Guidance on Stress Testing

Dodd-Frank Wall Street Reform and the Consumer Protection Act have been among the key concerns for bankers in recent times. One of the more confusing issues that community banks must address is stress testing. While community banks with $10 billion or less in total assets are not required by the new laws to perform stress tests on their loan portfolios, they are strongly encouraged to do so by the regulators. In fact, the Office of the Comptroller of the Currency (OCC) expects community banks to have “the capacity to analyze the potential impact of adverse outcomes on their financial conditions,” as is stated in guidance that provides some regulatory clarity for community banks regarding stress testing.

Bulletin OCC 2012-33, Community Bank Stress Testing: Supervisory Guidance, helps community banks with $10 billion or less in total assets determine how they can identify and quantify risk in their loan portfolios by using stress testing. “Some form of stress testing or sensitivity analysis of loan portfolios on at least an annual basis is a key part of sound risk management for community banks,” states the OCC bulletin. “Community banks that have incorporated such concepts and analyses into their credit risk management and strategic and capital planning processes have demonstrated the ability to minimize the impact of negative market developments more effectively than those that did not use stress testing.”

According to the OCC bulletin, the financial crisis demonstrated how an unexpected economic downturn and rapid deterioration in market conditions can significantly hurt a bank’s financial condition. Concentrations of credit, especially in commercial real estate (CRE) and in acquisition, development and construction (ADC) loans, have been a common factor in community bank failures, it noted. An important part of this guidance is that it incorporates other factors into stress testing beyond interest rates, such as falling rents/sale prices and increasing operating expenses. The guidance also recommends that community banks perform testing on their entire portfolio in aggregate and not just individual loans, at least annually.

The bulletin acknowledges that well-managed community banks routinely conduct interest rate risk sensitivity analysis. However, it notes banks "do not have similar processes in place to quantify risk in loan portfolios, which often are the largest, riskiest and highest earning assets.” Your goal should be to determine the potential impact of your borrowers’ collective abilities to service debt and maintain proper margin collateral on your overall loan portfolio. Deciding which factors your bank should stress test for (other than interest rates) will depend on the nature of your concentration risk.

The bulletin states “A community bank’s approach to stress testing should fit its unique loan portfolio strategy, size, loan types, composition, operations and management.” There are three different types of stress tests that community banks might consider using:

1) Transaction stress test – Estimates potential losses on individual loans and borrower's debt service ability, in cases of changing economic conditions.

2) Portfolio stress test – Can be used to evaluate current and future portfolio risks by assessing the impact of changing economic conditions on borrower's repayment ability.

3) Reverse stress test – Analyzes the types of events that could lead to a specific adverse outcome assumed by the bank. The guidance suggests a few factors that should be considered in any stress test:

• The test evaluates realistic risk scenarios and key vulnerabilities.
• The test makes rational judgments about the effects on earnings and capital, were a risk event to occur.
• The test’s analysis is incorporated into the bank’s overall risk management process, asset/liability strategies, and strategic and capital planning processes.

For more guidance and details on stress testing, please give us a call 417-881-0145.