Typically, if community banks don’t stress test regularly for credit risks in their loan portfolios, they put themselves at greater risk. This is particularly true if they have a substantial amount of commercial real estate.
Stress testing improves risk management, strategic decision-making, capital adequacy, liquidity management, as well as bank value. However, unless a community bank has increased exposure to commercial real estate lending, most are not required to implement stress testing practices to mitigate their credit risk exposure.
In light of current economic factors, stressing your bank’s largest earning asset such as your loan portfolio can be a beneficial credit risk management technique to help identify and measure the loss exposure you could experience with potential future downturns and distress.
Various Approaches to Loan Portfolio Stress Testing
A few common methods used to stress the loan portfolio include:
Transactional 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
This method of 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.
Reverse Stress Testing
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.
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Invaluable Insight for Measuring Risk
With countless options available for community banks to conduct loan portfolio stress testing, the process can be very onerous for community banks. The key is to keep it simple. For many bankers, a simple spreadsheet can effectively to do the stress test. 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 in loan portfolio stress testing: to create a meaningful, routine practice of measuring risk that will produce valuable insight and can be incorporated into your strategic and capital planning processes for your community bank.Building an effective stress testing process for the riskiest asset on your 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 overall financial condition during difficult economic times.