How do banks perform stress tests?
A financial institution will complete a bank stress test in order to analyze effectively the impact of adverse outcomes on the institution’s financials. But, unlike regulatory guidance around ALLL methodologies, how banks should perform stress tests is a little unclear.
Guidelines for institutions involved with the Supervisory Capital Assessment Program are more concretely defined, and that list of institutions is growing. But at mid-size and small institutions, how do banks perform stress tests?
1. Top Down. Regulators describe top down stress testing as estimating stress loss rates under one or more scenarios in pools of loans with common risk characteristics. This approach doesn’t require as much loan-level data, so it’s often preferred by smaller institutions because of its simplicity. A top down stress test also complies with expectations that regulatory agencies have for community banks. For more information on this approach, read Benefits of Top Down Stress Testing.
2. Bottom Up. This approach to stress testing is more granular and is often preferred for institutions that have a significant CRE portfolio. With this approach, a sample of loans from a segment is stressed individually according to defined stress scenarios, and the results are aggregated and extrapolated to the rest of the segment to determine potential impact on the institution’s financials. The challenge with bottom up stress tests is the amount of financial and collateral data required for loans. Read more about What Data is Needed for Bottom Up Stress Testing.
Oftentimes, an institution’s stress test will be modified slightly to account for institution-specific risks. For example, an institution that primarily engages in agricultural lending will not find it sufficient to stress test the few CRE loans they might have. The bank’s greater risk lies in ag-specific threats and conditions.
Read Stress Testing: The Who, What, When and Why to learn more about examiner expectations and common stress testing practices.