One year after annual stress testing requirements under the Dodd-Frank Wall Street Reform and Consumer Protection Act became effective for banks with more than $50 billion in assets, the next phase of testing looms. And this time, it will apply to a large new subset of financial institutions.

Starting this fall, smaller banks with $10 billion to $50 billion in total consolidated assets will be subject to the stress tests. Although generally referred to as “bank stress testing,” the exercise applies to all bank and savings-and-loan companies, national banks, state member banks, state nonmember banks, federal savings associations and chartered savings associations.

At the highest level, the stress testing forces such companies to examine their risk profiles and vulnerabilities by answering a simple question: Given a particular set of macroeconomic circumstances, how would your business fare?

Administering the test and projecting outcomes, of course, is much more complicated and requires every segment of each bank to estimate and deliver data showing the expected impact on their consolidated losses, revenues, balance sheet and capital for at least three macroeconomic scenarios that the regulators will provide in November. Banks will be required to show data for a baseline scenario, an adverse scenario and a severely adverse scenario (see “Possible Scenarios,” p. 27). The banks will have to deliver results to their primary regulatory supervisor by March 31, 2014.

Learning Curve

On Aug. 5 the three federal agencies that will oversee the stress testing – the Federal Reserve Board (FRB), the Federal Deposit Insurance Corp. (FDIC) and the Treasury Department’s Office of the Comptroller of the Currency (OCC) – published proposed supervisory guidance outlining high-level principles for the process as it applies to midsize institutions. They took comments on the guidance through September.

The Dodd-Frank testing will present a sharper learning curve for these midsize banks. The largest banking firms with more than $50 billion in assets have submitted to similar stress testing since they participated in the Federal Reserve System’s first supervisory stress test, the Supervisory Capital Assessment Program (SCAP), in 2009. Since then, they have also participated in the Fed’s Comprehensive Capital Analysis and Review (CCAR). Dodd-Frank codified and expanded the practice, and in the fall of 2012, the 18 largest financial institutions began stress testing and delivered their results in March. The Fed said 17 of them could withstand a deep recession.

In an April speech, Federal Reserve Chairman Ben Bernanke said he saw SCAP as “one of the critical turning points in the financial crisis.” Bank stress testing, Bernanke said, has provided market participants with “deeper insight not only into the financial strength of each bank but also into the quality of its risk management and capital planning.”

Flexible Model

The rules for stress testing midsize banks provide greater flexibility with an eye toward smaller institutions’ more limited resources and also the more limited effect of their performance on the economy as a whole.

The guidance makes clear that stress testing won’t be a cookie-cutter exercise; rather, a range of responses will be acceptable depending on the institutions’ profiles. Throughout the guidance, the regulators outline both minimum and suggested additional requirements based on size, sophistication and other circumstances such as regional variables.

One of the challenges for banks will be determining what exactly will be required of them, as the guidance does not provide a bright-line test.

For example, one requirement outlined in the guidance is a balance sheet and risk-weighted asset projection for each of the scenarios in the first round of testing. “Companies may use a variety of methods” to do so, the guidance says. In some cases it may be appropriate for a company to use “simpler approaches” for these asset projections, such as a constant-portfolio assumption. More sophisticated banks may instead rely on estimates based on their own or industry-wide historical experience, and some “may choose to employ more advanced, model-based approaches.”

“[Applying a constant-portfolio assumption] may not be very difficult,” says Brian Barrett, a partner at Sutherland Asbill & Brennan and a former investment banker. “However, if you fall on the other side of the spectrum and are one of the most sophisticated banks in this subset, you are going to be held to a much higher standard. … Every bank has to get a very good read on where the regulators see them falling within the guidance so they don’t under-deliver on the stress test results.”

New Approach

Banks should already be putting internal controls in place so they’re ready to go when regulators publicize the scenarios. The guidance outlines that each of the banks “is required to establish and maintain a system of controls, oversight, and documentation, including policies and procedures, that are designed to ensure that its stress testing processes are effective.”

The level of detail the banks will have to deliver in their results will be deeper than they are used to under capital requirements and past regulatory safety and soundness checks.

The severity of the government provided scenarios will also be a departure for most of these institutions, and considering them will be a useful exercise, particularly in light of the events of the downturn, says Michael Mancusi, a partner at Kilpatrick Townsend & Stockton and a former attorney for the OCC.

“Historically, businesses don’t run their projections by looking at the ‘sky is falling’ scenario,” Mancusi says. “It’s a change from what banks and businesses are used to, and it’s a good mindset to think in those terms.”