What is a bank stress test?
In past posts, we’ve covered some granular topics like sourcing data for bank stress testing analysis, approaches or methodologies, and loss rate calculations, but some bankers are still asking the primary question, “What is a bank stress test?”
A typical stress test for a bank is a practice wherein bank management develops scenarios of stress environments (for example, property values declining by 20 percent), applies the stress scenarios to the bank’s portfolio, calculates the estimated impairment and finally uses that impairment to assess the potential impact the stress environment could have the bank’s capital and earnings.
Not all banks are required by examiners to perform this analysis. (What banks must stress test?) Yet, it is becoming a best practice for the banks that are more proactive and progressive in their risk management.
It can help identify the pockets of the portfolio that might be vulnerable to different factors and recognize overexposures in their concentrations, certain geographies, certain industries, other types of real estate, and so forth. Stress testing helps mitigate risk by looking at things more closely. It gives the financial institutions clues as to how they might improve their managerial practices by amending credit policies, pricing, or business strategy based on the desired risk profile. If they see some different things or unique things in the stress test, it can point them in the right direction. They say stress testing isn’t an exact science- it’s not going to give exact answers on anything- but it helps management. It gives them the ability to do scenario analysis and look at the different things they can do to better manage the bank.
To learn more about stress testing in community banks, download this whitepaper: Actionable Stress Test Results for Community Banks.
Or, learn more about why community and larger financial institutions rely on Sageworks’ top down stress testing solution, Sageworks Stress Testing, to understand their risk.