Community banks, by and large, loathe the notion of mandatory stress testing.

Federal Reserve Board Gov. Jerome Powell understands that view. Powell, during a conference call Monday, told attendees that "large-bank supervisory approaches are just not appropriate" for community banks, singling out stress tests as a prime example of something that all regulators want to keep out of small bank exams.

"We do very complex stress tests for the largest banks which require literally hundreds of people to work on them," Powell said, addressing concerns that standards for big institutions could became a requirement for smaller ones. "We've done everything we can to make sure those expectations don't migrate to community banks … and don't become baseline supervisory expectations for smaller institutions."

Many small banks would struggle to satisfy the stress-testing requirement. Chris Cole, senior regulatory counsel at the Independent Community Bankers of America said stress testing would require small banks to expend scores of work hours and hire costly third-party consultants.

Powell's comments are heartening for community bankers concerned about increased regulatory burden. Unfortunately for the industry's optimists, Powell conceded that, for all their resolve, there is no way to guarantee that stress testing will not eventually creep into community bank exams.

"We understand full well that community banks were not a principal cause of the financial crisis," Powell said. "We also recognize that things will trickle down unless we take active, strong steps to stop that from happening. We've tried to take those steps knowing we'll have to keep watching, because it's just the nature of things that [trickle-down] will happen."

Michael Stevens, senior executive vice president at the Conference of State Bank Supervisors, agreed with Powell's assessment. He said regulations tend to creep downhill as a result of the leeway individual bank examiners are given to exercise judgment. Examiners have at times guided banks to adopt technique they see working at other institutions, he said.

Such thinking could also bring stress testing to smaller banks, Cole said.

"That's exactly the way it would happen, particularly if [an examiner] said your lending portfolio is risky enough for stress testing," he said. "After a while, you'd have a minority of community banks undergoing these tests, then some sort of guidance would come out. It could happen real quickly."

Stevens, who co-authored a white paper in 2010 suggesting that small banks should consider using some form of stress testing as a risk-management tool, agreed with Powell that it should not be required. "It should not be a regulatory expectation for community banks," he said.

Stress tests are regulatory exercises required by the Dodd Frank Act for banks with more than $10 billion of assets. They require institutions to predict how their business lines would fare in a series of progressively more dire economic scenarios. Regulators were permitted to modify the regulation to make it less burdensome for institutions with less than $50 billion of assets.

Banks with less than $10 billion of assets are exempt.

Community bankers' aversion to stress testing can be traced back to general regulatory fatigue, said Peter Cherpack, senior director at Ardmore Banking Advisors in Pennsylvania. "They've thrown the baby out with the bathwater when it comes to stress testing," he said.

Larger community banks are likely to implement stress tests voluntarily, Cherpack said, particularly if they have ambitions to grow. He said smaller banks might adopt limited forms of stress testing to please regulators. "There are methods of stress testing that are very relevant and not hard to do," Cherpack added. "It's symbolic of a bank that has good credit management."

Regarding the supervisory process, Esther George, president of the Federal Reserve Bank of Kansas City, said during a conference last month that she thought examiners needed more autonomy. George, who was speaking at a Fed conference dedicated to community banking, said doing so would give supervisors more discretion when applying complex regulation to smaller institutions.

"Regulation and supervisory frameworks have evolved with far less reliance on examiner experience … and more emphasis on data-driven" models, George said.

While supervisory frameworks are considered highly successful for big banks, she said that substituting rigid rules for examiner judgment at small banks "has altered the supervisory process without adding value and has instead created higher costs of compliance."

Examiners' ability to exercise individual discretion adds significant value to the regulatory process, Powell said, adding that he wanted community bankers to inform the Fed if they were being asked to perform stress tests.

"If we fail on this, we sure hope they'll let us know," he said.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.