Asset Quality, Earnings, and Capital, Oh My!
How would a recession impact your institution?
Over the past two years, the Fed’s multiple steps to avoid a credit crisis have created “ripples” in the economy – including record-setting deposits, significant inflation, and more – that have resulted in an uncharted risk management situation.
Where are things headed from here? While unemployment has remained low, it is generally a lagging indicator – and more firms across a multitude of industries are starting to point to potential layoffs. Meanwhile, consumer loan delinquencies are quietly ticking up.
All of this raises some important questions: What will the Fed do next with rates? Are we headed for a recession? Trying to foresee the answers is something of a fool’s errand – no one can predict the future. But fortunately for risk managers, accurately predicting the next major economic moves is not a job requirement. Rather, their goal is to understand the potential impact of various possibilities on the balance sheet. And one of the ways to do that is by stress testing.
The importance of stress testing
While most risk managers will admit to the importance of stress testing in theory, far too many demur when it comes to putting that theory into practice. Whether they’ve never experienced losses, never been asked about it by their examiner, have a history of high starting capital ratios, or always relied on their strong underwriting, many have plenty of excuses for not stress testing more regularly.
But particularly in these volatile economic times, stress testing isn’t about relying on what has gotten an institution through in the past. It’s about working toward an answer to one crucial question going forward: How do I know if I’m OK or not?
It’s worth noting as well that regulatory focus on stress testing is growing. In fact, a line from CRE concentration guidance dating back to 2006 has found renewed life in today’s regulatory discussions, zeroing in on the ability of an institution “to quantify the impact of changing economic conditions on asset quality, earnings and capital.”
Understanding the difference between sensitivity and scenario analysis
Quality stress testing should incorporate both sensitivity analysis and scenario analysis. When considering the difference between these two elements, imagine setting out for a drive in a car. Just as the tread quality of the car’s tires will have a noticeable effect on handling, road conditions likewise play a major role in the overall safety of the journey. When it comes to stress testing, the tires are the sensitivity analysis, and the surrounding environment is the scenario analysis – both must be taken into consideration before setting out.
Sensitivity Analysis. Sensitivity analysis is meant to measure how changes in independent variables (e.g., DSCR, LTV/collateral value, market capitalization rates, property vacancy rates) may affect a dependent variable (e.g., risk ratings). Many institutions measure sensitivity by placing these types of factors into a basic matrix. Potential benefits of sensitivity analysis include the ability to assess risk in specific loan segments (e.g., office, lowest FICO, etc.) and to isolate one variable for examination. That said, there are limitations to sensitivity analysis, including the use of arbitrary stress levels, the lack of loss projections, the inability to tie back to an economic forecast, and the overall availability and accuracy of the data. The biggest potential risk associated with sensitivity analysis, however, is doing so without performing an accompanying scenario analysis. Great tires will only get you so far, after all – particularly if there’s a massive pothole or nasty storm brewing up ahead.
Scenario Analysis. Scenario analysis helps institutions better understand how changes in input variables over time may impact a given output. The idea is to take a portfolio-level approach that helps quantify how changes in economic conditions affect loan loss projections. Potential benefits of scenario analysis include the ability to more accurately project losses, to link economic conditions to those losses, to test multiple independent variables, to support assumptions and, most importantly, to complement sensitivity analysis and thus round out the institution’s overall risk management process. Even seemingly solid scenario analysis can be undermined by the biggest potential pitfall: interdepartmental gaps. For example, earnings simulations tend to happen in Finance, while Credit often performs the sensitivity and scenario analyses. These two functions must cooperate to get the full picture and ensure these analyses are incorporated into capital forecasts and earnings-at-risk discussions. Ultimately, the information derived from this process should be reported up to the board of directors.
Making stress testing a priority
The results of a stress testing program that effectively incorporates both sensitivity and scenario analysis will spark conversations about capital adequacy, and potentially about how to improve an institution’s capital position and create a remediation plan to deal with problem areas. The institution may decide to sell assets, de-lever the balance sheet, raise capital, reduce/eliminate dividends, divest of riskier asset classes – or to undertake some combination of these ideas. Regardless of the chosen strategy, it’s important to quantify and document three key components:
The amount of time required to execute the strategy
The immediate impact on the institution’s capital ratios
The ongoing earnings impact to capital ratios
In the end, stress testing should be part of the institution’s regular and ongoing risk management regimen. After all, while it may be impossible to always accurately predict what will happen next with the economy, being well-informed about myriad possibilities is always the best preparation.
For more insights about current capital/credit-related market conditions and recent client case studies in the area of credit and capital forecasting, watch the replay of DCG's recent webinar Bracing for the “Ripple Effect:” Implications for Asset Quality, Earnings, and Capital.
To learn more about how DCG’s Credit Stress Testing helps empower institutions with forward-looking analyses, click here.
ABOUT THE AUTHOR
John Demeritt is a Managing Director at Darling Consulting Group, working directly with financial institution executives to improve the effectiveness of their asset liability management (ALM) process. In this capacity, he provides insight and education in managing interest rate risk, liquidity risk, credit risk, and capital. John also advises on regulatory compliance, stress testing, and contingency planning.
John began his career with DCG in 2006 as a financial analyst and currently manages DCG’s Risk Analyzer Plus product and Loan Credit Loss Model solution. He is a graduate of the University of Massachusetts with a degree in finance and marketing.
Contact John Demeritt: firstname.lastname@example.org or call 978-499-8144.
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