Federal Register, Volume 76 Issue 115 (Wednesday, June 15, 2011)

[Federal Register Volume 76, Number 115 (Wednesday, June 15, 2011)]
[Notices]
[Pages 35072-35084]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2011-14777]

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DEPARTMENT OF THE TREASURY

Office of the Comptroller of the Currency

[Docket No. OCC-2011-0011]

FEDERAL RESERVE SYSTEM

[Docket No. OP-1421]

FEDERAL DEPOSIT INSURANCE CORPORATION

Proposed Guidance on Stress Testing for Banking Organizations
With More Than $10 Billion in Total Consolidated Assets

AGENCIES: Office of the Comptroller of the Currency, Treasury
(``OCC''); Board of Governors of the Federal Reserve System (``Board''
or ``Federal Reserve''); Federal Deposit Insurance Corporation
(``FDIC'').

ACTION: Proposed joint guidance with request for public comment.

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SUMMARY: The OCC, Board, and the FDIC (collectively, the ``agencies'')
request comment on proposed guidance on stress testing (proposed
guidance). The proposed joint guidance outlines high-level principles
for stress testing practices, applicable to all Federal Reserve-
supervised, FDIC-supervised, and OCC-supervised banking organizations
with more than $10 billion in total consolidated assets. The proposed
guidance highlights the importance of stress testing as an ongoing risk
management practice that supports a banking organization's forward-
looking assessment of its risks.

DATES: Comments must be submitted on or before July 29, 2011.

ADDRESSES: OCC: Please use the title ``Proposed Guidance on Stress
Testing'' to facilitate the organization and distribution of the
comments. You may submit comments by any of the following methods:
E-mail: regs.comments@occ.treas.gov.
Mail: Office of the Comptroller of the Currency, 250 E
Street, SW., Mail Stop 2-3, Washington, DC 20219.
Fax: (202) 874-5274.
Hand Delivery/Courier: 250 E Street, SW., Mail Stop 2-3,
Washington, DC 20219.
Instructions: You must include ``OCC'' as the agency name and
``Docket Number OCC-2011-0011'' in your comment. In general, OCC will
enter all comments received into the docket and publish them on the
Regulations.gov Web site without change, including any business or
personal information that you provide such as name and address

[[Page 35073]]

information, e-mail addresses, or phone numbers. Comments received,
including attachments and other supporting materials, are part of the
public record and subject to public disclosure. Do not enclose any
information in your comment or supporting materials that you consider
confidential or inappropriate for public disclosure.
You may review comments and other related materials that pertain to
this notice by any of the following methods:
Viewing Comments Personally: You may personally inspect
and photocopy comments at the OCC, 250 E Street, SW., Washington, DC.
For security reasons, the OCC requires that visitors make an
appointment to inspect comments. You may do so by calling (202) 874-
4700. Upon arrival, visitors will be required to present valid
government-issued photo identification and to submit to security
screening in order to inspect and photocopy comments.
Docket: You may also view or request available background
documents and project summaries using the methods described above.
Board: When submitting comments, please consider submitting your
comments by e-mail or fax because paper mail in the Washington, DC area
and at the Board may be subject to delay. You may submit comments,
identified by Docket No. OP-1411, by any of the following methods:
Agency Web Site: http://www.federalreserve.gov. Follow the
instructions for submitting comments at http://www.federalreserve.gov/generalinfo/foia/ProposedRegs.cfm.
Federal eRulemaking Portal: http://www.regulations.gov. Follow the instructions for submitting comments.
E-mail: regs.comments@federalreserve.gov. Include docket
number in the subject line of the message.
Fax: (202) 452-3819 or (202) 452-3102.
Mail: Jennifer J. Johnson, Secretary, Board of Governors
of the Federal Reserve System, 20th Street and Constitution Avenue,
NW., Washington, DC 20551.
All public comments are available from the Board's Web site at
http://www.federalreserve.gov/generalinfo/foia/ProposedRegs.cfm as
submitted, unless modified for technical reasons. Accordingly, your
comments will not be edited to remove any identifying or contact
information. Public comments may also be viewed electronically or in
paper form in Room MP-500 of the Board's Martin Building (20th and C
Street, NW.,Washington, DC 20551) between 9 a.m. and 5 p.m. on
weekdays.
FDIC: You may submit comments by any of the following methods:
Agency Web site: http://www.FDIC.gov/regulations/laws/federal/propose.html. Follow the instructions for submitting comments.
Federal eRulemaking Portal: http://www.regulations.gov.
Follow the instructions for submitting comments.
E-mail: comments@FDIC.gov. Include ``Stress Testing
Guidance'' in the subject line of the message. Comments received will
be posted without change to http://www.FDIC.gov/regulations/laws/federal/propose.html, including any personal information provided.
Mail: Robert E. Feldman, Executive Secretary, Attention:
Comments/Legal ESS, Federal Deposit Insurance Corporation, 550 17th
Street, NW., Washington, DC 20429.
Hand Delivery/Courier: Guard station at the rear of the
550 17th Street Building (located on F Street), on business days
between 7 a.m. and 5 p.m. (EDT).

FOR FURTHER INFORMATION CONTACT: OCC: Robert Scavotto, Lead
International Expert, International Analysis and Banking Condition
(202) 874-4943, Tanya Smith, NBE, Basel II Program Manager, Large Bank
Supervision (202) 874-4464, Akhtarur Siddique, Deputy Director,
Enterprise Risk Analysis Division (202) 874-4665, or Jeanette Quick,
Attorney, Legislative and Regulatory Activities Division (202) 874-
5090, Office of the Comptroller of the Currency, 250 E Street, SW.,
Washington, DC 20219.
Board: Anna Lee Hewko, Assistant Director, Capital and Regulatory
Policy (202) 530-6260, or Constance M. Horsley, Manager, Capital and
Regulatory Policy (202) 452-5239, David Palmer, Senior Supervisory
Analyst, Risk Section, (202) 452-2904, Sviatlana Phelan, Financial
Analyst, Capital and Regulatory Policy (202) 912-4306, Division of
Banking Supervision and Regulation; or Benjamin W. McDonough, Counsel,
(202) 452-2036, or Dominic A. Labitzky, Senior Attorney, (202) 452-
3428, Legal Division, Board of Governors of the Federal Reserve System,
20th and C Streets, NW., Washington, DC 20551.
FDIC: George French, Deputy Director, Policy, (202) 898-3929;
Robert Burns, Chief, Exam Support & Analysis Section, (704) 333-3132
x4215; Karl Reitz, Senior Capital Markets Specialist, (202) 898-6775,
Division of Risk Management Supervision; or Mark Flanigan, Counsel,
(202) 898-7426; Ryan Clougherty, Senior Attorney, (202) 898-3843,
Supervision Branch, Legal Division.

SUPPLEMENTARY INFORMATION:

I. Background

All banking organizations should have the capacity to understand
their risks and the potential impact of stressful events and
circumstances on their financial condition.\1\ The U.S. Federal banking
agencies have previously highlighted the use of stress testing as a
means to better understand the range of a banking organization's
potential risk exposures.\2\ The 2007-2009 financial crisis further
underscored the need for banking organizations to incorporate stress
testing into their risk management, as banking organizations unprepared
for stressful events and circumstances can suffer acute threats to
their financial condition and viability. The proposed guidance is
intended to be consistent with industry practices and with
international supervisory standards.\3\
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\1\ For purposes of this guidance, the term ``banking
organization'' means national banks and Federal branches and
agencies supervised by the OCC; state member banks, bank holding
companies, and all other institutions for which the Federal Reserve
is the primary Federal supervisor; and state nonmember insured banks
and other institutions supervised by the FDIC.
\2\ See, for example, Supervision and Regulation (SR) letter 10-
6 or OCC Bulletin 2010-13 or FDIC FIL-13-2010, ``Interagency Policy
Statement on Funding and Liquidity Risk Management''; SR 10-1 or OCC
Bulletin 2010-1 or FDIC Financial Institution Letter (FIL-2-2010),
``Interagency Advisory on Interest Rate Risk''; SR letter 09-04,
``Applying Supervisory Guidance and Regulations on the Payment of
Dividends, Stock Redemptions, and Stock Repurchases at Bank Holding
Companies''; SR letter 07-1, ``Interagency Guidance on
Concentrations in Commercial Real Estate'' or OCC Bulletin 2006-46
or FDIC FIL-104-2006, ``Interagency Guidance on CRE Concentration
Risk Management''; SR letter 99-18, ``Assessing Capital Adequacy in
Relation to Risk at Large Banking Organizations and Others with
Complex Risk Profiles''; OCC Bulletin 2008-20 or FDIC FIL-71-2008
``Supervisory Guidance: Supervisory Review Process of Capital
Adequacy (Pillar 2) Related to the Implementation of the Basel II
Advanced Capital Framework''; the Supervisory Capital Assessment
Program (see http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20080715a1.pdf); and Comprehensive Capital Analysis and Review:
Objectives and Overview (see www.federalreserve.gov/newsevents/press/bcreg/20110318a.htm ).
\3\ See ``Principles for Sound Stress Testing Practices and
Supervision,'' Basel Committee on Banking Supervision, May 2009.
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Building upon previously issued supervisory guidance that discusses
the uses and merits of stress testing in specific areas of risk
management, the proposed guidance provides an overview of how a banking
organization should structure its stress testing activities and ensure
they fit into overall risk management. The purpose of this guidance is
to outline broad principles for a satisfactory stress testing framework
and describe the manner in

[[Page 35074]]

which stress testing should be employed as an integral component of
risk management that is applicable at various levels of aggregation
within a banking organization, as well as for contributing to capital
and liquidity planning. While the guidance is not intended to provide
detailed instructions for conducting stress testing for any particular
risk or business area, the proposed guidance aims to describe several
types of stress testing activities and how they may be most
appropriately used by banking organizations. The guidance does not
explicitly address the stress testing requirements imposed upon certain
companies by section 165(i) of the Dodd-Frank Wall Street Reform and
Consumer Protection Act.\4\ The Board, FDIC, and OCC expect to
implement that provision in a future rulemaking that would be
consistent with the principles in the proposed guidance.
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\4\ Public Law 111-203, 124 Stat. 1376. Section 165(i) of the
Dodd-Frank Act is codified at 12 U.S.C. 5365(i).
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II. Principal Elements of the Proposed Guidance

The agencies are issuing this proposed guidance to emphasize the
importance of stress testing as an ongoing risk management practice
that supports banking organizations' forward-looking assessment of
risks and better equips them to address a range of adverse outcomes.
The proposed joint guidance is applicable to all banking organizations
supervised by the agencies with more than $10 billion in total
consolidated assets. Specifically, with respect to the OCC, these
banking organizations would include national banking associations and
Federal branches and agencies; with respect to the Board, these banking
organizations would include state member banks, bank holding companies,
and all other institutions for which the Federal Reserve is the primary
Federal supervisor; with respect to the FDIC, these banking
organizations would include state nonmember insured banks or insured
branches of foreign banks. A banking organization should develop and
implement its stress testing framework in a manner commensurate with
its size, complexity, business activities, and overall risk profile.
The uses of a banking organization's stress testing framework
should include, but are not limited to, augmenting risk identification
and measurement; estimating business line revenues and losses and
informing business line strategies; identifying vulnerabilities and
assessing their potential impact; assessing capital adequacy and
enhancing capital planning; assessing liquidity adequacy and informing
contingency funding plans; contributing to strategic planning; enabling
senior management to better integrate strategy, risk management, and
capital and liquidity planning decisions; and assisting with recovery
planning.

A. Stress Testing Principles

Principle 1: A banking organization's stress testing framework
should include activities and exercises that are tailored to and
sufficiently capture the banking organization's exposures, activities,
and risks.
An effective stress testing framework covers a banking
organization's full set of material activities, exposures, and risks,
whether on or off the balance sheet. An effective stress testing
framework should be applied at various levels in the banking
organization, such as business line, portfolio, and risk type, as well
as on an enterprise-wide basis. Each stress test should be tailored to
the relevant level of aggregation, capturing critical risk drivers,
internal and external influences, and other key considerations at the
relevant level. Stress testing should capture the interplay among
different exposures, activities, and risks and their combined effects.
Scenarios used in a banking organization's stress tests should be
relevant to the direction and strategy set by its board of directors.
Principle 2: An effective stress testing framework employs multiple
conceptually sound stress testing activities and approaches.
Banking organizations should use multiple stress testing activities
and approaches and ensure that each is conceptually sound. Stress tests
usually vary in design and complexity, including the number of factors
employed and the degree of stress applied. Effective stress testing
relies on high-quality input data and information to produce credible
outcomes. A banking organization should document the assumptions used
in its stress tests and note the degree of uncertainty that may be
incorporated into the tools used for stress testing. Furthermore,
almost all stress tests, including well-developed quantitative tests
supported by high-quality data, employ a certain amount of expert or
business judgment that should be made transparent to users of stress
test results.
Principle 3: An effective stress testing framework is forward-
looking and flexible.
A stress testing framework should be sufficiently dynamic and
flexible to incorporate changes in a banking organization's on- and
off-balance-sheet activities, portfolio composition, asset quality,
operating environment, business strategy, and other risks that may
arise. While stress testing should utilize available historical
information, a banking organization should look beyond assumptions
based only on historical data and challenge conventional assumptions. A
banking organization should carefully consider the incremental and
cumulative effects of stress conditions. In addition to conducting
formal, routine stress tests, a banking organization should have the
flexibility to conduct new or ad hoc stress tests in a timely manner to
address rapidly emerging risks. A banking organization should continue
updating and maintaining its stress testing framework in light of new
risks, better understanding of the banking organization's exposures and
activities, and any changes in its operating structure and environment.
Principle 4: Stress test results should be clear, actionable, well
supported, and inform decision-making.
Stress testing should incorporate measures that adequately and
effectively convey the results of its tests. In addition, all stress
test results should be accompanied by descriptive and qualitative
information (such as key assumptions and limitations) to allow users to
interpret the exercises in context. A banking organization should
regularly communicate stress test results to appropriate levels within
the banking organization to foster dialogue around stress testing, keep
management and staff apprised, and to inform stress testing approaches,
results, and decisions in other areas of the banking organization. In
addition, management should review stress testing activities on a
regular basis to determine, among other things, the validity of the
assumptions, the severity of scenarios and sensitivity tests, the
robustness of the estimates, the performance of any underlying models,
and the stability and reasonableness of the results. Finally, stress
test results should inform a banking organization's analysis and
decision-making.

B. Stress Testing Approaches and Applications

The proposed guidance describes certain stress testing approaches
and applications--scenario analysis, sensitivity analysis, enterprise-
wide testing, and reverse stress testing--that a banking organization
should strongly consider using within its stress testing framework, as
appropriate. Each banking organization should apply these approaches
and applications

[[Page 35075]]

commensurate with its size, complexity, and business profile, and may
not need to incorporate all of the details described in the proposed
guidance.
Scenario Analysis
Scenario analysis refers to a type of stress testing in which a
banking organization applies historical or hypothetical scenarios to
assess the impact of various events and circumstances, including
extreme ones. Scenarios usually involve some kind of coherent, logical
narrative or ``story'' as to why certain events and circumstances are
occurring and in which combination and order they occur, such as a
severe recession, failure of a major counterparty, loss of major
clients, natural or man-made disaster, localized economic downturn, or
a sudden change in interest rates brought about by unfavorable
inflation developments. Stress scenarios should reflect a banking
organization's unique vulnerabilities to factors that affect its
exposures, activities, and risks.
Sensitivity Analysis
Sensitivity analysis refers to a banking organization's assessment
of its exposures, activities, and risks when certain variables,
parameters, and inputs are ``stressed'' or ``shocked.'' Generally,
sensitivity analysis differs from scenario analysis in that it involves
changing variables, parameters, or inputs without an explicit
underlying reason or narrative, in order to explore what occurs under a
range of inputs and at extreme or highly adverse levels. Sensitivity
analysis can also help to assess the combined impact on a banking
organization of several variables, parameters, factors, or drivers.
Enterprise-Wide Stress Testing
Enterprise-wide stress testing involves assessing the impact of
certain specified scenarios on the banking organization as a whole,
particularly on capital and liquidity. As is the case with scenario
analysis more generally, enterprise-wide stress testing involves robust
scenario design and effective translation of scenarios into measures of
impact. Enterprise-wide stress tests can help a banking organization in
its efforts to assess the impact of its full set of risks under adverse
events and circumstances, but should be supplemented with other stress
tests and other risk measurement tools given inherent limitations in
capturing all risks and all adverse outcomes. Selection of scenario
variables is important for enterprise-wide tests, because they
generally serve as the link between the overall narrative of the
scenario and tangible impact on the banking organization as a whole.
For an enterprise-wide test, assumptions across business lines and risk
areas should remain constant for the chosen scenario, since the
objective is to see how the banking organization as a whole responds to
a common outcome.
Reverse Stress Testing
Reverse stress testing is a tool that allows a banking organization
to assume a known adverse outcome, such as suffering a credit loss that
breaches regulatory capital ratios or suffering severe liquidity
constraints making it unable to meet its obligations, and then deduce
the types of events that could lead to such an outcome. This type of
stress testing may help a banking organization to consider scenarios
beyond its normal business expectations and see the impact of severe
systemic effects on the banking organization. It also allows a banking
organization to challenge common assumptions about its performance and
expected mitigation strategies. Reverse stress testing helps a banking
organization evaluate the combined effect of several types of extreme
events and circumstances that might threaten the survival of the
banking organization, even if in isolation each of the effects might be
manageable.

C. Stress Testing for Assessing Adequacy of Capital and Liquidity

Given the importance of capital and liquidity to a banking
organization's viability, stress testing should be applied to these two
areas on a regular basis. Stress testing for capital and liquidity
adequacy should be conducted in coordination with a banking
organization's overall strategy and annual and planning cycles. Results
should be refreshed in the event of major strategic decisions, or other
decisions that can materially impact capital or liquidity. Banking
organizations should conduct stress testing for capital and liquidity
adequacy periodically.
Capital stress testing supplements a banking organization's
regulatory capital analysis by providing a forward-looking assessment
of capital adequacy, usually with a forecast horizon of at least two
years, and highlighting the potential adverse effects on capital levels
and ratios of risks not fully captured in regulatory capital
requirements.\5\ Stress testing can aid capital contingency planning by
helping management identify exposures or risks that would need to be
reduced and actions that could be taken to bolster capital levels or
otherwise maintain capital adequacy, as well as actions that in times
of stress might not be possible--such as raising capital.
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\5\ The portions of the proposed guidance that discuss stress
testing for capital adequacy do not apply to U.S. branches and
agencies of foreign banking organizations.
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Using liquidity stress testing, a banking organization can work to
identify vulnerabilities related to liquidity adequacy in light of both
firm-specific and market-wide stress events and circumstances.\6\
Effective stress testing helps a banking organization identify and
quantify the depth, source, and degree of potential liquidity strain
and to analyze possible impacts on its cash flows, liquidity position,
profitability, and other aspects of its financial condition over
various time horizons. These tests also help determine whether the
banking organization has a sufficient liquidity buffer to meet various
types of future liquidity demands. In this regard, liquidity stress
testing should be an integral part of the development and maintenance
of a banking organization's contingency funding planning.
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\6\ See SR letter 10-6, SR letter 10-1; OCC Bulletin 2010-13,
OCC Bulletin 2010-1; FDIC FIL 13-2010 and FIL 2-2010.
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An effective stress testing framework should explore the potential
for capital and liquidity problems to arise at the same time or
exacerbate one another. A banking organization's liquidity stress
analysis should explore situations in which the banking organization
may be operating with a capital position that exceeds regulatory
minimums, but is nonetheless viewed within the financial markets or by
its counterparties as being of questionable viability. For its capital
and liquidity stress tests, a banking organization should articulate
clearly its objectives for a post-stress outcome, for instance to
remain a viable financial market participant that is able to meet its
existing and prospective obligations and commitments.

D. Governance Over the Stress Testing Framework

[[Page 35076]]

assumptions, uncertainties, and limitations. A banking organization
should ensure that the stress testing framework is not isolated within
a banking organization's risk management function, but is firmly
integrated into business lines, capital and asset-liability committees,
and other decision-making bodies.
The results of stress testing analyses should facilitate decision-
making by the board and senior management. Stress testing results
should be used to inform the board about alignment of the banking
organization's risk profile with the board's chosen risk appetite, as
well as inform operating and strategic decisions. Stress testing
results should be considered directly by the board and senior
management for decisions relating to capital and liquidity adequacy.
The board and senior management should ensure that the stress testing
framework includes a sufficient range of stress testing activities
applied at the appropriate levels of the banking organization (i.e.,
not just one enterprise-wide stress test).

III. Request for Comment

The agencies invite comment on all aspects of the proposed
guidance. More specifically, what, if any, additional elements or
aspects of an effective stress testing framework should the agencies
consider including in this guidance? What additional approaches and
applications of stress testing have been found to be particularly
useful aside from those included in the proposed guidance? What
challenges, if any, exist in applying this guidance generally or at
particular banking organizations and why? Are there any terms described
by the proposed guidance that require further clarification and how
should they be defined?

IV. Administrative Law Matters

A. Paperwork Reduction Act Analysis

In accordance with the Paperwork Reduction Act (``PRA'') of 1995
(44 U.S.C. 3506; 5 CFR part 1320 Appendix A.1), the agencies reviewed
the proposed guidance. The agencies may not conduct or sponsor, and an
organization is not required to respond to, an information collection
unless the information collection displays a currently valid OMB
control number. The agencies have determined that certain aspects of
the proposed guidance may constitute a collection of information. In
particular, these aspects are the provisions that state a banking
organization should (i) have a stress testing framework that includes
clearly defined objectives, well-designed scenarios tailored to the
banking organization's business and risks, well-documented assumptions,
conceptually sound methodologies to assess potential impact on the
banking organization's financial condition, informative management
reports, and recommended actions based on stress test results and (ii)
have policies and procedures for a stress testing framework. The
agencies estimate that the above-described information collections
included in the proposed guidance would take respondents, on average,
260 hours each year. The frequency of information collection is
estimated to be annual. Respondents are banking organizations with more
than $10 billion in total consolidated assets, as defined in the
guidance:
OCC:
Respondents: 50.
Estimated annual burden: 13,000 hours.
Board:
Respondents: 120.
Estimated annual burden: 31,200 hours.
FDIC:
Respondents: 22.
Estimated annual burden: 5,720 hours.
OCC: For purposes of the PRA, this information collection will be
titled Recordkeeping and Disclosure Provisions Associated with Stress
Testing Guidance.
This information collection is authorized pursuant to the National
Bank Act, (12 U.S.C. 1 et seq.; 12 U.S.C. 161) and the International
Banking Act (12 U.S.C. 3101 et seq.). The OCC expects to review the
policies and procedures for stress testing as part of its supervisory
process. To the extent the OCC collects information during an
examination of a banking organization, confidential treatment may be
afforded to the records under exemption 8 of the Freedom of Information
Act (``FOIA''), 5 U.S.C. 552(b)(8). Comments should also be sent to the
Communications Division, Office of the Comptroller of the Currency,
Mailstop 2-3, Attention: 1557-NEW, 250 E Street, SW., Washington, DC
20219. In addition, comments may be sent by fax to (202) 874-5274 or by
electronic mail to regs.comments@occ.treas.gov. You may personally
inspect and photocopy comments at the OCC, 250 E Street, SW.,
Washington, DC 20219. For security reasons, the OCC requires that
visitors make an appointment to inspect comments. You may do so by
calling (202) 874-4700. Upon arrival, visitors will be required to
present valid government-issued photo identification and to submit to
security screening in order to inspect and photocopy comments.
Additionally, please send a copy of your comments by mail to: OCC Desk
Officer, 1557-NEW, U.S. Office of Management and Budget, 725 17th
Street, NW., 10235, Washington, DC 20503, or by fax to (202)
395-6974. For further information or to request a copy of the OCC's
collection, please contact Mary H. Gottlieb, OCC Clearance Officer,
(202) 874-5090, Legislative and Regulatory Activities Division, OCC,
250 E Street, SW., Washington, DC 20219.
Board: For purposes of the PRA, this information collection will be
titled Recordkeeping and Disclosure Provisions Associated with Stress
Testing Guidance. The agency form number for the collection is FR 4202.
The agency control number for this new collection will be assigned by
OMB.
This information collection is authorized pursuant to sections
11(a), 11(i), 25, and 25A of the Federal Reserve Act (12 U.S.C. 248(a),
248(i), 602, and 611), section 5 of the Bank Holding Company Act (12
U.S.C. 1844), and section 7(c) of the International Banking Act (12
U.S.C. 3105(c)). The Board expects to review the policies and
procedures for stress testing as part of the Board's supervisory
process. To the extent the Board collects information during an
examination of a banking organization, confidential treatment may be
afforded to the records under exemption 8 of the Freedom of Information
Act (``FOIA''), 5 U.S.C. 552(b)(8).
Comments on the collection of information should be sent to Cynthia
Ayouch, Acting Federal Reserve Board Clearance Officer, Division of
Research and Statistics, Mail Stop 95-A, Board of Governors of the
Federal Reserve System, Washington, DC 20551, with copies of such
comments sent to the Office of Management and Budget, Paperwork
Reduction Project (Docket No. OP-1374), Washington, DC 20503.
Comments are invited on:
(1) Whether the proposed collection of information is necessary for
the proper performance of the Federal Reserve's functions, including
whether the information has practical utility;
(2) The accuracy of the Federal Reserve's estimate of the burden of
the proposed information collection, including the cost of compliance;
(3) Ways to enhance the quality, utility, and clarity of the
information to be collected; and
(4) Ways to minimize the burden of information collection on
respondents, including through the use of automated collection
techniques or other forms of information technology.

[[Page 35077]]

FDIC: You may submit comments by any of the following methods:
Agency Web site: http://www.FDIC.gov/regulations/laws/federal/propose.html. Follow the instructions for submitting comments.
Federal eRulemaking Portal: http://www.regulations.gov.
Follow the instructions for submitting comments.
E-mail: comments@FDIC.gov. Include ``Stress Testing
Guidance'' in the subject line of the message. Comments received will
be posted without change to http://www.FDIC.gov/regulations/laws/federal/propose.html, including any personal information provided.
Mail: Robert E. Feldman, Executive Secretary, Attention:
Comments/Legal ESS, Federal Deposit Insurance Corporation, 550 17th
Street, NW., Washington, DC 20429.
Hand Delivery/Courier: Guard station at the rear of the
550 17th Street Building (located on F Street), on business days
between 7 a.m. and 5 p.m. (EDT). Comments are invited on:
(1) Whether the proposed collection of information is necessary for
the proper performance of the Federal Reserve's functions, including
whether the information has practical utility;
(2) The accuracy of the agencies' estimate of the burden of the
proposed information collection, including the cost of compliance;
(3) Ways to enhance the quality, utility, and clarity of the
information to be collected; and
(4) Ways to minimize the burden of information collection on
respondents, including through the use of automated collection
techniques or other forms of information technology.

B. Regulatory Flexibility Act Analysis

Board:
While the guidance is not being adopted as a rule, the Board has
considered the potential impact of the proposed guidance on small
banking organizations in accordance with the Regulatory Flexibility Act
(5 U.S.C. 603(b)). For the reason discussed in the Supplementary
Information above, the Board is issuing the proposed guidance to
emphasize the importance of stress testing as an ongoing risk
management practice to support a banking organization's forward-looking
assessment of risks in order to better equip such organization to
address a range of adverse outcomes. The guidance provides an overview
of how a banking organization should structure its stress testing
activities to ensure they fit into the organization's overall risk
management program. The guidance outlines broad principles for a
satisfactory stress testing framework, and describes the manner in
which a banking organization should employ stress testing as an
integral component of risk management. Based on its analysis and for
the reasons stated below, the Board believes that the proposed guidance
will not have a significant economic impact on a substantial number of
small entities. Nevertheless, the Board is publishing an initial
regulatory flexibility analysis, and seeking comment on whether the
proposed guidance would impose undue burdens on, or have unintended
consequences for, small organizations.
Under regulations issued by the Small Business Administration
(``SBA''), a small banking organization is defined as a banking
organization with total assets of $175 million or less. See 13 CFR
121.201. The guidance being proposed by the Board is intended for
banking organizations supervised by the agencies with more than $10
billion in total assets, including state member banks, bank holding
companies, and U.S. branches and agencies of foreign banking
organizations. Banking organizations that are subject to the proposed
guidance therefore substantially exceed the $175 million total asset
threshold at which a banking organization is considered a small banking
organization under SBA regulations.
In light of the foregoing, the Board does not believe that the
proposed guidance, if adopted in final form, would have a significant
economic impact on a substantial number of small entities. As noted
above, the Board specifically seeks comment on whether the proposed
guidance would impose undue burdens on, or have unintended consequences
for, small organizations and whether there are ways such potential
burdens or consequences could be addressed in a manner consistent with
the guidance.

V. Proposed Guidance

The text of the proposed guidance is as follows:

Office of the Comptroller of the Currency

Federal Reserve System

Federal Deposit Insurance Corporation

Guidance on Stress Testing for Banking Organizations With Total
Consolidated Assets of More Than $10 Billion

I. Introduction

All banking organizations should have the capacity to understand
fully their risks and the potential impact of stressful events and
circumstances on their financial condition. The U.S. Federal banking
agencies have previously highlighted the use of stress testing as a
means to better understand the range of a banking organization's
potential risk exposures.\1\ The 2007-2009 financial crisis further
underscored the need for banking organizations to incorporate stress
testing into their risk management practices, demonstrating that
banking organizations unprepared for stressful events and circumstances
can suffer acute threats to their financial condition and viability.\2\
The Federal Reserve, the Office of the Comptroller of the Currency, and
the Federal Deposit Insurance Corporation (collectively, the
``agencies'') are issuing this guidance to emphasize the importance of
stress testing as an ongoing risk management practice that supports
banking organizations' forward-looking assessment of risks and better
equips them to address a range of adverse outcomes. This proposed joint
guidance is applicable to all institutions supervised by the agencies
with more than $10 billion in total consolidated assets. Specifically,
with respect to the OCC, these banking organizations would include
national banking associations and Federal branches and agencies; with
respect to the Board, these banking organizations would include state
member banks, bank holding companies, and all other institutions for
which the Federal Reserve is the primary Federal supervisor; with
respect to the FDIC, these banking organizations would include state

[[Page 35078]]

nonmember insured banks or insured branches of foreign banks.
---------------------------------------------------------------------------

\1\ See, for example, Supervision and Regulation (SR) letter 10-
6 or OCC Bulletin 2010-13 or FDIC FIL-13-2010, ``Interagency Policy
Statement on Funding and Liquidity Risk Management''; SR 10-1 or OCC
Bulletin 2010-1 or FDIC FIL-2-2010, ``Interagency Advisory on
Interest Rate Risk''; SR letter 09-04, ``Applying Supervisory
Guidance and Regulations on the Payment of Dividends, Stock
Redemptions, and Stock Repurchases at Bank Holding Companies''; SR
letter 07-1, ``Interagency Guidance on Concentrations in Commercial
Real Estate'' or OCC Bulletin 2006-46 or FDIC FIL-104-2006,
``Interagency Guidance on CRE Concentration Risk Management''; SR
letter 99-18, ``Assessing Capital Adequacy in Relation to Risk at
Large Banking Organizations and Others with Complex Risk Profiles'';
OCC Bulletin 2008-20 or FDIC FIL-71-2008 ``Supervisory Guidance:
Supervisory Review Process of Capital Adequacy (Pillar 2) Related to
the Implementation of the Basel II Advanced Capital Framework''; the
Supervisory Capital Assessment Program (see http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20080715a1.pdf);
and Comprehensive Capital Analysis and Review: Objectives and
Overview (see www.federalreserve.gov/newsevents/press/bcreg/20110318a.htm).
\2\ Moreover, the Dodd-Frank Wall Street Reform and Consumer
Protection Act (Pub. L. 111-203, 124 Stat. 1376) requires financial
organizations with more than $10 billion in total consolidated
assets to conduct a stress test at least annually. See generally 12
U.S.C. 5365(i)(2).
---------------------------------------------------------------------------

Building upon previously issued supervisory guidance that discusses
the uses and merits of stress testing in specific areas of risk
management, this guidance provides an overview of how a banking
organization should structure its stress testing activities and ensure
they fit into overall risk management. The guidance outlines broad
principles for a satisfactory stress testing framework and describes
the manner in which stress testing should be employed as an integral
component of risk management that is applicable at various levels of
aggregation within a banking organization, as well as for contributing
to capital and liquidity planning. While the guidance is not intended
to provide detailed instructions for conducting stress testing for any
particular risk or business area, the document describes several types
of stress testing activities and how they may be most appropriately
used by banking organizations.

II. Overview of Stress Testing Framework

For purposes of this guidance, stress testing refers to exercises
used to conduct a forward-looking assessment of the potential impact of
various adverse events and circumstances on a banking organization.
Stress testing occurs at various levels of aggregation, including on an
enterprise-wide basis. As outlined in section IV, there are several
approaches and applications for stress testing and a banking
organization should consider the use of each in its stress testing
framework.
An effective stress testing framework provides a comprehensive,
integrated, and forward-looking set of activities for a banking
organization to employ along with other practices in order to assist in
the identification and measurement of its material risks and
vulnerabilities, including those that may only manifest themselves
during stressful economic or financial environments, or arise from
firm-specific adverse events. Such a framework should supplement other
quantitative risk management practices, such as those that rely
primarily on statistical estimates of risk or loss estimates based on
historical data, as well as qualitative practices. In this manner,
stress testing can assist in highlighting unidentified or under-
assessed risk concentrations and interrelationships and their potential
impact on the banking organization during times of stress.\3\
---------------------------------------------------------------------------

\3\ For purposes of this guidance, the term ``concentrations''
refers to groups of exposures and/or activities that have the
potential to produce losses large enough to bring about a material
change in a banking organization's risk profile or financial
condition.
---------------------------------------------------------------------------

A banking organization should develop and implement its stress
testing framework in a manner commensurate with its size, complexity,
business activities, and overall risk profile. Its stress testing
framework should include clearly defined objectives, well-designed
scenarios tailored to the banking organization's business and risks,
well-documented assumptions, sound methodologies to assess potential
impact on the banking organization's financial condition, informative
management reports, ongoing and effective review of stress testing
processes, and recommended actions based on stress test results. Stress
testing should incorporate the use of high-quality data to ensure that
the outputs are sufficiently credible to support decision-making.
Importantly, a banking organization should have a sound governance and
control infrastructure with objective, critical review to ensure the
stress testing framework is functioning as intended.
A stress testing framework should allow a banking organization to
conduct consistent, repeatable exercises that focus on its material
risks, exposures, activities, and strategies, and also conduct ad hoc
scenarios as needed. The framework should consider the impact of both
firm-specific and systemic stress events and circumstances that are
based on historical experience as well as on hypothetical occurrences
that could have an adverse impact on a banking organization's
operations and financial condition. Banking organizations subject to
this guidance should formally review and assess the effectiveness of
their stress testing frameworks at least once per year.

III. General Stress Testing Principles

A banking organization should develop and implement an effective
stress testing framework as part of its broader risk management and
governance processes. The framework should include several activities
and exercises, and not just rely on any single test or type of test,
since every stress test has limitations and relies on certain
assumptions.
The uses of a banking organization's stress testing framework
should include, but are not limited to, augmenting risk identification
and measurement; estimating business line revenues and losses and
informing business line strategies; identifying vulnerabilities and
assessing their potential impact; assessing capital adequacy and
enhancing capital planning; assessing liquidity adequacy and informing
contingency funding plans; contributing to strategic planning; enabling
senior management to better integrate strategy, risk management, and
capital and liquidity planning decisions; and assisting with recovery
planning. This section describes general principles that a banking
organization should apply in implementing such a framework.
Principle 1: A banking organization's stress testing framework
should include activities and exercises that are tailored to and
sufficiently capture the banking organization's exposures, activities,
and risks.
An effective stress testing framework covers a banking
organization's full set of material activities, exposures, and risks,
whether on or off the balance sheet. The framework should also address
non-contractual sources of risks, such as those related to a banking
organization's reputation. Appropriate coverage is important as stress
test results could give a false sense of comfort if certain portfolios,
exposures, or business line activities are not captured. Stress testing
exercises should be part of a banking organization's regular risk
identification and measurement activities. For example, in assessing
credit risk a banking organization should evaluate the potential impact
of adverse outcomes, such as an economic downturn or declining asset
values, on the condition of its borrowers and counterparties, and on
the value of any supporting collateral. As another example, in
assessing interest-rate risk, banking organizations should analyze the
effects of significant interest rate shocks or other yield-curve
movements.
An effective stress testing framework should be applied at various
levels in the banking organization, such as business line, portfolio,
and risk type, as well as on an enterprise-wide basis. In many cases,
stress testing may be more effective at business line and portfolio
levels, as a higher level of aggregation may cloud or underestimate the
potential impact of adverse outcomes on a banking organization's
financial condition. In some cases, stress testing can also be applied
to individual exposures or instruments. Each stress test should be
tailored to the relevant level of aggregation, capturing critical risk
drivers, internal and external influences, and other key considerations
at the relevant level.
Stress testing should capture the interplay among different
exposures, activities, and risks and their combined

[[Page 35079]]

effects. While stress testing several types of risks or business lines
simultaneously may prove operationally challenging, a banking
organization should aim to identify common risk drivers across risk
types and business lines that can adversely affect its financial
condition. Accordingly, stress tests should provide a banking
organization with the ability to identify potential concentrations--
including those that may not be readily observable during benign
periods and whose sensitivity to a common set of factors is apparent
only during times of stress--and to assess the impact of identified
concentrations of exposures, activities, and risks within and across
portfolios and business lines.
Stress testing should be tailored to the banking organization's
idiosyncrasies and specific business mix and include all major business
lines and significant individual counterparties. For example, a banking
organization that is geographically concentrated may determine that a
certain segment of its business may be more adversely affected by
shocks to economic activity at the state or local level than by a
severe national recession. On the other hand, if the banking
organization has significant global operations, it should consider
scenarios that have an international component and stress conditions
that could affect the different aspects of its operations in different
ways, as well as conditions that could adversely affect all of its
operations at the same time.
A banking organization should use its stress testing framework to
determine whether exposures, activities, and risks are aligned with the
banking organization's risk appetite.\4\ A banking organization can use
stress testing to help inform decisions about its strategic direction
and/or risk appetite by better understanding the risks of its exposures
or of engaging in certain business practices. For example, if a banking
organization pursues a business strategy for a new or modified product,
and the banking organization does not have long-standing experience
with that product or lacks extensive data, the banking organization can
use stress testing to identify the product's potential downsides and
unanticipated risks. Scenarios used in a banking organization's stress
tests should be relevant to the direction and strategy set by its board
of directors, as well as sufficiently severe to be credible to internal
and external stakeholders.
---------------------------------------------------------------------------

\4\ For purposes of this guidance, risk appetite is defined as
the level and type of risk an organization is able and willing to
assume in its exposures and business activities, given its business
objectives and obligations to stakeholders. See Senior Supervisors
Group report, ``Observations on Developments in Risk Appetite
Frameworks and IT Infrastructure,'' December 2010 (see http://www.newyorkfed.org/newsevents/news/banking/2010/an101223.pdf).
---------------------------------------------------------------------------

Principle 2: An effective stress testing framework employs multiple
conceptually sound stress testing activities and approaches.
All estimates of risk, including stress tests, have an element of
uncertainty due to assumptions, limitations, and other factors
associated with using past performance measures and forward-looking
estimates. Banking organizations should, therefore, use multiple stress
testing activities and approaches (consistent with section IV), and
ensure that each is conceptually sound. Stress tests usually vary in
design and complexity, including the number of factors employed and the
degree of stress applied. A banking organization should ensure that the
complexity of any given test does not undermine its integrity,
usefulness, or clarity. In many cases, relatively simple tests can be
very useful and informative.
Additionally, effective stress testing relies on high-quality input
data and information to produce credible outcomes. A banking
organization should ensure that it has readily available data and other
information for the types of stress tests it uses, including key
variables that drive performance. In addition, a banking organization
should have appropriate management information systems (MIS) and data
processes that enable it to collect, sort, aggregate, and update data
and other information efficiently and reliably within business lines
and across the banking organization for use in stress testing. If
certain data and information are not current or not available, a
banking organization should analyze the stress test outputs with an
understanding of those data limitations.
A banking organization should also document the assumptions used in
its stress tests and note the degree of uncertainty that may be
incorporated into the tools used for stress testing. In some cases, it
may be appropriate to present and analyze test results not just in
terms of point estimates, but also including the potential margin of
error or statistical uncertainty around the estimates. Furthermore,
almost all stress tests, including well-developed quantitative tests
supported by high-quality data, employ a certain amount of expert or
business judgment; the role and impact of such judgment should be
clearly documented. In some cases, when credible data are lacking and
more quantitative tests are operationally challenging or in the early
stages of development, a banking organization may choose to employ more
qualitatively based tests, provided that the tests are properly
documented and their assumptions are transparent. Regardless of the
type of stress tests used, a banking organization should understand and
clearly document all assumptions, uncertainties, and limitations, and
provide that information to users of the stress testing results.
Principle 3: An effective stress testing framework is forward-
looking and flexible.
A stress testing framework should be sufficiently dynamic and
flexible to incorporate changes in a banking organization's on- and
off-balance-sheet activities, portfolio composition, asset quality,
operating environment, business strategy, and other risks that may
arise over time from firm-specific events, macroeconomic and financial
market developments, or some combination of these events. A banking
organization should also ensure that its MIS are capable of
incorporating relatively rapid changes in exposures, activities, and
risks.
While stress testing should utilize available historical
information, a banking organization should look beyond assumptions
based only on historical data and challenge conventional assumptions. A
banking organization should ensure that it is not constrained by past
experience and that it considers a multiple scenarios, even scenarios
that have not occurred in the recent past or during the banking
organization's history. For example, a banking organization should not
assume that if it has suffered no or minimal losses in a certain
business line or product that such a pattern will continue. Structural
changes in customer, product, and financial markets can present
unprecedented situations for a banking organization. A banking
organization with any type of significant concentration can be
particularly vulnerable to rapid changes in economic and financial
conditions and should try to identify and better understand the impact
of those vulnerabilities in advance. For example, the risks related to
residential mortgages were underestimated for a number of years by a
large number of banking organizations, and those risks eventually
affected the banking organizations in a variety of ways. Effective
stress testing can help a banking organization identify any such
concentrations and help understand the potential impact of several key
aspects of the business being exposed to common drivers.
Stress testing should be conducted over various relevant time
horizons to

[[Page 35080]]

adequately capture both conditions that may materialize in the near
term and adverse situations that take longer to develop. For example,
when a banking organization stress tests a portfolio for market and
credit risks simultaneously, it should consider that certain credit
risk losses may take longer to materialize than market risk losses, and
also that the severity and speed of mark-to-market losses may create
significant vulnerabilities for the firm, even if a more fundamental
analysis of how realized losses may play out over time seems to show
less threatening results. A banking organization should carefully
consider the incremental and cumulative effects of stress conditions,
particularly with respect to potential interactions among exposures,
activities, and risks and possible second-order or ``knock-on''
effects.
In addition to conducting formal, routine stress tests, a banking
organization should have the flexibility to conduct new or ad hoc
stress tests in a timely manner to address rapidly emerging risks.
These less routine tests usually can be conducted in a short amount of
time and may be simpler and less extensive than a banking
organization's more formal, regular tests. However, for its ad hoc
tests, a banking organization should still have the capacity to bring
together approximated information on risks, exposures, and activities
and assess their impact.
More broadly, a banking organization should continue updating and
maintaining its stress testing framework in light of new risks, better
understanding of the banking organization's exposures and activities,
new stress testing techniques, and any changes in its operating
structure and environment. A banking organization's stress testing
development should be iterative, with ongoing adjustments and
refinements to better calibrate the tests to provide current and
relevant information. Banking organizations should document the ongoing
development of their stress testing practices.
Principle 4: Stress test results should be clear, actionable, well
supported, and inform decision-making.
Stress testing should incorporate measures that adequately and
effectively convey results of the impact of adverse outcomes. Such
measures may include, for example, changes to asset values, accounting
and economic profit and loss, revenue streams, liquidity levels, cash
flows, regulatory capital, risk-weighted assets, loan loss provisions,
internal capital estimates, levels of problem assets, breaches in
covenants or key trigger levels, or other relevant measures. Stress
test measures should be tailored to the type of test and the particular
level at which the test is applied (for example, at the business line
or risk level). Some stress tests may require using a range of measures
to evaluate the full impact of certain events, such as a severe
systemic event. In addition, all stress test results should be
accompanied by descriptive and qualitative information (such as key
assumptions and limitations) to allow users to interpret the exercises
in context. The analysis and the process should be well documented so
that stress testing processes can be replicated if need be.
A banking organization should regularly communicate stress test
results to appropriate levels within the banking organization to foster
dialogue around stress testing, to keep the board of directors,
management, and staff apprised, and to inform stress testing
approaches, results, and decisions in other areas of the banking
organization. A banking organization should maintain an internal
summary of test results to document at a high level the range of its
stress testing activities and outcomes, as well as proposed follow-up
actions. In addition, management should review stress testing
activities on a regular basis to determine, among other things, the
validity of the assumptions, the severity of tests, the robustness of
the estimates, the performance of any underlying models, and the
stability and reasonableness of the results.
Stress test results should inform analysis and decision-making
related to business strategies, limits, risk profile, and other aspects
of risk management, consistent with the banking organization's
established risk appetite. A banking organization should review the
results of its various stress tests with the strengths and limitations
of each test in mind (consistent with Principle 2), determine which
results should be given greater or lesser weight, analyze the combined
impact of its tests, and then evaluate potential courses of action
based on that analysis. A banking organization may decide to maintain
its current course based on test results; indeed, the results of highly
severe stress tests need not always indicate that immediate action has
to be taken. Wherever possible, tools such as benchmarking or other
comparative analysis should be used to evaluate the stress testing
results relative to other tools and measures, both internal and
external to the banking organization, to provide proper context and a
check on results.

IV. Stress Testing Approaches and Applications

This section discusses some general types of stress testing
approaches and applications. For any type of stress test, banking
organizations should indicate the specific purpose and the focus of the
test. Defining the scope of a given stress test is also important,
whether it applies at the portfolio, business line, risk type, or
enterprise-wide level, or even just for an individual exposure. Based
on the purpose and scope of the test, different stress testing
techniques are most useful. Thus, a banking organization should employ
several stress testing approaches and applications, as needed. Among
them should be approaches or applications such as scenario analysis,
sensitivity analysis, enterprise-wide stress testing, and reverse
stress testing. Consistent with Principle 1, banking organizations
should apply these commensurate with their size, complexity, and
business profile, and may not need to incorporate all of the details
described below. Consistent with Principle 3, banking organizations
should also recognize that stress testing approaches will evolve over
time and they should update their practices as needed.

Scenario Analysis

Scenario analysis refers to a type of stress testing in which a
banking organization applies historical or hypothetical scenarios to
assess the impact of various events and circumstances, including
extreme ones. Scenarios usually involve some kind of coherent, logical
narrative or ``story'' as to why certain events and circumstances are
occurring and in which combination and order, such as a severe
recession, failure of a major counterparty, loss of major clients,
natural or man-made disaster, localized economic downturn, or a sudden
change in interest rates brought about by unfavorable inflation
developments. Scenario analysis can be applied at various levels of the
banking organization, such as within individual business lines to help
identify factors that could harm those business lines most.
Stress scenarios should reflect a banking organization's unique
vulnerabilities to factors that affect its exposures, activities, and
risks. For example, if a banking organization is concentrated in a
particular line of business, such as commercial real estate or
residential mortgage lending, it would be appropriate to explore the
impact of a downturn in those particular market segments. Similarly, a
banking organization with lending

[[Page 35081]]

concentrations to oil and gas companies should include scenarios
related to the energy sector. Other relevant factors to be considered
in scenario analysis relate to reputational and legal risks to a
banking organization, such as an existing major lawsuit, potential
litigation, or a situation when a banking organization feels compelled
to provide support to an affiliate or provide other types of non-
contractual support to avoid reputational damage. Scenarios should be
internally consistent and portray realistic outcomes based on
underlying relationships among variables, and should include only those
mitigating developments that are consistent with the scenario.
Additionally, a banking organization should consider the best manner to
try to capture combinations of stressful events and circumstances,
including second-order and ``knock-on'' effects. Ultimately, a banking
organization should select and design multiple scenarios that are
relevant to its profile and make intuitive sense, use enough scenarios
to explore the range of potential outcomes, and ensure that the
scenarios continue to be timely.
A banking organization may apply scenario analysis within the
context of its existing risk measurement tools (e.g., the impact of a
severe decline in market prices on a banking organization's value-at-
risk (VaR) measure) or use it as an alternative, supplemental measure.
For instance, a banking organization may use scenario analysis to
measure the impact of a severe financial market disturbance and compare
those results to what is produced by its VaR or other measures. This
type of scenario analysis should account for known shortcomings of
other risk measurement frameworks. For example, market risk VaR models
generally assume liquid markets with known prices. Scenario analysis
could shed light on the effects of a breakdown in liquidity and
valuation difficulties.
One of the key challenges with scenario analysis is to translate a
scenario into balance sheet impact, changes in risk measures, potential
losses, or other measures of adverse financial impact, which would vary
depending on the test design and the type of scenario used. For some
aspects of scenario analysis, banking organizations may use econometric
or similar types of analysis to estimate a relationship between some
underlying factors or drivers and risk estimates or loss projections
based on a given data set, and then extrapolate to see the impact of
more severe inputs. Care should be taken not to make assumptions that
relationships from benign or mildly adverse times will hold during more
severe times or that estimating such relationships is relatively
straightforward. For example, linear relationships between risk drivers
and losses may become nonlinear during times of stress.

Sensitivity Analysis

Sensitivity analysis refers to a banking organization's assessment
of its exposures, activities, and risks when certain variables,
parameters, and inputs are ``stressed'' or ``shocked.'' A key goal of
sensitivity analysis is to test the impact of assumptions on outcomes.
Generally, sensitivity analysis differs from scenario analysis in that
it involves changing variables, parameters, or inputs without an
explicit underlying reason or narrative, in order to explore what
occurs under a range of inputs and at extreme or highly adverse levels.
In this type of analysis a banking organization may realize, for
example, that a given relationship is much more difficult to estimate
at extreme levels.
A banking organization may apply sensitivity analysis at various
levels of aggregation to estimate the impact from a change in one or
more key variables. The results may help a banking organization better
understand the range of outcomes from some of its models, such as
developing a distribution of output based on a variety of extreme
inputs. For example, a banking organization may choose to calculate a
range of changes to a structured security's overall value using a range
of different assumptions about the performance and linkage of
underlying cash flows. Sensitivity analysis should be conducted
periodically due to potential changes in a banking organization's
exposures, activities, operating environment, or the relationship of
variables to one another.
Sensitivity analysis can also help to assess a combined impact on a
banking organization of several variables, parameters, factors, or
drivers. For example, a banking organization could better understand
the impact on its credit losses from a combined increase in default
rates and a decrease in collateral values. A banking organization could
also explore the impact of highly adverse capitalization rates,
declines in net operating income, and reductions in collateral when
evaluating its risks from commercial real estate exposures. Sensitivity
analysis can be especially useful because it is not necessarily
accompanied by a particular narrative or scenario; that is, sensitivity
analysis can provide banking organizations more flexibility to explore
the impact of potential stresses that they may not be able to capture
in designed scenarios. Furthermore, banking organizations may decide to
conduct sensitivity analysis of their scenarios, i.e., choosing
different levels or paths of variables to understand the sensitivities
of choices made during scenario design. For instance, banking
organizations may decide to apply a few different interest-rate paths
for a given scenario.

Enterprise-Wide Stress Testing

Enterprise-wide stress testing is an application of stress testing
that involves assessing the impact of certain specified scenarios on
the banking organization as a whole, particularly on capital and
liquidity. As is the case with scenario analysis more generally,
enterprise-wide stress testing involves robust scenario design and
effective translation of scenarios into measures of impact. Enterprise-
wide stress tests can help a banking organization in its efforts to
assess the impact of its full set of risks under adverse events and
circumstances, but should be supplemented with other stress tests and
other risk measurement tools given inherent limitations in capturing
all risks and all adverse outcomes in one test.
Scenario design for enterprise-wide stress testing involves
developing scenarios that affect the banking organization as a whole
that stem from macroeconomic, market-wide, and firm-specific events.
These scenarios should incorporate the potential simultaneous
occurrence of both firm-specific and macroeconomic and market-wide
events, considering system-wide interactions and feedback effects. For
example, price shocks may lead to significant portfolio losses, rising
funding gaps, a ratings downgrade, and diminished access to funding. In
general, it is a good practice to consult with a large set of
individuals within the banking organization--in various business lines,
research and risk areas--to gain a wide perspective on how enterprise-
wide scenarios should be designed and to ensure that the scenarios
capture the relevant aspects of the banking organization's business and
risks. Banking organizations should also conduct scenarios of varying
severity to gauge the relative impact. At least some scenarios should
be of sufficient severity to challenge the viability of the banking
organization, and should include instant market shocks and stressful
periods of extensive duration (e.g., not just a one or two-quarter
shock after which conditions return to normal).
Selection of scenario variables is important for enterprise-wide
tests,

[[Page 35082]]

because they generally serve as the link between the overall narrative
of the scenario and tangible impact on the banking organization as a
whole. For instance, in aiming to capture the combined impact of a
severe recession and a financial market downturn, a banking
organization may choose a set of variables such as changes in GDP,
unemployment rate, interest rates, stock market levels, or home price
levels. However, particularly when assessing the impact on the whole
banking organization, using a large number of variables can make a test
more cumbersome and complicated--so a banking organization may also
benefit from simpler scenarios or from those with fewer variables.
Banking organizations should balance the comprehensiveness of
contributing variables and tractability of the exercise.
As with scenario analysis generally, translating scenarios into
tangible effects on the banking organization as a whole presents
certain challenges. An institution should identify appropriate and
meaningful mechanisms for translating scenarios into relevant internal
risk parameters that provide a banking organization-wide view of risks
and understanding of how the risks are translated into loss estimates.
Not all business areas are equally affected by a given scenario, and
problems in one business area can have effects on other units. However,
for an enterprise-wide test, assumptions across business lines and risk
areas should remain constant for the chosen scenario, since the
objective is to see how the banking organization as a whole responds to
a common outcome.

Reverse Stress Testing

Reverse stress testing is a tool that allows a banking organization
to assume a known adverse outcome, such as suffering a credit loss that
breaches regulatory capital ratios or suffering severe liquidity
constraints making it unable to meet its obligations, and then deduce
the types of events that could lead to such an outcome. This type of
stress testing may help a banking organization to consider scenarios
beyond its normal business expectations and see the impact of severe
systemic effects on the banking organization. It also allows a banking
organization to challenge common assumptions about its performance and
expected mitigation strategies.
Reverse stress testing helps to explore so-called ``break the
bank'' situations, allowing a banking organization to set aside the
issue of estimating the likelihood of severe events and to focus more
on what kinds of events could threaten the viability of the banking
organization. Reverse stress testing helps a banking organization
evaluate the combined effect of several types of extreme events and
circumstances that might threaten the survival of the banking
organization, even if in isolation each of the effects might be
manageable. For instance, reverse stress testing may help a banking
organization recognize that a certain level of unemployment would have
a severe impact on credit losses, that a market disturbance could
create additional losses and result in rising funding costs, and that a
firm-specific case of fraud would cause even further losses and
reputational impact that could threaten a banking organization's
viability. In some cases, reverse stress tests could reveal to a
banking organization that ``breaking the bank'' is not as remote an
outcome as originally thought.
Given the numerous potential threats to a banking organization's
viability, the organization should ensure that it focuses first on
those scenarios that have the largest firm-wide impact, such as
insolvency or illiquidity, but also on those that seem most imminent
given the current environment. Focusing on the most prominent
vulnerabilities helps a banking organization prioritize its choice of
scenarios for reverse stress testing. However, a banking organization
should also consider a wider range of possible scenarios that could
jeopardize the viability of the banking organization, exploring what
could represent potential blind spots.

V. Stress Testing for Assessing the Adequacy of Capital and Liquidity

There are many uses of stress testing within banking organizations.
Prominent among these are stress tests designed to assess the adequacy
of capital and liquidity. Given the importance of capital and liquidity
to a banking organization's viability, stress testing should be applied
in these two areas in particular, including an evaluation of the
interaction between capital and liquidity and the potential for both to
become impaired at the same time. Depletions and shortages of capital
or liquidity can cause a banking organization to no longer perform
effectively as a financial intermediary, be viewed by its
counterparties as no longer viable, become insolvent, or diminish its
capacity to meet legal and financial obligations. A banking
organization's capital and liquidity stress testing should consider how
earnings, capital, and liquidity would be affected in an environment in
which multiple risks manifest themselves at the same time, for example,
an increase in credit losses during an adverse interest-rate
environment. Additionally, banking organizations should recognize that
at the end of the time horizon considered by a given stress test, the
banking organization may still have substantial residual risks or
problem exposures that may continue to pressure capital and liquidity
resources.
Stress testing for capital and liquidity adequacy should be
conducted in coordination with a banking organization's overall
strategy and annual planning cycles. Results should be refreshed in the
event of major strategic decisions, or other decisions that can
materially impact capital or liquidity. Banking organizations should
conduct stress testing for capital and liquidity adequacy periodically.

Capital Stress Testing \5\

Capital stress testing results can serve as a useful tool to
support a banking organization's capital planning and corporate
governance.\6\ They may help a banking organization better understand
its risks and evaluate the impact of adverse outcomes on its capital
position and ensure that the banking organization holds adequate
capital given its business model, including the complexity of its
activities and its risk profile. Capital stress testing supplements a
banking organization's regulatory capital analysis by providing a
forward-looking assessment of capital adequacy, usually with a forecast
horizon of at least two years, and highlighting the potential adverse
effects on capital levels and ratios of risks not fully captured in
regulatory capital requirements. It should also be used to help a
banking organization assess the quality and composition of capital and
its ability to absorb losses. Stress testing can aid capital
contingency planning by helping management identify exposures or risks
that would need to be reduced and actions that could be taken to
bolster capital levels or otherwise maintain capital adequacy, as well
as actions that in times of stress might not be possible--such as
raising capital.
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\5\ The portions of this guidance related to capital stress
testing do not apply to U.S. branches and agencies of foreign
banking organizations.
\6\ In this manner, stress testing can form an integral part of
an organization's internal capital adequacy process, consistent with
supervisory standards outlined in SR letter 09-04, SR letter 99-18,
OCC Bulletin 2008-20 or FDIC FIL-71-2008 ``Supervisory Guidance:
Supervisory Review Process of Capital Adequacy (Pillar 2) Related to
the Implementation of the Basel II Advanced Capital Framework.''
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A capital stress testing framework should include exercises that
analyze the potential for changes in earnings,

[[Page 35083]]

losses, reserves, and other potential effects on capital under a
variety of stressful circumstances. The framework should also capture
any potential change in risk-weighted assets, the ability of capital to
absorb losses, and any resulting impact on the banking organization's
capital ratios. The framework should include all relevant risk types
that have a potential to affect capital adequacy, whether directly or
indirectly. A banking organization should also explore the potential
for possible balance sheet expansion to put pressure on capital ratios
and consider mitigation options, other than simply shrinking the
balance sheet. Capital stress testing should assess the potential
impact of a banking organization's material subsidiaries suffering
capital problems on their own, even if the consolidated banking
organization is not encountering problems.\7\
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\7\ For regulated subsidiaries, stress testing activities should
be fully consistent with the regulations and guidance of the
relevant primary Federal supervisor.
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Enterprise-wide stress testing, as described in section IV, should
be an integral part of a banking organization's capital stress testing.
Such enterprise-wide testing should include pro forma estimates of not
only potential losses and resources available to absorb losses, but
also potential planned capital actions (such as dividends or share
repurchases) that would affect the banking organization's capital
position, including regulatory and other capital ratios. There should
also be consideration of the impact on the banking organization's
provision for loan and lease losses and other relevant financial
metrics. Even with very effective enterprise-wide tests, banking
organizations should use capital stress testing in conjunction with
other internal approaches (in addition to regulatory measures) for
assessing capital adequacy, such as those that rely primarily on
statistical estimates of risk or loss estimates based on historical
data.

Liquidity Stress Testing

A banking organization should also conduct stress testing for
liquidity adequacy.\8\ Through such stress testing a banking
organization can work to identify vulnerabilities related to liquidity
adequacy in light of both firm-specific and market-wide stress events
and circumstances. Effective stress testing helps a banking
organization identify and quantify the depth, source, and degree of
potential liquidity strain and to analyze possible impacts on its cash
flows, liquidity position, profitability, and other aspects of its
financial condition over various time horizons. For example, stress
testing can be used to explore potential funding shortfalls, shortages
in liquid assets, the inability to issue debt, exposure to possible
deposit outflows, volatility in short-term brokered deposits, and the
impact of reduced collateral values on borrowing capacity at the
Federal Home Loan Banks, the Federal Reserve discount window, or other
secured wholesale funding sources.
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\8\ See SR letter 10-6, OCC Bulletin 2010-13, OCC Bulletin 2010-
1, and SR letter 10-1.
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Liquidity stress testing should explore the potential impact of
adverse developments that may affect market and asset liquidity,
including the freezing up of credit and funding markets, and the
corresponding impact on the banking organization. Such tests can also
help identify the conditions under which balance sheets might expand,
thus creating additional funding needs (e.g., through accelerated
drawdowns on unfunded commitments). These tests also help determine
whether the banking organization has a sufficient liquidity buffer to
meet various types of future liquidity demands. In this regard,
liquidity stress testing should be an integral part of the development
and maintenance of a banking organization's contingency funding
planning. Liquidity stress testing should include enterprise-wide tests
as discussed in section IV, but should also be applied, as appropriate,
at lower levels of the banking organization, particularly for entities
that might face regulatory restrictions or limitations on receiving or
providing funds. As with capital stress testing, banking organizations
may need to conduct liquidity stress tests at both the consolidated and
subsidiary level. In undertaking enterprise-wide liquidity tests
banking organizations should make realistic assumptions as to the
implications of liquidity stresses in one part of the banking
organization on other parts.
An effective stress testing framework should explore the potential
for capital and liquidity problems to arise at the same time or
exacerbate one another. For example, a banking organization in a
stressed liquidity position is often required to take actions that have
a negative direct or indirect capital impact (e.g., selling assets at a
loss or incurring funding costs at above market rates to meet funding
needs). A banking organization's liquidity stress analysis should
explore situations in which the banking organization may be operating
with a capital position that exceeds regulatory minimums, but is
nonetheless viewed within the financial markets or by its
counterparties as being of questionable viability. As with other
applications of stress testing, for its capital and liquidity stress
tests, it is beneficial for a banking organization to articulate
clearly its objectives for a post-stress outcome, for instance to
remain a viable financial market participant that is able to meet its
existing and prospective obligations and commitments.

VI. Governance

Similar to other aspects of its risk management, a banking
organization's stress testing framework will be effective only if it is
subject to strong governance and controls to ensure the framework is
functioning as intended. Strong governance and controls help ensure
that the framework contains core elements, from clearly defined stress
testing objectives to recommended actions. Importantly, strong
governance provides critical review of elements of the stress testing
framework, especially regarding key assumptions, uncertainties, and
limitations. A banking organization should ensure that the stress
testing framework is not isolated within a banking organization's risk
management function, but is firmly integrated into business lines,
capital and asset-liability committees, and other decision-making
bodies. The extent and sophistication of a banking organization's
governance over its stress testing framework should align with the
extent and sophistication of that framework.
Governance over a banking organization's stress testing framework
rests with the banking organization's board of directors and senior
management. As part of their overall responsibilities, a banking
organization's board and senior management should establish a
comprehensive, integrated and effective stress testing framework that
fits into the broader risk management of the banking organization.
While the board is ultimately responsible for ensuring that the banking
organization has an effective stress testing framework, senior
management generally has responsibility for implementing that
framework. Senior management duties should include establishing
adequate policies and procedures and ensuring compliance with those
policies and procedures, assigning competent staff, overseeing stress
test development and implementation, evaluating stress test results,
reviewing any findings related to the functioning of stress test
processes, and taking prompt remedial action where necessary. Senior
management, directly and through

[[Page 35084]]

relevant committees, also should be responsible for regularly reporting
to the board on stress testing developments and results from individual
and collective stress tests as well as on compliance with stress
testing policy. Board members should actively evaluate and discuss
these reports, ensuring that the stress testing framework is in line
with the banking organization's risk appetite, overall strategy and
business plans, and directing changes where appropriate.
A banking organization should have written policies, approved and
annually reviewed by the board, that direct and govern the
implementation of the stress testing framework in a comprehensive
manner. Policies, along with procedures to implement them, should:
Describe the overall purpose of stress testing activities;
Articulate consistent and sufficiently rigorous stress
testing practices across the entire banking organization;
Indicate stress testing roles and responsibilities,
including controls over external resources used for any part of stress
testing (such as vendors and data providers);
Describe the frequency and priority with which stress
testing activities should be conducted;
Indicate how stress test results are used and by whom;
Be reviewed and updated as necessary to ensure that stress
testing practices remain appropriate and keep up to date with changes
in market conditions, banking organization products and strategies,
banking organization exposures and activities, the banking
organization's established risk appetite, and industry stress testing
practices.
A stress testing framework should incorporate validation or other
type of independent review to ensure the integrity of stress testing
processes and results, consistent with existing supervisory
expectations.\9\ If a banking organization engages a third party vendor
to support some or all of its stress testing activities, there should
be appropriate controls in place to ensure that those externally-
developed systems and processes are sound, applied correctly, and
appropriate for the banking organization's risks, activities, and
exposures. Additionally, senior management should be mindful of any
potential inconsistencies, contradictions, or gaps among its stress
tests and assess what actions should be taken as a result. Internal
audit should also play a role focused on ensuring the ongoing
performance, integrity, and reliability of the stress testing
framework. A banking organization should ensure that its stress tests
are documented appropriately, including a description of the types of
stress tests and methodologies used, key assumptions, results, and
suggested actions. The board and senior management should review stress
testing activities and results with an appropriately critical eye and
ensure that there is objective review of all stress testing processes.
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\9\ For validation of models and other quantitative tools used
for stress testing, see OCC Bulletin 2011-12 ``Supervisory Guidance
on Model Risk Management'', or SR letter 11-7, ``Guidance on Model
Risk Management.''
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The results of stress testing analyses should facilitate decision-
making by the board and senior management. Stress testing results
should be used to inform the board about alignment of the banking
organization's risk profile with the board's chosen risk appetite, as
well as inform operating and strategic decisions. Stress testing
results should be considered directly by the board and senior
management for decisions relating to capital and liquidity adequacy,
including capital contingency plans and contingency funding plans. The
board and senior management should ensure that the stress testing
framework includes a sufficient range of stress testing activities
applied at the appropriate levels of the banking organization (i.e.,
not just one enterprise-wide stress test). Sound governance also
includes using stress testing to consider the effectiveness of a
banking organization's risk mitigation techniques for various risk
types over their respective time horizons, such as to explore what
could occur if expected mitigation techniques break down during
stressful periods.

VII. Conclusion

A banking organization should use the principles laid out in this
guidance to develop, implement, and maintain an effective stress
testing framework. Such a framework should be adequately tailored to
the banking organization's size, complexity, risks, exposures, and
activities. A key purpose of stress testing is to explore various types
of possible outcomes, including rare and extreme events and
circumstances, assess their impact on the banking organization, and
then evaluate the boundaries up to which the banking organization plans
to be able to withstand such outcomes.
While stress testing can provide valuable information regarding
potential future outcomes, similar to any other risk management tool it
has limitations and cannot provide absolute certainty regarding the
implications of assumed events and impacts. Furthermore, management
should ensure that stress testing activities are not constrained to
reflect past experiences, but instead consider a broad range of
possibilities. No single stress test can accurately estimate the impact
of all stressful events and circumstances; therefore, a banking
organization should understand and account for stress testing
limitations and uncertainties, and use stress tests in combination with
other risk management tools to make informed risk management and
business decisions.
This concludes the text of the proposed guidance.

Dated: June 2, 2011.
John Walsh,
Acting Comptroller of the Currency.
By order of the Board of Governors of the Federal Reserve
System, June 8, 2011.
Jennifer J. Johnson,
Secretary of the Board.
Dated at Washington, DC, this 7th of June 2011.

By order of the Board of Directors.
Federal Deposit Insurance Corporation.
Valerie J. Best,
Assistant Executive Secretary.
[FR Doc. 2011-14777 Filed 6-14-11; 8:45 am]
BILLING CODE 4810-33-P; 6210-01-P