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How to use stress testing as a tool for risk management

August 16, 2014
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By now, we should all be familiar with the term “stress testing.” And while stress testing is not a new concept – it is an important part of the risk management process for every institution. Recent mandates from regulatory bodies have placed a renewed emphasis on it. Most institutions perform routine stress tests with loan decisioning or during annual reviews. However, the emphasis from the regulatory bodies, borne out of the need to examine capital adequacy for the institution, has been to expand stress testing to be more encompassing, usually from a top-down perspective.

While stress testing may not be mandatory for institutions under $2 billion in assets, the need to perform stress tests is still viewed as critical. In the 2006 Interagency Guidance, the FDIC provided direction for institutions to conduct stress tests if certain circumstances were met, including certain portfolio compositions. For community banks, regardless of size, examiners have been particularly focused in Commercial Real Estate (CRE) because “CRE has been a common factor in bank failures during stressful periods and certain concentrations may make institutions more vulnerable to cyclical CRE markets.”

The following circumstances could prompt further scrutiny of the portfolio:

– An institution with rapid growth in CRE lending, growing that portion of the portfolio by 50% or more in 36 months

– Notable experience in a specific type of CRE (segments)

– 100% of Total Capital in loans for construction, development, and other land loans

– Total reported loans for construction and land development are greater than 100% of bank’s Total RBC

– CRE is more than 300% of RBC

Examiners are asking banks to focus stress tests on the more vulnerable segments of the portfolio or segments that create vulnerability in the institution. Those are slightly different criteria. For instance, the CRE may be a vulnerable segment due to volatility of the market, while the Agricultural segment may create vulnerabilities for the institution because it comprises more than 30% of the portfolio – if adverse conditions arise (Mother Nature wreaks havoc) then the bank will be heavily impacted.

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Managing the Loan Portfolio

The first order of business for stress testing as a tool for risk management is to examine the portfolio to understand those vulnerabilities. A bank’s loan policy should address the composition of the loan portfolio as a whole and should have standards for individual credit decisions. The policy should outline the following:

– The percentage of loan type to the overall loan portfolio

– The geographic trade area in which the loans will be made

– The types of loans to be made

– Individual credit requirements (DSCR, LTV)

– Loan underwriting criteria (DSCR, LTV)

– Limits on credit concentrations

Below is a sample breakdown of a portfolio by total dollar amounts. The real estate components alone comprise approximately 54% of the total portfolio. Along with the C&I and CRE, Residential Real Estate, at one fourth of the total loan portfolio, is an obvious example of a segment that creates vulnerability to the institution. Adverse conditions affecting these segments will have an outsized impact on the institution’s financials.

Stress testing ultimately is about analyzing the potential effects of adverse conditions (a stressed environment) on the bank’s portfolio, capital and earnings. The key becomes using this information to forward the bank’s business strategy while mitigating risk and appropriately planning for and maintaining adequate capital.

While stress tests can be used as a tool for risk management and are conducted to satisfy regulatory requirements, the true value of stress tests can be measured in the way the results and insights are applied to the bank’s decision making. A thorough stress test seeks to assess whether capital levels are commensurate with the institution’s risk management practices.

To find out more information on stress testing, register for our upcoming webinar with CEIS Review on Drafting a Battle Plan for the CRE Portfolio.

About the Author


Raleigh, N.C.-based Sageworks, a leading provider of lending, credit risk, and portfolio risk software that enables banks and credit unions to efficiently grow and improve the borrower experience, was founded in 1998. Using its platform, Sageworks analyzed over 11.5 million loans, aggregated the corresponding loan data, and created the largest

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