The Business Case for Portfolio Stress Testing

Some financial institutions consider stress testing the loan portfolio as one more regulatory issue to address, but that view is short-sighted, according to John P. Behringer, RSM’s national leader for credit risk services.

Portfolio stress tests can provide a number of benefits beyond compliance with regulatory expectations, Behringer said at the 2015 Risk Management Summit hosted by Abrigo (formerly Sageworks). These include:

• Early warning on potential problem loans
• Broader perspective on the loan portfolio’s overall level of credit risk
• More precise scenarios for use in capital stress testing
• Data point for consideration in ALLL adequacy analysis
• Assistance preparing for the implementation of the FASB’s current expected credit loss model, or CECL
• The ability for directors to establish and monitor portfolio risk against established risk appetite.

It should be similar to the way most people look at the stress tests for their heart, he said. “You don’t get a stress test because your doctor thinks it’s a good idea, right?” Behringer said. “You do it because you care about the results, and because it’s preventive medicine.”

In practice, however, board members or senior management may question the necessity of stress testing the loan portfolio or otherwise discourage the practice, Behringer noted. These skeptics may assert that the institution’s current loan-level stress testing is sufficient, that the results don’t make any sense, or that they don’t know how to use the results effectively.

In that situation, Behringer says asking the board or management some questions about potential future scenarios can crystallize the business case for stress testing. Here are five questions he recommends asking:

1. “How would a 100 or 200 basis point interest rate shock impact our borrowers’ ability to repay their loans?” While some institutions are eager for higher interest rates because they expect the change to boost profitability, a key assumption underlying that optimism is that borrowers will be able to repay, even with higher interest rates, Behringer noted. Stress testing helps predict whether that confidence is warranted.

2. “How does a drop in commodity prices impact our marginal borrowers’ ability to service debt?” Certain agricultural borrowers who had been doing well financially may be unable to make their payments in the face of lower commodity prices, Behringer said. Building a stress test that shows, for example, how a 10 percent drop in revenue could affect those borrowers would identify any need to restructure or work with some of those borrowers now, he said.

3. “How does a negative change in capitalization rates on multi-family or non-owner occupied commercial real estate impact net operating income for our borrowers?” Behringer noted that capitalization rates affect rent expectations for investors, which can impact not just the potential loss given default (LGD) but also the probability of default (PD) for an institution’s borrowers. Stress testing can help identify the risks related to a changing environment.

4. “Are we effectively monitoring concentrations, and how does a negative event in any one industry or vertical impact the asset quality of our entire loan portfolio?” For example, a bank or credit union with a lot of exposure to the oil and gas industry should be able to demonstrate how falling energy demand could affect not just oil and gas producers, but also suppliers and shippers tied to those industries.

5. “How would a stress event impact our aggregate loan portfolio, and, in turn, how does that impact capital?” With upcoming changes to regulations that could impact capital requirements, institutions should be looking at how they are positioned to handle those if, at the same time, interest rates increase or the economy slows, Behringer said. “What does all that do? We really need to think about that,” he said.

Many institutions cannot answer these questions without additional analysis, or leaders may be unpleasantly surprised by the answers, Behringer said. Once directors or executives realize this, they may more clearly recognize the benefits of stress testing that go beyond merely complying with examiners’ expectations.

“Think about how much money you spent in the last cycle, and how much heartache and stress was created by those bad borrowers,” Behringer said. Many institutions have indicated they would’ve done things differently had they known then what they know now about certain borrowers. Stress testing, Behringer said, “is a way to hopefully help you identify those” borrowers for the future.