WASHINGTON — Federal banking regulators on Monday finalized guidance on how the largest institutions should move ahead with their internal annual stress testing exercises.
The guidance, issued by the Federal Reserve Board, the Federal Deposit Insurance Corp., and the Office of the Comptroller of the Currency, highlighted the importance regulators place on institutions incorporating robust stress testing as part of their risk management practices.
"The recent financial crisis underscored the need for banking organizations to incorporate stress testing into their risk management practices, demonstrating that banking organizations unprepared for particularly adverse events and circumstances can suffer acute threats to their financial condition and viability," regulators wrote in their final guidance.
The guidance was released as observers have begun questioning the Fed's own stress tests. JPMorgan Chase & Co, which passed the Fed-administered tests in March, announced last week that it had taken an unexpected $2 billion loss in its trading activities oversees.
The final guidance does not govern the Fed tests, but a separate requirement that larger firms conduct their own internal assessments every year.
"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," regulators wrote.
The final release follows draft guidance released last June clarified that smaller-sized institutions — those with less than $10 billion of assets — are exempt from the requirements.
In the guidance, regulators said banks must tailor their stress tests to activities and exercises that would capture any risk at their specific institution, use sound stress testing activities and approaches, show significant flexibility, and allow results to inform decision-making.
In practice, stress testing should be able to assist both banks and regulators in calling attention to unidentified or under-assessed concentrations of risk, and ultimately the potential impact it could have on banks during stressful times.
"Stress testing should be part of a banking organization's regular risk identification and measurement activities," according to the guidance. "Appropriate coverage is important as stress testing results could give a false sense of comfort if certain portfolios, exposures, liabilities, or business line activities are not included."
Banks, they said, should also use their stress tests to assess whether exposures, activities and risks under normal and stressed conditions are aligned with the banking organization's risk appetite.
"A banking organization can use stress testing to help inform decisions about its strategic direction and/or risk appetite by better understanding the risk from its exposures or of engaging in certain business practices," according to the guidance.
Banks' individual stress testing frameworks should also include estimating business line revenues and losses and informing business line strategies; identifying vulnerabilities; assessing the potential impact, regulators specified.
But regulators stressed any framework should be supplemented with other risk management practices, which rely on statistical estimates of risk or loss estimates based on historical data, as well as qualitative practices.
Still, banking supervisors noted that since all stress tests hold an element of uncertainty, any effective framework will require sound testing activities and approaches.
"Effective stress testing relies on high-quality input data and information to produce credible outcomes," according to the guidance. "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."
Separately, banks should be flexible to conduct new or ad hoc stress tests in a timely fashion to address emerging risks and continue to update its stress test framework.
Regulators also called on banks to regularly review results of the stress tests to help track the impact of ongoing business activities or changes in exposures.
But even with its all benefits, regulators warned of short falls of stress testing.
"While stress testing can provide valuable information regarding potential future outcomes, similar to any risk management tool it has limitations and cannot provide absolute certainty regarding the implications of assumed events and impacts," according to the guidance.
Banking regulators also issued guidance to alleviate concerns by smaller-sized institutions that they may be subject to similar stress testing as the 19 largest U.S. bank holding companies, additional capital, and other rules in Dodd-Frank meant for the most complex firms.
They said community banks already overburdened by a slew of new regulations would not face rigorous stress testing like their larger brethren.
"The agencies understand that these initiatives for larger organizations are raising some questions on the part of community bankers regarding supervisory expectations for stress testing by community banks," regulators said.
Still, regulators noted that regardless of size all banks should be able to analyze whether their institution could impact tough economic episodes as part of their risk management practices.