Community Bank Stress Testing

For a hypothetical example to accompany this article, please see "Community Bank Stress Testing: A Hypothetical Example."

While community banks may be insulated from certain more onerous stress testing and capital expectations placed upon larger financial institutions, recent regulatory guidance suggests that community banks should be developing and implementing some form of stress testing and/or scenario analyses. The OCC’s supervisory guidance in October 2012 stated “community banks, regardless of size, should have the capacity to analyze the potential impact of adverse outcomes on their financial conditions.”¹ Further, the OCC’s guidance considers “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.”² A stress test can be defined as “the evaluation of a bank’s financial position under a severe but plausible scenario to assist in decision making with the bank.”³

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. However, the guidance does note that stress testing can be applied at various levels of the organization including:

Transaction Level Stress Testing: This method is a “bottom up” analysis that looks at key loan relationships individually, assesses the potential impact of adverse economic conditions on those borrowers, and estimates loan losses for each loan.

Portfolio Level Stress Testing: This method involves the determination of the potential financial impact on earnings and capital following the identification of key portfolio concentration issues and assessment of the impact of adverse events or economic conditions on credit quality. This method can be applied either “bottom up,” by assessing the results of individual transaction level stress tests and then aggregating the results, or “top down,” by estimating stress loss rates under different adverse scenarios on pools of loans with common characteristics.

Enterprise-Wide Level Stress Testing: This method 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.”⁴ The risks might include credit risk, counter-party credit risk, interest rate risk, and liquidity risk. In its simplest form, enterprise-wide stress testing can entail aggregating the transaction and/or portfolio level stress testing results to consider related impacts across the firm from the stressed scenario previously considered.

Further, stress tests can be applied in “reverse” 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.

Regardless of the stress testing method, determining the appropriate stress event to consider is an important element of the process. Little guidance was provided although the OCC’s guidance did note that the scenarios should include a base case and a more adverse scenario based on macro and local economic data. Examples of adverse economic scenarios that might be considered include a severe recession, downturn in the local economy, loss of a major client, or economic weakness across a particular industry for which the bank has a concentration issue.

The simplest method described in the OCC guidance as a starting point for stress testing was the “top-down” portfolio level stress test. The “Hypothetical Stress Testing Example” that follows provides an illustrative example of a portfolio level stress test based largely on the guidance and the example provided from the OCC.

What Should We Do with the Stress Test Results?

The answer to this question will likely depend on the bank’s specific situation. For example, let’s assume that your bank is relatively strong in terms of capital, asset quality, and recent earnings performance and has taken a proactive approach to stress testing. A well-reasoned and documented stress test could serve to provide regulators, directors, and management with the knowledge to consider the bank’s capital levels more than adequate and develop and approve the deployment of that excess capital through a shareholder buyback plan, elevated dividend, capital raise, merger, or strategic acquisition. Alternatively, let’s consider the situation of a distressed bank, which is in a relatively weaker position and facing heightened regulatory scrutiny in the form of elevated capital requirements. In this case, the stress test may be more reactive as regulators and directors are requesting a more robust stress test be performed. In this case, the results may provide key insight that leads to developing an action plan around filling the capital shortfall (if one is determined) or demonstrating to regulators and directors that the distressed bank’s existing capital is adequate. The results of the stress test should enhance the bank’s decision-making process and be incorporated into other areas of the bank’s management of risk, asset/liability strategies, capital and strategic planning.

How Mercer Capital Can Help

Having successfully completed thousands of community bank engagements over the last 30 years, Mercer Capital has the experience to solve complex financial issues impacting community banks. 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 that incorporates your bank’s desired level of complexity and adequately captures the unique risks facing your bank. 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. Feel free to call Mercer Capital to discuss your bank’s unique situation in confidence.

Endnotes¹OCC 2012-33 “Supervisory Guidance” on Community Bank Stress Testing dated October 18, 2012 and accessed at www.occ.gov/news-issuances/bulletins/2012/bulletin-2012-33.html. ²Ibid. ³“Stress Testing for Community Banks” presentation by Robert C. Aaron, Arnold & Porter LLP, November 11, 2011. ⁴OCC 2012-33 “Supervisory Guidance” on Community Bank Stress Testing dated October 18, 2012 and accessed at www.occ.gov/news-issuances/bulletins/2012/bulletin-2012-33.html.