What Boards Need to Know About Stress Testing

Banks above $10 billion in assets are required to do stress testing per the Dodd-Frank Act. What is happening with banks below this level?

Mid-size and community banks are not required or expected to have the same type of stress tests as the largest institutions. But regulators expect all financial institutions to understand how adverse events could impact their financial condition. It’s very common for a community bank to do a what-if scenario, looking at the attributes of the credit portfolio and coming up with plausible adverse events that could impact the bank’s earnings or cause deterioration in the credit portfolio. Community banks are simpler. When an examiner comes in and says, “Are you doing stress testing?” The right answer is not, “I don’t need to.” The right answer is, “I have these portfolios and risks and I have analyzed them under plausible adverse conditions and these are the resulting impacts on my financial condition.” 

What factors should a community bank consider in deciding whether to do enterprise-wide stress testing?

The types of issues that might prompt a smaller institution to consider broader stress testing include if the bank has gone into new markets, if it has grown its loan portfolio rapidly, if there are volatile market conditions or significant changes in its customer base, product mix and services. Then it makes sense for a bank to look beyond the credit portfolio. Some banks take on a fair amount of operational risk. One would want to be able to say, “If I take my credit risk, plus my operational risk, plus my funding or investments (market risks), what is the aggregate exposure I have and do I have enough capital for that?” 

What should the board of directors ask management about stress testing?

For an institution required to do stress testing under Dodd-Frank, the board of directors or a board committee must approve and review the policies and procedures relating to stress testing at least annually, but also when conditions change. Secondly, the board of directors must be provided with the results of stress testing.

Boards should keep in mind the objectives of performing the stress test exercise. It is part of the regulators’ and management’s evaluation of a bank’s capacity to make a capital distribution, for example. The board should be sufficiently comfortable with the feedback they’ve gotten from management on stress testing to conclude that it’s appropriate to pay a dividend or undertake other capital actions.

Finally, there should be sufficient time at the board meeting for a meaningful discussion.

What are some best practices in stress testing?

You need good planning and project management and it’s important to get the right parties involved early and clearly articulate the requirements and the roles of each of the various business or risk or operating managers. It is important to start early with the right level of intensity so you can test the datasets with the right level of analytical rigor.

Are regulators concerned about models used in stress testing and what should banks do about that?

Yes. Model governance is important; the roles and responsibilities for model development and validation should be very clearly defined to ensure model integrity.

In selecting a modeling methodology, management should be able to justify why the methodology was preferable over other industry methodologies. A model is just a tool and it is an imperfect tool with limitations on use. There is an expectation that compensating controls will be applied to those limitations when possible. There is a lot of research and testing before a model is ready for use. That should be subject to documentation.