Despite the lack of legal requirements for community banks to perform stress tests, recent regulatory commentary suggests that community banks should develop and implement some form of stress testing on at least an annual basis.
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. The guidance also notes that stress testing can be applied at various levels of the organization including transactional level stress testing, portfolio level stress testing, enterprise-wide level stress testing, and reverse stress testing.
In order to have a better understanding of the stress testing process, this whitepaper walks through an illustrative example of the primary steps to construct a “top-down” portfolio-level stress test. These steps include determining appropriate the economic scenarios, segmenting the loan portfolio and estimating losses, estimating the impact of stress on earnings, and estimating the stress on capital.