Portfolio and Credit-related stress testing are key components of a risk management strategy for both community banks and credit unions. In its most simplistic definition, portfolio stress testing is the process of determining the effect of a change to your portfolio in light of an extreme, realistic event or events.
Although the Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd–Frank) made stress testing mandatory for large banks and financial institutions with assets greater than $10 billion, the majority of industry statement and regulatory guidelines clearly state that community banks that usually have far fewer assets gain the same benefits of identifying credit risks. Portfolio stress testing improves:
- Risk management
- Capital adequacy
- Liquidity management
- The value of the community bank or credit union
- Strategic policymaking
Choosing the Appropriate Portfolio Stress Test for Your Community Bank or Credit Union
There are many types of stress tests that assess the effects of every imaginable scenario on your loan portfolio, including:
Sensitivity analyses – Determines the impact of a large movement on single factor or parameter of the model.
Scenario analyses – Gives full representations of possible future situations to which portfolio may be subjected and specific scenarios today compared to worst case.
Historical – Follows a “history repeats itself” scenario and uses past events and actual outcomes experienced.
Hypothetical – Considers credible events that have or may happen and their plausible effect.
Event-based scenarios – Estimates the effect of one specific event on the market in general.
Portfolio-driven scenarios – Estimates the effect of one specific event that is directly linked to the portfolio.
Macroeconomic scenarios – Gauges the impact of an economic shift that is felt across various industries in varying degrees.
Market scenarios – Measures the impact of a historical or hypothetical shock to the financial and capital markets.
Catastrophe scenarios – Weighs the effect of catastrophes and post-event changes on portfolios and risk exposure.
At the very least, community banks and credit unions should stress test how market conditions could upset their portfolio segments. Even better is credit transaction stress testing, which you can use to estimate potential losses on an individual loan level by assessing the effect of changing economic conditions on a borrower’s ability to service debt. This proves to be invaluable data for community banks and credit unions where individual loans have a broader impact on the institution’s financial health.
The bottom-up method stress tests at the individual transaction level and then aggregates the results. Transaction level scenario stress testing can help in a “bottom up” analysis to:
- Determine a borrower’s vulnerability to default and loss
- Foster early problem loan identification and strategic decision making
- Strengthen strategic decisions about key loans, especially in certain segments such as agricultural, construction or commercial real estate (CRE)
From local economic changes and national interest rate changes to global pandemics and national emergencies, everyone in the banking and credit union industry knows that these factors affect a loan portfolio. No one can control the future, but you can perform credit risk analysis to come up with a plan for whatever the future holds. The Square 1 Credit Suite is a comprehensive tool for performing stress tests at the credit transactional level to give community banks and credit union leaders and boards the data they need to manage risk.
Maximizing the Benefits of Credit Risk Management Software
Maximizing the benefits of credit risk management software involves integrating the transactional stress testing component across your overall credit risk management process. Specifically:
- Developing and sticking to proper lending policies and procedures
- Following internal control procedures
- Identifying events that trigger the need for additional stress testing beyond the annual test, such as a local or national economic downturn
- Substantiating results
- Reporting results to your leadership and board who can lead the charge in responding with revised risk management and underwriting policies, asset liability management or capital accumulation and such
The Square 1 Credit Suite has simplified performing credit transactional stress tests, thus giving community banks and credit unions the ability to carefully manage credit risk. 2008’s Great Recession, the large number of community banks and credit unions that failed as a result and the subsequent Dodd–Frank Act is fresh enough in our memories to know that credit risk analysis and management are vital to a successful future for both community banks and credit unions.
For more information on credit transaction stress testing or CRE portfolio stress testing solutions for your community bank or credit union, contact our experts at Suntell, the maker of Square 1 credit risk management software today. Call 888.848.7349. Ext. 250 and ask for Kerry Ronquillo to discover how community banks and credit unions are using credit-related stress testing software to better manage risk.