Although community banks are not yet required to develop a stress testing program, increasing expectations have rightfully placed it at the top of many banks’ to-do lists. Required or not, stress testing is an effective way of understanding an institution’s potential risk exposures and the potential impact on liquidity, earnings, and capital.
During RMA’s November 15th audioconference, Edward P. Schreiber, Alvarez & Marsal (former CRO of TD Bank and special consultant to RMA), outlined the steps that banks ($10 billion in assets or less) should take to establish a stress testing program.
Mr. Schreiber stated that the stress testing program should be developed by management, particularly the credit administration or risk management areas. If a bank does not have these groups, then the finance department would be a second suitable choice. However, Mr. Schreiber advised against control residing in lending, citing the need for an independent group to oversee the process. Once developed, the program needs to be reviewed and approved by the Board or Committee of the Board.
The following key individuals or business lines should be involved:
- CEO
- CFO
- Senior Commercial Lender
- Head of Retail Lending
- Chief Credit Officer
- Chief Risk Officer
Management should take a holistic approach to designing the stress testing program, ensuring that it adheres to the institution’s risk appetite, liquidity plan, and capital plan. But Mr. Schreiber noted that before beginning this process, banks need to first look at data management. He argued that the quality of the data is the most important element of a sound stress testing program – a program can only be as good as the data.
Management and control of the data should always reside with the business line – never the IT department. Smaller banks can manage data with an Excel spreadsheet or Access database, however limitations exist. Larger banks should invest in a data mart or data warehouse.
Mr. Schreiber stressed that concentrations are king. Regulators question a bank’s concentrations and how the data is managed, which is important to the Board as well. To that point, commercial and retail books should be segmented. Commercial books, with regard to investment real estate, should be segmented as follows:
- Office
- Warehouse
- Hotel
- Apartment
- Retail
Once the book has been segmented, then key data elements need to be obtained to assist in the stress testing. For example, regarding Office Lending:
- LTV
- DSC
- Current rent role
- Occupancy
Retail books should be segmented as follows:
- Home Equity Loans
- Home Equity Lines of Credit
- Note: Home Equity loans or lines should be divided by the following:
- 1st liens and 2nd liens
- Geography
- FICO Scores
- Year the Loans were made
- Mortgage Lending
- Note: Book should be divided by geography and FICO scores
- Auto Lending, either direct or indirect
- Consumer loans
Again, Mr. Schreiber stressed that the ability to manage the data is critical to the effectiveness of the stress testing program.
Once the books have been segmented and key data elements are obtained and tested for data quality, stress test scenarios should be applied. Scenarios should be done on a best case, most likely, and worst case basis, considering key factors such as unemployment rate, oil prices, real estate market data by segment and geography, and historical loss data by loan segment.
The impact to earnings and capital should be estimated and analyzed with appropriate recommendations identified to address the impact. Findings should be presented to the Board for review and approval.
Mr. Schreiber ended the presentation by reinforcing the two critical components of a successful stress testing program: 1) quality data management; and 2) adherence to the institution’s risk appetite, liquidity plan, and capital plan.
