Small Banks and Stress Testing: Five Steps to Taking the Anxiety Out of Highly Anticipated Requirements


2-12-14-Crowe.pngAs banks with $10 billion to $50 billion of assets scramble to meet federal regulators’ new stress-testing requirements mandatory for 2013 reporting, smaller banks can breathe a fleeting sigh of relief. Although banks with less than $10 billion in assets currently are not subject to the stress testing required by the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), experts widely believe that the new regulations eventually will apply to these smaller banks.

Time Is an Asset

An April 2013 Crowe Horwath LLP survey revealed that only 20 percent of banks with assets between $10 billion and $50 billion considered themselves ready to comply with Dodd-Frank Act stress testing (DFAST). It is likely that if—or when—new regulations are applied to smaller banks, they, too, will find themselves racing to meet requirements.

Small banks can take advantage of a benefit their larger counterparts no longer have: time. Before facing tight deadlines, small banks should prepare now for what many industry participants see as inevitable.

Be Proactive and Prepare

The following are five important activities small banks can initiate to prepare and position themselves for compliance with stress-testing requirements:

  1. Consistently capture data. All relevant loan data, including collateral descriptions, current appraised values and risk ratings, should be captured digitally as soon and as quickly as possible. This effort to assess your data ahead of time will be a tremendous benefit down the road.
  2. In addition, many small banks do not take advantage of advanced credit technology such as probability of default measures to evaluate loans. These types of financial technologies are essential to integrating enterprise loan data with complex econometric forecast models. Small banks that have not done so should implement credit risk metrics with granular capabilities.

  3. Create a cross-functional team. A stress-testing framework should capture an entire institution’s exposures, activities and risks. This enormous task must involve departments that typically operate independently from one another—risk, finance, treasury and credit. A designated cross-functional team can break down any existing silos and put its institution’s process on track.
  4. Include business-line heads. The back office on its own cannot create a road map for stress testing. Heads of each line of business must have input and a critical stake in the process. For example, if forecasts show an unfavorable capital position for a business unit, its leader and team likely will face constrained opportunities. Each business unit leader’s perspective is important, particularly in budgeting, planning, providing data, reporting and challenging forecasts.
  5. Expand budget forecast horizons. Banks with $10 billion to $50 billion in assets are required to stress test budget forecasts for two to three years into the future. Small banks, which typically forecast budgets that extend from six months to a year, need to start planning further ahead. Adding consideration of scenario-based budgets—alternative business plans based on potential events—also will need to become part of the regular planning process.
  6. Educate the board of directors. Preparing for effective stress testing involves extensive internal resources as well as potentially engaging external experts to assist with modeling and providing stress-testing support or systems. Boards of directors should have a strong understanding of the investment necessary to accomplish this effort successfully.
  7. Directors also should have full knowledge of their own role in the process. Boards of directors at banks with assets greater than $10 billion must approve their bank’s stress-testing results, so it is reasonable to conclude that directors at small banks could be required to do the same. Stress-testing results relate directly to directors’ responsibilities because the analysis can help set the strategic direction of a bank or should align with the strategy and risk appetite the board of directors already has established.

Every Bank Could Need to “Stress”

Federal regulators already say that all banks should be able to analyze how they would perform under a variety of scenarios and if they have sufficient capital to weather those situations. In addition, scrutiny of small banks making acquisitions has increased, with regulators asking acquirers to demonstrate the effect of a given transaction on their bank’s capital position.

Regardless of the impetus for readying to comply with stress-testing requirements, small banks should be realistic in setting goals. For many institutions, it can take between 18 and 24 months to prepare. With that in mind, now is the best possible time to get started.