How Banks Get More Value Out of Conducting Stress Tests
Most people who exercise regularly can vouch for the side benefits of physical activity. Putting periodic, controlled physical stress on your heart, lungs, and muscles often produces more than just improved fitness; people also report better moods and lower appetites, for example.
In the same way, financial institutions conducting stress tests to satisfy prudential regulators’ queries on reserves and capital can generate additional benefits from this process, according to Elizabeth Williams, managing director of financial consulting firm CEIS Review Inc. Incorporating some of the findings from the stress tests into strategic plans, forecasting, and other risk management processes can provide more value.
“It is a good way for banks to get more bang for their buck,” she said in a recent interview.
In fact, now that the concepts and processes of stress testing are becoming more universally understood, regulators’ focus is often shifting from implementing stress testing to more qualitative issues, such as integrating results with capital planning and embedding the stress testing inputs, analysis and outputs into overall risk management and planning processes, she said.
Better identify potential trouble spots in the portfolio for risk management.
Williams discussed how to use results of portfolio stress testing at the 2015 Risk Management Summit hosted by Abrigo. These are the six ways financial institutions can get more value out of their stress testing processes and results, according to Williams.
1. Manage concentration risk
One of the primary purposes of stress testing is to identify and measure risks associated with loan portfolio concentrations. In fact, stress testing is one of the best ways for a bank to justify why its commercial real estate concentration is acceptable. Over time, the institution may decide to re-evaluate its CRE limits if stress test results change, or it might use stress testing to evaluate potential changes in portfolio limits.
2. Identify vulnerable segments
“Stress test results may reveal patterns whereby certain segments show up as underperforming,” Williams said. “This could provide good insight into where a bank might want to revisit underwriting standards, cease originations in that segment, exit segments or consider other risk-mitigation efforts before conditions deteriorate. For example, if loans in the Retail income property segment consistently show higher losses and/or greater migration into criticized/classified rating categories, it may make sense to review the underwriting criteria for that segment for future originations, or consider heightened monitoring efforts or loan sales for the existing portfolio.”
3. Evaluate business line risk/reward
Williams believes one area where banks haven’t truly leveraged their stress test results relates to making sure they get compensated for additional or higher risk. “Looking at stressed loss rates in combination with profitability or return measures can help identify segments where the risk-reward balance is not there,” she said. “That information can be used in strategic planning.”
4. Identify vulnerable borrowers
It can be helpful to identify borrowers that essentially flunk most or all stress-test scenarios, even when their loans are currently pass-rated, Williams said. “This can give you a heads up that they may not be able to weather much stress or a downturn,” she said. Knowing which borrowers are more vulnerable could help the bank decide whether to press for additional financial information, schedule site visits or view any modification requests more critically, she said. “You want to have these borrowers on your radar.”
5. Assess the impact of near-term increases in interest rates
Although forecasters have been predicting for years that rates will go higher, it does seem likely in the near term, Williams said. Banks can find helpful information to shape their ALLL analysis by looking at how the portfolio could fare under a 50 or 100 basis-point increase and the resulting impact on any incremental provision needed. ”This could be something that you use in the evaluation of qualitative factors – how future losses might be different based on increases in interest rates,” Williams said.
6. Incorporate into the capital-planning process
Regulators increasingly want to see that stress testing is a key component of the financial institution’s broad capital-planning process, Williams said. “Capital-planning really is a kind of iterative process,” she said. “You make your risk-reward determinations, you make some assumptions, you stress those, you assess your capital adequacy under that scenario, and that may cause you to change some of your risk-reward assumptions and objectives.”
Many banks have spent the last several years clarifying and implementing exactly what regulators require them to do related to stress testing portfolios, and it appears they have made great strides on those fronts. An Abrigo survey found that more than two-thirds of respondents reported examiners had no or few problems with their institution’s stress testing practices.
Like a person who gains in multiple ways from exercise, however, financial institutions are also achieving side benefits when they incorporate the processes and results of their stress testing analyses into additional areas of the bank.