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4 Methods of stress testing

Posted by Sageworks
4 Methods of stress testing

By Mary Ellen Biery, Sageworks

The Office of the Comptroller of the Currency’s October 2012 Supervisory Guidance and other guidance notes that an institution can use a variety of methods of stress testing to evaluate loan portfolio risk and to measure the potential impact on earnings and capital based on its own specific risk profile. The selected methodology should reflect the institution’s unique size, product mix, business strategy and sophistication.

Among the many methods available:

1. transaction stress testing, 

2. portfolio stress testing, 

3. enterprise-level stress testing and 

4. reverse stress testing. 

Both transaction stress testing and some portfolio stress testing approaches help create a “bottom up” look to assess borrower vulnerabilities as they relate to default. According to the OCC, transaction stress testing “estimates potential losses at the loan level by assessing the impact of changing economic conditions on a borrower’s ability to service debt.” The borrower being stressed could be a single customer or complex borrowing entity.

Stress testing benefits from this method include early identification of problem loans, which can help with early detection, relationship management and strategic decision making about key loans.

Similarly, a “bottom up” portfolio stress testing approach aggregates the individual transaction-level stress test results in an effort to identify risks within certain credit concentrations. With this methodology, a bank identifies or creates a new concentration to analyze, and then stresses it  These concentrations can be stressed to identify risky concentrations and assess potential impact.

A “top down” portfolio stress testing approach, by contrast, applies “estimated stress loss rates under one or more scenarios to pools of loans with common risk characteristics,” according to the OCC.

Regulators recommend that financial institutions create the various adverse scenarios based on macro and local economic data. “A bank may have to develop different variable assumptions for pools of loans with similar characteristics, such as geography and collateral type, within each scenario,” the OCC’s October guidance says. But the benefits may be numerous. “The process of stress testing portfolios can aid in strategic decision making, credit policy development, strengthen the quality of concentration risk management, support reserve methodology, and determine regulatory capital at risk,” the agency said.

Financial institutions with larger portfolios and more comprehensive internal databases can use loan migration analysis to assess how a “downward migration” in internal loan ratings might affect asset quality, earnings and capital, according to the OCC.

Enterprise-level stress testing considers the interrelated effects on the overall financial impact of multiples types of risk in a given scenario. Examples of types of risk include interest rate risk, counter-party credit risk and changes in the institution’s liquidity. The size and complexity of the institution should determine the sophistication of this type of stress testing.

Reverse stress testing is another type of “top down” approach, in that this method starts with the institution assuming a scenario that could critically harm it – a “break the bank” scenario. Then it works backward to evaluate the likelihood of such a scenario, to develop contingency plans and perhaps to mitigate identified risks.

To learn more about factors in stress tests and these different methodologies, download this new whitepaper, "Stress Testing: Who, What, When and Why". Or, watch a demo to see how financial institutions are using Sageworks Stress Testing, a portfolio stress testing solution, to systematize their data collection and analysis.

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