Community Bank Stress Testing: Where to Begin

While banks under $10 billion in assets aren’t technically required to stress test, recent data suggests the practice is becoming the norm. According to a 2015 Abrigo (formerly Sageworks) Bank and Credit Union Exam Survey, more than 40 percent of the 180 responding institutions had already begun stress testing, and it was recommended to 30 percent that they begin stress testing or expand current stress test practices. But community banks’ resources are generally less of their larger counterparts, so beginning, keeping up with or expanding stress testing can be a burden.

A whitepaper from McGladrey, “4 Steps to Effective Stress Testing for Community Bank Loan Portfolios,” highlighted that community banks, unlike larger institutions impacted by Dodd-Frank, don’t have a guide to stress testing. The authors recommended a four-step process for community banks to develop a sound stress testing program:

1. Understand your portfolio and its risk factors. McGladrey recommends that bankers, in addition to gaining a true understanding of their loan portfolio (available products, borrowers, concentrations, etc.), also must understand the unique risk characteristics across all levels and how these characteristics will impact their borrowers’ ability to repay under various scenarios. An example highlighted in the whitepaper surrounds a strong concentration of agricultural borrowers, and how changes in commodity prices or weather conditions would impact loan performance. Here, it would be important to review if the bank’s borrowers all grow the same crops or if there is proper diversification. While all banks should review national/federal numbers, community banks should emphasize local conditions. In many cases, a single industry dominates their local economy.

2. Ensure proper data. A significant problem with community banks attempting to implement a stress testing program is poor data integrity, according to McGladrey. Institutions must ensure they’re collecting the right data for stress testing, that it is timely and accurate, and that it is easy to access and use. While many community banks focus on their competitive advantage, building relationships with borrowers, it often results in a “lack of focus on collecting and updating data.” When determining what data to collect, institutions should consider data tied to key risk factors. Core systems and automated solutions can help collect data for stress testing.

3. Stress test for risk. According to the whitepaper, community banks should “weight the various risk factors that could impact your portfolio and then determine how they would affect the various components of your loan portfolio.” Multiple scenarios should be considered, including moderate and severe stress environments, to understand how changes would impact revenue, earnings, and capital.

4. Use results to take action. While more community banks are being asked by examiners to stress test, the purpose for it should go beyond compliance. Banks can use stress test results to make strategic decisions, both on the individual loan or portfolio level. This would include decisions to diversify the portfolio or make changes in the volume of lending in riskier areas. The whitepaper also stated that board participation in stress testing is critical.

For more information on the four-step stress testing process, bankers can access the entire McGladrey whitepaper. To learn more about how stress testing can lead to better risk-mitigating credit policies and procedures, access this complimentary whitepaper: Stress Testing: The Who, What, When, and Why.