Why Stress Testing is a Must at Community Banks

5-7-14-credit-risk-management.pngWhile there is a lot of understandable energy being spent by community bankers and advocates to waive various mandates for community banks coming out of the Dodd-Frank Act and the international capital rules Basel III, there is one concept, periodic stress testing, which must be embraced going forward. Although it is not required for banks under $10 billion in assets, stress testing is a crucial tool for banks of all sizes to manage assets and risks. Stress testing is really nothing to fear. It can be done inexpensively. It’s also an integral component of emerging enterprise risk management (ERM) practices at community banks. Here are five reasons why stress testing helps your bank:

  1. Stress testing gives early warnings.
    No more important lesson was learned from the financial crisis than the need to move from a chronicling the past to a more forward-focused, risk assessment mindset. Virtually everything about ERM is about looking to the future, and stress testing helps banks identify early potential weak spots in product and collateral. This enables management to be more proactive. Time is very much the essence in reducing loan losses. And, through the use of unlikely hypotheticals, stress testing helps establish quantified boundaries of acceptable risk as well as quick, red light indicators of possible near-term problems.
  2. Stress testing ties traditional transactional credit risk to modern macro portfolio risk.
    Community banks are still struggling to grasp the benefits of macro portfolio management with its modeling and quantitative disciplines, still foreign to classic credit analysis and underwriting protocols. Stress testing is a perfect bridge between these two equally important credit risk management concepts. Trends emerging at the macro level can inform needed adjustments at the product offering and loan origination level.
  3. Stress testing provides in-depth concentration management.
    Stress testing allows you to understand your product lines in a more intimate manner—both for imbedded weaknesses and potential opportunities. It goes beyond the bluntness of raw concentration exposures to inform qualities of: underwriting, portfolio growth, infrastructure, personnel, training and even pricing.
  4. Stress testing documents defense of strategic/capital initiatives.
    Stress testing is no longer just about a theoretical portfolio loan loss estimate in a vacuum. It has emerged as an important tool in strategic, capital, liquidity and contingency planning by incorporating the impact of potential outcomes during times of stress. Within ERM, it forces not elimination, but mitigation of risk. Given the increase in small bank consolidations, stress testing also provides one of the most informative tools in evaluating strategic M&A initiatives. For example, estimating a targeted loan portfolio’s credit mark can be the by-product of stress testing.
  5. Stress testing engenders confidence in management.
    After reeling from the difficulties and distractions of the past five years, perhaps no benefit is greater than that of stress testing—along with ERM—imbuing bank boards and management with a legitimate sense that they are in command of their own destiny. As it validates the presence of effective planning and controls at community banks, early adopters of stress testing inevitably will improve regulatory and audit relationships. Bankers must get over the fear of being presented negative data: unattended, problems almost always get worse. Even when stress tests point out weaknesses or reduced capacity to withstand losses, it’s always better to have made those assessments on your own—thus beginning your own suggested remediation strategies. Not many people are talking about it, but one provision of Dodd-Frank allows regulators to assign a potentially punitive supervisory assessment of capital beyond the broader increased levels prescribed in the law. If such an assessment occurs, you could presume regulators thought management was unaware of the full scope of the organization’s risks. Active use of periodic stress testing can help immunize a bank from such an unwanted perception.

Stress testing at community banks is as beneficial as it is at the larger banks. An advantage the smaller institutions have is their greater implementation flexibility, given these tools are not specifically prescribed at their level. As long as the approach is practical, documented, and rational, its effectiveness is in the eye of the beholder—perhaps a rare win for community banks.