Strategic Benefits of Stress Testing in an Uncertain Economic Environment
Having gone on many a camping trip over the years, the only consistency between these trips into the woods is that there is no consistency. While some trips might have beautiful weather, others might be plagued with storms, cold fronts, heat waves, or strong winds. The campsite may or may not have amenities. And most importantly, contending with the wildlife adds another variable that can’t be predicted. However, the key element of how the trip goes is how prepared we are. The trips where we assumed blue skies were by far the most stressful. If we prepared for different outcomes and weather based on the uncertainty of going into the woods, the trip could always be salvaged.
Banks and credit unions are currently facing a similar “into the woods” predicament, as the economic environment seems to grow more volatile and contradictory day by day. While hiring remains strong and unemployment continues to stay near historically low levels with the Bureau of Labor Statistics reporting 3.6% as of June 2022, other indicators are flashing warning signs. Inflation concerns continues to plague the economy after accelerating to 9.1% in June 2022, the highest increase since November 1981. Drivers of inflation in the past several months include rising food and gas prices as global supply remains disrupted from Russia’s invasion of Ukraine and the remnants of the pandemic. Economists are taking notice, with nearly 70% of economists surveyed by the Financial Times and the Initiative on Global Markets believing that the National Bureau of Economic Research (NBER) will make a call at some point in 2023 identifying a recession.
These conflicting indicators are convoluting the economic forecast through the rest of 2022 and 2023, and the differing potential circumstances would have very different impacts on banks and credit unions. Though this uncertainty can certainly cause headaches and stress for banks and credit unions worried about their capital positions in a severely adverse economic scenario, stress testing can help to prepare your bank or credit union in the face of uncertainty and help to optimize strategic decisions.
Stress Test Overview
A stress test is defined as a risk management tool that consists of estimating the bank’s financial position over a time horizon – approximately two years – under different scenarios (typically a baseline and severely adverse scenario). The OCC’s supervisory guidance in October 2012 stated “community banks, regardless of size, should have the capacity to analyze the potential impact of adverse outcomes on their financial conditions.” 1 Further, the OCC’s guidance considers “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.” 2 A stress test can be defined as “the evaluation of a bank’s financial position under a severe but plausible scenario to assist in decision making with the bank.” 3
There are a few different types of stress tests that banks and credit unions can utilize in estimating their financial position:
Transaction Level Stress Testing: This method is a “bottom up” analysis that looks at key loan relationships individually, assesses the potential impact of adverse economic conditions on those borrowers, and estimates loan losses for each loan.