Bank Stress Testing: Check The Box Exercise or Competitive Advantage?

Bank stress testing is credited with restoring stability during the financial crisis and is featured prominently as a critical forward-looking risk management tool. In congressional testimony Jamie Dimon recently championed the need for rigorous stress testing and independent review. Dodd-Frank requires all banks over $10 billion to perform annual company run stress tests and the largest banks get an additional annual FED conducted supervisory stress test. Results from both tests will be disclosed publicly adding a market discipline aspect to stress testing.

This intense focus on stress testing is cascading down to community banks. Recent regulatory clarification confirms community banks are not required to perform enterprise wide stress testing, but indicates that all banks should have the capacity to analyze adverse outcomes on financial condition consistent with existing guidance on commercial real estate concentrations, funding, liquidity, and interest rate risk. The bottom line is stress testing is here to stay and if performed correctly can sharpen your bank’s competitive advantage instead of just another check the box exercise.

Stress tests at the enterprise-wide, loan portfolio, or individual loan level all answer this key question, “How much stress can be absorbed before the bank is negatively impacted?”The enterprise-wide test quantifies the impact on earnings, the ALLL, and capital providing management and the board with a tangible downside limit for the bank. The associated competitive advantage stems from having better informed management and board level risk decisions, improved capital and strategic planning, objective capital at risk estimates for concentration limits, and enhanced regulatory and customer credibility. At its core, a good stress test is uniquely grounded in a bank’s risk profile and measures the cash flow/value of assets, liabilities, and contingent commitments under different scenarios.

This objective drill down on cash flow/value stress can also be applied to loan risk ratings, loan review, and loan monitoringThe effectiveness of these risk management tools when linked to stress testing can be significantly increased at a reduced cost further enhancing a bank’s competitive advantage.

Albert L. Knotts, Partner
Stephen Lane, Partner
Strategic Risk Associates