Stress testing: No one size fits all
While the 2008 financial crisis may be only an unpleasant memory to some industries, the event changed the way bankers do their jobs and how they keep their institutions running effectively. In light of the crisis, regulators are asking more banks to stress test. Bankers now need to go far beyond the risk management practices of yesterday, in favor of running worst case scenario situations to ensure their bank can remain standing should another crisis arise. Stress testing is not only a practice that federal regulators require for a lot of banks, it’s also a sensible business practices following a volatile economy, regardless of a bank’s size.
Stress testing may be just one hammer in a bank’s risk management toolbox, but it is a crucial one. The results of the stress testing process are helpful for a bank of any size to adjust their risk management strategies accordingly.
But, if stress testing is such a critical tool for financial institutions, then why isn’t there a standard model for the process? In 2012 the Office of the Comptroller of the Currency noted that banks can use a variety of methodologies for stress testing, including – transaction stress testing, portfolio stress testing enterprise-level stress testing and reverse stress testing. Each of these methods are accepted by regulators, so it’s imperative that the process be tailored to fit to reflect the institution’s unique size, product mix, business strategy and sophistication. There is no one size fits all model. The ‘what if’ scenarios and reporting can vary by financial institution, but many questions focus on changing interest rates, lending requirements, or overall health of the American economy.
The simulation can identify pockets of a financial institution’s portfolio at are more vulnerable than others to significant, or even minor changes to the economy. Two elements to these scenarios, however, are crucial – asking plausible questions within each situation, and honing in on the bank’s key vulnerabilities. Regulators will want to know the method used, and the results of the stress test, in addition seeing the documentation and data. Finally, the creation of a strategic plan of action determined by the bank’s management in light of the stress test report results. Aside from “checking the box” for regulators, this is the element of the stress testing process that is most beneficial to the individual institution – establishing a strategy unique to them.
Each spring, the Federal Reserve completes its annual stress testing of the largest financial institutions, as a result of the Dodd-Frank Act. Earlier this year, mid-sized banks – those with $10-50 billion in assets – were required to conduct stress testing for the first time. And while immune from required stress testing, community banks have been encouraged by regulators to implement the practice on their own. And while it still will not be required of community banks, when Basel III goes into effect on January 1, 2015, the new rules will impose significant changes to the regulatory capital framework. These new rules will likely making stress testing a more useful tool for risk management at the community bank level.
For more information on stress testing, download this complimentary whitepaper, Actionable Stress Test Results for Community Banks.