Loan Portfolio Stress Testing

On May 14, 2012, the OCC, FDIC and Federal Reserve issued a Statement to Clarify Supervisory Expectations for Stress Testing by Community Banks. The guidance definitely states that the the “top down” stress testing programs currently required of larger US banks will not be pushed down to the community bank level. However, the Statement does not rule out all forms of stress testing for community banks, as it goes on to state:

“The agencies continue to emphasize that all banking organizations, regardless of size, should have the capacity to analyze the potential impact of adverse outcomes on their financial condition. Certain portions of existing interagency guidance applicable to all banking organizations discuss addressing potential adverse outcomes as part of sound risk management practices. The agencies note that such existing guidance, including that covering interest rate risk management, commercial real estate concentrations, and funding and liquidity management (among others), continues to apply.”1 (emphasis added).

This statement, combined with recommendations contained in many regulatory Reports of Examination issued over the past few years, highlights the continued expectation that all banks, including community banks, should consider some form of stress testing in managing significant risk concentrations. In many community banks, the largest concentrations have been in commercial real estate (CRE), including multifamily lending.

While the prospect of implementing a stress testing model may seem daunting, CEIS’ discussions with clients and reviews of regulatory examinations have consistently revealed that regulatory expectations around CRE-related stress testing are focused on the development of a process and framework for stress testing, and not on achieving 100% coverage of the loan portfolio on Day 1 or implementing sophisticated models.

Establishment of a stress testing process and framework includes (1) establishing procedures for initial and on-going gathering of information; (2) documenting an approach for analyzing those areas within the portfolio which are believed to be most vulnerable or which represent sizeable concentrations; (3) analyzing the results of stress test scenarios and estimating potential impact on charge offs, reserve levels and, ultimately, capital; (4) determining whether stress test results suggest higher levels of risk for certain portfolio segments and evaluating potential action plans (selling some participations, modifying underwriting standards, increasing pricing, etc), and (5) mapping out a plan to increase portfolio coverage over time.

CEIS can assist in creating an effective and manageable stress testing process and framework. We have provided the following CRE-related stress testing analysis and advisory services to our clients for a number of years.

 

Data Gathering and Scrubbing

• Much of the information needed for meaningful stress testing is not currently resident in the bank’s loan system. This often represents the greatest initial stumbling block to the development of a stress testing process.
• CEIS will gather the necessary information from credit files or other sources, including appraised values and dates, information on rents, expenses, NOI, vacancy rates, cap rates, etc.  CEIS will ensure that the data is accurate and complete.
• Stale data – if necessary, CEIS can utilize data from Reis or other public sources to “normalize” or bring current stale information.
• To the extent that information is available, CEIS can also gather tenant and lease-level information to facilitate analysis of tenant concentrations, lease roll-over risk, etc.
• For owner-occupied CRE loans (where the bulk of the rental income is derived from an affiliated entity), CEIS will gather cash flow information for the affiliate to incorporate in the stress testing process.
• Data gathering is most cost-effective when performed as part of the loan review process.  However, CEIS can also assist with standalone data mining needs for non-loan review clients.
• For loan review clients, data is gathered for the loans in each loan review sample.  Portfolio coverage increases with each loan review.

 

Stress Test Analysis

• CEIS analyzes the impact of changes in key indicators on debt service coverage and/or loan to value.  Examples of key indicators analyzed include increases in interest rates and changes in vacancy rates, effective rents, expenses, NOI, cap rates, etc.  Results are provided for the aggregate population in the database, and for individual property type segments.
• CEIS works with the client to develop assumptions regarding grade migration and estimates potential migration to criticized or classified ratings in each stress test scenario.  For loans which are identified as possibly migrating to a criticized or classified grade, CEIS estimates potential impairment amounts.  In addition, for loans potential migrating to Special Mention, application of the bank’s ASC 450 / FAS 5 pool rates can be applied to further estimate potential reserve implications.
• Scenario selection is a dynamic process which can be changed each quarter in consultation with the client.  CEIS can add or modify scenarios to address potential issues in specific segments of the portfolio.

 

Advisory Services to Assist Clients with In-House Stress Test Programs

• CEIS can assist clients in developing and implementing in-house stress test programs
• In some cases, clients have elected to have CEIS perform the stress test data gathering and analysis for a year or two, and then brought the process in-house.  In such cases, the complete and accurate data set from CEIS’ cumulative stress test database is migrated to the client’s system of record.  At that point, the client has also gained a familiarity with the types of scenarios and analyses typically performed in CEIS’ stress test reports.
• In some cases, clients have asked CEIS to review their existing stress test programs and Validate the results, including the reasonableness of assumptions, inputs and interpretation of findings.

 

Additional Benefits of Stress Test Analysis

• Comparative data – CEIS is able to provide comparisons of a bank’s portfolio characteristics and stress test results to those of other CEIS stress test clients.  Comparison can also include summary-level information on terms for recent new transactions (average LTV, DSC by property type).  While the identity of CEIS’ other stress test clients is carefully protected, in aggregate, this information can provide valuable indications of current market terms.
• Concentration Analysis – For banks in the Northeast and select other markets, recent credit losses have been centered in certain types of construction lending, while CRE lending (including multifamily) has weathered the most recent cycle with relatively low levels of net charge offs.  Stress testing results for a well-underwritten CRE portfolio can often be used to help support or justify what might appear to be a large CRE concentration.

Depending on which scenario you deem appropriate for your institution, CEIS has developed and successfully implemented various effective and manageable stress testing frameworks and processes.

Unlike many of the “black box” solutions common in today’s marketplace, our process is designed and proven to be transparent from end to end which has led to our approach being well received in the community banking marketplace.

Inquire now to see how CEIS CRE Stress Testing can help you stay ahead of your competition while also assisting in easing any qualm’s that bank leadership may have. Additionally, you may follow the links below to find out more about the specific loan review programs CEIS offers its clients:

• “Bottom Up” Loan Level Approach

• “Top Down” Capital Adequacy Assessment

 

[1] “Statement to Clarify Supervisory Expectations for Stress Testing by Community Banks” issued 5/14/12 by the Federal Reserve Board, the FDIC and the OCC.

[2] “Concentrations in Commercial Real Estate Lending – Sound Risk Management Practices” issued 12/12/06 by the Federal Reserve Board, the FDIC and the OCC.

[3] “Concentrations of Credit – Comptroller’s Handbook” updated December 2011, page 11.