When it comes to why they’re not performing credit/capital stress testing, institutions generally share five common objections:
1. Credit quality is strong today
2. We have plenty of capital
3. Historical loan losses are extremely low
4. No loan concentrations
5. Stress testing only needs to be completed when conditions deteriorate
But are these objections sound business strategies… or potential blind spots?
What these institutions may not know is that this type of thinking can preclude a deeper understanding of potential risks, leaving them vulnerable to a sudden downturn in credit and, in many cases, at risk of forgoing potential earnings enhancement strategies.
1. Credit quality is strong today
Many institutions proudly extol their high credit standards and resulting credit quality. However, an important caveat to consider is that credit deterioration is historically a lagging indicator. Do high credit standards imply that there will never be losses? If unemployment climbs to 10% locally, will the strong underwriting of these loans prevent charge offs?
In the movie The Big Short, we hear the line: “People hate to think about bad things happening, so they always underestimate their likelihood.” History is filled with idiosyncratic events, so take caution in assuming today’s conditions will carry on in perpetuity. To be appropriately prepared – for whatever environment materializes – it can be invaluable to envision the worst and determine what your contingency plan should be.
2. We have plenty of capital
Plenty of capital for what business objective? Institutions may very well be able to confidently state the amount of capital desired for growth, dividend distributions, and other strategic initiatives; however, not quantifying the capital required to absorb potential losses in moderate and severe stress events creates a blind spot with respect to appropriate capital minimums. Capital is a critical element in providing protection to help withstand a major credit event. Understanding both strategic goals and potential loss implications that avoid simply restating historical losses can provide a comprehensive substantiation for “plenty” of capital.
3. Historical loan losses are extremely low
Low loan loss history can indicate strong risk management practices ranging from prudent underwriting and monitoring to expertise in loan workouts. But low loan loss history can also indicate another potential blind spot: assuming that those same practices will prevent charge offs from occurring during the next credit downturn.
Past experiences may cause a false sense of security, when in reality, there is no certainty about what the impact of the next crisis will be. The industry is still reeling from a series of “Black Swan” events over just the past few years (e.g., COVID, rate shocks, bank failures). There are many institutions that did not experience losses leading up to the Great Recession that were hit extremely hard from a credit perspective. Additionally, low loan losses are often more reflective of local vs national market conditions. For example, New England was not hit as hard as the “sand states” during the Great Recession. Will your region be hit harder during the next downturn?
4. No loan concentrations
Are you sure? Loan concentrations can present themselves in many different forms. They can be based on industry or sector, geographic region, type of collateral, specific FICO bands, etc.
Concentrations elevate the risk of material capital erosion if an adverse event results in defaults to a specific group of borrowers. Having a forecast of the potential asset quality impact of an event specific to the concentration will create clarity in determining capital adequacy and preparing accordingly.
Today, areas of focus include not only commercial real estate and construction lending but growth in credit card and auto loans which are showing signs of stress. As a rule of thumb, institutions should consider anything over 25% of capital a concentration and evaluate it accordingly.
5. Stress testing only needs to be completed when conditions deteriorate
When COVID hit in the spring of 2020, DCG fielded hundreds of calls from institutions trying to understand the potential severity of loan losses given how quickly the environment was deteriorating. Banks and Credit Unions wanted to know if they had adequate capital to support these potential losses. An important lesson learned from this scenario is that by the time a crisis hits, it may be too late.
The options available to increase capital during a stress environment will not be as plentiful – and will be more costly – than those that are executed during “good times.” Think about today’s environment of elevated credit uncertainty: selling investments at a gain to offset losses is not an option, and cost of capital is the highest it has been in decades.
Waiting to stress test loan portfolios until times of economic downturn could be the difference between an agile response and potential turmoil.
As Morgan Housel said in the book The Psychology of Money, “Things that have never happened before happen all the time,” highlighting the importance of risk management and the strategic benefits of credit and capital stress testing. For the same reason, Bank and Credit Union regulatory bodies continue to emphasize how crucial it is to perform these exercises.
On December 18, 2023, the FDIC published an advisory stating:
Portfolio and loan level stress tests or sensitivity analysis can be an invaluable tool in identifying and quantifying the impact of changing economic conditions . . . on asset quality, earnings, and capital.
Applying adverse scenarios while conducting stress tests . . . helps banks adjust risk management processes, capital planning, liquidity management, collateral valuation processes, and workout procedures to prepare for credit risk problems before they impact earnings and capital.1
DCG has consulted with hundreds of Banks and Credit Unions to develop and/or enhance their credit stress testing and capital planning exercises to improve their risk management process, provide clarity to their capital adequacy, and illuminate potential opportunities that otherwise may have gone unnoticed.
If your institution would like guidance as you develop a deeper understanding of potential risks in advance of an unexpected credit downturn, click here to reach the DCG Credit Stress team.
John Demeritt is a Managing Director at Darling Consulting Group, where he works directly with financial institution executives to improve the effectiveness of their asset / liability management (ALM) process. In this capacity, he provides insight and education on 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.
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