The Federal Reserve has issued a detailed statement indicating the standards by which BHCs with assets over $50 billion will be judged when they begin the next round of stress testing in the fall. Stress-test results are critical because failing to pass means difficulty accomplishing desired dividend or stock-repurchase plans with negative market-capitalization and reputational-risk results evident when BHCs have failed prior stress tests. To date, these tests have been done only for the very largest BHCs and focused principally on capital adequacy under scenarios that address only credit risk and, of late for a still more limited class of big BHCs, trading losses. Now, however, the FRB has adjusted its expectations for stress tests to bar reliance on its own models, require consideration of unique factors across the full range of activities at each BHC, mandate considerable board and senior-management involvement and active decision-making and ensure that risks addressed go beyond those to date to include operational, reputational, strategic, compliance and other risks not necessarily suitable for quantitative analytics and external models. Indeed, much in the statement makes clear that BHCs should not only cease to rely on FRB stress-test scenarios, but also that use without refinement, validation and adjustment of external models is also a “weak practice.” Many practices the FRB found now in wide use may well be sufficient for planned capital distributions, but none will afford a safe harbor. As a result, most if not all large BHCs will need quickly to make their stress testing more robust, far more sensitive to non-credit risk and considerably more intuitive, transparent and accountable within the BHC and to the FRB. These standards do not apply to subsidiaries within a BHC, but by inference they will require considerable changes at bank and non-bank entities within the BHC because of the FRB’s focused on enterprise-wide risk management.
The full report is available to retainer clients. To find out how you can sign up for the service, click here