Stress Testing for Risk Management and Capital Planning

Stress testing can be a powerful tool for evaluating the impact of adverse external events on a bank’s earnings, capital adequacy and other performance measures. It also can guide your institution’s risk management and capital planning efforts.

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 requires large banks — those with more than $10 billion in assets — to conduct annual stress tests. But until recently, there’s been some confusion about regulators’ expectations for stress testing by community banks.

Late last year, the Office of the Comptroller of the Currency (OCC) issued supervisory guidance (OCC Bulletin 2012-33) that provides some clarity on this subject. Although community banks need not adopt the “holistic” stress testing required of large institutions, the OCC considers “some form of stress testing or sensitivity analysis of loan portfolios on at least an annual basis to be a key part of sound risk management for community banks.”

Getting started

The OCC guidance recommends no particular stress testing method. But Appendix A to the guidance outlines several methods to consider, ranging from transaction (individual loan) testing to portfolio testing to enterprise-level testing.

These methods generally involve scenario analysis: The bank applies historical or hypothetical scenarios to predict the impact of various events, including severe recession, loss of a major client or a localized economic downturn.

The right method — it can range from a simple spreadsheet to more sophisticated models — depends on a particular institution’s portfolio risk and complexity. Most community banks can begin with a “top-down” approach at the portfolio level to determine whether additional analysis is needed. Using this approach, a bank applies estimated stress loss rates, under one or more scenarios, to pools of loans with common risk characteristics, focusing on concentrations of credit or loan portfolio segments that are significant to its overall business strategy.

Appendix B to the guidance provides a simple example illustrating this method. The bank begins by dividing the loan portfolio into pools, including “construction and development,” “1-4 family housing,” “nonfarm nonresidential property” and several other categories.

For each pool, it applies aggregate stress loss rates to quarter-end loan balances over a two-year stress test horizon. (According to the guidance, the impact of stress events typically evolves over a two-year period or longer.) The example uses OCC benchmark data to estimate loss rates. But institutions also can use their own historical data from previous stress periods.

The results are used to estimate the potential impact of the scenario on earnings and capital. The earnings impact is calculated by taking estimated “pre-provision” net income for the stress period, deducting the estimated loss, deducting a provision to maintain adequate loan loss reserves and then adding an income tax benefit.

The example uses Tier 1 capital and Tier 1 leverage ratios to estimate changes in capital caused by a scenario. But banks also may examine changes in other capital measures.

Digging deeper

Depending on the complexity of a bank’s portfolio and the results of initial testing, additional analysis may be appropriate. In some cases, a “bottom up,” loan-by-loan analysis may be valuable. And for other cases further segmentation of certain loan pools — such as commercial mortgages or construction loans — may be useful. For instance, an institution might segment commercial mortgages by debt-service-coverage or loan-to-value ratios to reflect different levels of risk.

The guidance also refers to the banking agencies’ 2006 guidance on commercial real estate (CRE) concentrations. The OCC expects banks that exceed the concentration thresholds established in that guidance to use more robust stress testing, taking into account property-specific characteristics and variables. 

Appendix C provides an extensive list of CRE-related stress-testing factors — interest and capitalization rates, collateral values, marketing costs, energy costs, vacancy rates and others — for various property types.

Taking action

Community banks can use portfolio-level stress testing to establish reasonable risk tolerances, set concentration limits, adjust strategies, and plan for and maintain adequate capital levels. If the results reveal significant risks or vulnerabilities, institutions should take action to mitigate them. This can be achieved by, for example, increasing portfolio monitoring, adjusting underwriting standards, selling or hedging assets, or increasing capital.

According to the OCC, community banks that have incorporated stress testing into their planning typically demonstrate an ability to withstand negative market developments more effectively than other banks do.

Managing CRE risk

The recent OCC guidance isn’t the first time banking regulators have encouraged community banks to conduct stress tests. In 2006, the FDIC, OCC and Federal Reserve published interagency guidance on Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices. Regulators expect institutions to employ enhanced risk management techniques, including stress testing, if they exceed or are approaching these thresholds:

• Total reported loans for construction, land development and other land represent 100% or more of total capital, or
• Total CRE loans represent 300% or more of total capital and the outstanding balance of their CRE loan portfolio has increased by 50% or more during the previous 36 months

In its recent guidance, the OCC says that banks exceeding these thresholds “are expected to use more robust stress testing practices to effectively manage the concentrations and maintain adequate capital.”