Lessons Learned From the Stress Tests
In the wake of the implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act stress test (DFAST) regulations, the term “stress test” has become a familiar part of the banking lexicon. The DFAST regulations require midsize banks—those with assets between $10 billion and $50 billion—to project the expected impact of three economic scenarios—baseline, adverse, and severely adverse—on their financial statements and capital ratios. Midsize financial institutions were required to report this year’s stress test results to their regulators by March 31, 2015, the second round of stress tests required for these banks.
Although the submission that was due in March was round two, most banks felt that it demanded just as much effort as the first round of stress tests. Regula-tors focused more on process than re-sults in round one and clearly stated that what was acceptable in the first sub-mission would be insufficient for subse-quent examinations. Little formal feed-back is in so far, but what we have heard indicates that continuous improvement was definitely expected.
Model Mechanics
In the first round, most banks either used simplistic models or projections that did not capture their risks fully. Banks now are expected to develop en-hanced models, and more significant portfolios are being modeled using bot-tom-up rather than top-down approach-es. In assessing models, regulators are questioning assumptions and methodol-ogies and looking for well documented, sound conceptual bases for the modeling choices made. Overly manual modeling processes also are being flagged as im-practical for ad hoc use. The message is loud and clear: stress testing models are expected to be integrated into risk man-agement practices.
Life in the DFAST Lane
As with most important business pro-cesses, effective DFAST risk manage-ment requires significant input from business management, risk manage-ment, and internal audit. A collaborative relationship among these three lines of defense results in the strongest DFAST processes. With reporting deadlines for the next cycle in 2016 being delayed from March 31 to July 31, banks have a bit of breathing room to assess the effec-tiveness and efficiency of their DFAST programs. Banks should use this extra time to further develop documentation, address highest priority issues, and con-tinue to integrate stress testing into rou-tine risk management practices.