On October 18, 2012, the OCC released stress testing guidance for national banks and federal savings associations with $10 billion or less in total assets. While the regulatory authorities clarified in May of this year that the Supervisory Guidance on Stress Testing for Banking Organizations with More than $10 Billion in Total Consolidated Assets would not apply to community banks, the OCC has now confirmed that the stress testing requirements in Dodd-Frank have “trickled down” to community banks, at least to those regulated by the OCC. The guidance states that appropriate stress testing should be performed at least annually.
Fortunately for community bankers, the stress testing guidance is greatly scaled back from the rules applicable to larger institutions, and the requirements are flexible in many respects. The guidance specifically states that the OCC does not specifically endorse any particular stress testing model and that banks with smaller scale and lesser complexity may be able to satisfy the requirements of the guidance by performing single spreadsheet analysis in some cases. This acknowledgement is in stark contrast to the onerous requirements applicable to larger banks, which can be read to require testing of all likely and unlikely scenarios using a wide variety of scenarios through the use of a number of different models.
On May 14, 2012, the Federal Reserve, FDIC and the OCC released a joint statement confirming that that banking organizations with total consolidated assets of $10 billion and under will not be required to conduct formal stress tests. Management of many smaller banking organizations had been concerned that the stress testing required of larger banks would “trickle down” in an informal sense to smaller banks. With this regulatory statement, that concern is alleviated, at least in the official sense.
We continue to believe that the heightened (or perhaps renewed) emphasis on risk management by the regulators will affect banks of all sizes. It is likely that regulators, directors, and shareholders of all banks will want to confirm that management has identified the key risk factors affecting the institution and that the board has established the institution’s tolerance for accepting those risks and implemented any appropriate mitigants.
We recommend that banks of all sizes, even the smallest community banks, undertake an enterprise risk management analysis to identify the key risks facing the institution. The board of the institution, as a subpart of its strategic planning function, should review those risks and establish the institution’s risk tolerance with respect to each category of risk (many consultants will capture this analysis in a “risk appetite statement”). Establishing and understanding those risk tolerances will form a roadmap for setting and executing the institution’s strategic initiatives. In implementing this analysis, some institutions may undertake some level of stress testing with respect to certain risks.
This risk management analysis is a natural adjunct to the self examination process used we recommend using in preparing for a regulatory exam (see our prior “Self Exam” post). While the self exam process is typically more focused on the bank’s current position and past performance and this risk management analysis is more forward-looking, both processes require an introspective review. Senior regulators have repeatedly confirmed to us (and we have seen in practice) that where banks take the initiative in implementing credible risk management programs and other pre-examination preparation, the examiners are much more likely to defer to the judgment of management and the board of the bank – with the result being a much better interaction with regulators (who, in an ideal scenario, can be a partner in the risk identification process).
Debate Over Extension of Bush Tax Cuts Continues
On Thursday, House Majority Leader Steny Hoyer (D-MD) and House Speaker Nancy Pelosi (D-CA) told House Democrats at a closed door meeting that the House would vote before the end of the year on extending the Bush tax cuts for only those individuals making less than $250,000. However, even if such a measure were to pass in the House, it is unclear whether the Senate will agree to such a vote. There is still the possibility the bill may not pass the House if Republicans are able to successfully pass a procedural response, known as a “motion to recommit,” that could force a House vote on a full extension of the Bush tax cuts. According to sources, Pelosi told President Barack Obama that House Democrats remain firmly committed to allowing Bush-era tax cuts to expire for earners making more than $250,000, which complicates the Administration’s efforts to reach a compromise with Senate Republicans.
Preview of Next Year’s Budget Fight
On Thursday, Senate Minority Leader Mitch McConnell (R-KY) announced he would oppose the pending omnibus appropriations bill, thereby forcing Congress to rely on another stopgap “continuing resolution,” or CR, to keep the government funded after December 3. If Republicans are able to block the omnibus spending bill, it would set up an early confrontation with President Obama next year over not just deeper cuts from the President’s 2011 budget but also tens of billions of dollars in rescissions from prior years. The White House is seeking a continuing funding resolution which would cover the next 10 months of the fiscal year until September 30, which would deny House Republicans a chance to defund portions of the healthcare bill early next year.
Fed Orders New Stress Tests
On Wednesday, the Federal Reserve announced plans to scrutinize the nation’s top 19 banks through a second round of “stress tests.” The stress tests will require the bank-holding companies to submit capital plans by early 2011 proving their capability to handle losses under a set of conditions including “adverse” economic conditions and continuing real estate-related problems. In its announcement, the Fed said it plans to perform such reviews regularly on an ongoing basis. The Fed also issued a road map for banks that want to raise dividends or buy back stock saying firms must show they have sufficient capital in place to withstand losses over the next two years and demonstrate an ability to satisfy new, tougher global capital requirements.
On June 1, 2009, the Federal Reserve announced the standards that the Federal Reserve would apply in determining whether the nineteen largest bank holding companies (the “Stress Test” participants) would be permitted to redeem their outstanding TARP Capital Purchase Program securities.
Under the TARP Capital Purchase Program, an institution may seek to redeem the TARP investment at any time, subject to the approval of the institution’s primary federal regulator. While institutions were initially limited in their ability to redeem the TARP investment during its first three years, Congress removed that limitation under the American Recovery and Reinvestment Act of 2009. As of June 1, 2009, 20 institutions had redeemed their TARP Capital Purchase Program investment. The Federal Reserve announced that the first approvals for redemptions by the nineteen largest bank holding companies would be announced during the week of June 8, 2009.
On May 7, 2009, the Federal Reserve released its Overview of Results of the Supervisory Capital Assessment Program (or Stress Test). The headlines regarding the Stress Test Results are likely to emphasize that ten of the 19 participating institutions are required to collectively raise $74.6 billion in new common equity, as follows:
- American Express – $0
- Bank of America – $33.9 billion
- BB&T – $0
- Bank of New York Mellon – $0
- Capital One – $0
- Citigroup – $5.5 billion
- Fifth Third – $1.1 billion
- GMAC – $11.5 billion (of which $9.1 billion must be new Tier 1 Capital)
- Goldman Sachs – $0
- JP Morgan – $0
- Key Corp – $1.8 billion
- MetLife – $0 billion
- Morgan Stanley – $1.8 billion
- PNC Financial – $0.6 billion
- Regions – $2.5 billion (of which $400 million must be new Tier 1 Capital)
- State Street – $0
- SunTrust – $2.2 billion
- U.S. Bancorp – $0
- Wells Fargo – $13.7 billion
Notably, only GMAC and Regions have to raise new Tier 1 Capital in order to satisfy the Stress Test standards; the remaining entities may satisfy the standard by converting existing Tier 1 Capital (such as the TARP Capital Purchase Program funds) into Common Stock. This can be accomplished under the TARP Capital Assistance Program without any additional use of Treasury funds.
For the 8,000+ banks that did not participate in the Stress Test, however, the takeaways are likely to be completely unrelated to the actual results encountered by the 19 participating institutions.
In advance of releasing the “Stress Test” results (scheduled for 5:00pm on Thursday, May 7, 2009), the Treasury and the federal banking regulators released a joint statement about the Supervisory Capital Assistance Program on May 6, 2009. The joint statement also includes information about the process that will be used for institutions desiring to redeem their TARP Capital Purchase Program Preferred stock.
A few key points about the Stress Test:
- The government intends to announce, for each of the 19 institutions individually and in the aggregate, estimates of: losses and loss rates across select categories of loans; resources available to absorb those losses; and the resulting necessary additions to the capital buffers.
- Any of the 19 needing to raise capital will be given until June 8, 2009 to develop a detailed capital plan, and until November 9, 2009 to implement that plan.
- As part of the capital plan, an institution may apply for Mandatory Convertible Preferred under the TARP Capital Assistance Program, and may convert its existing TARP Capital Purchase Program Preferred shares into the Capital Assistance Program Convertible Preferred shares.
- “Smaller financial institutions generally maintain capital levels, especially common equity, well above regulatory capital standards.”
- Accordingly, the government does not intend to expand the Stress Test beyond the initial 19 bank holding companies (at least officially).
- The Treasury reiterates that the TARP Capital Assistance Program is available to other institutions on the same terms and conditions applicable to the 19 Stress Tested banks. The Treasury intends to process applications received “in an expedient manner.” (No discussion is made of when or if term sheets will be made available for non-publicly traded institutions to participate in the Capital Assistance Program.
On April 24, 2009, the Federal Reserve published a white paper describing the process and methodologies employed by the federal banking supervisory agencies in their forward-looking capital assessment of large U.S. bank holding companies. The white paper is thin on new details, but does provide a base for understanding the stress tests being undertaken of 19 bank holding companies with total assets in excess of $100 billion.
Purpose and Effect of the Stress Tests
The stress tests are designed as the first part of the Capital Assistance Program to demonstrate which institutions the government believes will need to raise additional capital. If a stress test demonstrates that an institution requires additional capital, the institution will be required to enter an agreement to issue convertible preferred securities to the U.S. Treasury in an amount sufficient to meet the capital shortfall under the TARP Capital Assistance Program. Each such institution will then be permitted up to six months to raise private capital in public markets to meet their capital needs, and would be able to cancel the obligation to the government without penalty. Participants would also be given the opportunity to convert their existing TARP Capital Purchase Program preferred stock into the convertible preferred stock to be issued under the TARP Capital Assistance Program (such a conversion would not affect the institution’s Tier 1 capital, but could affect the institution’s tangible common equity and their dividend obligations).