Community Bank Stress Testing Defined

A stress test is defined as a risk management tool that consists of estimating the bank’s financial position over a time horizon – approximately two years – under different scenarios (typically a baseline, adverse, and severe scenario).


Is Stress Testing Mandatory?

Recent regulatory commentary suggests that community banks should be developing and implementing some form of stress testing on at least an annual basis. For additional perspective, consider the following excerpts:

  • A 2015 Sageworks Exam Survey found that over 75% of bank and credit union respondents (99% of which were below $10 billion in assets) are either already implementing stress tests, have been asked to expand their stress testing, or have been asked to start stress testing by examiners.
  • FDIC Governor Daniel K. Tarullo stated the following in June 2014, “Supervisory stress testing has fundamentally changed the way we think about capital adequacy. The need to specify scenarios, loss estimates, and revenue assumptions—and to apply these specifications on a dynamic basis—has immeasurably advanced the regulation of capital adequacy and, thus, the safety and soundness of our financial system. The opportunities it provides to incorporate macroprudential elements make it, in my judgment, the single most important advance in prudential regulation since the crisis.”
  • The OCC noted in October of 2012, “Some form of stress testing or sensitivity analysis of loan portfolios on at least an annual basis to be a key part of sound risk management for community banks.”


Benefits of Stress Testing

While the potential regulatory benefits are notable, stress testing should be viewed as more than just a regulatory check-the-box exercise. Similar to stress tests performed by cardiologists to determine the health of a patient’s heart, bank stress tests can provide a variety of benefits that could serve to ultimately improve the health of the bank. Stress testing benefits include:

  • Enhancing strategic decisions
  • Improving risk management and capital planning
  • Enhancing the value of the bank

For example, a stronger bank may determine that it has sufficient capital to withstand extremely stressed scenarios and thus can consider acquisitions, special dividends, or buybacks. Alternatively, a weaker bank may determine that considering a sale or capital raise is the optimal path forward. Additionally, estimating loan losses embedded within a sound stress test can provide the bank with a head start on the pending shift in loan loss reserve accounting from the current “incurred loss” model to the more forward-looking approach proposed in FASB’s CECL (Current Expected Credit Loss) model.


Mercer Capital Stress Testing Services

We acknowledge that community bank stress testing can be a complex exercise as it requires the bank to essentially perform the role of both doctor and patient. For example, the bank must administer the test, determine and analyze the outputs of its performance, and provide support for key assumptions/results. There are also a variety of potential stress testing methods and economic scenarios for the bank to consider when setting up their test. In addition, the qualitative, written support for the test and its results is often as important as the results themselves. For all of these reasons, it is important that banks begin building their stress testing expertise sooner rather than later.

In order to assist community bankers with this complex and often time-consuming exercise, we offer three potential solutions to make the process as efficient and valuable as possible.

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Stress Testing & Capital
Planning Toolkit

You do it yourself using our model – with a twist

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Custom Stress Testing & Capital Planning

Outsource the entire process to Mercer Capital

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Model Confirmation & Validation Services

Our experts will review and validate your existing stress test model


 

Mercer Capital Community Bank Stress Testing & Capital Planning Toolkit

This Toolkit provides a wealth of qualitative and quantitative data as well as excel models to assist your bank with the preparation of its Stress Test and/or Capital Plan. It was created specifically for community banks and intended to provide all the tools needed to perform a sound Stress Test.

While helpful for a variety of stress testing methods, the Toolkit is specifically designed to provide all the quantitative and qualitative pieces to assist banks with “top down” portfolio stress testing. OCC Supervisory Guidance noted, “For most community banks, a simple, stressed loss-rate analysis based on call report categories may provide an acceptable foundation to determine if additional analysis is necessary.”

“Top Down” stress testing consists of estimating stress loss rates under different scenarios on pools of loans with common characteristics. Four key steps that this Toolkit can assist you with:

  1. Determining the Economic Scenarios to Consider
  2. Segmenting the Loan Portfolio and Estimating Loan Portfolio Stress Losses
  3. Estimating the Impact of Stress on Earnings of Your Institution
  4. Estimating the Impact of Stress on Capital of Your Institution

The Toolkit is our most cost-effective option and provides bank managers and directors with the key qualitative and quantitative tools needed to prepare a reasonable and sound stress test efficiently.

Mercer Capital’s Toolkit contains the following analyses specifically tailored to your institution:

  • Local Economic and Market Demographics Snapshot
  • Overview of Key National Economic Conditions
  • Overview of Potential Stressed Scenarios to Consider (including key variables as outlined in the most recent Federal Reserve’s Stressed Scenarios)
  • An Overview of Historical Loss Rates for Different Loan Categories for Your Institution vs. Peer Group(s)
  • A Projection Model Designed to Assist with Estimating the Impact of the Baseline and Stressed Scenarios on Your Bank’s Earnings and Capital 

For more information on Mercer Capital’s Stress Testing and Capital Planning Toolkit, contact Jay Wilson here.

 

MERCER CAPITAL’S BANK STRESS TESTING & CAPITAL PLANNING TOOLKIT

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Mercer Capital’s Custom Stress Testing & Capital Planning

The hallmark of community banking has historically been the diversity across institutions and the guidance from the OCC suggests that community banks should keep this in mind when adopting appropriate stress testing methods by taking into account each bank’s attributes, including the unique business strategy, size, products, sophistication, and overall risk profile. While not prescriptive in regards to the particular stress testing methods, the guidance suggests a wide range of effective methods depending on the Bank’s complexity and portfolio risk.

Having successfully completed thousands of community bank engagements over the last 30 years, Mercer Capital has the experience and expertise to understand your bank’s unique strengths and weaknesses and help to solve your complex stress testing issues.

The Process

Mercer Capital can help scale and improve your bank’s stress testing by assisting your bank in a variety of ways, ranging from providing advice and support for assumptions within your Bank’s pre-existing stress test to developing a unique, custom stress test for your bank that incorporates your bank’s desired level of complexity and adequately captures the unique risks facing your bank.

Depending on the design of your stress tests and the potential economic scenarios under consideration, we will prepare a stress test and provide specific research to assist with key assumptions. During the planning process of the engagement, we will work with you to determine the level of complexity needed to address your concerns and objectives.

Regardless of the approach, the desired outcome is a stress test that can be utilized by managers, directors, and regulators to monitor capital adequacy, manage risk, enhance the bank’s performance, and improve strategic decisions.

For more information, contact Jay Wilson here.

Types of Custom Stress Tests

We provide custom stress testing services ranging from the “top-down” stress test to more rigorous forms of stress testing.

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icon_top-down-stress-testTop Down Stress Testing

Top Down stress testing consists of estimating stress loss rates under different adverse scenarios on pools of loans with common characteristics. Top down stress testing consists of four key steps:

  1. Determine the Economic Scenarios to Consider
  2. Segment the Loan Portfolio and Estimate Loan Portfolio Stress Losses
  3. Estimate the Impact of Stress on Earnings
  4. Estimate the Impact of Stress on Capital

Mercer Capital has designed a stress test Toolkit specifically to assist with the Top Down Stress Testing Process and also has stress testing models that can be customized to fit your bank’s needs.

For more information or to speak with Mercer Capital, click here.

icon_bottom-up-stress-testBottom Up Stress Testing

“Bottom Up” (also often referred to as transaction level stress testing) looks at key loan relationships individually, assessing the potential impact of adverse economic conditions on those borrowers, and estimating loan losses for each loan. The results of individual transaction level stress tests can then be aggregated to provide portfolio level results.

Here the key steps include determining which loan relationships to assess individually (should it be limited to particular types of loans or relationships above a specific size or loans tied to a specific industry/sector or some other factor).

In order to assess the potential impact of the economic scenarios and loss rates under each scenario, estimates of the probability of default as well as severity of loss in the event of default should be determined. This typically requires an intensive analysis of each credit and looking at key characteristics for each credit such as financial performance (debt-service coverage ratios, guarantor support), past-due history, collateral type and estimated value.

Once the loss rates are estimated for particular loans or loan relationships then the losses are estimated for each loan portfolio segment by aggregating the results.

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icon_reverse-stress-testReverse Stress Testing

Reverse Stress Testing can also be performed whereby a specific adverse outcome is assumed that is sufficient to breach the bank’s capital ratios (often referred to as a “break the bank” scenario). Management then considers what types of events could lead to such outcomes. Once identified, management can then consider how likely those conditions are and what contingency plans or additional steps should be made to mitigate this risk.

icon_enterprise-stress-testEnterprise-Wide Level Stress Testing

Enterprise-Wide Level Stress Testing attempts to take risk management out of the silo and consider the enterprise-wide impact of a stress scenario by analyzing “multiple types of risk and their interrelated effects on the overall financial impact.”

The risks might include credit, counter-party credit, interest rate, liquidity, reputational, operational, or legal risk. In its simplest form, enterprise-wide stress testing can entail aggregating the transaction and/or portfolio level stress testing results and then incorporating these other risks into scenario modeling to consider related impacts across the firm from the stressed scenario previously considered.

Board Presentations

We can discuss your internally or externally prepared stress test with your board to ensure that they understand the results and help to prioritize their strategic objectives/initiative.

For more information, contact Jay Wilson here.

 


 

Mercer Capital Model Confirmation & Validation Services

If you need an expert to review or validate your existing stress test model, we can help.

Mercer Capital is one of the nation’s leading financial institution valuation and consulting firm. Our professionals have over 30 years of experience working with bank management and boards of directors on strategic issues.

Mercer Capital’s confirmation & validation service can include:

  • Evaluating and assessing Stress Tests previously performed by management
  • Assessing the reasonableness of assumptions, results, and analytical approaches (both qualitative and quantitative)
  • Assisting management and the bank’s directors with incorporating the Stress Test results into strategic and capital planning
  • Propose recommendations to further enhance future stress tests

A qualitative review of the conceptual soundness of the methodologies being used, as well as the depth and appropriateness of supporting documentation is part of our service. Also included in our validation services is an in-depth report to assist your internal teams with stress testing requirements and help gain regulatory approval.

For more information, contact Jay Wilson here.

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To discuss your internally prepared stress test, complete the information below. One of our professionals will contact you.

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Stress Testing Timeline

We created a timeline that can help your bank develop a stress testing process and framework appropriate for the size and complexity of your institution.

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Benefits of Working with Mercer Capital

Mercer Capital is the nation’s premier financial institution valuation and consulting firm. Mercer Capital assists banks, thrifts, credit unions, and other depository institutions with significant corporate valuation requirements, transactional advisory services, and other strategic decisions.

Founded in 1982, in the midst of and in response to a previous crisis affecting the financial services industry, Mercer Capital has witnessed the industry’s cycles. Today, as in 1982, Mercer Capital’s largest industry concentration is financial institutions.

Despite industry cycles, Mercer Capital’s approach has remained the same – understanding key factors driving the industry, identifying the impact of industry trends on our clients, and delivering a reasoned and supported analysis in light of industry and client specific trends.

The Financial Institutions Group of Mercer Capital provides a broad range of specialized valuation and advisory services to the financial services industry.

Through a number of community bank engagements performed, Mercer Capital has developed several areas of expertise.

  • Mercer Capital regularly assesses and writes about economic and bank industry trends and market conditions.
  • Mercer Capital has analyzed and ultimately valued a number of community bank loan portfolios across the US ranging from clean to highly distressed, with sizes ranging up to several billion in unpaid principal balance. The process to value a loan portfolio is relatively similar to certain techniques utilized for stress testing including analyzing relevant economic and credit cycle trends and outlooks, historical loss performance, as well as expectations for future performance.
  • Mercer Capital has developed a proprietary loan scoring model to develop unique estimates as to the likelihood of default and severity of loss for loans. Mercer Capital has applied this scoring model to thousands of loans totaling over billons of dollars in unpaid principal balance.

Mercer Capital’s loan valuation work product, including likelihood of default and loss severity assumptions for both loan portfolios, as well as individual loans, has withstood review and scrutiny of both accounting firms and regulatory agencies.

You can rely on the industry expertise and analytical rigor of Mercer Capital for your stress testing needs.

 

To discuss a stress testing issue in confidence, contact a Mercer Capital professional.

Jay D. Wilson, Jr., CFA, ASA, CBA
901.685.2120 | wilsonj@mercercapital.com

Andrew K. Gibbs, CFA, CPA/ABV (Andy)
901.685.2120 | gibbsa@mercercapital.com

Jeff K. Davis, CFA
615.345.0350 | jeffdavis@mercercapital.com