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Bank regulating authorities have finally approved the new stress test rules under the purview of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 for assessing the capacities of banks to withstand severe financial crisis. These rules are an expansion of the stress test developed by the Federal Reserve following the 2008 recession. The new rules are applicable for banks with consolidated assets of more than $10 billion.

The new set of rules was jointly approved by the Federal Deposit Insurance Corporation (FDIC), the Federal Reserve Board and the Office of the Comptroller of the Currency (OCC).

The New Rule

The final rule, which implements section 165(i)(2)(A) of the Dodd-Frank Act, requires all financial institutions with assets more than $10 billion and regulated by a primary regulatory authority to carry out an annual company-run stress test. The regulation requires stress tests based on three scenarios – a baseline scenario, an adverse scenario and a severely adverse scenario.

Initially, regulators were of the idea that banks should publicly announce all the results under these three scenarios. However, banks were unwilling to declare results of the baseline and adverse scenario since a conventional earnings forecast backed it, which had high chances of being misconstrued. Therefore, both banks and regulators have agreed to declare only the results of the severely adverse scenario forecasting a profound economic depression.

The rule states that institutions with assets of more than $50 billion – such as JPMorgan Chase & Co. (JPM - Analyst Report), Bank of America Corporation (BAC - Analyst Report), Morgan Stanley (MS - Analyst Report), Citigroup, Inc. (C - Analyst Report) and The Goldman Sachs Group, Inc. (GS - Analyst Report) – will initiate stress test in November 2012, using data as of September 30, 2012 and declare the results by January 2013.

However, flexibility has been provided regarding a delay in implementation only if certain cases demand so. The rule delays the execution for covered institutions (mid-size banks) with total consolidated assets between $10 billion and $50 billion until October 2013.

Relief for Mid-Size Banks

Finally, mid-size banking institutions can breathe a sigh of relief as the banking regulators have delayed the implementation of the stress test. These regulators have planned to withhold the final rule making and immediate execution of the proposed rules till October 2013. These banks would have to start with the stress test immediately if the final rules related to it were announced.

One of the main pre-conditions for implementation of the rule is that these companies should have a strong and efficient system in place to conduct the stress test. However, many concerns were put forward regarding the resources and the ability of the companies to conduct the tests in the short span between the declaration of the final rule and onset of the stress test procedure. Hence, the delay till October 2013 will give the companies sufficient time to put the required system in place for conducting the test.

Approximately 108 mid size banks and financial institutions – including CIT Group Inc. (CIT - Analyst Report), First Niagara Financial Group Inc. (FNFG - Snapshot Report), Synovus Financial Corporation (SNV - Analyst Report), E*TRADE Financial Corporation (ETFC - Analyst Report) and First Horizon National Corporation (FHN - Analyst Report), –  will go through the stress test in October 2013.

New Rule About Deposit Insurance Assessment System

The FDIC also approved a final rule pertaining to the deposit insurance assessment system for insured depository institutions with assets greater than $10 billion. The final rule brings forth necessary changes in the definitions used to identify the concentrations in higher-risk assets to reflect the risk posed to institutions and the FDIC in a better way.

The FDIC also updated its loss, income, and reserve ratio expectations for the Deposit Insurance Fund (DIF) over the next several years and inferred that the DIF reserve ratio is on its way to reach the statutory minimum target of 1.35% by the end of September 30, 2020.

Our View

Conducting stress test is an efficient step taken by the regulators to evaluate the overall performance of the banking industry. These tests would enable banks to build up sound capital position to absorb any financial distress. In addition, this could ultimately translate into less involvement of the taxpayers’ money for the bailout of troubled financial institutions.

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