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Stress testing revisited to avert risk and improve risk ratings

David Kistler
Posted by David Kistler
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There is a wealth of information made available by regulatory agencies and consultants around which types of loan portfolio stress testing methods should be used by financial institutions. Two ways in which stress testing results can be used to an institution’s advantage is to avert risk and improve the risk rating process. 

Avert Risk

The OCC’s October 2012 Supervisory Guidance notes that financial institutions that perform stress testing “have the ability to minimize the impact of negative market developments more effectively” than those that do not have a stress testing process in place. As CEIS Review Managing Director of Special Projects Elizabeth Williams explains: “Stress testing should help management identify pockets of the portfolio that may be vulnerable to changes in short-term interest rates or deteriorating real estate market conditions. Hopefully, that gives them a chance to make some changes today or prior to experiencing the actual stress.”

In addition to preventative benefits, stress testing may provide advantages in recovery. According to the OCC, institutions that have incorporated stress testing into their planning typically demonstrate an ability to withstand negative market developments more effectively than other financial institutions as a result of these beneficial risk management practices. In addition, “Management can use stress testing to establish and support reasonable risk appetite and tolerances, set concentration limits, adjust strategies and appropriately plan for and maintain adequate capital levels.

Improve Risk Ratings

A well-defined and executed portfolio stress testing process is certain to help financial institutions better understand, maintain and support appropriate risk levels within their loan portfolios. First City Bank, a $60 million-asset institution in Columbus, Ohio, has been performing bottom-up stress testing on their portfolio for over six years. Bank President Charlie Cecil explained that the bank segments their portfolio by filters such as geographic region and product type and then tracks the migration of risk grading by utilizing market data on trends in property values. Appraised values for properties are then adjusted by the amount of average decline in the market. Cecil commented, “These tests have provided us the ability to look at loan migration over time and see how things change from a stress standpoint.”

Like First City Bank, financial institutions can use the results of this type of stress testing to understand potential risk migration and to develop better risk rating strategies. As the 2012 FDIC Supervisory Insights suggests, “Stress-test results for individual loans can be used by loan officers and credit committees to better understand a borrower’s or property’s risk characteristics and position the bank (as lender) for unexpected adverse circumstances.” They can then use this information to update the risk ratings and pricing strategy.

Financial institutions can also utilize the results of portfolio stress testing to increase understanding of the risks inherent in certain segments of their portfolio and to leverage that information for strategic decisions on concentration limits and portfolio mix.

For example, executives at financial institutions are finding that an effective stress testing program can help them better understand where the loan portfolio may be overexposed in terms of concentration, type of real estate, geography or other factors. They are better able to identify which types of loans within a certain concentration have more potential for troubles, allowing them to make adjustments accordingly.

Learn more about stress testing methodology by downloading this guide, Actionable Stress Testing Results For Community Banks.

tags: bank regulations, OCC, portfolio risk management, stress testing