Stress Test for Rising Rates and Other Adverse Outcomes

Last year, the Federal Reserve finally pulled the trigger on its first interest rate hike in nearly a decade. The rate increase was expected, and was small at only a quarter of a percentage point, but it did serve as a wake-up call to community banks reminding them that rates can and will go up. This has also reinforced the importance of assessing your current interest rate position and taking steps to protect your bank from any significant negative effects of rising rates. Not only will higher rates impact borrowers’ cash flow and ability to service debt, but they will also lower the value of income-producing property.

Stress Test Loans and Portfolio If you haven’t yet, you should stress test certain individual loans, and your portfolio as a whole, to see how they will be affected by rising interest rates. We have developed a few steps to help you get started in this process. The first step to stress testing is to develop internal policies as to which loans are required to be stress tested, at what points are they to be stress tested, and how often this is to occur. You will most likely have two types of stress tests. One at the individual loan level, which will be done prior to approval of new loans, and on an ongoing periodic basis (for example, with the annual credit review). This will aid management in underwriting and monitoring the relationship. The other type of stress test will be on the loan categories as a whole, done at least on an annual basis. The actual calculation to stress test these loans is fairly simplistic.

Add several hundred basis points to variable rate loans (both at your institution and debt elsewhere) and see what impact this would have on borrowers’ debt service capacity. Would borrowers still be able to generate enough cash flow to service debt given the incremental interest expense? In stress testing the whole portfolio, you will want to determine what percentage of the portfolio will no longer cash flow when rates rise 100, 200 or 300 basis points or more, or will fall below your margin collateral guidelines. By determining these impacts now, before rates have risen significantly, you can be proactive in helping borrowers take steps to minimize the detrimental impact of higher rates before it’s too late.

Testing Beyond Rates Interest rates aren’t the only factor you should be stress testing for. As regulatory guidance on stress testing makes clear, community banks should move stress testing beyond just interest rates to include other potentially adverse factors and outcomes. These might include:

• Falling rental rates and sale prices,
• Rising vacancy rates,
• Slowing absorption rates,
• Increasing operating expenses, and
• Rising capitalization rates.

So, for example, you could stress test your commercial real estate loans for a 10 percent decline in gross potential rent, a 15 percent increase in vacancy rates, a 5 percent rise in operating expenses, and a 10 percent increase in capitalization rates. Your goal is to quantify the point at which borrowers no longer generate enough cash flow to service their debt. For more guidance on stress testing, please give us a call 417-881-0145.