Stressing out stress testing for community banks
Following the 2008 financial crisis, the Basel Committee of Banking Supervision (BCBS) set out to “strengthen global capital and liquidity rules with the goal of promoting a more resilient banking sector,” formulating rules of which the final phase went into effect in January. Banks now will be required to identify areas of risks that are not in line with their risk profile and adjust their capital where it is appropriate.
Although bankers are now coming to grips with the new capital requirements, too many have struggled to develop the stress testing structure and capital analysis required by the new enterprise risk management programs. That’s unfortunate because these programs will be something that examiners look for and scrutinize. Consequently, many institutions have started to organize stress testing programs, using spreadsheets and whatever direction can be gleaned from regulators.
Community banks typically have less complex loan portfolios than larger institutions, so their actual capital calculations may not be difficult. However, supporting that calculation with a thoughtful, documented stress testing analysis will be challenging for banks that continue to use basic spreadsheet analyses. Basel III was developed to ensure a bank’s ability to withstand shocks, but it was also developed with the goal of bolstering risk management techniques among banks, regardless of size. And, unquestionably, stress testing is a critical risk management technique that deserves bolstering, through practices such as external data to support scenarios, real-time portfolio data from the bank’s core system and the ability to run and compare multiple scenarios.
Many banks already stress their liquidity positions and interest rate risk, but a stress test regimen that analyzes both credit concentrations and institution risks should be performed quarterly or annually for optimal performance. An institution-level, or top down stress test, can be quickly prepared using historical loss rates to calculate a two-year loss expectation. This test takes on more meaning, however, when additional tests are run using more extreme loss rates to create a range of potential losses for management to consider. Those losses could then be added to the balance sheet and income statement to create scenarios showing changes to capital and ratios such as return on assets and net interest margin.
Another test to consider is a bottom up stress test for each of the two or three largest product concentrations. These concentration tests would use actual customer financial information combined with hypothetical risk factors to simulate both reasonable and extreme situations. These tests are useful to manage concentration risk but are also valuable to set informed lending limits, manage the institution’s risk appetite and balance capital needs.
Basel III and its requirements are not intended to inspire fear; rather, they should help managers better run the bank and understand risk.