Although regulatory guidance has been clear in the petition for stress testing, it has been less clear in defining a stressed environment. To get the complete picture, a comprehensive stress test should be performed at three levels:
1. Top Down / Whole Portfolio – Institution Level
2. Concentration Level – Pools/segments and concentrations of loans
3. Customer Level – Individual persons, businesses or group relationships
Top down stress tests consider the interrelated and overall financial impact that multiple risk factors cause in a given scenario. Examples 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.
This type of stress testing may not necessarily require the use of a sophisticated model. It may be as simple as analyzing the potential effect of stressed loss rates on the CRE portfolio, capital and earnings. In the October 2012 Supervisory Guidance, the OCC called for annual, top down stress tests and bottom up stress tests on a concentration and loan level.
Guidance is provided for top down stress testing using loss rates, but little guidance is provided for bottom up concentration stress testing. Methodology is often left up to the financial institution.
The second and third levels mentioned above, concentration and customer level tests, can be considered bottom up stress testing.
Customer level stress testing focuses on the impact changing economic conditions have on a borrower’s ability to service debt. The relationship being stressed could be a single customer or complex borrowing entity, and the institution should use factors such as Cap Rate, Collateral Value, EBITDA, Interest Rate, Net Operating Income, Personal Income, Potential Gross Income or Vacancy Rate to ascertain estimated impact on cash flows. This analysis is typically performed as part of the underwriting process.
Concentration segment stress testing should use those same factors, but is applied to a larger contingent. A key, first step in concentration level stress testing is determining the segments and concentrations, which should include vulnerable segments or the segments that create vulnerability.
The institution can also consider using the stratifications outlined for FAS 5 Pools, which segregate loans based on similar characteristics such as geography and collateral type. Typically this would involve using filters such as Federal Call Code, Collateral Code, Product Code, Risk Rating, Total Exposure, MSA Code (geographic market), Origination Date or Loan Officer. Other filters can include NAICS code, tenant industries or loan structure.
An effective concentration will typically involve more than one filter. Start with homogenous-like pools for the appropriate segmentation code (collateral code, product, call code, loan type) and then drill down to more specific factors like exposure, risk rating or loan officer. For example, Commercial Real Estate, Retail; Risk Rated 5 or higher. In this example, an even more specific segment of an already vulnerable concentration is designated for stress evaluation.
Ultimately, the segmentation depends on the composition of a financial institution’s portfolio and how those assets are different in terms of loss drivers, data availability and overall level of risk to the institution. The goal is to better understand the vulnerability that those segments introduce – where the portfolio may be overexposed in a concentration, either in type of asset, geography or other factors, as well as adverse circumstances that would cause deterioration in the portfolio.
To find out more about the basics of stress testing, download this complimentary whitepaper on Stress Testing: The Who, What, When & Why.