Why top-down stress testing is important
By Emily Li, Sageworks
According to the OCC, a “top-down” portfolio stress testing approach applies “estimated stress loss rates under one or more scenarios to pools of loans with common risk characteristics.” It provides an aggregate view of a portfolio or portfolio segment during stress scenarios, rather than analyzing the performance of individual loans. Top-down stress testing requires financial institutions to properly segment their portfolio into reasonable pools for setting loss rates and using an appropriate methodology for each of the segments. If used appropriately, top-down stress testing adds additional insight to a financial institution’s risk management practices.
The OCC has put out guidance on stress testing for community banks, saying that stress tests should be performed on the institution’s portfolio at least annually. In it, the OCC published a sample output of a portfolio level stress test as shown below, which contains key metrics on the impact on earnings and capital. Sageworks has also made available to institutions a downloadable, portfolio stress testing template with this same structure.
Top-down stress testing provides financial institutions with a high-level picture of their portfolio under stress scenarios that are not immediately apparent when analyzing loans on the individual level. It exposes concentration risks within the portfolio, as well as portfolio-wide risk. The results of top-down stress testing are important for making capital allocation and risk management decisions.
Results can highlight the magnitude of losses by segment and may inform the financial institution on which loan segments it should focus risk management practices, as well as pointing towards areas of emphasis in bottom-up stress test.
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.