When we talk about bank “stress testing,” we are clearly not referring to running a treadmill and checking our blood pressure to gauge the likelihood of our survival (although that does sound a lot like banking in 2011, doesn’t it?). No, we mean applying future-looking, “what if” scenario models to various key bank measurements, ratios, portfolio values and amounts and then using the results to see if the bank is adequately prepared to deal with potential risks revealed in the process.
So why has stress testing been treated like the “crop circles” of banking since 2009? Just the mention of a stress test will induce finance and credit managers to either look the other way until the examiners force them to look at it, or cause them to shrug their shoulders in miscomprehension.
There are essentially three types of stress testing regulators are looking for banks to perform today:
While these differing exercises are not specifically required by any banking regulation today, it is clear that it’s just a matter of time before they are.
Having worked with banks that were attempting to make sense out of stress testing since 2007, I have had the unique opportunity to observe the continued evolution, confusion and concern over stress testing in the banking market. As a banker-turned-consultant, I have witnessed three types of approaches banks take to stress testing:
I spend a lot of time talking to regulators and bankers on this topic, and I’d say that all banks are now expected to do some kind of stress testing. To put a stake in the heart of the crop circle analogy, let’s look at trends in stress testing and see whether “if we build it, the regulators will come.”
From the 2006 Interagency Guidance on Commercial Real Estate Lending, this June’s Guidance on Stress Testing for Banks Over $10B in Assets, to the Dodd Frank stress testing requirements for larger institutions, we can all see the writing on the regulatory wall, right? So, for banks that haven’t been told to do it, asked to do it or even asked about it by the regulators by now, it’s just a matter of time.
At a recent industry event sponsored by the Conference of State Banking Supervisors, I got to ask an FDIC representative what his expectations are now around stress testing. The rep, while conceding that the FDIC has not been consistent enough in leading banks to apply stress testing, said that now that the most dire portion of the crisis is over, they want to see all banks set up some kind of repeatable stress testing process. He suggested that the field examiners will now be more focused on the Sensitivity/Scenario testing (CRE) for community banks, but the ideas around programs of capital stress testing for community banks are percolating in larger institutions today. The new guidance suggests that banks close to $10B will have to do it, and Dodd Frank clearly includes some kind of capital stress testing for bigger banks – though this is not totally defined.
So what’s a GonzoBanker to do? Here are a few pointers to help keep the regulators happy and manage the bank’s risk levels.
Stress testing is clearly a growing area in bank risk management, with more definition and recipes for bankers to use coming in the near future. Yes, there is stress in the unknown, and gosh knows bankers have plenty of regulatory concerns on their plate right now that are easier for them to understand and address than stress testing. But establishing a stress testing program is something that can’t just be ignored today.Unlike crop circles, there are clear signs out there that something serious is going on that will impact all banks. I don’t think it’s a ruse that will go away, and it’s clear that proactive risk control practices are proven to be worth the time and effort. Many of the banks that didn’t use such practices are on the troubled bank list right now. And, these signs clearly point to a change for a bank’s risk management practices. So, let’s turn down the knobs on the stress and focus on using the simpler concepts of this important testing exercise process to reduce bank risk.
Peter Cherpack is a director of Ardmore Banking Advisors where he manages the Credit Technology Division. Contact him at firstname.lastname@example.org