According to economists, a recession is looming. In a recent survey by the National Association for Business Economics, 74% of economists who responded expect a recession by the end of 2021.
Historically low levels of losses have allowed reserve levels to go below pre-financial crisis levels. Charge offs were close to zero for most banks since 2013, according to call report data from S&P Market Intelligence. So the question remains: would they hold up against a recession? Stress testing gives an institution a serious look into their capital and reserves, and if they possess enough of each to remain viable, should a recession hit. It also provides guidance for the impact of the new accounting standard, Current Expected Credit Losses (CECL), on the portfolio. The impending implementation of CECL is forcing institutions to perform economic forecasts, as opposed to the current allowance for loan and lease losses (ALLL) model which focuses on previously incurred losses, to have a more holistic and accurate depiction of risk. It takes into account the entire life of a loan instead of just looking a few years down the road.
Both CECL and stress testing take top-down and bottom-up approaches to test the capital adequacy of a financial institution. However, it is important to determine which method is right for your institution. In a recent Abrigo webinar, CEIS Review’s Dean Giglio and David Vest and Abrigo’s Tim McPeak discussed the pros and cons of each approach in both CECL implementation and stress testing.