How to Use Stress Testing to Identify Credit Risks in Your Loan Portfolio

Community banks are recommended to stress test for credit risks in their loan portfolios, especially if you have significant commercial real estate concentrations.  If your bank fails to do so at least annually, it is putting itself at risk of experiencing adverse outcomes.

Although only required for large institutions, community banks benefit from stress testing the risk level of individual, product and portfolio levels. The importance of stress testing has been noted in several interagency regulatory statements and guidelines including Funding and Liquidity Risk, Concentrations in Commercial Real Estate and Statement of Interest Rate Risk. Stress testing improves risk management, strategic decision-making, capital adequacy, liquidity management, and bank value.

Using the Ideal Stress-Testing Strategy

There are a variety of stress test types for assessing credit risk. Knowing which ones to use is the first challenge. The general rule of thumb is to, at a minimum, consider the performance of portfolio segments that may experience similar risks when market conditions change. Some tests, like the transactional sensitivity analysis, evaluate each proposed or current loan. However, many stress tests evaluate a whole loan portfolio or major portfolio loan segments based on projected responses to certain conditions, like an economic downturn, increases in delinquency rates, or dramatic interest rate increases. Examples of loan segments are groups of loans classified as residential mortgages, construction or commercial real estate (CRE). Smaller financial institutions can also use the top 10 to 20 individual loan exposures in a major loan portfolio segment, like CRE, and create stressed scenarios.

Loan portfolio level stress testing can be applied top down or bottom up. Top-down testing projects losses that would be experienced under different adverse scenarios on pools of loans determined to have similar characteristics. The bottom-up method stress tests at the individual transaction level and then aggregates the results. Another type of loan portfolio stress testing will evaluate loan portfolios and aggregate the transactions, and management uses the results to assess enterprise-wide impacts.

Strategic Approach to Stress Testing

To ensure stress testing generates the most benefits, community banks should integrate the testing process in the overall credit risk management process. That includes developing appropriate policies and procedures, applying internal control procedures, validating results, and reporting them to the Board of Directors and senior management. There should also be a process for triggering stress tests at any time when difficult conditions occur that could impact loans, like a local economic downturn. Board reviews of stress test results can lead to changes in risk management policies, underwriting policies, asset liability management or capital accumulation, to name a few.

Technologies have simplified the ability of community banks to perform stress tests and assist with analyzation processes. The 2008 Recession is constant reminder that strategic bank credit risk management is critical to bank sustainability. Government regulators encourage community banks to be forward-looking because future events include many risks – credit risk, interest rate risk, liquidity risk, operational risk, legal risk, IT risk and reputation – and credit risk overshadows them all.

For more information and tips on stress testing for your bank, contact the experts at Bank Strategic Solutions today by calling (800) 281-9980 and discover what we can do for you.