The Scoop on Stress Tests

Originally published in the Virginia Association of Community Bankers Newsletter (September, 2009)

Have you performed a stress test this year on your Bank? If you have, that’s great news. If you haven’t, then you better get ready. Bank examiners are asking to see them, and buyers and investors are doing them on you.

As you probably know, stress tests are a hot item this year. The treasury completed stress tests on the 19 largest banks and now regulators are looking at tests for the rest. Bank examiners are interested in stress tests because they measure your capital adequacy and your ability to survive a further weakening in the economy and the impact on your loan portfolio. If your capital or ALLL is light, they will require you to increase reserves or raise more capital.

Stress tests come in different forms.

  • The highest level stresses key elements of the balance sheet and analyzes the impact against Tier 1 and Tier 2 Capital.
  • A portfolio-level stress test examines specific loans and tests the sensitivity of loans to changes at the portfolio level relative to borrower income, interest rates and collateral values and the impact on debt service coverage ratios, loan to value ratios and capital ratios.
  • The most rigorous test includes a detailed analysis of each loan and projects losses, if any, for each loan. Those losses are then compared against the bank’s capital.

In the portfolio and rigorous level stress tests, approximately 60% to 70% of the loan portfolio is typically tested and then extrapolated to cover the rest. If there is a large consumer portfolio, that portfolio is analyzed separately.

With bank examiners asking about stress tests and increasing concerns about CRE, A&D and C&I loans, every bank needs to complete a stress test. At Strategic Risk Associates (SRA) we’ve completed dozens of stress tests this year. Clients have included banks wanting to stress their own balance sheets and loan portfolios and private equity groups and other buyers or investors in banks. In each case, the client has gained a better understanding of their exposure to potential losses and their capacity to absorb those losses.