What to do with top down stress testing results
By Emily Li, Sageworks
In previous posts, we looked at the benefits that come with a top down or institution level stress test and reviewed the best methods for finding loss rates. Armed with that data, it’s time to review the results.
While financial institutions may be trying to stress test to satisfy regulators and check a box, they can better manage risks if they effectively use their stress test results in decision-making. Stress testing should inform and influence the management of portfolio concentrations that may be vulnerable to changes in market conditions. By knowing possible portfolio consequences, the institution’s management can assess these results and take action today to strengthen their institution’s financial position.
For example, a financial institution might change its loan pricing on certain types of real estate to attract or discourage loans in those areas. Or, it might modify its marketing efforts to target one sector or another. Indeed, executives at financial institutions are finding that an effective stress testing program can help them:
• Better understand where the portfolio may be overexposed in a concentration, either in type of asset, geography or other factors, as well as the type of economic events that may be especially damaging to the portfolio. Here, it is important to have clear reports from portfolio-level stress tests that highlight these overexposures. See an on-demand webinar on how to re-balance the portfolio using this information.
• Set appropriate policies, procedures, and limits for financial institution operations based on stress testing results. For example, stress testing may reveal weaknesses in current concentration limits. By setting more stringent concentration limits, institutions may be able to reduce future stress loss rates.
• Set appropriate capital reserves in preparation for possible adverse economic scenarios. Stress testing can provide a check of whether current capital reserve levels are adequate, allowing financial institutions to make well-supported adjustments to reserves.
The OCC’s October 2012 Supervisory Guidance noted various key metrics that an institution can use to evaluate the loan portfolio risk and to measure the potential impact on earnings and capital based on its own specific risk profile. Ultimately, the selected methodology should reflect the institution’s unique size, product mix, business strategy and sophistication. These chosen metrics should be used regularly and consistently to track changes in potential impairment amounts, as well as relative changes over time.
Learn more about top down stress testing by downloading a whitepaper: Benefits of Top Down Stress Testing.
This article was written by Emily Li, a project manager and quantitative analyst at Sageworks, who was involved with the development of Sageworks’ top down stress testing solution, Sageworks Stress Testing.