Supervisory and Company-Run Stress Test Requirements

Posted by H. Rodgin Cohen, Sullivan & Cromwell LLP, on Thursday November 15, 2012 at 9:14 am
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Editor’s Note: H. Rodgin Cohen is a partner and senior chairman of Sullivan & Cromwell LLP focusing on acquisition, corporate governance, regulatory and securities law matters. This post is an abridged version of a Sullivan & Cromwell publication by Janine Guido; the full version, including footnotes, is available here.

Summary

In October 2012, the Board of Governors of the Federal Reserve System (the “FRB”) published in the Federal Register final rules implementing the requirements of Section 165(i)(1) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) concerning supervisory stress tests to be conducted by the FRB (the “Annual Supervisory Stress Test Rule”) and Section 165(i)(2) of Dodd-Frank regarding semi-annual company-run stress tests (the “Semi-Annual Company-Run Stress Test Rule,” and, together with the Annual Supervisory Stress Test Rule, the “Stress Test Rules”). The Stress Test Rules apply to bank holding companies (“BHCs”) with total consolidated assets of $50 billion or more (“Large BHCs”) and nonbank financial companies designated by the Financial Stability Oversight Council (“Designated SIFIs,” and together with Large BHCs, “Covered Companies”). Concurrent with the Stress Test Rules, the FRB, Office of the Comptroller of the Currency (“OCC”) and Federal Deposit Insurance Corporation (“FDIC,” and together with the FRB and OCC, the “Agencies”) published separate final rules implementing the requirements of Section 165(i)(2) of Dodd-Frank regarding annual company-run stress tests (the “Annual Company-Run Stress Test Rules”) for supervised entities (BHCs, savings and loan holding companies (“SLHCs”) and depository institutions) with average total consolidated assets greater than $10 billion other than Covered Companies (together “Covered Institutions”). The Stress Test Rules and Annual Company-Run Stress Test Rules have substantial implications for capital planning, including capital distributions.

The specific application of the rules generally depends on the type of entity involved (for example, BHC, depository institution, or SLHC), the size of the institution and its applicable regulator. In summary, the requirements of the Stress Test Rules and Annual Company-Run Stress Test Rules are as follows:

  • For BHCs:
    • Large BHCs (that is, with over $50 billion in total consolidated assets) that participated in the 2009 Supervisory Capital Assessment Program (“SCAP”) or are a successor to such a Large BHC (“SCAP BHCs”) must comply with the supervisory and company-run stress test requirements starting November 15, 2012. The annual company-run stress test must be conducted and results reported to the FRB by January 5, 2013 and the results publicly disclosed, starting with the 2012 stress test, during the period March 15 through March 31, 2013. Mid-year company-run stress tests must be completed and results reported to the FRB by July 5, 2013 and the results publicly disclosed during the period September 15 through September 30, 2013. The FRB will conduct its supervisory stress test, report a summary of the results to the SCAP BHCs and publicly disclose the summary by March 31, 2013. The timing of these disclosure requirements creates a number of difficult issues relating to the quarterly earnings statements, the potential differences between the company-run and supervisory stress test results, and “window” and “black-out” periods for trading in securities of the Large BHC and the offering of securities by the Large BHC.
    • Large BHCs that did not participate in SCAP must comply with the supervisory and company-run stress test requirements starting in the fall of 2013. The annual company-run stress test must be conducted and results reported to the FRB by January 5, 2014 and the results publicly disclosed, starting with the 2013 stress test, during the period March 15 through March 31, 2014. Mid-year stress tests must be completed and results reported to the FRB by July 5, 2014 and the results publicly disclosed during the period September 15 through September 30, 2014. The FRB will conduct its supervisory stress test, report a summary of the results to the Large BHC and publicly disclose the summary by March 31, 2014.
    • BHCs with $10 billion or more but less than $50 billion in average total consolidated assets must comply with the supervisory and company-run stress test requirements starting in the fall of 2013. The annual company-run stress test must be conducted and results reported to the FRB by March 31, 2015 and publicly disclosed, starting with the 2014 stress test, during the period June 15 through June 30, 2015.
  • For State Member Banks:
    • State banks that are members of the Federal Reserve System and are subsidiaries of SCAP BHCs must comply with the annual company-run stress test requirements starting November 15, 2012. Any other state member bank must comply with the annual company-run stress test requirements starting in the fall of 2013.
      • If the state member bank is a subsidiary of a Large BHC (regardless of whether that BHC participated in SCAP), the annual company-run stress test must be conducted and results reported to the FRB by January 5 of each year and the results publicly disclosed during the period March 15 through March 31 of each year. If the state member bank has average total consolidated assets of less than $50 billion, its initial public disclosure begins with the 2014 stress test.
      • For any other state member bank, the annual company-run stress test must be conducted and results reported to the FRB by March 31 of each year and the results publicly disclosed, starting with the 2014 stress test, during the period June 15 through June 30 of each year.
  • For National Banks, Savings Associations and State Non-member Banks:
    • National banks, savings associations and state non-member banks with average total consolidated assets of $50 billion or more must comply with the annual company-run stress test requirements immediately. The annual company-run stress test must be conducted and results reported to their primary federal regulatory agency and the FRB by January 5, 2013 and the results publicly disclosed, starting with the 2012 stress test, during the period March 15 through March 30, 2013.
    • National banks, savings associations, and state non-member banks with average total consolidated assets of $10 billion or more but less than $50 billion must comply with the annual company-run stress test requirements starting in the fall of 2013. The annual company-run stress test must be conducted and results reported to their primary federal regulatory agency and the FRB by March 31, 2014 and the results pubicly disclosed, starting with the 2014 stress test, during the period June 15 through June 30, 2015.
  • For SLHCs:
    • SLHCs with average total consolidated assets of $50 billion or more must comply with the annual company-run stress test requirements and run their first stress test in the fall of the calendar year after they first become subject to minimum capital requirements. The annual company-run stress test must be conducted and results reported to the FRB by January 5 of each year and the results disclosed during the period March 15 through March 31 of each year.
    • SLHCs with average total consolidated assets of $10 billion or more but less than $50 billion must comply with the annual company-run stress test requirements and run their first stress test in the fall of the calendar year after they first becomes subject to minimum capital requirements. The annual company-run stress test must be conducted and results reported to the FRB by March 31 of each year and the results publicly disclosed during the period June 15 through June 31 of each year.

The Semi-Annual Company-Run Stress Test Rule requires a Covered Company with a Covered Institution that is a depository institution as a subsidiary to disclose a summary of the subsidiary’s stress test results as part of the parent Covered Company’s own public disclosure. The Annual Company-Run Stress Test Rules allow these Covered Institutions generally to rely on this disclosure by their parent holding company in satisfaction of the subsidiary’s disclosure requirements. In addition, these Covered Institutions, to the extent that their reporting and disclosure requirements have been extended by the Annual Company-Run Stress Test Rules as described above, are permitted (but not required) to conduct their stress tests and report and publicly disclose results on the same timeline as their parent holding company.

The Agencies expect that the stress tests required under these rules will be only one component of the broader stress testing activities conducted by Covered Companies and Covered Institutions, including stress tests for BHCs with $50 billion or more of total consolidated assets under the FRB’s capital plan rule (the “Capital Plan Rule”). The Agencies previously highlighted the use of stress testing as a means to better understand the range of a banking organization’s potential risk exposures in joint guidance issued in 2011.

Background

Section 165(i)(1) of Dodd-Frank requires the FRB to conduct a supervisory stress test of each Covered Company on an annual basis to determine whether the Covered Company holds sufficient capital to absorb losses resulting from adverse economic conditions. The FRB must administer the stress test under at least three different sets of conditions—baseline, adverse and severely adverse—and publish a summary of the supervisory stress test results.

Section 165(i)(2) of Dodd-Frank requires the Agencies to issue regulations that require Covered Institutions to conduct company-run stress tests on an annual basis, and the FRB to issue regulations that require Covered Companies to conduct stress tests twice a year. In January 2012, the FRB published for comment a notice of proposed rulemaking (“NPR”) to implement the enhanced prudential standards and early remediation requirements established under Sections 165 and 166 of Dodd-Frank (the “165/166 NPR”), which included proposed rules addressing the supervisory, semi-annual and annual stress tests. The FRB received various comments highlighting concerns with the 165/166 NPR, including the supervisory and company-run stress tests. The FRB discusses many of the comments received in the preambles to the Stress Test Rules, and the final rules contain several changes from the 165/166 NPR. However, the Stress Test Rules do not address several of the key concerns of many commenters, including the opaque nature of the FRB’s supervisory stress test models and the lack of opportunity for mid-course correction and communication with the FRB.

The OCC and FDIC also issued NPRs in January 2012 that proposed regulations requiring the respective Covered Institutions supervised by them to conduct annual company-run stress tests. The Annual Company-Run Stress Test Rules contain several differences from the NPRs and, in certain instances, among the Agencies, which are discussed below.

The FRB notes in the preamble to the Stress Test Rules that it issued the rules in advance of the other enhanced prudential standards and early remediation requirements in the 165/166 NPR. It remains to be seen whether other aspects of the FRB’s 165/166 NPR, such as the corporate governance and single counterparty credit limit rules, also will be finalized separately.

I. Annual Supervisory and Semi-Annual Company-Run Stress Tests for Large BHCs and Designated SIFIs

Scope

As noted above, the Stress Test Rules apply to Large BHCs and Designated SIFIs—that is, Covered Companies. They do not currently apply to foreign banking organizations (“FBOs”) themselves. The FRB, however, anticipates issuing separate proposals for comment on enhanced prudential standards, including stress test requirements, for FBOs at a later date. Nevertheless, these requirements will apply to U.S.-domiciled subsidiaries of FBOs currently relying on the FRB’s Supervision and Regulation Letter SR 01-1 (“SR 01-1”) starting in 2015.

Effective Dates

Under the Stress Test Rules, SCAP BHCs are subject to the supervisory and company-run stress test requirements under the Stress Test Rules beginning November 15, 2012 for company-run stress tests and capital plans that must be submitted to the FRB by January 5, 2013. Large BHCs that are not SCAP BHCs are subject to these stress test requirements beginning in the fall of 2013 for company-run stress tests and capital plans that must be submitted to the FRB by January 5, 2014. A BHC that becomes a Covered Company after November 15, 2012 is not required to conduct its first company-run stress test or be subject to with the requirements of the Annual Supervisory Stress Test Rule until the calendar year after the year in which it becomes a Covered Company.

A company that becomes a Designated SIFI must comply with the Stress Test Rules the calendar year after the year in which the company first becomes subject to the FRB’s minimum regulatory capital requirements. The Stress Test Rules grant the FRB discretion to extend the effective date for Large BHCs and accelerate or extend it for Designated SIFIs.

The delay in the effective date for Large BHCs that are not SCAP BHCs is a change from the 165/166 NPR, which would have required all Covered Companies to comply with these stress test requirements in late 2012. The 165/166 NPR also would have required a BHC that becomes a Covered Company after November 15, 2012 to comply with the requirements of the Stress Test Rules in the same calendar year if it became a Covered Company no less than 90 days before September 30 of that year.

Stress Scenarios

The Stress Test Rules require a minimum of three different sets of economic and financial conditions, including baseline, adverse and severely adverse scenarios, to be used by the FRB when conducting supervisory stress tests and by Covered Companies when conducting their annual company-run stress test.

Except as discussed below, under the Semi-Annual Company-Run Stress Test Rule, the FRB will provide Covered Companies baseline, adverse and severely adverse scenarios no later than November 15 of each year to be used in their annual company-run stress test. However, the FRB will not provide scenarios to Covered Companies for the mid-year company-run stress tests. Instead, Covered Companies must develop their own three sets of scenarios, including a baseline, adverse and severely adverse scenario, reflecting the Covered Company’s unique vulnerabilities and risk profiles. The FRB indicates that it will use the same scenarios for its supervisory stress tests as Covered Companies will use for their annual company-run stress tests.

The Stress Test Rules define the term “scenario” and elaborate upon the conditions to be used in the supervisory and annual company-run stress tests as follows:

  • “Scenario” means those sets of conditions that affect the U.S. economy or the financial condition of a Covered Company that the FRB annually determines are appropriate for use in the stress tests, including, but not limited to, baseline, adverse and severely adverse.
  • “Baseline Scenario” means a set of conditions that affect the U.S. economy or the financial condition of a Covered Company and reflect the consensus views of the economic and financial outlook. The baseline will reflect the macroeconomic outlook based on the consensus views of professional forecasters, government agencies and other public-sector organizations.
  • “Adverse Scenario” means a set of conditions that affect the U.S. economy or the financial condition of a Covered Company that are more adverse than those associated with the baseline scenario and may include trading or other additional components. At a minimum, the adverse scenarios will include economic variables consistent with mild or moderate recessions.
  • “Severely Adverse Scenario” means a set of conditions that affect the U.S. economy or the financial condition of a Covered Company and that overall are more severe than those associated with the adverse scenario and may include trading or other additional components. At a minimum, the severely adverse scenario will include economic variables consistent with severe post-war U.S. recessions.

The FRB indicates that it may modify these scenarios to reflect the characteristics of a particular company or economic climate. For instance, under the Stress Test Rules, a Covered Company with significant trading activity, as determined by the FRB and evidenced by the company’s FR Y-14A, FR Y-14Q and FR Y-14M (collectively, “Form FR Y-14”), may be required to include a global market shock component in the adverse and severely adverse scenarios of the stress test that measures potential stress losses from trading activities and counterparty exposures, which will be communicated to the Covered Company by December 1. The Annual Supervisory Stress Test Rule also allows the FRB to use other components of the scenarios or additional scenarios in its analysis that will be communicated to the Covered Company by December 1. Similarly, the Semi-Annual Company-Run Stress Test Rule allows the FRB to require a Covered Company to use one or more additional components in its adverse and severely adverse scenarios or additional scenarios for both its annual and mid-year company-run stress tests based on the company’s financial condition, size, complexity, risk profile, scope of operations or activities, or risks to the U.S. economy. The FRB will use notice and response procedures for the additional components or scenarios in the company-run stress test and communicate the as-of date and a description of the component or scenario to the Covered Company no later than December 1.

The FRB, however, generally rejected suggestions by commenters to tailor scenarios for Designated SIFIs in certain industries, indicating that a general uniform set of scenarios is necessary to provide a basis for comparison across companies. Commenters expressed concern about applying the Stress Test Rules to Designated SIFIs and requested the FRB either to tailor further the requirements for Designated SIFIs in the final rule or issue a separate rule for these companies. In response, the FRB did indicate that it may tailor the application of the enhanced standards, including stress test requirements, to Designated SIFIs on an individual basis or by category, as appropriate.

Company-Run Stress Test Methodology

Under the Semi-Annual Company-Run Stress Test Rule, for both annual and mid-year stress tests, Covered Companies must estimate for each scenario to be used:

  • Losses, pre-provision net revenue, provision for loan and lease losses and net income; and
  • The potential impact on pro forma regulatory capital levels and pro forma capital ratios, incorporating the effects of any capital actions over the planning horizon and maintenance of an allowance for loan losses appropriate for credit exposures throughout the planning horizon.

The Semi-Annual Company-Run Stress Test Rule also requires a Covered Company to make certain assumptions regarding its capital actions over the nine quarter planning horizon in conducting its annual and mid-year stress tests. For the first quarter, the Covered Company must consider its actual capital actions as of the end of the calendar quarter. For the second through ninth quarters of the planning horizon, the Covered Company must include the following assumptions in its projections of capital:

  • Common stock dividends equal to the quarterly average dollar amount of common stock dividends that the company paid in the previous year;
  • Payments on any other instrument eligible for inclusion in the numerator of a regulatory capital ratio equal to the stated assumption dividend, interest or principal due on such instrument during the quarter; and
  • An assumption of no redemption or repurchase of any capital instrument that is eligible for the inclusion in the numerator of a regulatory capital ratio.

These assumptions were added to the Semi-Annual Company-Run Stress Test Rule in response to commenters who requested an approach utilizing a uniform set of assumptions of capital actions across BHCs.

Supervisory Stress Test Methodology

Under the Annual Supervisory Stress Test Rule, the FRB will use its own models to evaluate whether each Covered Company has the capital, on a total consolidated basis, necessary to continue operating under the economic and financial market conditions of each scenario. The FRB’s analysis will include an assessment of the projected losses, net income, and pro forma capital levels and regulatory capital ratio, tier 1 common ratio and other capital ratios for the Covered Company and use such analytical techniques the FRB determines to be appropriate to identify, measure and monitor risks of the Covered Company that may affect the financial stability of the United States.

Neither the Annual Supervisory Stress Test Rule nor the preamble thereto commits the FRB to provide additional meaningful details concerning the methodology and models to be used in supervisory stress tests despite the request from many commenters for greater clarity with respect to the application of the supervisory stress test models and increased transparency of the FRB’s analysis, modeling techniques and assumptions used to analyze Covered Companies. Commenters’ concerns focused on the substantial differences, using the same scenarios, between results produced by bank models and those produced by supervisory models. The preamble to the Stress Test Rules does note, however, that the FRB is still considering methods to increase transparency while being careful not to eliminate the incentives for companies to develop better internal stress test models.

In addition, the FRB notes that it has established an independent internal model validation group to review supervisory models and their implementation, which is intended to foster continuing improvements in supervisory modeling practices. The FRB has also formed the Model Validation Council, composed of independent, external experts to improve the quality of the FRB’s model validation process and strengthen confidence in the FRB’s stress tests.

Reporting of Results to the FRB

Under the Semi-Annual Company-Run Stress Test Rule, Covered Companies must file reports of results with the FRB by January 5 of each year, reflecting data as of September 30 of the previous year. The reports should contain information reporting the results of the annual company-run stress test and will assist the FRB in conducting its supervisory stress tests. This information is collected on a single set of regulatory reports, Form FR Y-14, which contains information that the FRB has determined is necessary in order for the FRB to derive the relevant pro forma estimates of a Covered Company over the planning horizon both for the Stress Test Rules and the FRB’s Capital Plan Rule.

Reports for mid-year company-run stress tests must be submitted by July 5 of each year, reflecting data as of March 31 of that same year. The FRB expects this report will be identical to or modeled on the FR Y-14A and will seek public comment on it. Echoing the general concerns of commenters, the FRB notes that the timing of these reports coincides with the Capital Plan Rule and is intended to minimize the burden on institutions and avoid duplication. The FRB also indicates in the preamble that it expects to apply Form FR Y-14 to a Designated SIFIs upon such company’s designation. The confidentiality of any information submitted to the FRB for the supervisory and company-run stress tests will be determined in accordance with the FRB’s rules regarding public availability of information.

In addition, as necessary, the FRB may require the submission of additional information to enable the FRB to conduct its supervisory stress test and to project a company’s losses, pre-provision net revenue, provision for loan and lease losses, pro forma capital levels, regulatory capital ratios and tier 1 common ratio under the scenarios provided.

Public Disclosure of Supervisory and Company-Run Stress Test Results

Dodd-Frank and the Stress Test Rules require the FRB to publicly disclose a summary of its annual supervisory stress test for each Covered Company, and for Covered Companies to publicly disclose a summary of their company-run stress tests. Covered Companies must disclose a summary of their annual stress tests results in the period beginning March 15 through March 31 of each year and their mid-year stress test results in the period beginning September 15 through September 30 of each year. As a practical matter for public reporting companies, these periods roughly correspond to traditional pre-quarter end “black-out” periods. The FRB must disclose a summary of its results under the supervisory stress test by March 31 of each year. These disclosure dates are earlier in the calendar than FRB practice under the Comprehensive Capital Analysis and Review (“CCAR”) and SCAP. The timing creates a number of difficult issues relating to the quarterly earnings statements, the potential differences between the company-run and regulatory stress test results, and “window” and “black-out” periods for trading in securities of the Covered Company and the offering of securities by the Covered Company.

For the company-run stress tests, Covered Companies are required under the Semi-Annual Company-Run Stress Test Rule to publicly disclose only the results under the severely adverse scenario and to include the following minimum disclosure:

  • A description of the types of risks included in the stress test;
  • A general description of the methodologies used in the stress test, including those employed to estimate losses, revenues, provision for loan and lease losses and changes in capital positions over the planning horizon;
  • Estimates of: (i) pre-provision net revenue and other revenue; (ii) provision for loan and lease losses, realized losses or gains on available-for-sale and held-to-maturity securities, trading and counterparty losses and other losses or gains; (iii) net income before taxes; (iv) loan losses in the aggregated and by subportfolio; and (v) pro forma regulatory capital ratios and the tier 1 common ratio and any other capital ratios specified by the FRB; and
  • An explanation of the most significant causes for the changes in regulatory capital ratios and the tier 1 common ratio.

The Semi-Annual Company-Run Stress Test Rule also requires a Covered Company to disclose changes in its regulatory capital ratios and any other capital ratios specified by the FRB of its depository institution subsidiary that are Covered Institutions over the planning horizon, including an explanation of the most significant causes for the changes in regulatory capital ratios. This disclosure generally satisfies the publication requirements for these Covered Institutions as further discussed in Part II below.

For the supervisory stress tests, the FRB indicates in the preamble that for stress tests conducted in 2012 it will limit public disclosure of the results to the severely adverse scenario only. When reporting on the results of the severely adverse scenario, the FRB indicates that it will disclose information about a company’s revenue, losses and gains, net income before taxes, loan losses, and pro forma regulatory and other capital ratios. The FRB acknowledges commenters’ concerns that the publication of the baseline scenario could be perceived as earnings guidance. However, the FRB intends, as it implements the supervisory and company-run stress test requirements for Covered Companies, to evaluate whether public disclosure of the results of the adverse and baseline scenarios would assist in informing the Covered Company and market participants about the condition of the banking organization. Thus, it expects periodically to revisit the scope of disclosure and may choose to disclose, or require Covered Companies to disclose, the results of the adverse and baseline scenarios in the future.

Furthermore, the FRB rejected requests from commenters to institute a formal appeals process to allow Covered Companies to dispute the FRB’s findings under the supervisory stress tests prior to their publication. By appealing the FRB’s findings, commenters had argued, companies could defend their internally conducted stress tests and explain any differences between FRB and company-run results. The Annual Supervisory Stress Test Rule does not include an appeals process, failing to address concerns regarding mid-course correction and discussions with the FRB prior to disclosure. The FRB contends that its models and assumptions are consistent across all companies.

Management and Board Oversight of the Company-Run Stress Test Process

The Semi-Annual Company-Run Stress Test Rule imposes responsibility on the board of directors and senior management of each Covered Company to establish and maintain a system of controls, oversight and documentation for each company’s stress tests to ensure effective compliance with the FRB’s regulations. Under the Semi-Annual Company-Run Stress Test Rule, senior management must ensure the establishment of company policies outlining the practices and methodologies of their institution in compliance with stress test requirements. The board of directors or a committee thereof must review and approve these policies and procedures at least once a year. In addition, stress test results must be given to the board of directors and senior management.

Under the Stress Test Rules, the board of directors and senior management must consider the results of the semi-annual stress test and the analysis conducted by the FRB in the supervisory stress tests in their decision making, including: (i) as part of the company’s capital plan, including contemplating changes to the company’s capital structure; (ii) in assessments of the company’s exposures, concentrations and risk positions; and (iii) in the development and implementation of any plans for recovery or resolution. Each Covered Company also is required under the Annual Supervisory Stress Test Rule to update its resolution plan, as the FRB determines appropriate based on the FRB’s analysis of the company under the rule.

These revised final provisions are in response to the requests of several commenters to the FRB to clarify the role of the board of directors and senior management in overseeing the company-run stress test process.

Coordination Among Agencies

The Annual Supervisory Stress Test Rule explicitly provides that the FRB will coordinate with the other Agencies and the Federal Insurance Office, as appropriate, in conducting the analysis required under that rule. In addition, the FRB indicates that it plans to consult with the OCC and FDIC when developing scenarios for supervisory and company-run stress tests.

Moreover, as noted above, the Semi-Annual Company-Run Stress Test Rule requires Covered Companies with a Covered Institution that is a depository institution as a subsidiary to disclose the subsidiary’s stress test results as part of the Covered Company’s own disclosure. Disclosure by a BHC of its stress test results and those of any subsidiary member bank will generally satisfy any disclosure requirements applicable to the state member bank subsidiary, as discussed in Part II.

The full publication is available here.

 

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