By Scott Klitsch, Principal CLA on behalf of Erica Crain, leader of CLA’s national credit risk services
It is no surprise stress testing would move to the top of the list during a global pandemic and economic crisis. If there is one thing present in most people and in most places right now, it is stress. So, why not put stress to good use? At a time when loan portfolios are impacted by the COVID-19 pandemic, overall credit risk soars. As such, it is a pivotal time to utilize credit risk stress testing as a key component for capital planning and developing strategies to drive long-term value.
The purpose of stress testing is to provide predictive and forward-looking information to assist with identifying and understanding potential risk and vulnerabilities in an institution’s loan portfolio. Regulators have repeatedly emphasized that some form of loan portfolio stress testing, on at least an annual basis, is an essential part of prudent risk management for community financial institutions. During this challenging time, most financial institutions are impacted by the COVID-19 pandemic. When economic relief funding from the Federal government is the most prevalent source of cash flow for borrowers, capital planning and liquidity management for a financial institution take center stage in response to the present credit risk. Regardless of size or risk profile, each financial institution is expected to have an effective internal process to assess capital adequacy in relation to its overall risks, and to plan for maintaining appropriate capital levels. Stress testing is a viable tool for devising those capital plans and ensuring required levels are maintained.
Two types of stress testing most commonly utilized by community financial institutions include stressed portfolio loss rates and scenario analysis. As such, the following are fundamental actions to take when performing a stress test that may provide opportunities to act quickly in response to the pandemic. These steps will assist a community financial institution in evaluating the impact to capital and make more informed decisions as an institution continues to work with borrowers affected by COVID-19.
Stress loan portfolio
- Design scenarios (i.e. supply chain disruption, retail shocks, hospitality downturn, travel bans) for overall inclusion
- Establish baseline (actual) financial performance and ramp up stress tests to a “moderate” and “severe” stressed scenario
- Stress cash flow and debt service coverage for all borrowers with supplemental shock to collateral values
- Determine impact to probability of default at the loan level and expected loss
Identify what loan segments are most vulnerable or “at risk”
- Segmentation may include various factors such as: industry type (particularly where concentrations are present), geographic location, type of loan
- Examples of COVID-19 related considerations include:
- Concentrations or exposure to segments such as hospitality, retail (including restaurants), multi-family residential, warehouses, office space, student housing
- Geographies with high level of outbreak or impact, extended travel bans, shelter in place considerations
- Loan types including lines of credit such as home equity lines, credit cards, and commercial lines of credit and the related unfunded exposure that may be funded in the near future
Create scenarios and assumptions for vulnerable loan segments
- Incorporate relevant economic and market trends
- Consider supply chain impact as disruptions could last for many months
- Review collateral coverage and guarantees in place for projected shortfalls that may arise from decreased cash flow
- Consider new programs to work with COVID-19 affected borrowers
Evaluate the impact to loan loss provisions
- Apply current macroeconomic projections based on current market data (i.e. unemployment rate)
- Incorporate findings from portfolio stress test with updated probability of default and expected losses
- Consider adjusting qualitative factors for increased risks identified in each loan segment
- Utilize the information gathered to work with customers and sectors that evidence weakening according to the stress test results
- Formulate further relief measures for targeted groups
- Revise risk management strategy, capital planning initiatives, liquidity impact, and earnings outlook accordingly.
There are many evolving considerations in this environment. CLA is here to help. Please contact us.