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What is stress testing, and why should smaller financial institutions do it?

Apr 13, 2021

Stress testing is a management tool that helps a financial institution forecast its financial position using different what-if scenarios. It’s a way to understand your financial strength and identify risks that could have an adverse impact on your portfolio and earnings. 

Typically, if your financial institution is doing portfolio stress testing, you start with a baseline that would be your norm and then you would apply an adverse and then a severely adverse scenario and see how that affects your portfolio.

For example, you might model what would happen with high unemployment, a stock market crash or a recession. The Federal Reserve issues hypothetical scenarios each year to help financial institutions identify assumptions to test for. 

Why should we perform a loan portfolio stress test? 

It's often thought that stress tests are something only the largest financial institutions need to worry about. But that isn't true. Financial institutions with concentrations in commercial real estate are also expected to perform stress testing. And even when portfolio stress testing may not be expected, it’s certainly encouraged. 

Why stress testing is critical for any risk management practice

Stress tests can help you find the strategy that works best for bringing you through a crisis. Stress requirements for the largest financial institutions have contributed to the resiliency they've shown through the COVID-19 pandemic, which makes stress testing beneficial in a real, practical sense.

Conditions can deteriorate rather rapidly. The stress test itself can provide a better understanding of risk by providing a more forward-looking view to help you anticipate what's coming. Here’s why it’s critical: 

  • Identify risk: Stress testing will identify areas of heightened risks and potential concentrations of risk.
  • Strategy: Stress testing helps to form the strategy for dealing with risk. Plus, it can also help identify strategies you might currently have in play that could exacerbate unforeseen risks.
  • Communication: The stress test itself can help promote greater communication of risk information throughout the organization.
  • Mitigation: Better communication and understanding can, in turn, help formulate more effective mitigation against those risks.
  • Opportunity: Stress testing can identify potential areas of opportunity that you could take advantage of or exploit to a greater extent.

Stress testing should not be a “box checking” exercise, because it offers more than just risk mitigation. Stress testing can be opportunity seeking as well. We want to get as much value out of it as we can.

What's the best type of stress testing for your institution?

Your financial institution is unique. Your portfolio mix is unlike that of your competitors, and your capital structure is singular. Regulators recognize that a one-size-fits-all approach to stress testing is not reasonable. You have to figure out what works for your institution.

If you have the manpower internally, by all means, design your own stress test. That's definitely a good option, and lots of analysis can be done using simple spreadsheets. 

Maybe a software model is a more attractive alternative for you. If so, check with your current software vendors to see if they offer a stress testing component or a standalone model.

Where is regulatory guidance leading?

The implementation of company-run loan portfolio stress tests was a mandate of the Dodd-Frank Wall Street Reform and Consumer Protection Act for all FDIC-supervised banks and savings associations with at least $10 billion in total consolidated assets. Dodd-Frank Act Stress Testing (DFAST) was enacted in 2010. 

If your financial institution is not in one of the $10 billion or more categories, the mandate does not apply. However, per the Federal Reserve: 

“[Stress tests] force bankers to think through the implications of scenarios that may seem relatively unlikely but could pose serious risks if those scenarios materialized. Stress tests must be an integral part of a firm's processes for ensuring their capital is adequate.”

 

As the Federal Reserve aptly observes, the purpose of stress testing is to help financial institutions analyze, recognize and then act to ensure that risks, especially those related to your capital adequacy, are mitigated.

Clarifications for community financial institutions

Regulatory agencies continue to emphasize that all banking organizations, regardless of size, should have the capacity to analyze the potential impact of adverse outcomes on their financial condition. 

The controllers handbook Loan Portfolio Management issued in April 1998 says banks of all sizes will benefit by supplementing stress testing of individual loans with portfolio stress testing. Since then, we’ve seen regular and consistent encouragements in FDIC supervisory insights in the Federal Reserve System publications as well as other sources.

  • FDIC Press Release 54-2012, Agencies Clarify Supervisory Expectations for Stress Testing by Community Banks, May 2012
    • This stipulates that financial institutions with less than $10 billion in assets are not required to conduct the “types of stress testing articulated in the final supervisory guidance.” Note this should not be interpreted as “no stress testing.”
  • FDIC Supervisory Insights – Summer 2012
    • In a 2012 follow up, the FDIC acknowledged that expectations for community banks are more discrete and limited, but not nonexistent
    • Stipulates that portfolio stress tests are an important part of regular risk management.
    • Simple approaches to credit risk stress testing are acceptable.
    • As an example, guidance suggested that an analysis of interest rate shocks or loss rate simulations would be a good type of portfolio stress test.

So while there remains no broad mandate for smaller financial institutions, loan portfolio stress testing is a risk management best practice that is here for the long term. 

Commercial real estate concentration assessments

Note that stress testing is expected for community financial institutions with commercial real estate loan portfolios that meet the regulatory high level indicators. If yours is a financial institution that has a growing commercial real estate portfolio, you might want to review Federal Reserve S.R. Letter 07 01 entitled Concentrations in Commercial Real Estate, Sound Risk Management Practices. 

That guidance specifies the criteria that the agencies use to identify institutions that are potentially exposed to significant concentration risk when: 

  • Total reported loans for construction, land development and other land (Schedule RC-C, item 1a) represent 100% or more of the institution’s total capital (Schedule RC-R, line 21); and
  • Total commercial real estate loans as defined in this Guidance (Schedule RC-C, items 1a, 1d, 1e and Memorandum Item #3) represent 300% or more of the institution’s total capital, and the outstanding balance of the institution’s commercial real estate loan portfolio has increased by 50% or more during the past 36 months.

How Wipfli can help

Wipfli’s resources are deep. We have community banking and credit union specialists who have worked in your shoes and understand your regulatory environment. Contact us to learn about our stress testing model validation service.

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Author(s)

Janeen Bradshaw
Manager
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Karen A. Mitchell
Senior Manager, Risk Advisory Services
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Cynthia Brzeski, CPA, CRC
Manager
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