The $700 Billion Credit Question for Banks

It’s the $700 billion question: How bad could it get for banks?

That’s the maximum amount of losses that the Federal Reserve modeled in a special sensitivity analysis in June for the nation’s 34 largest banks over nine quarters as part of its annual stress testing exercise.

Proportional losses could be devastating for community banks, which also tend to lack the sophisticated stress testing models of their bigger peers and employ a more straight-forward approach to risk management. Experts say that community banks should draw inspiration from the Fed’s analysis and broad stress-testing practices to address potential balance sheet risk, even if they don’t undergo a full stress analysis.

“It’s always good to understand your downsides,” says Steve Turner, managing director at Empyrean Solutions, an asset and liability tool for financial institutions. “Economic environments do two things: They tend to trend and then they tend to change abruptly. Most people are really good at predicting trends, very few are good at forecasting the abrupt changes. Stress testing provides you with insight into what could be the abrupt changes.”

For the most part, stress testing, an exercise that subjects existing and historical balance sheet data to a variety of adverse macroeconomic outlooks to create a range of potential outcomes, has been the domain of the largest banks. But considering worst-case scenarios and working backward to mitigate those outcomes — one of the main takeaways and advantages of stress testing — is “unequivocally” part of prudent risk and profitability management for banks, says Ed Young, senior director and capital planning strategist at Moody’s Analytics.

Capital & Liquidity
The results of the Fed’s sensitivity analysis underpinned the regulator’s decision to alter planned capital actions at large banks, capping dividend levels and ceasing most stock repurchase activity. Young says bank boards should look at the analysis and conclusion before revisiting their comfort levels with “how much capital you’re letting exit from your firm today” through planned distributions.

Share repurchases are relatively easy to turn on and off; pausing or cutting a dividend could have more significant consequences. Boards should also revisit the strategic plan and assess the capital intensity of certain planned projects. They may need to pause anticipated acquisitions, business line additions and branch expansions that could expend valuable capital. They also need to be realistic about the likelihood of raising new capital — what form and at what cost — should they need to bolster their ratios.

Boards need to frequently assess their liquidity position too, Young says. Exercises that demonstrate the bank can maintain adequate capital for 12 months mean little if sufficient liquidity runs out after six months.

When it comes to credit, community banks may want to start by comparing the distribution of the loan portfolios of the banks involved in the exercise to their own. These players are active lenders in many of the same areas that community banks are, with sizable commercial and industrial, commercial real estate and mortgage portfolios.

“You can essentially take those results and translate them, to a certain degree, into your bank’s size and risk profile,” says Frank Manahan, a managing director in KPMG’s financial services practice. “It’s not going to be highly mathematical or highly quantitative, but it is a data point to show you how severe these other institutions expect it to be for them. Then, on a pro-rated basis, you can extract information down to your size.”

Turner says many community banks could “reverse stress test” their loan portfolios to produce useful insights and potential ways to proceed as well as identify emerging weaknesses or risks.

They should try to calculate their loss-absorbing capacity if credit takes a nosedive, or use a tiered approach to imagine if something “bad, really bad and cataclysmic” happens in their market. Credit and loan teams can leverage their knowledge of customers to come up with potential worst-case scenarios for individual borrowers or groups, as well as what it would mean for the bank.

“Rather than say, ‘I project that a worst-case scenarios is X,’ turn it around and say, ‘If I get this level of losses in my owner-occupied commercial real estate portfolio, then I have a capital problem,’” Turner says. “I’ll have a sense of what actions I need to take after that stress test process.”

A key driver of credit problems in the past has been the unemployment rate, Manahan says. Unemployment is at record highs, but banks can still leverage their historical experience of credit performance when unemployment hit 9.5% in June 2009.

“If you’ve done scenarios that show you that an increase in unemployment from 10% to 15% will have this dollar impact on the balance sheet — that is a hugely useful data point,” he says. “That’s essentially a sensitivity analysis, to say that a 1 basis point increase in unemployment translates into … an increase in losses or a decrease in revenue perspective to the balance sheet.”

After identifying the worst-case scenarios, banks should then tackle changing or refining the data or information that will serve as early-warning indicators. That could be a drawdown of deposit accounts, additional requests for deferrals or changes in customer cash flow — anything that may indicate eventual erosion of credit quality. They should then look for those indicators in the borrowers or asset classes that could create the biggest problems for the bank and act accordingly.

Additional insights

  • Experts and executives report that banks are having stress testing conversations monthly, given the heightened risk environment. In normal times, Turner says they can happen semi-annual.
  • Sophisticated models are useful but have their limits, including a lack of historical data for a pandemic. Young points out that the Fed’s sensitivity analysis discussed how big banks are incorporating detailed management judgement on top of their loss models.
  • Vendors exist to help firms do one-time or sporadic stress tests of loan portfolios against a range of potential economic forecasts and can use publicly available information or internal data. This could be an option for firms that want a formal analysis but don’t have the time or money to implement a system internally.
  • Experts recommend taking advantage of opportunities, like the pandemic, to enhance risk management and the processes and procedures around it.

Recalibrating Bank Stress Tests to a New Reality

Any bank that stress tested its loan portfolios prior to the Covid-19 pandemic probably used a worst-case scenario that wasn’t nearly as bad as the economic reality of the last five months.

Stress tests are an analysis of a bank’s loans or revenue stream against a variety of adverse computer-generated scenarios. The results help management teams and their boards of directors gauge whether the bank has adequate reserves and capital to withstand loan losses of various magnitudes. One challenge for banks today that incorporate stress tests into their risk management approach is the lack of relevant historical data. There is little modern precedent for what has befallen the U.S. economy since March, when most of the country went into lockdown to try to flatten the pandemic’s infection rate. The shutdowns tipped the U.S. economy into its steepest decline since the Great Depression.

Does stress testing still have value as a risk management tool, given that we’re navigating in uncharted economic waters?

“I would argue absolutely,” says Jay Gallagher, deputy comptroller for systemic risk identification support and specialty supervision at the Office of the Comptroller of the Currency. “It is not meant to be an exercise in perfection. It’s meant to say within the realm of possibility, these are the scenarios or variables we want to test against. Could we live with what the outcome is?”

The Dodd-Frank Act required banks with assets of $10 billion or greater to run annual stress tests, known as DFAST tests, and report the results to their primary federal regulator. The requirement threshold was raised to $100 billion in 2018, although Gallagher believes that most nationally chartered banks supervised by the OCC still do some form of stress testing.

They see value in the exercise and not having the regulatory framework around it makes it even more nimble for them to focus on what’s really important to them as opposed to checking all the boxes from a regulatory exercise,” says Gallagher. “We still see a lot of banks that used to have to do DFAST still use a lot of the key tenets in their risk management programs.”

Amalgamated Bank, a $5.8 billion state chartered bank headquartered in New York, has been stress testing its loan portfolios on an individual and macro level for several years even though it sits well below the regulatory threshold. For the first time ever, the bank decided to bring in an outside firm to do its own analysis, including peer comparisons.

President and CEO Keith Mestrich says it is as much a business planning tool as much as it is a risk mitigation tool. It gives executives insight into its loan mix and plays an important role in decisions that Amalgamated makes about credit and capital.

It tells you, are you going to have enough capital to withstand a storm if the worst case scenario comes true and we see these loss rates,” he says. “And if not, do you need to go out and raise additional capital or take some other measures to get some risk off the balance sheet, even if you take a pretty significant haircut on it?”

Banks that stress test have been forced to recalibrate and update their economic assumptions in the face of the economy’s sharp decline, as well as the government’s response. The unemployment rate spiked to 14.7% in April before dropping to 11.1% in June when the economy began to reopen, according to the Bureau of Labor Statistics. But the number of Covid-19 cases in the U.S. has surged past 3 million and several Western and Southern states are experiencing big increases in their infection rates, raising the possibility that unemployment might spike again if businesses are forced to close for a second time.

“I feel like the unemployment numbers are probably the most important ones, but they’re always set off by how the Covid cases go,” says Rick Childs, a partner at the consulting firm Crowe. “To the extent that we don’t get [the virus] back under control, and it takes longer to develop a vaccine and/or effective treatment options for it, I think they’ll always be in competition with each other.”

Another significant difference between the Great Recession and the current situation is the unparalleled level of fiscal support the U.S. Congress has provided to businesses, local governments and individuals through the $2 trillion CARES Act. It is unclear another round of fiscal support will be forthcoming later this year, which could also drive up the unemployment rate and lead to more business failures. These and other variables complicate the process of trying to construct a stress test model, since there aren’t clear precedents to rely on in modern economic history.

Stress testing clearly still has value despite these challenges, but Childs says it’s also important that banks stay close to their borrowers. “Knowing what’s happening with your customer base is probably going to be more important in terms of helping you make decisions,” he says.