Regulators expect banks of all sizes to perform some level of stress testing. Regulatory guidance tells every bank, regardless of size or risk profile, to have effective internal process to assess its capital adequacy in relation to overall risks, and plan for maintaining appropriate capital levels.
Bank stress testing is a forward-looking simulation of scenarios that could impact an institution’s financial condition and capital position. There are a wide range of methods that we can use based on size, complexity, and risk characteristics of the portfolios and balance sheet structure. We tend to rely on historical data and use of historical scenarios for stress testing to see how an institution will perform.
Supervisory expectations for stress testing
The 2008-09 financial crisis dramatically accelerated the use of stress testing by regulators. Each year, the Federal Reserve (Fed) conducts supervisory stress tests that apply to large firms. These tests use projections based on macroeconomic scenarios required by the Dodd-Frank Act and developed by the Fed. The Fed released the hypothetical stress test scenarios for this year in early February—before the markets had time to react to the pandemic.
This year’s stress tests include two hypothetical scenarios: baseline and severely adverse. The baseline scenario uses a set of conditions that reflect the views of the economic and financial outlook. The severely adverse scenario features a severe global recession in which the U.S. unemployment rate reaches 10%, and elevated stress in corporate debt markets and commercial real estate. This scenario follows the paths consistent with the depth and duration of previous recessions in the U.S. where unemployment hovered around 10%.
The National Bureau of Economic Research announced that the U.S. entered a recession in February. And in April, the unemployment rate reached 14.7%–exceeding the Fed’s worse case hypothetical severe adverse scenario by 4.7%. Given the current state of the economy, the Federal Reserve announced they will conduct additional sensitivity analysis that reflect the ongoing pandemic. The Fed’s theoretical crisis based on historical data fell short when compared to the current economic environment.
Community bank stress testing
Stress testing expectations for community banks is more discrete and less rigorous than what is required in the regulatory exercises. The agency’s existing supervisory guidance states that banks with significant commercial real estate (CRE) concentrations should conduct portfolio stress tests. Interest-rate simulations are another form of suggested bank stress testing. The guidance states that all institutions should incorporate a funding and liquidity management plan under stressed conditions. Community banks can use these tools to proactively manage their loan portfolio and attempt to plan for, measure and mitigate risk to adverse events.
What stress tests should banks run in response to the pandemic?
The financial sector vulnerabilities are likely to be significant given the severe toll on economic activity. Banks entered the pandemic well capitalized and capable of absorbing near-term loan losses. But how long will this last? We expect to see rising household and business debt and deteriorations of borrowers’ ability to repay. Hospitality has taken a hit with vacancies in hotels and travel restrictions. Office spaces sit empty while employees work remotely. Major companies have already made the decision to cut costs and have announced permanent work-from-home policies. Online shopping is booming while stores closed and consumers were stuck at home.
As the economy reopens and social distancing restrictions are lifted, the hospitality market should recover. As office work environment changes and department stores take a hit, we can expect to see long-term adjustments in the CRE business. Given these developments, banks should test loan loss exposure and scenario analysis over several time horizons. Listed below are a few bank stress testing simulation examples:
- Rate ramp and non-parallel rate scenarios
- Negative market rates
- Reverse modeling to find what level of provisions takes capital below 8%
- Deposit growth
- Decreasing loan production
- Modeling forbearance
- Increase in nonperforming loans
Using the results from the stress tests enables comparison between the base case scenario and the effects of different stressed environments. We can then estimate the potential impact on earnings over a specified time horizon – specifically net interest income, net interest margin and return on assets.
Finally, we estimate the stress on capital measures – economic value of equity and return on equity. This allows us to pinpoint instances, if any, when an institution might exceed risk tolerances. With these results the bank can develop strategies based on various outcomes.
Effect of the pandemic moving forward
The COVID-19 pandemic is one of the most significant economic events of our lifetime. No one predicted the widespread disruption this would have on our economy. Banks have a long road ahead and should use every tool they have available. For some institutions, running a stress test is a box-ticking exercise, but there are many benefits of running stress tests, especially to prepare for these uncertain events. Banks that integrate stress findings in their risk management and strategic planning process can better position themselves during a time of crisis.
UMB Bank Investment Banking Division delivers a comprehensive suite of solutions, including market data and modeling, technology platforms and fixed income sales. Visit umb.com to learn how UMB Bank Investment Banking Division can support your bank or organization, or contact us to be connected with an investment banking team member.
The article does not reference any internal stress testing efforts performed by UMB Bank.
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