Unless a community bank has an elevated exposure to commercial real estate lending, most are not required to implement stress testing practices to mitigate credit risk exposure. In light of current economic factors, stressing your bank’s largest earning asset can be a beneficial credit risk management technique to identify and measure the loss exposure you could experience with potential future distress.
A few common methods used to stress the loan portfolio include transactional, portfolio-level and reverse stress testing. Several community banks have successfully implemented the first stage of the transactional method when underwriting credits. This bottom-up approach involves stressing specific elements, such as net income, for each individual credit or lending relationship. The second step aggregates these individual results to evaluate the overall impact to the loan portfolio.
Portfolio-level stress testing is a top-down approach used to assess the potential impact of deteriorating performance metrics to the loan portfolio as a whole, or a specific segment of it. A metric frequently used is an estimated loss rate, which is applied to the entire portfolio. The rate can be based on historical loss rates incurred during an economic environment similar to the one the stress test scenario is simulating. History indicates loss rates can vary for each loan type. Given this, a best practice for this approach is to apply assorted loss rates to different loan segments.
Community banks that stress their loan portfolios often blend the transactional and portfolio-level methods. This includes dividing the portfolio and pooling together loans with analogous characteristics. The individual segments are then stressed using metrics specific to each segment. The end product combines the results from each segment to illustrate the aggregated impact to the loan portfolio in a weakening economic environment.
The reverse method is a “break the bank” approach that examiners commonly calculate when assessing a community bank’s capital adequacy. This method determines the losses a bank can withstand before it falls below well-capitalized. Senior management teams can then brainstorm and document different scenarios that would realistically fit the level of losses calculated.
With countless options available, loan portfolio stress testing can be onerous for community banks. The key is to keep it simple. For many, a spreadsheet can effectively do the trick. Additionally, we’ve found that community banks have the most success with this risk measurement technique when they customize it and apply a few select metrics that address the most significant risks contained in their loan portfolio. It’s important to always remember the overall objective: to create a meaningful practice that will produce valuable insight and can be incorporated into your strategic and capital planning processes.
Building an effective stress testing process for the riskiest asset on the balance sheet can be an invaluable credit risk management practice. Adding this process to your risk management toolbox provides senior management teams and boards of directors the knowledge they need to plan and better manage their bank’s financial condition during the rougher times.
Contact your Eide Bailly Professional for assistance with stress testing tips and guidance.
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