The OCC defines “top down” stress testing as “applying estimated stress loss rates under one or more scenarios to pools of loans with common risk characteristics.” This method of stress testing provides deeper insight into a financial institution’s portfolio or portfolio segment during stressed scenarios. For top down stress testing to be performed properly, banks and credit unions must appropriately segment their portfolio into pools of like characteristics, to which loss rates can then be applied.
Top down stress testing can uncover concentration and/or portfolio-wide risks – something that isn’t immediately apparent when analyzing individual loans or even groups of loans. If bankers know where vulnerabilities exist, they can use stress test results to allocate capital and make more effective risk management decisions. Here are two examples:
• Set appropriate capital reserves in preparation for potential adverse scenarios. Stress testing can determine if current capital reserve levels are sufficient or if changes are needed.
• Understand where your portfolio may be overexposed in a concentration – either due to type of asset, geography or potentially damaging economic events.
While the benefits are clear, obstacles to implementing a top down stress test certainly exist. One common issue faced by bankers surrounds the data requirements to accurately perform top down stress testing. Attempting to collect and update data can be a deterrent to stress testing, especially if the practice isn’t required (or enforced) by regulators.