How to present stress test results to the bank Board: Part I
As part of a series, this article focuses on communicating actionable stress test results to a bank or credit union board of directors, as well as how to structure the executive summary. Part II will focus on the remainder of the presentation including local and national conditions, methodology, and results.
Keep in mind these tests can and should be used for more than satisfying regulators. They are also tools to assist in setting capital levels, addressing risk appetite and setting product lending limits.
Stress testing analysis is an important risk management tool but only worth the board’s time if the report empowers directors to assess current and potential risks within the loan portfolio.
Because a bank board meets periodically, sometimes only quarterly, and may only have a few minutes to review stress testing results each year, it is important for senior management to put together a report describing risks but also putting those risks into context with the bank’s current risk appetite and the overall economy.
The first step is to work with senior management to identify which stress tests should be presented to the Board. At first, this decision may seem daunting because there are a number of different stress test options and methodologies that demonstrate potential, future losses differently.
But this variability in reporting and methodologies is an advantage because senior management can therefore present a range of potential results. No, single model will ever be perfect in describing portfolio risk, but presenting to the board a summary of three or four stress tests allows the Board to consider each test and its applicability for future board meetings.
It is important for a stress testing analysis to reflect the size and complexity of the bank and address risk specific to the bank. Each test should be run to include at least two results: one expected result and one adverse, but possible, result.
When you select stress tests, consideration must be given to what is being tested: the entire loan portfolio, one or two of the largest product concentrations or both. For most banks, stressing the entire loan portfolio using two or three top down tests is appropriate. For banks with a large construction and/or commercial real estate portfolio, at least one or two bottom up tests should be added to the two or three top down portfolio tests. These concentrations have proven to be especially risky and merit a closer look at the bank’s credit exposure in the event of a downturn.
Thought should also be given to including a bottom up test that varies each year according to what is going on in the credit portfolio at that time. For example, is there a product the bank is looking to expand? Is there one geographic region with significant volume, or even a test of the largest ten borrowers?
After selecting appropriate stress tests, the next step is to prepare a brief Board presentation, summarizing risks and narrative on the bank’s plans. As mentioned earlier, the Board may only have a few minutes to review stress testing so it is critical for bank management to keep the presentation brief but meaningful since this document will likely be entered into the official minutes of the meeting.
A stress test report should start with a one-page Executive Summary including sufficient information that, if a Board Member reads only this page, they could walk away with an informed opinion of the bank’s risk. It should include:
a. Address recent portfolio and industry trends for key segments of the portfolio
b. Include year-to-date net charge offs for the bank and key segments
c. Identify changes in portfolio credit quality, such as changes to risk level
d. Summarize the range of potential losses identified by the pool of stress tests and include the bank’s own forecast of losses, as well as an explanation of the difference between the forecast and the stress test results
2. Key Risks and Trends
a. Identify the two or three largest product concentrations and potential market risks that management expects to impact the portfolio and how they will change loss expectations
b. Summarize additional items such as changes in interest rates, product mix, asset values, economic conditions, etc.
c. Explain in narrative how management plans to mitigate these risks
3. Conclusions and Implications
a. Summarize local and national, current economic conditions and how the portfolio has performed relative to those conditions
b. Identify management objectives to improve credit quality and manage risk
Part II of this article series will focus on what to include after the summary including local and national conditions, stress test methodology and results.