Pub. 6 2011-2012 Issue 3

September/October 2011 19 Extraordinary Service for Extraordinary Members. to and sufficiently capture the banking organization’s exposures, activities, and risks; Principle 2 —an effective stress test- ing framework employs multiple, con- ceptually sound stress testing activities and approaches; Principle 3 —an effective stress test- ing framework is forward-looking and flexible; and, Principle 4 —stress test results should be clear, actionable, well supported, and inform decision-making. Additionally, a discussion of several different approaches to stress tests, including sensitivity analysis, scenario analysis, enterprise-wide stress testing, and reverse stress testing is included in the Proposed Guidance. Although the Proposed Guidance focuses on banking organizations with total assets in excess of $10 bil- lion, smaller banking organizations should consider how the concepts around enhanced capital and liquidity planning may improve their existing processes. Regulators are beginning to discuss the importance of stress testing for smaller banking organizations. 10 Consequently, higher expectations of regulators on risk management, based on riskmanagement standards applied to larger banking organizations, are likely to become “best practices” for all banking organizations. While the Proposed Guidance and Dodd-Frank target banking organiza- tions of certain size, the entire indus- try should be prepared for increased expectations as regulators become accustomed to seeing stress testing as part of riskmanagement framework. In the future, bankmanagement will likely find it harder to demonstrate sufficient risk management processes without incorporating some elements of stress testing. Banking organizations should (i) review their existing stress testing processes (if any) against the Proposed Guidance and understand any potential changes to existing processes, and (ii) anticipate additional guidance through the rule-writing requirements under Dodd-Frank. What This Means to You As a result of Dodd-Frank, banks will be subject to more stringent regu- lations with regard to capital. While risk retention’s potential impact on originating banks may vary, the re- quirements associated with retaining additional assets on balance sheets have material consequences on earn- ings and capital allocation for affected banks. Going forward, banks should begin considering whether to securi- tize loans, hold them on the balance sheet, or sell them as whole loans in light of the impact of the risk retention provisions of Dodd-Frank. Ultimately, this decision and the corollary loan pricing decision will be driven by the bank’s current balance sheet, the marketplace, and rulemaking under Dodd-Frank. Banks also should consider ways to incorporate into their business deci- sions the basic concepts inherent in stress testing. Getting into the habit of regular discussions of “what ifs” will aid banks in understanding the potential impact of adverse events on their banks and prepare them for any increased expectations of stress testing by bank regulators. Banks should be aware that the stress testing principles set forth in the Proposed Guidance, even though specifically directed at institutions with assets in excess of $10 billion, may eventually find their way into the requirements for banks of all sizes. Z 1 Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376 (July 2010). 2 Other banking organizations can voluntarily choose to be subject to the advanced approach. 3 See 12 C.F.R. part 3, Appendix C; 12 C.F.R. part 208, Appendix F; 12 C.F.R. part 225, Appendix G; and 12 C.F.R. part 325, Appendix D. The advanced approach was adopted in 2007 and is based on the Basel II international capital accords. 4 See 12 C.F.R. part 3, Appendix A; 12 C.F.R. parts 208 and 225, Appendix A and 12 C.F.R. part 325, Appendix A. The general approach was adopted in 1989 and is based on the original Basel I international capital framework. Q Capital Confusion? — continued on page 20