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How the 2022 Stress Test Scenarios Can Help Small Banks & Credit Unions

Zach Englert
March 17, 2022
Read Time: 0 min

The Stress Test Scenarios for Big Banks Are Useful for Smaller Institutions' Own Tests 

Banking regulators recently released the 2022 scenarios for upcoming stress tests by the biggest banks. But small banks and credit unions can benefit from the stress test scenarios, too.

You might also like this webinar, "Gauge Your Institution's Risk from Inflation: Plan Ahead with Stress Testing."

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Why financial institutions stress test

Banking regulators including the Federal Reserve and the Office of the Comptroller of the Currency (OCC) recently released the economic and financial market scenarios for covered institutions to use in upcoming stress tests. Institutions required to follow Dodd-Frank Act Stress-Test (DFAST)-level stress tests include financial institutions with total assets of at least $250 billion. This covers only the 34 largest institutions in the U.S.

However, community financial institutions can incorporate the new scenarios for their own stress tests to help determine how their capital levels will fare in severe economic situations.

Why smaller institutions stress test

Despite the total assets threshold noted above, regulators continue to emphasize that all banking organizations regardless of size should have the capacity to analyze the potential impact of adverse outcomes on their financial condition. Agencies note that existing guidance, including that covering interest rate risk management, commercial real estate concentrations, and funding and liquidity management (among others), continues to apply. In addition, given increased volatility in the commercial real estate landscape, financial institutions should expect continued scrutiny surrounding CRE portfolios.

Regardless of regulatory pressure, measuring and managing key risks are the cornerstone of community financial institutions’ enterprise risk management (ERM) programs. Prudent stress testing as a risk management tool helps the enterprise see where the potential pitfalls are in their plans. Banks and credit unions must be able to adjust when necessary to ensure viability of the institution and the ability to supply capital to their local economy. In other words, financial institutions conduct stress testing not only to mitigate financial institution risk but also to provide the board and management with key decision-making information on capital allocation and other decisions that drive achievement of long-term goals.

The 2022 stress test scenarios provide a blueprint for community banks and credit unions to get started on their own stress tests. Banks and credit unions can tailor them to their own instances rather than building them from the ground up – editing the regulator-developed scenarios as opposed to creating them from scratch.

"a blueprint for community banks and credit unions to get started on their own stress tests"

Banks and credit unions can tailor them to their own instances rather than building them from the ground up – editing the regulator-developed scenarios as opposed to creating them from scratch.

Baseline & Severely Adverse
What's in the 2022 stress test scenarios

The Federal Reserve Board, OCC, and FDIC provided two hypothetical scenarios: baseline and severely adverse. The stress test scenarios present hypothetical levels on common national level economic factors. The scenarios start in the first quarter of 2022 and extend through the first quarter of 2025. Each scenario includes 28 variables in total, with 16 of the variables being specific to the United States. The U.S. variables are:

stress tests economic variables for banks and credit unions

Baseline scenario

Generally, the baseline outlook for U.S. reactivity inflation and interest rates is very similar to October 2021 and January 2022 consensus projections that were utilized with the Blue Chip Economic Indicators report as well as the Blue Chip Financial Forecast. It’s important to note that these scenarios do not represent a forecast by the banking regulators.

The baseline scenario tracks an economic expansion, with the U.S. doing very well in 2022. This follows a 13-quarter economic expansion, and the unemployment rate goes from close to 4.5% at the end of 2021 to about 3.5% by the end of the total scenario. This decrease is tied directly to strong real GDP growth, which declines from about 6% at the beginning of 2022 to around 2% at the end of the scenario.

CPI inflation is also declining from the height of 8.5% at the beginning of 2022 to about 2.25% by the end of the baseline scenario. This scenario also includes an increase in interest rates to combat the aforementioned CPI inflation data.

All in all, the baseline scenario outlines a quite optimistic scenario following two years of the pandemic.

Severely adverse scenario

Conversely, the severely adverse scenario presented by regulators presents a very severe global recession combined with severe stress in the commercial real estate market as well as the corporate debt market. One of the key items driving commercial real estate price declines in this scenario is remote work, which largely started in the pandemic era and will then spill over to the corporate sector and affect investor sentiment.

The severely adverse scenario outlines the U.S. unemployment rate climbing to a peak of 10% in the third quarter of 2023. This is 5.75 percentage points higher than the fourth quarter 2021 level. The sharp increase in unemployment in this scenario is tied to a very tight decline in real GDP throughout 2022, followed by a very strong recovery. However, real GDP declines by more than 3.5% from the fourth quarter of 2021 levels to a trough in the first quarter of 2023.

During this period, CPI inflation falls from an annual rate of 8.5%, which is what it was at the end of 2021, to an annualized rate of about of 1.25% in the third quarter of 2022 before gradually increasing back above 1.5% by the end of the scenario. Long-term interest rates during this period remain relatively low compared to expectations in the baseline scenario.

Impacts on credit losses, home prices

It's important to note a few key components of the severely adverse scenario. Due to stress on corporate borrower balance sheets, we expect to see higher credit losses on corporate loans. This should be especially high in non-financial corporate borrowers.

We expect to see large declines in U.S. home prices, specifically in areas with rapid price gains over the past two years. Most of the rapid gains have happened in high-growth population centers.

The drop in housing prices would be combined with the drop in commercial real estate prices, particularly in areas that are tied to offices or hotels in urban locations that are particularly connected to business travel as well as other leisure activities such as shopping malls and strip centers.

Stay up to date with stress testing best practices.

With most institutions being tied directly to either 1-4 family lending or commercial real estate lending, the scenarios outlined here would result in dire circumstances for many community financial institutions.

Relevant Loss Rates
Applying the stress test scenarios practically

One of the ways institutions can use the material available in these stress test scenarios Is to tie their asset performance and their underlying financials to some of the economic indicators listed above.

One option is to look at historical performance and highlight the correlation or perform a regression analysis to determine which indicators have impacted the loan portfolio. Once the institution determines the relationship between its portfolio performance and relevant economic indicators such as unemployment or PCE or GDP, it can then tie those loss rates directly to the current portfolio.

Next, assuming higher levels of losses in a period such as the severely adverse scenario, it would be important for an institution to determine whether projected capital levels would suffice or whether they would fall under regulatory thresholds.

regulatory capital ratios chart for 2022

regulatory capital ratios for credit unions 2022

Should the institution fall under regulatory thresholds, it would have to propose a plan to ensure it would be able to increase capital levels during the same period that they would have higher losses.

Other benefits of stress testing

Institutions that have a strong stress testing process will find that the results also inform capital planning and asset/liability management exercises, enabling them to have more efficient use of capital or capital allocations.

The DFAST stress testing scenarios may technically be meant only for the biggest of the big U.S. financial institutions. However, smaller financial institutions can benefit from using the scenarios as a starting point to conduct their own assessments of capital resilience in a severe economic downturn.

How can you identify key vulnerabilities in the current environment? Read the whitepaper, "Stress Testing: Managing Capital Levels and Credit Risk."

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About the Author

Zach Englert

Consultant, Advisory Services
Zach Englert is a Consultant with the Abrigo Advisory Team, helping provide institutions with real-time solutions in the form of applicable credit risk management strategies and regulatory compliance. Zach routinely speaks at conferences and webinars covering current events and the impact on community financial institutions’ portfolios. By working with hundreds

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Abrigo enables U.S. financial institutions to support their communities through technology that fights financial crime, grows loans and deposits, and optimizes risk. Abrigo's platform centralizes the institution's data, creates a digital user experience, ensures compliance, and delivers efficiency for scale and profitable growth.

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