Stressed Into Selling?


3-18-15-Al.pngLast week, the largest U.S.-based banks passed the Federal Reserve’s stress tests. These results suggest each institution has sufficient capital to weather a significant financial shock. While the largest institutions in the U.S. remain, for the most part, on the sidelines when it comes to bank M&A, the test itself had me thinking about merger activity for the balance of the industry—roughly 6,600 organizations in total. Depending on the complexity of one’s business model, could modeling various economic conditions help a bank’s board to anticipate potential challenges and opportunities?

Banks above $10 billion in assets are required to conduct company-run capital stress tests, per the Dodd-Frank Act.  Banks below that are not. But what if they did anyway? I know for a fact that many of the banks below $10 billion do undergo the exercise not only for the sake of capital planning, but for other reasons as well. While stressing a smaller bank would certainly be expensive and time consuming, I see the exercise as valuable for many banks. With a bank’s capital tested, it strikes me that a follow-on to the results is a conversation about where the business might grow or expand and to shore up any vulnerabilities. For some, such a candid assessment of its strengths and weaknesses should lead to a discussion about a merger or acquisition, since M&A remains a principal growth strategy. So let’s play out a few scenarios.

Imagine a $2 billion asset bank with a significant commercial real estate exposure decides to shock its portfolio against various economic scenarios to make sure (1) it has sufficient capital and (2) it is generating sufficient return for the risk it takes on. While stress testing is primarily a risk management exercise, the results of the test might raise all kinds of questions, including whether or not the bank should remain independent, find a merger partner or consider staging an exit.  Admittedly, I have a hard time imagining that a bank would want to sell just because it can’t survive a worst case scenario. I do, however, think the results might reveal profitability weaknesses and make obvious potential problems with certain business lines that may not be fixed solely through “organic” means.

Alternatively, consider a similar-sized bank with a robust and diverse lending platform along with a proven credit culture. Testing its capital might reveal a credit engine running smoothly. Such a result could encourage the bank’s board to more actively pursue growth whether through organic means or mergers and acquisitions.

It strikes me that a number of factors are driving today’s bank consolidation: low valuations, lack of capital access, margin compression and slow loan growth. Given that the results of last week’s tests show the biggest players in our space are at least adequately capitalized and in a position to take on new risk, doesn’t it make sense for smaller banks to “plan for the worst and hope for the best” as they consider their future?

Assess, Don’t Assume: The Board’s Role in Basel III


With the change in capital requirements quickly approaching, many community banks believe they are well capitalized under the new Basel III standards. Yet most banks have not used the Basel III calculator provided by the regulators to truly assess their capital levels. In this video, Orlando Hanselman of Fiserv shares his thoughts on why the majority of community banks are not ready for this unprecedented shift to the basic banking business model, and outlines what boards should do to ensure their bank is not caught off guard.

For more information, check out Orlando Hanselman’s article on this topic

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.

Stress Testing: Should A Bank Build or Buy?


4-14-14-Trepp.pngThe banking industry received a rude awakening in March when the Federal Reserve rejected five banks’ capital plans and stress testing reports, indicating that the stakes are rising for stress testing. More banks are beginning to develop stress testing programs and directors are faced with the decision to rely on internal systems and models or to look beyond their institution to third-party data and solutions. More commonly known as “build versus buy,” this choice is a difficult one to make, as there is no one-size-fits-all approach. To provide decision-makers with some helpful guidelines, we focus on the following key factors that will determine which route a bank should take.

Data
The completeness of a bank’s data set will be a strong determinant in making the decision to build or buy. Small and large banks alike have been criticized by regulators for their stress testing models resting on what is deemed an inadequate base. In August 2013, the Fed published a report citing strengths and weaknesses identified in large bank holding companies’ stress testing approaches. A key criticism was, “weaker practices [that] failed to compensate for data limitations or adequately demonstrate that external data reasonably reflect” the bank’s exposures. A bank’s data should contain the following:

  • Metrics on loan performance, such as payment and delinquency history
  • Metrics that influence payment behavior, such as loan-to-value ratios, debt service coverage ratios, credit rating and cash flows
  • Measures of loss severity
  • Descriptors of the relevant market backdrop for the loan, borrower and property

In addition, the data should span at least a full credit cycle and be able to accurately represent the market. If a bank’s data sets are lacking in any of these areas, management should strongly consider the “buy” side, whether that involves augmenting data with that of a third-party or using a third-party model.

Resources
If a bank does not have sufficient internal resources to complete the required work to build a stress testing model, some level of outsourcing should be considered.

Staffing: To conduct stress testing completely independently, a bank will need to allocate personnel for management and oversight, data analysis, model creation, documentation, testing and validation. To provide a point of reference, large banks employ teams of 50 or more people for their stress testing work. A hybrid approach, in which a bank builds some components of the model and outsources other work, is also an option. If a bank chooses to use third-party models, regulators expect its management team to understand the ins and outs of the tools they are using, particularly in their stress test reporting.

Development and Maintenance: In developing a stress testing system, a bank must commit substantial resources to both systems and people for data warehousing, creating forecasting models, output collection, reporting, and of course, maintenance of the systems. Requirements and expectations will evolve over time, which means there will constantly be areas in need of improvement. While the largest commitment is upfront when a bank decides to build, it is also a sustained commitment.

Cost
Cost considerations are undoubtedly a significant factor in a bank’s decision to build or buy. Choosing to build incurs the highest cost—for both initial development and ongoing maintenance. Beyond the maintenance expected as a result of evolving regulatory requirements, technological advances will also involve a substantial investment. Spending will vary by the size and complexity of the bank and its system. Last year, three banks in the $50-billion asset range—Comerica, Huntington Bancshares, and Zions Bancorp.—announced that they were each spending in the neighborhood of $10 million on their regulatory compliance efforts, a large portion of which was understood to be for stress testing expansion. Smaller institutions will not be expected to spend as much, but building a system will easily cost hundreds of thousands of dollars upfront, and similar amounts to maintain.

The build versus buy decision for stress testing is not always clear-cut, as there are advantages to both. As banks look to increase their focus on qualitative aspects of the process and the entirety of the reporting procedure, building an internal model will make the bank an expert on their stress tests. Using internal data also ensures that reporting accurately reflects the bank’s current operations. On the other hand, third-party tools can easily prevent a bank from falling short due to budgeting or data integrity. Given the maintenance involved, buying is also considered less of a risk. Whichever way your bank goes, including a hybrid approach, it will benefit from more rigorous approaches to capital planning and capital adequacy stress testing.

The Regulatory Agenda and the Board: Five Key Issues


2-17-14-Dinsmore.pngThe Dodd-Frank Wall Street Reform and Consumer Act has been in effect for nearly four years, and almost 75 percent of the required regulations have been written or proposed. Issued regulations help to clarify requirements, but the climate created by expectations of regulators continues to create additional challenges for boards.

Boards must first understand these regulatory expectations and then balance them against shareholder interests at a time when it is increasingly difficult to meet earnings expectations. As a result, financial institution directors are asking, “What should I know?” and “What may be coming next?” While it is impossible to know exactly what may be next, there are themes that are emerging from the current environment to which directors should pay particular attention.

Stress Testing
This will continue to evolve for the larger banks. Models for credit are changing to take into account improving credit statistics. Models for pre-provision net revenue and operational losses continue to be refined. Smaller banks without stress testing should be developing their testing. Banks with more than $10 billion in assets are required to stress test, so boards must ensure that their models continue to be challenged and validated. Simultaneously, similar testing for liquidity is being developed, and the regulatory pressure to understand liquidity positions and make progress toward achieving required liquidity ratios will be significant. The board should understand where the bank’s testing stands along the developmental curve and be prepared to challenge findings and address changing needs.

Compensation and Human Resource Practices
Dodd-Frank requires financial institutions to review incentive plans and eliminate rewards for risky activities. At the same time, the so-called horizontal review of pay practices at the largest financial institutions are creating regulatory expectations and standards that may not be as apparent, but will require more board involvement in pay decisions and structures. There is no area that will be more difficult to get right, as many of the regulatory requirements are inconsistent with the expectations and demands of shareholders. Risk and compensation committees will need to interact more as it relates to pay practices. The board should be prepared to challenge reporting structures that could increase risk or negatively impact controls in the financial institution.

Mortgage Lending Requirements and CRA Performance
It remains to be seen how the new ability-to- repay and qualified mortgage rules may impact a bank’s Community Reinvestment Act (CRA) performance. Directors will need to keep a close eye on CRA performance at their institutions, as it may be more difficult to generate loans in the more underserved communities.

Third Party Providers
Guidance issued by the Federal Reserve in December on managing outsourcing risk made clear that responsibility for the activities of third party providers remains with the financial institution. The board also must ensure that clear policies for managing these relationships are in place and followed. Less obvious are newly issued proposed rules related to diversity. These rules require boards to ensure that there are policies and practices in place to promote diversity in the supplier base as well as the financial institution’s workforce.

New Products and Services
As the earnings environment faces declining revenue streams (like mortgage) and increased compliance expenses, financial institutions will search for new ways to grow revenues. Boards will need to pay close attention to strategic plans and include risk reviews of strategies (including new products and services) to ensure that they align with their institution’s risk appetite.

Any of these topics could be the subject of its own article on the role of the board and its committees, and there are endless other issues that could (and must) be considered. It is clear that the responsibility and time commitment of boards of financial institutions will continue to expand and evolve at a rapid pace for the near future. Keeping abreast of regulatory interpretations and expectations has never been more important to the success of a financial institution and its board.

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.

Stress Testing Crib Sheet for Board Members


1-24-14-Trepp.pngA bank’s board of directors has the role of fundamental oversight in stress testing. The most recent guidelines released for the Federal Reserve’s Comprehensive Capital Analysis and Review (CCAR 2014) under the Dodd-Frank Act include several directives for bank boards. Although the guidelines are mandated for banks with between $10 billion and $50 billion in assets, stress testing will likely be broadened, making current guidance a good foundation for banks below $10 billion in assets. Looking to get started? Here are some key takeaways for board members as they prepare for future stress testing compliance.

  1. The buck stops… with you.
    Perhaps the most significant expectation for boards of directors is that they are “ultimately responsible” for the bank’s stress tests. Board members should be receiving summary information from their stress tests, including results from each scenario. Beyond this awareness, the board should also be evaluating the results to ensure they appropriately reflect the company’s risk appetite and overall strategy.
  2. It’s a framework, not the SATs.
    The goal of capital adequacy stress testing is not just to pass a test, but rather to ensure that the bank could withstand major challenges to its viability—and having enough capital is a major factor. For larger banks, the board “must consider the results of the stress test in the normal course of business, including, but not limited to, the company’s capital planning, assessment of capital adequacy, and risk management practices.” Stress testing should be an integral part of the bank’s business planning process, and direct involvement of senior management and the board are essential. The role of the board in responding to existing challenges is similarly important, and incorporating stress testing into business planning demonstrates that the board is doing its part in disaster preparedness.
  3. Get and stay involved.
    While it is management’s responsibility to design and implement stress testing, the board needs to be involved in order to ask the necessary questions to provide an effective challenge process. In doing so, board members should always be in a position “to assess and question methodologies and results,” including model assumptions, limitations, and uncertainties, all of which should be sufficiently documented.
  4. Keep up with the times.
    The board “must approve and review the policies and procedures for DFA stress tests to ensure that policies and procedures remain current, relevant, and consistent with existing regulatory and accounting requirements and expectations.” While this mandate is rather open-ended, there are a few things to bear in mind about the newer Dodd-Frank-mandated stress testing for capital adequacy. Stress testing results should be produced for a minimum of the three required scenarios. Board members should not be hesitant to request additional scenarios. Capital adequacy stress testing goes well beyond stressing certain loan segments, which is the most common form of stress testing already in place at many banks. Rather, capital adequacy stress testing is comprehensive and involves impacts throughout the income statement and balance sheet exposures. Impacts (such as losses) should be estimated by drawing relationships between economic factors (like GDP growth) and the line items being projected. Current practice at many firms typically assumes that stressed losses would be a multiple (e.g., 2x) of historical losses, but these results are arbitrary.
  5. Get it in writing.
    The board should examine documentation annually (at a minimum) to confirm that it is adequate and shows that the bank has a robust process for producing and evaluating results. At banks with more than $10 billion in assets, the board or a board committee “must approve and review the policies and procedures of the stress testing processes as frequently as economic conditions or the condition of the company may warrant, but no less than annually.” With that said, thorough documentation is essential.
  6. Make it add up.
    For the purpose of consistency with the bank’s strategy as well as the board’s history, projected capital actions should coincide with the scenarios and internal practices in the bank’s stress tests. For example, dividend policy in each scenario should be consistent with any corporate restrictions and the board’s decisions in historical stress periods.

While these directives can be easily delegated to members of management, bank regulators have made it clear that the bank’s board of directors is accountable for successful stress testing implementation, results, and integration into future planning. As stress testing becomes more frequent and rigorous, the process should already be in the forefront of board members’ minds and corporate agenda. Eventually, stress testing results will become public. Banks that score well and do so cost-effectively will be rewarded in the marketplace.

Five Signs Your Bank Could Be Tripped Up by Stress Testing


11-22-13-Trepp.pngNote: This fall, banks with more than $10 billion in assets will be preparing stress test results for submission to regulators in early 2014, as required by the Dodd-Frank Act. This will be the first time stress testing is required of banks in the $10 to $50 billion range. While regulators are asking banks with less than $10 billion in assets about their stress testing plan, there is no current mandate subjecting them to the tests.

Bank directors working to implement a defensible stress testing framework are often challenged to strike a balance between rigor and flexibility. With the rules coming out of the Dodd-Frank Act subject to change, this is no easy task. Once the stress testing process is underway, bank teams can be quickly lulled into a false sense of security and fail to recognize seemingly innocent warning signs that stress testing is going to be a problem. We have identified five signs that suggest a bank is at risk to bungle its stress testing framework. If directors of large banks (with over $10 billion in assets) have not yet come across these topics in their stress testing process, it may be time to start asking questions. For smaller banks (under $10 billion in assets), there is no immediate cause for alarm, but starting to pose these questions will put the bank on firm footing when the time comes to begin running stress tests.

Red Flags to Watch For:

1. Stress testing is managed by analysts.

Be careful if stress testing is managed by analysts and the topic is not discussed in detail at board meetings from the beginning of the process. If management is not talking about the framework, cost of compliance, or the time involved, it is possible that the program has not been taken seriously or has not begun at all. For large banks, this would be troubling.

Some of the broader questions facing management include:

  • Should we build internal models or outsource?
  • Do we have enough data to construct and calibrate the model?
  • How do we validate the models?
  • Do we have the right people?

It should be noted that compliance with the stress testing mandates does not come cheaply. One large bank recently noted that it was spending $3 million per quarter on stress testing. While that kind of spending is not necessary for banks with assets below $20 billion, stress testing will still be a large line item. Making the correct decisions along the way can help to limit the amount on the check you need to write.

2. Stress testing is being conducted using an asset-liability management (ALM) model
(or by building a spreadsheet or application of historical industry levels).

Your models should utilize macro-economic variables, such as those supplied by regulators, to drive the results. If your bank is planning to use an existing system, an accounting database, and/or an ALM system, chances are that system has not been modernized to link macro-economic variables to probabilities of default across loan types, loan growth by business line, or net charge offs. The burden of proof that the bank’s assumptions are defensible, given the data, will be high.

Small and mid-sized banks do not have the staff in place to determine probabilities of default and loss given default across a spectrum of interest rate scenarios, unemployment levels, and GDP projections. As a result, retrofitting an existing model can’t be done easily. The biggest risk in going down this path is spending a lot of money up front only to learn that the regulators want something entirely different. Banks should look internally to determine what they are capable of, as well as at third-party vendors to attain the right model.

3. The model is built to handle only three defined scenarios.

The bank regulators have mandated that three separate scenarios be run by the banks: a baseline case, an adverse scenario, and a severely adverse scenario. The baseline case assumes an economy that is growing moderately. The adverse scenario is a currently a “stagflation” scenario—low growth, higher interest rates. The severely adverse scenario is a deep recession projection.

Banks that have implemented a model that meets these requirements may feel their work is done, but there is no obligation on the part of the regulators to maintain the same three scenarios. When the next set of regulatory macro-economic variables are released in mid-November, the Fed could opt for something entirely new, like a deflationary scenario. Accordingly, the models should be built to handle a wide array of inputs. Otherwise the bank will be re-building the model year after year and will be slow to see any benefits of cost tapering. Banks that get stress testing right may spend a lot up front but see costs taper over time. In order to see those benefits down the road, it is critical that a bank build the program on a solid foundation.

4. Regulators are brought into the process when results are submitted.

Banks want to ensure that they build a well-constructed model to accommodate future changes to regulatory requirements. Given that the regulations are still evolving, banks may find it difficult to follow a “measure twice and cut once” practice. The solution is to stay close to the regulators throughout the process. If your management team is not actively asking the regulators questions, whether it is about data sources, how they expect stress tests to look, how they feel about a top-down model versus a bottom-up model, or how to validate a model, the team is taking unnecessary risk. A bank does not want to submit results only to learn later that it had been going down the wrong path.

5. Stress testing is conducted as a separate mission from overall bank operations.

As many banks go through the stress testing process for the first time, they may set up their stress testing team as a separate unit from other divisions of the bank. Currently, that is probably a smart idea. The most important item right now for large banks is meeting the mandate. Along these lines, minimizing distractions and completing the task at hand is the focus for 2013 and 2014.

However, as stress testing evolves from a 100-yard dash to a more routine process, banks will be at a disadvantage if stress testing does not become part of a broader internal dialogue. Capital planning and forecasting should include stress testing results as a part of their ongoing processes, and management should challenge internal staff to consider alternative scenarios for risk management purposes. Those responsible for collecting the bank’s internal loan data should continually ask what data could be gathered to help generate more accurate projections. Over time, stress testing should develop to become an important consideration for all departments of a bank.

Most bank directors are worried about meeting the existing requirements under Dodd-Frank at the moment, but directors thinking about the next steps will avoid unnecessary pitfalls and costs. Given the amount of uncertainty that remains on this topic, board members should not hesitate to get more involved and ask questions, both of their teams and of the regulators. Hedging some of these common issues we have identified can cut costs both in the short- and long-term, minimize frustration when results are due, and help to develop an easily replicable process for the future.

Easing the Stress of Stress Testing


4-29-13_Crowe.pngDeadlines are looming for implementation of the stress tests required under the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank). The Office of the Comptroller of the Currency (OCC) has issued its final details on stress testing for banks, which went into effect on Oct. 9, 2012.

Executives should make sure that their board members have a thorough understanding of the organization’s compliance effort and the bank’s resulting additional responsibilities. Boards should also understand the potential benefits of getting implementation right.

Understanding What Stress Testing Entails
All banks with assets between $10 billion and $100 billion will need to put in place strong methods for producing forecasts for credit risk management and capital planning. However, the level of detail and reporting schedules will vary by asset category. Financial institutions with assets between $10 billion and $50 billion must submit their initial results in March 2014. While banks might feel as though they have plenty of time, implementing a stress-testing framework will take five to six months.

An effective framework should define how various levels of the organization—segments, business lines, and risk types—will work together to accomplish the following objectives:

  • Produce credible outcomes based on high-quality input data and information
  • Identify concentrations of exposures and risks
  • Reflect a bank’s unique vulnerabilities to economic factors that affect exposures and risks
  • Assess and forecast capital and liquidity adequacy at various quarterly horizons
  • Capture “interplay” among different exposures and risks and their combined effects

Managing the Increased Complexity of Stress Tests
The Dodd-Frank stress test is far more complex than the forecasts, loan-loss statements, and other reports that institutions currently must produce. To estimate a bank’s overall health, the stress-test provision mandates the use of prescribed economic scenarios issued by the federal government as well as a bank-defined scenario. These forecasts must cover rolling nine-quarter time horizons, beginning with position information as of Sept. 30 of each year.

The submission package includes the following components:

  • Capital plan, including risk appetite
  • Risk register
  • Risk assessment
  • Portfolio assessment and scoping
  • Stress-testing methodology approach and documentation
  • Fiscal year 2014 submission documentation and data templates

Instructions and templates can be found on the OCC website.

The OCC will assess the processes and practices banks use to analyze and assess capital adequacy, along with processes for risk identification and measurement and management practices supporting its analysis of a bank’s overall health.

Preparing the Board for Effective Oversight
The regulations stipulate that the stress test should adequately and effectively estimate how the bank’s portfolio may respond to prescribed shock scenarios. These estimates and measures need to include each exposure, expected losses, and capital demands throughout the multiyear horizon. These stress tests will become a key component of the bank’s ever-increasing capital planning and compliance requirements. The entire production, from data extracts through board review and approval, must have strong controls, documentation, and audit trails. Therefore, board members should be prepared to verify that their institution’s framework meets this baseline for effective procedures and that the stress-testing production provides effective and actionable information. The board should have an active oversight of both the stress-testing implementation project and the ongoing production.

Executives can help their board members by sharing quarterly updates and making sure board members are familiar with the institution’s credit portfolio, the different scenarios, understanding and interpreting stress-test results, and integrating and “harmonizing” stress-testing views with other existing and future forecasting and asset liability management functions.

Building on Initial Successes
Complying with the stress-testing provision will require a multiyear commitment on the part of institutions and their boards. Banks have the opportunity to both meet their initial regulatory obligations and advance and improve the sophistication of their bank’s risk management operations. In the first year, many banks will struggle to implement a foundational framework and basic processes. Over time, though, executives can develop additional capabilities to enhance the organization’s view of its risk. To support this progression, executives should present board members with a comprehensive strategy for implementation as well as a multiyear road map.

Moving Forward
In the coming months, financial institutions will have to undertake an ambitious effort to put the necessary controls and systems in place to support stress testing. As this endeavor will involve a substantial enterprise-wide investment, executives should confirm that their board members have a full understanding of and commitment to the requirements and potential benefits of effective stress tests. With a unified approach, a bank will be well-positioned to both meet the regulatory compliance objectives and enhance its organization’s risk management capabilities.

Stress Testing: Top Down or Bottoms Up?


Stress_Test_1-9-13.jpgRecent rule making for expansion of stress testing requirements to new constituencies and Basel III implementation have stirred uncertainty and angst among banks. Stress testing regulation includes significant detail on reporting templates, model management and capital planning guidance. Standards of practice are beginning to form.  However, regulatory guidance provided on methodological and modeling approaches to date has created confusion and caused a divergence of practice and a variety of modeling approaches among financial institutions. The appropriateness of each approach is widely debated. 

One point often lost in the discussion is that multiple approaches are suggested by the regulators’ Interagency Guidance on Stress Testing (SR 12-7) published in May, 2012, to properly manage and control model risk:

“An effective stress testing framework employs multiple conceptually sound stress testing activities and approaches.”

This guidance applies across the capital planning process, including credit loss estimation, liabilities, new business volumes, and pro-forma balance sheet and income statements. In this article, we limit our discussion to two conceptual approaches for modeling stressed credit losses: top-down and bottoms-up. 

In top-down modeling, exposures are treated as pools with homogeneous characteristics. Scenarios (i.e., macroeconomic or idiosyncratic, event-driven) are correlated to historical portfolio experience. The outputs from this approach are intuitive and easily understood outside of the credit risk function and can be readily calibrated and back-tested against on-going actual and projected performance. This is increasingly important as stress testing and capital planning requirements are forcing stress-testing analytics to be coordinated among treasury, finance and risk groups.

Top-down approaches can also be easier to develop since pool modeling is not exposed to idiosyncrasies or noise of modeling single-firm financial statements.  Additionally, historical data is readily available at most institutions since the same type of data is needed for modeling allowances for loan losses. A bank’s own loss experience can, therefore, be incorporated into the analysis, satisfying an element of the “use-test” criteria to validate models, which is so critical for management and regulators. 

Top-down modeling is well adopted for retail portfolios where homogeneous groupings are more easily identifiable. This approach can ignore important risk contributors and nuances for more heterogeneous portfolios (e.g., commercial real estate, commercial and industrial loans, project finance, municipal exposures). For these portfolios, top-down models serve better as a secondary or “challenger” modeling approach, rather than a firm’s primary modeling methodology. 

Bottoms-up modeling refers to counterparty or borrower-level analyses. Typically, the risk drivers for a specific segment or industry are correlated to macroeconomic variables.  Granular, borrower-level analysis reaches beyond regulatory mandated stress testing and can serve as a foundation for risk-based pricing, improved budgeting and planning, economic capital modeling and limit- and risk-appetite setting. It can also highlight the most desirable banking relationships while isolating the riskiest relationships and concentrations.   

Methodologically, there are several approaches to bottoms-up modeling. Many banks use actuarial modeling to determine credit risk transition, delinquency, default, as well as loss frequency and magnitude, but often miss critical factors such as the timing of delinquency, default and losses, which requires cash-flow based approaches. Many organizations do not possess the required data necessary to calibrate credit-adjusted, cash-flow models.

Few institutions have systemically collected borrower-level financial statements, or default and loss data over several business cycles. However, many treasury and asset-liability committee (ALCO) members prefer to think of balance sheet risk in a cash-flow (i.e., option-adjusted) fashion.  As a result, many organizations are required to supplement internal modeling with external data, modeling, and model calibration techniques from third parties. 

Bottoms-up modeling for stress testing will soon be applied to Basel III, potentially making it the preferred methodology in the long term.  For bank officers embarking on developing a stress-testing program who are less familiar with data and risk quantification requirements, development and firm-wide adoption may require additional time and cross-organizational buy-in.  Rapid implementation timelines driven by regulation, flexibility and intuitiveness of the approach, may make top-down modeling more attractive in the short-run; however, while expediency to meet requirements is critical, it is equally important to ensure the firm’s modeling architecture is designed to be leveraged and re-used once the firm is ready to graduate to a more comprehensive and holistic approach. 

While no single modeling approach has been blessed by regulators or emerged as a best practice, one thing appears clear: Use of multiple, conceptually sound approaches is prudent given the imprecision of existing state-of-the-art modeling techniques. Regulators also recommend multiple approaches.