Taking a Common-Sense Approach to Commercial Loan Stress Testing

David_EtterBy David Etter

The initial reaction to reading the above headline from a number of bankers will be: “There’s no common sense involved in stress testing. Why do I need to do it? It’s not applicable to my institution … and even the big banks can’t get it right.”

Unfortunately, stress testing is here and now for financial institutions, and not just for the $50 million or $10-plus billion ones – and it’s not going away. Both the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC) have stated that stress testing is required, even for the smaller institutions (Credit Unions are still only required to do so at the $10-plus billion level). In a speech delivered electronically to the Independent Community Bankers of America Annual Conference on March 4, 2014, Thomas Curry (Comptroller of the Currency, spoke on a number of topics, including stress testing. On this topic, he said: “I can’t think of a more fundamental risk management practice than subjecting your credit book to rigorous testing.”

A common-sense approach to completing this required task is to first understand what are you stress testing. For this discussion, we will focus on the commercial loan portfolio.

For many institutions, the primary source of repayment for the majority of their Commercial Mortgages and Commercial Loans is cash flow. Focus on stressing your primary source of repayment. You do not have to stress your entire loan portfolio; you can stress a meaningful portion of it and apply the result to the portion of the portfolio not tested.

Many first reactions to the question of what to stress results in a litany of variables to be included. For much of your Commercial Real Estate portfolio, stressing the NOI and measuring the resultant risk based upon the revised cash flow directly or indirectly incorporates many of these factors. For example, if NOI declines, does not the value of the property? The level of risk in the credit is indicated by its risk rating assigned after the stress scenario is applied.

Not all loans will be impacted in a like manner to a stress scenario. Certain discretionary spending loan segments (such as hospitality) will likely react differently than others (such as multifamily). To this end, a risk based approach of assigning different stress amounts to high/medium/low risk loan types is appropriate.

The impact of applying a stress scenario is best understood using a risk migration analysis. Migration of risk ratings is a language that bankers and board members all understand, and are comfortable with. It is also one method where the FDIC and OCC were in complete agreement on in their written guidance on stress testing. The migrations analysis, as applied to the entire portfolio, can provide you with the pro-forma impact on Asset Quality – the first of the findings from a stress test as required by the regulators.

The results of a migration analysis can be incorporated into a re-run of your recent ALLL model on an “as stressed” basis. Inputting the results of the migration analysis into the ASC 450 portion of the ALLL calculation as well as adjustments to qualitative factors (such a changes to the level of Classified loans and changes to the collateral value of collateral dependant loans) will provide you with an “as stressed” ALLL. This leads to the calculation of a pro-forma Provision expense. This pro-forma Provision can now be inserted into the Earnings calculation to produce the second required findings – pro-forma impact on Earnings.  Once you have the pro-forma impact on Earnings, it is straightforward to calculate the pro-forma impact on Capital, the capstone of the exercise.

The above is a brief summary of one way to complete a stress test. Many of the bankers I have spoken to have focused on completing the stress test because the regulators require it of them. The following is a list of examples of where stress test results can provide meaningful information for bankers:

  • Portfolio concentration limits setting.
  • —Portfolio management resource allocation – pools less susceptible to adverse change in stress environment may receive lesser portfolio scrutiny or allocation of scarce resources.
  • — Annual strategic plan updates and capital discussions.

David Etter is the managing director of loan review services for Bennington Partners/Sheshunoff Consulting + Solutions. BP/SCS provides credit risk management services to financial intuitions throughout the U.S. David has 30-plus years of commercial lending and credit experience and has completed numerous stress test for clients over the past several years.