Stress Testing: Think Forward - A Tool in Building an Effective Enterprise Risk Management (ERM) Framework

 

What Good is a Stress Test?

Do you fully understand your risks and the impact on capital and earnings? Stress testing may be helpful as stress testing is incorporated into effective risk management practices. The use of stress testing as a tool in risk management in the areas of commercial real estate concentrations, liquidity contingency planning, and interest rate risk management are the disciplines more often addressed in stress testing modeling.

Stress Testing Benefits: Consider in Your Risk Management Practices

Banks gain the most benefit from stress-testing exercises when they are incorporated into the overall risk management and strategic planning process. The strategic value of stress testing may be the greatest during the expansionary phase of business cycles. Source: FDIC Supervisory Insights – Summer 2012

Stress Test Defined

Stress testing is an exercise employed to conduct forward-looking assessment of the impact of a variety of adverse events. Stress testing is used at all levels focused on enterprise-wide basis known as enterprise risk management. Stress testing is a valuable tool in highlighting events and concentrations and interrelationships and the impact on the bank in the wake of financial crisis and stress.

Stress Elements 

The stress test is developed commensurate with the complexity, size, lines of business and overall risk profile of the institution. Several elements are present in the stress test framework.

Stress Test Elements:

Common Stress Test Approaches

You will be disappointed to know there is no one application when defining the scope and purpose of the test. The institution may employ several different approaches. What should be emphasized however, is the approach which should clearly have the elements referred to earlier.

Scenario Analysis

A popular test is the scenarios analysis which exposes the bank’s vulnerabilities to hypothetical scenarios and the effect on exposures, activities, and risks. Downturn in market segments, sector declines, changes in interest rates, inflation development, unemployment trends, bankruptcies, and foreclosures may all be impact elements. Risk measurement tools should translate a scenario into impacts on the balance sheet, changes in risk metrics, potential losses, deterioration in asset quality, rising levels of non- accrual assets, increasing Other Real Estate Owned (“OREO”) properties and the associated costs to manage bank properties.

Sensitivity Analysis

A second alternative known as Sensitivity Analysis differs from scenario analysis in that it involves changing variables, parameters, or inputs without a reason. For example, asset and liability activities commonly use interest rate shocks to judge the change in net interest income. Understanding credit losses may require an increase in default rates and a decrease in collateral values. Commercial real estate exposures are impacted by adverse capitalization rates declines in net operating income, and occupancy levels.

Enterprise-Wide Risk Stress Testing

This technique places heavy emphasis on capital and liquidity. Enterprise wide stress testing is a tool to assess a full set of risks under adverse conditions. This is a link among all levels at the macroeconomic and market wide events. The combination of risks addresses the recession and financial crisis and the selection of variables such as the change in economic growth (GDP), unemployment rate interest rates, stock market values, and housing starts and housing prices. The effects in one unit may cause effects on other units. Assumptions across business lines and risk areas should be constant to yield the impact of common scenarios and the effect on the bank as a whole.

Stress Testing Benefits Dealing with Adverse Events: How we measure the impact on earnings and capital.

Stress Test Results can help credit personnel better understand risk exposures and position the bank for unforeseen adverse market volatility and downturn conditions.

Capital and Liquidity Tests 

Recent tests of capital buffers in view of certain economic conditions were conducted to assess the adequacy of capital and liquidity. The test evaluates the interaction between capital and liquidity and the impact of impairment of both at the same time. The high stakes testing should be conducted in connection with the bank’s overall strategy and annual planning.

Capital Testing

Enterprise wide capital adequacy testing includes pro-forma estimates of income and losses and the resources available to absorb losses and planned capital actions. A bank’s allowance for loan and lease losses and other relevant financial measures are critical to judging the capital position and compliance with regulatory capital ratios.

Liquidity Testing

Liquidity tests and contingency planning helps the bank to identify and quantify the liquidity excesses, sources, and the possible impacts on cash flow (sources and uses statements), liquidity positions (ratios and limits), and profitability over various time horizons. Testing may reveal potential funding shortfalls, shortages in liquidity assets, possible deposit outflows, and volatility in short term brokered deposits. An effective stress framework must always explore the potential for capital and liquidity problems which often  arise simultaneously. For example, organizations with stressed liquidity positions may need to sell assets at a loss to meet funding needs. This event impacts both capital (loss) and liquidity at the same time.

Simple and Straightforward Processes of Stress Testing:

Methodologies can be simple in base line and adverse scenarios. Sensitivity and Scenarios Analyses enable a bank to quantify the changing economy on loan quality, capital and earnings.

Strong Governance

The Board and Senior Management are responsible for oversight of the stress testing framework. The stress testing should be comprehensive, integrated and applicable to the broader risk management process of the bank. The Board insures the bank has an effective stress testing framework and senior management is generally responsible for implementing the framework.

Keys to Effective Stress Testing Oversight

Conclusion

The sheer name Stress Test conjures up the picture of an overweight individual on a treadmill. If you have concentrations in Commercial Real Estate performing portfolio levels, stress testing may be your work on the tread mill.

The requirements of a valuation of potential losses jeopardizing earnings and capital should be an exercise to protect your bank and adhere to best practices in risk management.

The comprehensive understanding of potential loss exposure just seems like a standard practice in your earnings and capital planning processes.

There are no single stress tests that can accurately estimate the impact of the broad range of risks. The market volatility, uncertain economic times, and the unintended risks of banking all contribute to the need for stress testing. It is not a dictate from regulatory agencies (for banks under $ 1 billion in assets) but it is part of sound risk management practices. The best practices make stress testing an effective tool to make informed risk management and business decisions.

Risk Management and Stress Testing View
Management Benefits of Stress Testing

Establish an Integrated Risk Management Plan – Allows Effective Key Risk Indicators communicated across the enterprise

View Risk Across Organization – Analysis of risk/reward profiles by Lines of Business

Stress Testing and Modeling – Ongoing basis to adapt to changing business conditions today and in the future

Effective Risk Measures and Models – Establishes Standards and Controls and creates an auditable environment

Data Validity and Retrieval – Collaborated data sources across the enterprise including clearing systems, portfolio/loan accounting, and market data.

Create a Competitive Advantage – Ability to achieve better returns by optimizing risk /reward strategies

Minimizing Non Revenue Generating Activities – A coordinated and collaborative approach with solutions from data management, risk analysis monitoring and reporting

Bruce Naylor is a Chartwell Compliance consultant, with over 25 years of Chief Executive and Senior Level experience at successful community banks in Fort Myers, Titusville, Winter Park, and Lake City, Florida. Mr. Naylor’s prior experience includes various roles such as Vice President and Area President at Bank of America as well as Supervisory Associate in the Office of the Chairman of the Housing Finance Board in Washington D.C. and Cincinnati, Ohio.

Mr. Naylor holds an MBA from the University of Missouri and is a Graduate of the School of Banking. His areas of expertise include: all areas of strategic planning; bank turnarounds; and risk management. Mr. Naylor has advised, created, and measured all aspects of risk during his tenure as Chief Executive and is recognized as one of the top risk managers in the financial industry. Recently, he participated in the Annual Meeting of the Independent Community Bankers Association and the Enterprise Risk Management program sponsored by the Florida Bankers Association.

Mr. Naylor’s contributions include informative publications on subjects such as: Board Planning; Retail Sales and Service Programming; and the Principles of Credit Risk Management. He continues his professional development at the State and National levels through the Florida Bankers Association and Independent Community Bankers of America (“ICBA”).


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