
OF THE
FEDERAL RESERVE SYSTEM
WASHINGTON, D. C.  20551
DIVISION OF BANKING
SUPERVISION AND REGULATION
SR 14-3
March 6, 2014
TO THE OFFICER IN CHARGE OF SUPERVISION AND APPROPRIATE SUPERVISORY AND EXAMINATION STAFF AT EACH FEDERAL RESERVE BANK AND TO CERTAIN FINANCIAL INSTITUTIONS SUPERVISED BY THE FEDERAL RESERVE
SUBJECT:   Supervisory Guidance on Dodd-Frank Act Company-Run Stress Testing for Banking Organizations with Total Consolidated Assets of More Than $10 Billion but Less Than $50 Billion
Applicability:  This guidance does not apply to community banking organizations, defined as financial institutions supervised by the Federal Reserve with $10 billion or less in total consolidated assets.

The Federal Reserve, the Office of the Comptroller of the Currency (OCC), and the Federal Deposit Insurance Corporation (FDIC) (collectively referred to as the “agencies”) have issued the attached Supervisory Guidance on Implementing Dodd-Frank Act Company-Run Stress Tests for Banking Organizations with Total Consolidated Assets of more than $10 Billion but less than $50 Billion (Attachment 1).  The guidance discusses supervisory expectations for the Dodd-Frank Wall Street Reform and Consumer Protection Act (DFA) stress test practices for companies1 with total consolidated assets between $10-50 billion (referred to as “$10-50 billion companies” in this letter) and offers additional details about methodologies that should be employed by these companies.  This guidance builds upon the interagency stress testing guidance issued in May 2012 for companies with more than $10 billion in total consolidated assets that set forth general principles for a satisfactory stress testing framework.2

Background

In October 2012, the agencies issued the DFA stress test rules3 requiring companies with total consolidated assets of more than $10 billion to conduct annual company-run stress tests pursuant to section 165(i)(2) of DFA.4  The agencies determined that providing the accompanying supervisory guidance would be helpful to the $10-50 billion companies in carrying out their tests.

The supervisory expectations described in the guidance are tailored to the $10-50 billion companies, similar to the manner in which the requirements in the DFA stress test rules were tailored for this set of companies.  The additional information provided in this guidance should assist companies in complying with the DFA stress test rules and conducting DFA stress tests that are appropriate for their risk profile, size, complexity, business mix, and market footprint.5

The DFA stress tests may not necessarily capture a company’s full range of risks, exposures, activities, and vulnerabilities that have a potential effect on capital adequacy.  Additionally, the DFA stress tests assess the impact of stressful outcomes on capital adequacy, and are not intended to measure the adequacy of a company’s liquidity in the stress scenarios.  Finally, companies subject to this guidance are not subject to the Federal Reserve’s capital plan rule, the Federal Reserve’s annual Comprehensive Capital Analysis and Review (CCAR), supervisory stress tests for capital adequacy, or the related data collections supporting the supervisory stress test.  Attachment 2 provides several tables comparing the stress requirements, reporting, and expectations for companies with total consolidated assets of $50 billion or more to $10-50 billion companies.

Expectations for DFA Stress Tests

The supervisory expectations contained in the guidance follow the specific rule requirements contained in the final DFA stress test rules for $10-50 billion companies and are organized in a similar manner.  The guidance covers several categories, outlined below.  

DFA Stress Test Timelines

Under the DFA stress test rules, stress test projections are based on exposures with the as-of-date of September 30 and extend over a nine-quarter planning horizon that begins in the quarter ending December 31 of the same year and ends December 31 two years later.

Scenarios for DFA Stress Tests

Under the stress test rules implementing the DFA requirements, $10-50 billion companies must assess the potential impact on capital of a minimum of three macroeconomic scenarios (that is, baseline, adverse, and severely adverse scenarios) provided by their primary supervisor.  A company is not required to use all of the variables provided in the scenario, if those variables are not relevant or appropriate to the company’s line of business.  In addition, a company may, but is not required to, use additional variables beyond those provided by the agencies.  When using additional variables, companies should ensure that the paths of such variables (including their timing) are consistent with the general economic environment assumed in the supervisory scenarios.

DFA Stress Test Methodologies and Practices

The agencies expect that the specific methodological practices used by companies to produce the estimates of the impact on capital and that other measures may vary across organizations.6 In addition, DFA stress testing practices for $10-50 billon companies should be commensurate with each company’s size, complexity, and sophistication.  This means that, generally, larger or more sophisticated companies should consider employing not just the minimum expectations, but the more advanced practices described in this guidance.  In addition, $10-50 billion companies should consider using more than just the minimum expectations for the exposures and activities of highest impact and that present the highest risk.

  • Data sources.  Companies are expected to have appropriate management information systems and data processes that enable them to collect, sort, aggregate, and update data and other information efficiently and reliably within business lines and across the company for use in DFA stress tests.  In some cases, proxy data may be used.  Companies should challenge conventional assumptions to ensure that a company’s stress test is not constrained by its own past experience.
  • Data segmentation.  To account for differences in risk profiles across various exposures and activities, companies should segment their portfolios and business activities into categories based on common or related risk characteristics.  The company should select the appropriate level of segmentation based on the size, materiality, and risk of a given portfolio, provided there are sufficiently granular historical data available to allow for the desired segmentation.  The minimum expectation is that companies will segment their portfolios and business activities using the categories listed in the $10-50 billion reporting form.7
  • Model risk management.  Companies should have in place effective model risk management practices, including validation, for all models used in DFA stress tests, consistent with existing supervisory guidance.8  Companies should ensure an effective challenge process by unbiased, competent, and qualified parties is in place for all models.  There should also be sufficient documentation of all models, including model assumptions, limitations, and uncertainties.  Companies should ensure that their model risk management policies and practices generally apply to the use of vendor and third-party products as well.  Qualitative elements of models should also be subject to model risk management.
  • Loss estimation.  For their DFA stress tests, companies are expected to have credible loss estimation practices that capture the risks associated with their portfolios, business lines, and activities.  Credit losses associated with loan portfolios and securities holdings should be estimated directly and separately, whereas other types of losses should be incorporated into estimated pre-provision net revenue (PPNR).9  Each company’s loss estimation practices should be commensurate with the materiality of the risks measured and well supported by sound, empirical analysis.  Loss estimates should include projections of other-than-temporary impairments (OTTI) for securities both held for sale and held to maturity.
  • Pre-provision net revenue estimation.  For the DFA stress test, companies are required to project PPNR over the planning horizon for each supervisory scenario.  Companies should estimate PPNR at a level at least as granular as the components outlined in the $10-50 billion reporting form.  Companies should ensure that PPNR projections are generally consistent with projections of losses, the balance sheet, and risk-weighted assets.  A company may estimate the stressed components of PPNR based on its own or industry-wide historical income and expense experience.  Other types of losses that could arise under the supervisory scenarios should be included in projections of PPNR to the extent they would arise under the specified scenario conditions.
  • Balance sheet and risk-weighted asset projections.  A company is expected to project its balance sheet and risk-weighted assets for each of the supervisory scenarios.  In doing so, these projections should be consistent with scenario conditions and the company’s prior history of managing through the different business environments, especially stressful ones.  The projections of the balance sheet and risk-weighted assets should be consistent with other aspects of stress test projections, such as losses and PPNR.
  • Projections for quarterly provisions and allowance for loan and lease losses (ALLL).  The DFA stress test rules require companies to project quarterly provision for loan and lease losses (PLLL).  Companies are expected to project PLLL for each scenario based on projections of quarterly loan and lease losses and while maintaining an appropriate ALLL balance at the end of each quarter of the planning horizon, including the last quarter.
  • Projections for quarterly net income.  Under the DFA stress test rules, companies must estimate projected quarterly net income for each scenario.  Net income projections should be based on loss, revenue, and expense projections.

Estimating the Potential Impact on Regulatory Capital Levels and Capital Ratios

Companies must estimate projected quarterly regulatory capital levels and regulatory capital ratios for each scenario.  Any rare cases in which ratios are higher under the adverse and severely adverse scenarios should be very well supported by analysis and documentation.  Projected capital levels and ratios should reflect applicable regulations and accounting standards for each quarter of the planning horizon.  In their DFA stress tests, bank holding companies and savings and loan holding companies are required to calculate pro forma capital ratios using a set of capital action assumptions based on historical distributions, contracted payments, and a general assumption of no redemptions, repurchases, or issuances of capital instruments.  There are no specified capital actions for state member banks.

Controls, Oversight, and Documentation

A company must establish and maintain a system of controls, oversight, and documentation, including policies and procedures that apply to all of its DFA stress test components.  Senior management and the board of directors have specific responsibilities relating to DFA stress testing.  The board of directors should ensure it remains informed about critical review of elements of the DFA stress tests, especially regarding key assumptions, uncertainties, and limitations.  In addition, the board of directors and senior management of a $10-50 billion company must consider the role of stress testing results in normal business, including in the company’s capital planning, assessment of capital adequacy, and risk management practices.  A company should appropriately document the manner in which DFA stress tests are used for key decisions about capital adequacy, including capital actions and capital contingency plans.  The company should indicate the extent to which DFA stress tests are used in conjunction with other capital assessment tools.  

Report to Supervisors

A $10-50 billion company must report the results of its DFA company-run stress tests on the $10-50 billion reporting form (FR Y-16).  This report will include a company’s quantitative projections of losses, PPNR, balance sheet, risk-weighted assets, ALLL, and capital on a quarterly basis over the duration of the scenario and planning horizon.  In addition to the quantitative projections, companies are required to submit qualitative information supporting their projections.10

Public Disclosure of DFA Test Results

Under the DFA stress test rules, a $10-50 billion company must publicly disclose DFA stress test results between June 15 and June 30, with the first disclosure in 2015.  The summary of the results of the stress test, including both quantitative and qualitative information, should be included in a single release on a company’s web site, or in any other forum that is reasonably accessible to the public.  A company is required to publish results for the severely adverse scenario only. 

Conclusion

Federal Reserve Banks are asked to distribute this letter to banking organizations supervised by the Federal Reserve, as well as to their own supervisory and examination staff. Questions regarding this letter should be directed to the following staff in Division of Banking Supervision and Regulation: David E. Palmer, Senior Supervisory Financial Analyst, Risk Section, at (202) 452-2904; Keith Coughlin, Manager, Regional Banking Organizations, at (202) 452-2056; or Joseph Cox, Financial Analyst, Stress Testing Section, at (202) 452-3216.  In addition, questions may be sent via the Board’s public website.11

signed by
Michael S. Gibson
Director
Division of Banking
Supervision and Regulation


Cross References:
  • SR letter 12-7, "Supervisory Guidance on Stress Testing for Banking Organizations With More Than $10 Billion in Total Consolidated Assets"
  • SR letter 11-11, "Supervision of Savings and Loan Holding Companies (SLHCs)"
  • SR letter 11-7, "Guidance on Model Risk Management"
  • SR letter 09-4, "Applying Supervisory Guidance and Regulations on the Payment of Dividends, Stock Redemptions, and Stock Repurchases at Bank Holding Companies"
  • SR letter 99-18, "Assessing Capital Adequacy in Relation to Risk at Large Banking Organizations and Others with Complex Risk Profiles"
 
Notes:
  1. In this guidance, the term "company" refers to state member banks, bank holding companies, and savings and loan holding companies.  Return to text
  2. See 77 Fed. Reg. 29458, "Supervisory Guidance on Stress Testing for Banking Organizations With More Than $10 Billion in Total Consolidated Assets," (May 17, 2012).  Return to text
  3. The agencies' rules for "Annual Company-Run Stress Test Requirements for Banking Organizations with Total Consolidated Assets over $10 Billion Other than Covered Companies" were issued by the Board on October 12, 2012 (77 Fed. Reg. 623962), the OCC on October 9, 2012 (77 Fed. Reg. 61238), and the FDIC on October 15, 2012 (77 Fed. Reg. 62417).  Return to text
  4. Pub. L. 111-203, 124 Stat. 1376 (2010).  Return to text
  5. Notably, the DFA stress tests produce projections of hypothetical results and are not intended to be forecasts of expected or most likely outcomes.  Return to text
  6. In making projections, companies should make conservative assumptions about management responses in the stress tests, and should include only those responses for which there is substantial support.  For example, companies may account for hedges that are already in place as potential mitigating factors against losses, but should be conservative in making assumptions about potential future hedging activities and not necessarily anticipate that actions taken in the past could be taken under the supervisory scenarios.  Return to text
  7. For purposes of this letter, the term "$10-50 billion reporting form" generally refers to the FR Y-16.  However, for subsidiary banks and thrifts of $10-50 billion holding companies, it could be the relevant reporting form the subsidiary will use to report the results of its DFA stress tests to its primary federal financial regulatory agency.  Return to text
  8. Refer to SR letter 11-7, "Guidance on Model Risk Management."  Return to text
  9.   The DFA stress test rules define PPNR as net interest income plus non-interest income less non-interest expense.  Non-operational or non-recurring income and expense items should be excluded.  Return to text
  10. The $10-50 billion companies should look to the instructions for the $10-50 billion reporting for supervisory expectations regarding what information should be included in the report on the company's DFA stress test.   See FR Y-16 instructions:  http://www.federalreserve.gov/apps/reportforms/reportdetail.aspx?sOoYJ 5BzDbzK2O0R3zNJw==.  Return to text
  11. See http://www.federalreserve.gov/apps/contactus/feedback.aspx.  Return to text
Last update: March 18, 2014