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  • Writer's pictureJohn Demeritt

There Has Never Been a Better Time to Quantify the Overall Strength of Your Capital

There Has Never Been a Better Time to Quantify the Overall Strength of Your Capital

Capital Planning | Credit Stress Testing

When COVID-19 broke out in January of 2020, few expected it to spread the way it did. While a virus will spread from person to person, nobody expected the financial markets to catch it. Further, nobody expected it to be as crippling as it has become.

Pending how much more widespread COVID-19 will be, we surmise that the travel, tourism, and service industries at the very least will feel a significant impact. That is not great news if you’re an institution that has material exposure to these sectors. What does your growth outlook look like today versus the end of 2019? More importantly, what do your overall credit quality trends look like today compared to a few months ago?


From the Editor

First and foremost, we at DCG hope you, your family, friends, and colleagues are safe and healthy!

While this health crisis has been and will continue to be an economic challenge, financial institutions have the opportunity to be part of the solution going forward. To do that, liquidity and capital forecasting have never been more important. This month’s DCG Bulletin focuses on the importance of capital planning and credit stress testing as part of strategic balance sheet management.

Please continue to send thoughts/questions about this article, as well as potential topics for future articles, and be well!

Keith Reagan, Executive Managing Director


Current Focus on Credit Stress Testing

There has been increased demand for credit stress testing over the past few weeks as fears of the potential fallout from COVID-19 have been building. In this fluid and uncertain environment, institutions must be on high alert for potential credit-related issues and their impact on:

  • Forbearance/restructuring

  • Loss reserves

  • Loan charge-offs

  • Other credit-related costs

  • Loan cash flow and thus liquidity and earnings

  • Capital adequacy

The most recent jobless claims were at record high levels. In the coming weeks and months we will all learn a lot, as this extremely unfortunate COVID-19 induced reality plays out. We will experience, in real time, how high unemployment levels will get (some notable firms are modeling as high as 30%), and we will gain a better understanding as to how long this crisis may last and to what extent government intervention may help to mitigate its negative effects.

Regardless of these and other impactful variables, every bank and credit union will experience increased credit-related costs. Our research of previous economic cycles (since 1992) demonstrates that there is a strong correlation between historical net charge-off rates and unemployment levels…as well as a few other key variables.

Stress testing your portfolios today will help you to better understand:

  • Potential loan losses under various stressed scenarios (e.g. current Fed-defined scenarios and a more stressful COVID-19 recessionary scenario)

  • Potential impact on capital ratios relative to policy and well-capitalized minimums

  • Current ability to absorb losses while remaining above regulatory well-capitalized minimums

  • Whether capital buffer is sufficient for other capital management strategies and balance sheet growth

Common Practices

Do you have a capital plan, and what does it look like?

A recent survey conducted by Darling Consulting Group (DCG) found that 78% of respondents across a broad range of asset sizes (i.e. $35 million to $10 billion) have a capital plan. Approximately 30% of those have had regulatory feedback suggesting that their process “needs improvement.”

It is common to see a capital plan that reflects a straightforward pro forma look of how planned growth or budget expectations are expected to impact earnings and capital over a period of one to three years. This process can range from being as detailed as using budget modeling software that incorporates specific timing of cash flows to a process in which a high-level growth plan (i.e. from past growth experience) is layered onto a point in time balance sheet to project balance sheet expansion, earnings growth, and the related impact on capital. In some instances, the aforementioned pro forma capital plans do not incorporate any alternative operating or economic assumptions (i.e. stresses). They do, however, still provide an indication of how capital levels are projected to change based upon the business plan and economic environment assumed by the institution.

Does this approach add strategic value?

Under normal circumstances, understanding how capital levels are anticipated to change in the current economic environment can help you to determine the “right” level of capital for your institution. What you may find is that your growth expectations alone result in decreases in your capital ratios over time; this was not uncommon in 2017 and 2018. For some, this process alone facilitated a strategic discussion around the ability of the institution to continue with its current business plan given the anticipated level of capital at the end of the capital planning horizon.

Stress Testing Your Capital Plan

A pro forma capital plan based on normal/current operating conditions provides us with valuable information and a starting point. However, in order to make a more informed decision on what the “right” level of capital is, you will also want to understand how adverse economic environments could also impact capital given your business plan. Do you currently assess the impact of an interest rate risk or liquidity event on your projected capital? While these stresses are useful in gaining knowledge about potential capital fluctuations, running a stress that isolates possible credit-related losses in the loan portfolio will typically be the most material in gauging potential deterioration of capital.

In the DCG survey mentioned above, of the respondents that currently have a capital plan, 100% performed some type of credit stress on capital. The 30% that “need improvement” based on regulatory feedback may have been the result of capital plans that:

  • Lacked quantitative support for loan loss assumptions

  • Lacked appropriate documentation/sophistication of stress testing

  • Did not consider the use of the results strategically

  • Did not include a robust contingency plan

The FDIC’s Fall Supervisory Insights published in December of 2019 references the following findings in regards to portfolio level sensitivity analysis:

“Many concerns center on the overall implementation or quality of the sensitivity analyses. Others relate to failure to fully consider the results for budgeting, capital planning, and strategic planning purposes.”

Strategic Benefits of a Robust Capital Planning and Stress-Testing Process

1. Allows you to better determine the “right” level of capital, i.e. one that:

a) does not put the institution in a risk position that is uncomfortable to your board and management team; b) allows you to take advantage of potential growth opportunities; and c) will put you in a position to optimize earnings. With historically low rate levels and continued pressure expected on asset yields in the coming quarters, growth will be a valuable strategy for some in offsetting the earnings reduction associated with ongoing margin compression.

Building out a pro forma look at capital with the stress of an adverse economic environment, that includes credit-related losses within the loan portfolio, will give you a better understanding of your capital position in a potential worst-case scenario.

Quantifying how much additional capacity you have for loss will provide a gauge for how much capital you may need to have during times of stress. Additionally, quantifying how much growth capacity you have remaining (i.e. after loan losses) in an economic downturn will help you to understand if you can continue with your normal business plan, accelerate growth organically, or even acquire another institution.

2. Aids in establishing appropriate policies

Do you have internal policy guidelines on capital? Are the policy minimums aligned with the risk appetite of the institution? Is your capital buffer sufficient to absorb potential losses in another downturn? Will your current policy minimums limit growth opportunities?

The results of the stress testing will help you to answer these questions.

One of the biggest challenges for institutions is developing concentration limits for loan asset classes. Understanding how much capital (and expected earnings) you have is crucial in determining how much concentration risk you are willing to take in specific asset classes. Once you quantify potential loan losses under adverse scenarios your remaining capital buffer will help to inform if your concentration limits are too high, too low or just right.

Many institutions are reluctant to increase concentrations above the 300% of capital for commercial real estate (i.e. non-owner occupied) and 100% of capital for construction, land and development (referenced levels from the 2007 FDIC Supervisory Insights publication.) However, if you read further it also states:

“These criteria are not limits and are viewed neither negatively nor as a safe haven. A bank can have significant diversification within its CRE portfolio or have a concentration within a specific CRE category. If a bank’s portfolio goes outside of these general guidelines, as many do, the bank will not automatically be criticized, but heightened risk management practices may be needed.”

Taking a proven approach here to credit stress testing will help give you the confidence and support required to maintain higher concentration levels, if that is your plan.

3. Informs strategy decisions

For some institutions, building out a pro forma capital plan with budgeted growth will result in a situation in which earnings may not necessarily increase their capital ratios due to growth outstripping the benefit of the added earnings. This will lead into conversations surrounding the prudence of continuing with the growth plan at the expense of living with lower capital levels. There are many discussions to be had, depending on your risk tolerance, that include but are not limited to:

  • Are we comfortable with where capital is heading?

  • Do we need to raise capital today?

  • Are we able to grow?

  • If not, do we have capacity to shift the balance sheet mix (e.g. investments to loans)?

  • Do we need to revisit loan pricing and credit spreads?

  • Do we need to revisit deposit pricing?

  • Do we need to look to raise capital in some other fashion?

  • What would happen if we layer additional stress into our capital plan?


Two questions that remain are how much more widespread COVID-19 will be, and how the financial markets will digest the true impact once the hysteria of the virus spread eases. Assessing your capital levels today will give you and your board a level of comfort in the ability of your institution to weather the effects of this viral storm. Pinpointing your capital “sweet spot” will ultimately strengthen your strategic decision-making process which in turn should help you to optimize earnings and ultimately reduce your risk.


Learn more about capital planning and credit stress testing.



John Demeritt is a Managing Director at Darling Consulting Group working directly with senior management teams in capital planning and credit risk management initiatives. DCG’s web-based Credit Risk and Capital Simulator provides credit risk assessments through a multitude of macroeconomic scenarios and allows customizable and instantaneous capital ratio forecasting on growth plans.


© 2021 Darling Consulting Group, Inc.

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