Thinking Forward—and Broadly: Using stress testing to achieve effective enterprisewide risk management

Do you fully understand your community bank’s risks and their impact on its capital and earnings? More and more community banks are using stress-testing modeling—and sometimes encouraged by regulators to do so—as a risk management tool to better understand these very risks.

Stress-testing risk modeling tools are now being used effectively by community banks in the areas of commercial real estate concentrations, liquidity contingency planning and interest rate risk management. These constitute exercises employed to conduct forward-looking assessments of the impact of a variety of adverse events. Stress-testing modeling can be used at all levels of an organization to undertake what is known as enterprise risk management.

Stress tests are developed to be commensurate with the complexity, size, and number of lines of an institution’s business and overall risk profile. You will be disappointed to learn there is no one application that will fully define the scope and purpose of a stress test. An institution may employ several different approaches. However, these seven elements should be present in any comprehensive stress-test framework: defined objectives, scenarios tailored to the specific community bank, documented assumptions, sound methodologies, informative management reports, effective review of processes and recommended actions based on stress-test results.

Common stress-test approaches

One popular stress-test model involves a scenario analysis that exposes a bank’s vulnerabilities to hypothetical events and measures their effects on exposures, activities and risks. Downturns in markets and changes in interest rates, inflation, unemployment trends, bankruptcies and foreclosures may all influence the results of a scenario analysis test. Risk measurement tools should translate a scenario analysis into effects on the balance sheet, changes in risk metrics, potential losses, deterioration in asset quality, rising levels of non-accrual assets and increasing Other Real Estate Owned (OREO) properties and their associated costs.

A second alternative in stress-test modeling analysis is known as sensitivity analysis. This testing framework involves evaluating 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, for example, 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.

A third stress-test modeling option involves enterprisewide risk stress testing. This technique places heavy emphasis on evaluating capital and liquidity. Enterprisewide stress testing is a tool to assess a full set of risks under adverse conditions that links all levels of risk from macroeconomic and marketwide events. This analysis evaluates a combination of risks by selecting variables such as the change in economic growth (Gross Domestic Product); a shift in the unemployment rate, interest rates and stock market values; and fluctuations in housing starts and housing prices.

Capital and liquidity tests

Recent stress tests on capital buffers in view of certain changing economic conditions were conducted to assess the adequacy of capital and liquidity. These tests evaluate the interaction between capital and liquidity and what results if the two are simultaneously impaired. The high-stakes testing should be conducted in connection with a bank’s overall strategy and annual planning.

Enterprisewide capital adequacy testing should include 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 capital position and compliance with regulatory capital ratios.

Liquidity tests and contingency planning help a bank identify and quantify the liquidity excesses, sources and possible impacts on cash flow (sources and uses statements), liquidity positions (ratios and limits) and profitability over various time horizons. Liquidity testing may reveal potential funding shortfalls, shortages in liquidity assets, possible deposit outflows and volatility in short-term brokered deposits.

An effective stress-testing framework must always explore the potential for capital and liquidity problems, which often arise simultaneously. For example, banks 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.

Management issues

A bank’s board of directors and its senior management are responsible for overseeing the stress-testing framework. The stress testing should be comprehensive, integrated and applicable to a bank’s broader risk management process. A board should ensure its bank has an effective stress-testing framework, and senior management is generally responsible for implementing the framework.

The requirements of a valuation of potential losses that could jeopardize earnings and capital should be an exercise to protect your community bank and adhere to best practices in risk management. The comprehensive understanding of potential loss exposure just seems like a standard practice that would already occur in your community bank’s earnings and capital planning processes.

No single stress test 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 mandate from regulatory agencies (at least for banks under $1 billion in assets), but it is part of sound risk management. As such, the best practices utilize stress testing as an effective tool to make informed risk management and business decisions.

Seven Keys to Effective Stress-Testing Oversight

Source: Chartwell Compliance.

Bruce Naylor, a former community banker, is a consultant with Chartwell Compliance, a consulting service provider for ICBA Compliance & Risk Management, ICBA’s compliance and risk management services program for community banks.

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