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Stressing the importance of stress tests

Sageworks
March 6, 2015
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March comes in like a lion for the nation’s largest banks. Yesterday the Federal Reserve announced how “the big banks” fared on their annual stress tests (The Wall Street Journal’s Briefly blog offers what to know and what is relevant about the exams). The reports were positive: all 31 stressed banks “passed,” showing that they are stronger than they have been at any time since the tests began in 2009, the Fed reported.

It was a critical day in the eyes of those at Bank of America, Chase, Wells Fargo and others at the top. Thursday also served as a preview for their shareholders of what’s to come next Wednesday, when the Fed announces whether it has approved of each bank’s plans to return some of the reserved capital to shareholders, following the positive results.

Ultimately, the Fed’s annual stress tests of the largest 31 financial institutions is to ensure that the bank’s capital levels could withstand another financial collapse, should one occur. While federal regulators only require this small number of banks to be subject to these particular stress tests, as outlined in the Dodd-Frank Act following the economic crisis of 2008, stress testing is becoming a critical part of financial institutions’ risk management strategies, regardless of their asset sizes. Stress testing allow banks and credit unions to examine the portfolio, concentrations and specific borrower relationships to identify risk and make more informed capital planning and lending strategy decisions based on their individual results. Most importantly, each bank or credit union not under the Dodd-Frank criteria can use a variety of stress testing methods that best fit their needs and profile.

 

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During examination time, regulators are increasingly looking at a bank’s stress testing processes and resulting capital plans. Stress testing becomes particularly relevant following Basel III coming into effect in January. Banks of any asset size are now required to identify areas of risks that are not in line with their risk profile and adjust their capital where it is appropriate.

Community banks typically have less complex loan portfolios than larger institutions, so the actual capital calculation may not be as difficult. However, supporting that calculation with a reasoned stress testing analysis may become increasingly difficult for community banks that continue to use a basic spreadsheet analysis. The Basel III regulations were developed to ensure a bank’s ability to withstand an economic downtown, with the end goal of bolstering risk management techniques among banks, regardless of size. Stress testing is a critical risk management technique that deserves bolstering.

Rather than viewing Basel III as just another in a long list of regulations, banks should take it as an opportunity to develop a strong stress testing program and a strong risk management culture that will likely impress regulators.

To learn more about the advantages of stress testing, download this complimentary checklist, “A Banker's Checklist for Utilizing Stress Testing Results.”

 
About the Author

Sageworks

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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