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Stress Test Requirements for Community Banks: What Does the Future Hold?

The sweeping 2010 Dodd–Frank Wall Street Reform and Consumer Protection Act was enacted in response to the worst financial crisis since the Great Depression. Among the legislation’s principal provisions are several giving federal bank regulators greater power to identify and deal decisively with financially troubled banks before their problems threaten the entire financial system.

One tool the regulators now have is the so-called “stress test”, which is designed to gauge banks’ ability to withstand a future economic downturn as severe as any in U.S. history.   Earlier this year, nineteen of the nation’s largest commercial banks, which hold more than half of the nation’s total assets, were subjected to the initial round of testing. The rigorous “enterprise wide” process required thousands of agency and bank staff hours and involved aspects of the banks’ operations from commercial loan portfolio risk management to maintenance of adequate liquidity.

Some 7,000 other commercial banks, including many community institutions with assets of $10 billion or less, closely observed the process. Many community bank executives and trade associations questioned whether their institutions would – or should – be subjected to the same intensive scrutiny as their larger cousins. They asserted that they are already complaint with commercial lending regulations, follow “state of the art” commercial loan administration procedures and practice sound consumer and commercial loan risk management. They also noted that the expense of a full stress test would be burdensome and disproportionate to the risk.   

In May, the federal bank regulators responded with a “clarification of supervisory expectations”, assuring smaller banking organizations that they will not be subjected to the same extensive scrutiny as larger institutions. While providing this reassurance, however, the statement goes on to remind the smaller banks that they are nevertheless subject to a variety of risk management requirements, running the gamut from commercial loan risk management, commercial loan administration, commercial lending regulations and interest rate risk to funding and liquidity management.

Dodd-Frank established a variety of new or enhanced regulatory powers, even creating an entirely new agency to regulate consumer financial products and services. Much of the actual lawmaking, however, was left to federal regulatory bodies. In many instances, those agencies’ regulations remain works in progress more than two years after Dodd-Frank became law. The coming months and years will reveal the extent to which the lessons learned from stress tests of “megabanks” are relevant to smaller institutions.