Just 10 years ago, those outside of a financial institution likely associated the phrase “stress testing” with a heart-healthy medical exam. Now, the phrase garners consistent consumer media attention in the financial press thanks to the economic crisis of 2008.
But stress testing is not only becoming an increasingly important box to check for bank regulators. This tool can and should be used to assist in setting capital levels, addressing risk appetite, and setting product lending limits. As regulations for community bankers continue to tighten in the final quarter of 2014 and into the new year, reporting on stress-testing results that your bank performs may require extra attention from bank executives.
Since a bank or credit union’s board of directors meets only periodically, it is important for senior management to compile a meaningful report describing risks uncovered from the bank’s stress-testing efforts. This report should empower the board to assess current and potential risks within the loan portfolio.
A good first step to presenting the bank’s analysis is to determine which stress tests to include. This may seem daunting, since there is no one-size-fits-all approach, and various options and methodologies will demonstrate potential and future losses differently. When selecting stress tests, consideration should be given to what is being tested: the entire loan portfolio, one or two of the largest product concentrations, or both.
For most banks, stressing the entire loan portfolio using two or three top-down tests is appropriate. For banks with a large construction and/or commercial real estate portfolio, at least one or two bottom-up tests should be included. These two concentrations have proven to be especially risky and merit a closer look at the bank’s credit exposure in the event of a downturn.
After choosing the tests, consider keeping the presentation of the results brief. If the board only has a few minutes during the meeting to review a stress-testing report, summarizing the risks and building a narrative on the bank’s plans will need to happen quickly, yet still be effective. The report should start with a one-page executive summary including sufficient information that, if a board member reads only this page, he or she can walk away with an informed opinion of the bank’s risk.
Consider breaking the executive summary into three pieces that are easily digestible, including:
1. Summary. A summary which addresses recent portfolio and industry trends for key segments of the portfolio, including year-to-date net charge-offs for the bank and those segments. This section should also identify changes to portfolio risk level, as well as the stress-test results mentioned earlier.
2. Key risks and trends. Identify the two or three largest product concentrations and potential market risks that management expects to affect the portfolio, and explain how they will change loss expectations. It’s also important to summarize additional items such as interest rate changes in this section, and then go on to explain how management intends to mitigate these risks.
3. Conclusions and implications. This section is most likely to merit scrutiny from the board, since it will include management’s next-step recommendations. Identify the plan that management has in place to improve credit quality and improve overall risk. A strong narrative here will give a directive to the board. Additionally, plan to summarize economic conditions on a local and national level and offer an assessment of how the portfolio has performed relative to those conditions.
Pairing stress-testing results and analysis with an effective executive summary will allow for board members to best assess any necessary changes to be made within the bank’s portfolio, and to be in step with senior management on those actionable items.
Robert Ashbaugh is a senior risk management consultant at Sageworks and is responsible for assisting financial institutions with their ALLL and stress testing programs. Ashbaugh has more than 20 years of capital markets and commercial banking experience as both a portfolio ... View Full Bio