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Pass the Aspirin: Stress testing for banks that don’t have to

The Headache: Does your community bank stress test?

Pass the Aspirin: Stress testing for banks that don’t have to

While community banks have been told that Dodd-Frank stress test requirements don’t apply to them, regulators have pointed out that “all banking organizations, regardless of size, should have the capacity to analyze the potential impact of adverse outcomes on their financial condition.” We asked community bank "Aspirin" prescribers how they handle stress testing. Once you've read their thoughts, why not add your own in the comment section below?

“Stress” and “vacation” are two words most wouldn’t put in the same sentence. But for Dorothy Savarese at Cape Cod Five Cents Savings Bank, the risk of lending in the popular Massachusetts tourist destination makes it essential that even factors like the cost of gasoline and the state of the national economy be factored into commercial loan stress testing.

Not every institution faces risk based on the price at the pump as does $2.5 billion-assets Cape Cod Five, but every bank faces risk and the need to get a handle on it. Stress testing is a subset of enterprise risk management, something community banks are increasingly expected to address (see “Community Banking,” February 2014, p. 16).

At Cape Cod Five, multiple facets of the bank are subjected to stress testing. The outlook for the loan portfolio, and potential impacts on the bank’s capital position, is something the bank has been stress testing for nearly half a decade, according to Savarese, chairman, president, and CEO. The internal effort stresses for loss of market value, interest rate shocks, and other factors.

“We find it helpful because it forces us to drill into things,” says Savarese. On a broader scale, the bank stresses for overall loan growth to see how much the balance sheet can stand before capital is affected. Again, the tools are internal, working off an Excel form and a narrative drafted by bank staff.

At $1.7 billion-assets MidWestOne Financial Group, for several years management has been stress testing at the portfolio level, says James Cantrell, senior vice-president and chief risk officer. A factor given particular attention is the balance between potential loan losses versus a year of earnings on the portfolio.

Going forward, Cantrell says the bank plans to become more granular in approach, looking at more individual credits. Priorities include its ag, commercial real estate, and commercial and industrial credits. Some categories, such as consumer lending, will likely continue to be stressed at the portfolio level.

MidWestOne and Cape Cod Five do substantially all stress testing in-house. Banks that want to start internally can look to federal guidance. One is OCC 2012-33, Community Bank Stress Testing: Supervisory Guidance, designed for banks under $10 billion. Risk Management Consultant Michelle Lucci of Banker’s Toolbox, Austin, Tex., suggests the Fed’s Dodd-Frank Supervisory Stress Test Methodology booklet for concepts, though the details are for the largest banks.

Fitting stress to your bank

Tailoring stress testing to the bank’s business model and its circumstances is key. While much of stress testing relies on formulas, it can’t just be formulaic—banks must apply local knowledge and common sense.

At $317.5 million-assets Capital Bank of New Jersey, Vineland, stress testing focuses on the CRE portfolio, in overall compliance with the regulators’ 2006 guidelines. Joe Rehm, senior vice-president, commercial lending department, says the bank pays attention to loan-level stress tests and reviews concentration levels and their implications. Testing is done annually, but the bank tracks properties that face special factors. One example: A single-tenant commercial property, where the bank knows the lease will expire mid-year, likely faces an all-or-nothing income proposition. Monitoring is required so the bank doesn’t get caught flat-footed should the tenant not renew and the owner not obtain a new tenant immediately.

Likewise, when properties are stressed for various vacancy levels, the bank is cognizant of atypical factors that would pose risks beyond the impact of lost rental income. In general, the bank’s analysis tests for the owner’s ability to service outstanding debt, based on the latest rent rolls, owner financial statements, knowledge of the market, and potential levels of vacancy. Loans are shocked for interest rate impact. If the property is owner-occupied, the bank looks at owner cash flow, given that rental income isn’t present to service the loan.

Beyond the CRE portfolio, Capital Bank of New Jersey also tests lines of credit, both at inception and at renewal.

Lucci, whose Crest CRE portfolio stress-testing software is endorsed by ABA, is surprised that recently some bankers have been taken aback by notices from some regional regulators that they will expect portfolio-level CRE stress test results on the first day of exams. Lucci, a former FDIC examiner, says this is built into 2006 guidelines for banks with heavy concentrations.

Banks that need to get up to speed on portfolio-level stress tests in CRE can begin with the bank’s Interagency Loan Data File. Lucci says this is produced by every core banking system and gathers much of the relevant data on the bank’s loans. Some additional data, such as current property and borrower income levels, will need to be pulled in from other records, she adds.

If your bank suffered in the CRE crunch, Lucci recommends learning from that experience to create a “severe scenario” test for today’s portfolio. She adds: Sampling loans for the CRE guidelines stress test isn’t what the regulators had in mind when they published the document. “This may be a good starting point for your institution,” Lucci says. “But remember that the natural tendency is to sample loans that are highly visible in the institution, such as large dollar loans or loans that you regularly receive financial updates on.” If the bank must stress on a sample of loans, she recommends drawing representative credits from each major sub-segment, such as property type and geographic market.

Stressing for rate risk, liquidity risk

A key element of asset-liability management is stressing for rate risk. It’s one of the oldest forms of stress testing as banks have been “rate shocking” portfolios for decades. Given that rates will be rising in the future, regulators have been putting more stress on this.

At $300 million-assets Foothills Bank, Yuma, Ariz., Mary Lynn Lenz, president and CEO, says her bank uses an outside provider to run rate simulations on its investment portfolios quarterly. “The bottom line of the analysis will tell you what it will mean to the bank’s earnings in each rate scenario,” she says.

While discussions of stress testing often concern the asset side, bankers point out the importance of subjecting liquidity to its own analysis. At Cape Cod Five, Savarese says the bank’s liquidity position is regularly subjected to stress testing, projecting the impact on funding of various percentages of funds outflows. This feeds into the bank’s contingency funding plan, and helps keep management thinking about options. As a result of one liquidity test, management decided to add one more backstop: registering at the Fed’s liquidity window. The bank hasn’t used this tool to date.

Steve Cocheo

Steve Cocheo’s career in business journalism has taken him to all 50 states and nearly every corner of banking in institutions of all sizes. He is executive editor of ABA Banking Journal, digital content manager of, and editor of ABA Bank Directors Briefing. He coordinates the popular Pass the Aspirin and First Person features and wrote the booklet series Focus On The Bank Director. He is the only journalist to have sat in on three federal banking exams, was a finalist for the Jesse H. Neal national business journalism awards, and a winner of multiple awards from the American Society of Business Publication Editors.

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