Stress Testing

Nick Rossini | Director of Enterprise Risk Management | Yadkin Bank

A community banker should not dismiss stress testing as purely a big bank activity. Supervisory guidance indicates stress testing is required of all banks with a significant concentration in certain loan types, such as commercial real estate, interest rate risk, and liquidity and funding as part of their ongoing risk management practices. According to Nick Rossini, banks might want to extend that practice to additional areas in order to better understand how different situations might impact their portfolio and capital position; helping management and the board game plan for the long term profitability and success of the financial institution.

Stress testing is defined as a forward-looking quantitative evaluation of stress scenarios that could impact a bank’s financial condition and capital adequacy.

There are essentially four types of approaches to stress testing:

  • Transactional Sensitivity Analysis – analysis of financial and market assumptionsimpacting a borrower or a project on a loan being considered for approval
  • Portfolio Loss Rates – applying a set of loss rates to a portfolio or subset of the portfoliothat the bank might expect during an economic downturn
  • Scenario Analysis – evaluating by loan type or concentrated segment the impact ofcertain variables, selected by appropriateness for the particular bank and its servicearea
  • Loan Migration Analysis – how a significant loan grade downward migration wouldimpact the bank’s financial condition

Banks are likely gathering all the data they need for stress testing in their ALLL estimation process. Further, if they are using a migration analysis with LGD (loss given default) and PD (probability of default), those computations provide all the information required to stress test any scenario.