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Stress Testing: Are the Results Guiding Your CECL Decision-Making?

October 9, 2019
Read Time: 0 min

According to economists, a recession is looming. In a recent survey by the National Association for Business Economics, 74% of economists who responded expect a recession by the end of 2021.

Historically low levels of losses have allowed reserve levels to go below pre-financial crisis levels. Charge offs were close to zero for most banks since 2013, according to call report data from S&P Market Intelligence. So the question remains: would they hold up against a recession? Stress testing gives an institution a serious look into their capital and reserves, and if they possess enough of each to remain viable, should a recession hit. It also provides guidance for the impact of the new accounting standard, Current Expected Credit Losses (CECL), on the portfolio. The impending implementation of CECL is forcing institutions to perform economic forecasts, as opposed to the current allowance for loan and lease losses (ALLL) model which focuses on previously incurred losses, to have a more holistic and accurate depiction of risk. It takes into account the entire life of a loan instead of just looking a few years down the road.

Both CECL and stress testing take top-down and bottom-up approaches to test the capital adequacy of a financial institution. However, it is important to determine which method is right for your institution. In a recent Abrigo webinar, CEIS Review’s Dean Giglio and David Vest and Abrigo’s Tim McPeak discussed the pros and cons of each approach in both CECL implementation and stress testing.

The top-down approach

Larger financial institutions ($25B and up) have historically used the top-down method of stress testing, which uses pool orientation and segmentation, putting portfolios into pools with similar risk characteristics. It focuses on macro-economic changes and develops the stressed loss rates for each segment.

The top-down method uses information readily available at the institution, such as year-over-year losses, making it easier to implement because they do not have to source additional data. However, that doesn’t mean it comes without some warnings. Institutions might be tempted to segment their portfolios into too small of a population and risk appetite, making the data not statistically significant. The CECL standard requires institutions to pool loans based on common risk characteristics, but risks pools getting too thin may not produce meaningful results. With many institutions already over segmented with too many pools containing too few loans in them, it is challenging to balance between using meaningful risk characteristics and having the necessary loan counts in pools. Over segmentation can cause multiple issues, particularly with pools with little to no recent loss experience.

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The bottom-up approach

Bottom-up testing is typically used by smaller financial institutions (less than $25B) because it doesn’t require complex models or additional software. It relies on transactional data to apply a set of assumptions to a sample of individual transactions alone. It focuses on loans and leases, not letters of credit or stand-alone credit. With bottom-down testing, an institution can get granular in their results, creating various scenarios from mild to severe to determine the impact on debt service coverage, collateral values, and loss potential. The scenarios can include increases in interest rates, changes in cap rates by regions (this helps when evaluating collateral components), changes in rents, vacancies, or expenses, and CRE collateral stress. Institutions utilize current, forecast, and historical market data to put scenarios in context and, in some cases, combine scenarios to assess their impact. The concentration analysis as part of bottom-up stress testing can inform pooling for CECL and distinguish loss and downgrade behavior between segments in various economic scenarios.

The upside to bottom-up testing allows for a deeper dive into the results in a micro view and provides specific institutional impairment evaluation. The criteria institutions need to be conscious of is that it requires a large data population to produce. The data also has to be excellent quality, because holes in transactional data could result in problems, hence why it is not recommended for large institutions because they have too many loan transactions. Additionally, the financial information quality has to be current, fresh, and refreshed frequently.

Scenarios vs. forecasts

No matter if your institution decides to go with the transactional-based bottom-up approach to CECL and stress testing or the segmentation-focused top-down method, consistency is key. Regulatory communities and auditors want to see that CECL and stress testing remain as consistent as possible across the organization. Additionally, it is important to remember that CECL is an accounting exercise while stress testing is a regulatory or institution risk management process. Both the incurred loss model and CECL are subject to GAAP standards making it essential to delineate between scenarios (stress testing – what could happen and trying to quantify the impact of what that means) and forecasts (CECL – expectation for what we think will happen). Stress testing is still considered a model and needs to go through model validation. Substantial amounts of critical information can be obtained via the stress test activities, making it a handy tool to help guide CECL decisions.

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