I. INTRODUCTION
The Office of the Comptroller of the Currency (OCC) has issued a bulletin to provide guidance to national banks and federal savings associations (collectively, banks) with $10 billion or less in total assets (community banks) on using stress testing to identify and quantify risk in loan portfolios and help establish effective strategic and capital planning processes.
Community banks, regardless of size, should have the capacity to analyze the potential impact of adverse outcomes on their financial conditions. The OCC’s guidance describes various types of stress test methods that community banks may use and provides one example of a simple stress test framework to consider. The OCC encourages community banks to adopt a stress test method that fits their unique business strategy, size, products, sophistication, and overall risk profile.
Bank management and examiners should use the guidance in conjunction with the “Concentrations of Credit” booklet in the OCC’s Comptroller’s Handbook series, OCC Bulletin 2012-16, “Guidance for Evaluating Capital Planning and Adequacy,” and the Interagency Final Guidance on “Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices.” These documents provide additional information on stress testing objectives and methods.
II. BACKGROUND AND SUPERVISORY EXPECTATIONS
The financial crisis demonstrated how unexpected economic downturns and rapid deterioration in market conditions can significantly harm a bank’s financial condition and economic viability. Concentrations of credit, particularly in commercial real estate (CRE) loans for acquisition, construction, and land development purposes, have been a common factor in bank failures during stressful periods, especially for community banks. Other factors that have played a role in weakened bank conditions and failures include inadequate capital, dependence on brokered deposits, and dependence on assets whose valuations are highly sensitive to volatility in energy and commodity prices, interest rates, or farmland prices.
Sound risk management practices should include an understanding of the key vulnerabilities facing banks. For several years, supervisors have used the term “stress testing” in guidance and handbooks to refer to and encourage banks to incorporate this practice. Well-managed community banks routinely conduct interest rate risk sensitivity analysis to understand and manage the risk from changes in interest rates. Many community banks, however, do not have similar processes in place to quantify risk in loan portfolios, which often are the largest, riskiest, and highest earning assets.
The Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd–Frank) requires annual stress testing for banks with assets greater than $10 billion, and the federal banking agencies have issued separate guidance for stress testing standards in those institutions. The OCC recognizes that while some large community banks may find that guidance useful, community banks are not required to use such holistic stress testing.
The OCC, however, does consider some form of stress testing or sensitivity analysis of loan portfolios on at least an annual basis to be a key part of sound risk management for community banks. Community banks that have incorporated such concepts and analyses into their credit risk management and strategic and capital planning processes have demonstrated the ability to minimize the impact of negative market developments more effectively than those that did not use stress testing.
Community bank management can use stress testing to establish and support reasonable risk appetite and tolerances, set concentration limits, adjust strategies, and appropriately plan for and maintain adequate capital levels. Bank management should mitigate identified risks and vulnerabilities through such actions as increased portfolio monitoring, adjusted underwriting standards, selling or hedging assets, and increasing capital. In addition, bank management should use the results of stress tests to establish appropriate action plans that address risks when the results are inconsistent with risk tolerance levels and the bank’s overall strategic and capital plans.
III. STRESS TESTING METHODS
Stress testing is not a new concept for community banks. Scenario or sensitivity analysis and stress testing requirements have been used for subprime lending, interest rate risk, and liquidity management for several years. A community bank’s approach to stress testing should fit its unique loan portfolio strategy, size, loan types, composition, operations, and management. Given the smaller scale and lesser complexity of most community banks, assessing portfolio risk and capital vulnerability can be relatively simple.
The OCC does not endorse a particular stress testing method for community banks. Stress tests do not need to involve sophisticated analysis or third-party consultative support. Effective methods can range from a single spreadsheet analysis to a more sophisticated model, depending on portfolio risk and the complexity of the bank. Community banks may need to make only modest enhancements to existing risk management practices and techniques to ensure that potential adverse outcomes are appropriately considered.
Refer to appendix A of the bulletin for additional information on a variety of stress testing methods that community banks may consider.
Regardless of the testing method used, an effective stress test has common elements that a community bank should consider. These include:
For most community banks, a simple, stressed loss-rate analysis based on call report categories may provide an acceptable foundation to determine if additional analysis is necessary. Banks should primarily focus on concentrations of credit or loan portfolio segments that are significant to the overall business strategy. A community bank may be able to examine on a single spreadsheet its key assets and liabilities and link these to income and funding requirements. The loss stress rates used may be derived from a review of historical loss experience during previous stressful periods, historical market experience, or other estimates. Appendix B contains an example of this type of stress test method.
The potential adverse impact on earnings, loan loss reserves, and capital revealed by the stress test should be evaluated to understand the impact on capital and to ensure the bank can maintain appropriate capital commensurate with its overall risk profile. If the stress test reveals critical vulnerabilities, management and the board should take steps to mitigate those risks through such means as modifying loan growth, revising the risk tolerance strategy, adjusting the portfolio mix and underwriting criteria, altering concentration limits or other policies and procedures, and strengthening capital.
Community banks can conduct stress tests on identified credit concentrations, on other loan portfolio segmentations, and at the individual loan level. For example, a review by senior management may reveal two or three key concentrations in the loan portfolio, such as loans dependent on a type of agribusiness, loans with construction-related risks, long-term fixed rate municipal securities, commercial mortgage loans dependent on local market values, or consumer residential loans. Selecting the appropriate factors to stress depends on the nature of the bank’s concentration risk. Banks with an ability to perform migration analysis of credit risk ratings may be able to use that knowledge in evaluating changes in credit quality across different loan portfolios, because higher grade credits typically withstand market stresses better than lower grade credits.
While problem credits are routinely the focus of risk management, the potential effects on credit concentrations or other portfolio segments are the focus of portfolio level stress testing. Insight gained from such broad portfolio analysis can provide bank management useful information for strategic and capital planning initiatives and a better understanding of capital at risk. Furthermore, the appropriate time frame for a stress test scenario should be at least a two-year projection because, in any given credit cycle, losses generally emerge over a two-year period following the downturn. For example, in the recession that lasted from December 2007 to June 2009, the economy experienced a run of more than six quarters of weak or negative gross domestic product before commercial credit quality indicators reached their worse performance, and loan charge-off rates did not return to more normal historical rates until nine or 10 quarters after the initial economic downturn.
In some cases, a bottom-up, loan-by-loan analysis may help identify particular concerns. For more complex portfolios, such as commercial mortgages or construction loans, further segmentation may be helpful to differentiate various levels of risk. For example, management may link commercial mortgages to debt service coverage and loan-to-value ratios to project potential loss under possible adverse circumstances. Construction loans may be sensitive to particular variables such as selling rates, leasing activity, or oversupply.
Per OCC Bulletin 2006-46, “Interagency Guidance on CRE Concentration Risk Management,” banks that exceed certain CRE concentration thresholds are expected to use more robust stress testing practices to effectively manage the concentrations and maintain adequate capital. The OCC’s new stress test tool for income-producing CRE loan portfolios is available on the OCC’s BankNet website along with other tools banks may use to stress test other types of loans. Appendix C contains an example of factors to consider when conducting CRE loan stress tests or sensitivity analyses.
IV. STRESS TESTING AND CAPITAL PLANNING
The OCC expects every bank, regardless of size or risk profile, to have an effective internal process to (1) assess its capital adequacy in relation to its overall risks, and (2) to plan for maintaining appropriate capital levels. Stress testing can be a prudent way for a community bank to identify its key vulnerabilities to market forces and assess how to effectively manage those risks should they emerge.
If the results of a stress test indicate that capital ratios could fall below the level needed to adequately support the bank’s overall risk profile, the bank’s board and management should take appropriate steps to protect the bank from such an occurrence. This may include establishing a plan that requires closer monitoring of market information, adjusting strategic and capital plans to mitigate risk, changing risk appetite and risk tolerance levels, limiting or stopping loan growth or adjusting the portfolio mix, adjusting underwriting standards, raising more capital, and selling or hedging loans to reduce the potential impact from such stress events.
Appendix A-C can be found at by going to www.occ.gov and searching for "OCC Bulletin 2012-3."