Some financial institutions may view stress testing as a “check the box” practice to satisfy regulators, but others are making the most out of the process. Effective stress testing can benefit many different facets of lending, from risk management and strategic decision-making to capital adequacy and liquidity management. Stress testing enables financial institutions to identify and understand where the loan portfolio may be overexposed in concentrations, distinguish which loans are most susceptible to risk, and target problematic loans for additional scrutiny. Stress testing provides banks and credit unions with a unique opportunity to better manage their institution’s financial performance.
How Stress Test Results Can Yield Better Lending, Credit, and Risk Decisions
Stress testing and risk management
Following the 2008 financial crisis, financial institutions were required to examine loan portfolios more closely in order to plan appropriately for adequate capital levels, especially in unfavorable economic conditions. However, the lack of prescriptive guidance on how to effectively stress the loan portfolio has created challenges for some community financial institutions. Stress testing is an important component of sound risk management, but the expectations and use cases for stress tests aren’t always obvious.
Financial institutions see the most benefit from stress-testing exercises when they are embedded within an overall risk management process. First, in order to leverage stress testing as a tool for risk management, the institution must examine the portfolio to understand its vulnerabilities. An institution’s loan policy should speak to the loan portfolio as a whole and should have standards for individual credit decisions. The policy should address the following:
- Percentage of a loan type to the overall loan portfolio
- Geographic trade area in which the loan will be made
- Types of loans to be made
- Individual credit requirements
- Loan underwriting criteria
- Limits on credit concentrations
To manage credit risk exposures, regulators have repeatedly indicated that some form of stress testing loan portfolios – at least on an annual basis – is a critical part of sound risk management for community financial institutions. When a financial institution shifts its view of stress testing from a regulatory requirement to a critical component of the institution’s overall risk management process, as well as investing in the right tools, it opens the door to driving long-term value and growth.
Stress testing and capital adequacy
As stated in the agency’s statement on stress testing, “The OCC expects every bank, regardless of size or risk profile, to have an effective internal process to (1) assess its capital adequacy in relation to its overall risks, and (2) to plan for maintaining appropriate capital levels.” It is important to keep capital adequacy ratios above the thresholds set by examiners, but building a capital plan for stress testing can be challenging.
Whether the institution uses a complex set of spreadsheets or a stress testing software solution, stress testing results from a bottom up analysis can be used to determine potential changes in capital levels and new capital ratios. Examiners will use these capital ratios during a federal exam to determine if the institution is adequately capitalized or if additional capital reserves must be allocated.
An alternative to bottom up stress testing is a top down stress analysis, which will also produce results that can inform capital assessments. A top down analysis may be a more manageable approach for smaller financial institutions that lack the data required for a more granular test. Related to a top-down analysis is a reverse stress test. In this type of analysis, the financial institution works backward to evaluate what loss rate scenarios could cause the institution to breach capital thresholds. The institution would consider how likely the scenario or conditions are to “break the bank.” Then, the institution would develop contingency plans or take other steps to mitigate the identified risks.
No matter the approach or methodology, the results of a portfolio stress test can and should provide the financial institution with a better understanding of its current capital position as well as its potential capital position in the event of defined, adverse environments. Armed with the right data, the institution can compare capital levels to the thresholds set and expected by regulators.
How to take the “stress” out of stress testing
While stress testing provides significant value to community financial institutions, it can also place a heavy burden on smaller institutions. Today’s technology, however, enables community financial institutions of all sizes to gain access to the tools and talents to implement stronger stress-testing processes. Lending and portfolio stress testing systems that provide risk identification, risk management, and risk mitigation help to drive financial institutions’ long-term viability, while also opening the door to growth opportunities. Dave Koch, Managing Director of Advisory Services at Abrigo, identifies the following key components of a stress testing system:
- They are adaptable to the size and complexity of the institution. They allow institutions to stress the entire loan portfolio, concentrations, and specific borrower relationships to identify risk.
- They allow institutions to create custom concentrations and apply multi-variable stress scenarios using key factors such as interest rate, cash flow, and collateral value.
- They provide a structured, manageable process for data aggregation and governance.
- They automate reporting and documentation for examiner review of stress testing decisions.
- They integrate easily with loan origination, loan grading, loan pricing, and ALLL modules
- to reduce the efforts required for performing stress testing and reserve calculations while improving overall risk management capabilities.
- They provide “what if” analysis to show effects on capital and earnings.
“Some firms may see relief from requirements for implementing a DFAST regulatory-reporting framework and public-disclosure process, but most community financial institutions will see business as usual in the risk identification, management, and mitigation process,” Koch noted. “And in fact, they should, because risk identification, risk management, and risk mitigation are what drive long-term viability and enable growth opportunities for these critical institutions.”
To learn more about the ways your financial institution can benefit from stress testing, join Michelle Lucci on December 18, 2019 for a free webinar, “Ways to Leverage Portfolio Stress Testing Results.”