Strategic Benefits of Stress Testing

“Every decade or so, dark clouds will fill the economic skies, and they will briefly rain gold. When downpours of that sort occur, it’s imperative that we rush outdoors carrying washtubs, not teaspoons. And that we will do.”

– Warren Buffett, Berkshire 2017 Annual Shareholder Letter

While the potential regulatory benefits are notable, stress testing should be viewed as more than just a regulatory check-the-box exercise. The process of stress testing can help bankers find silver (or gold in Warren’s case) linings during the next downturn.

What Stress Testing Can Do For Your Bank

As we have noted before, a bank stress test can be seen as analogous to stress tests performed by cardiologists to determine the health of a patient’s heart. Bank stress tests provide a variety of benefits that could serve to ultimately improve the health of the bank and avoid fatal consequences. Strategic benefits of a robust stress test are not confined merely to the results and structure of the test. A robust stress test can help bank management make better decisions in order to enhance performance during downturns. A bank that has a sound understanding of its potential risks in different market environments can improve its decision making, manage risk appropriately, and have a plan of action ready for when economic winds shift from tailwinds to headwinds.

By improving risk management and capital planning through more robust stress testing, management can enhance performance of the bank, improve valuation, and provide better returns to shareholders. For example, a stronger bank may determine that it has sufficient capital to withstand extremely stressed scenarios and thus can have a game plan for taking market share and pursuing acquisitions or buybacks during dips in the economic, valuation, and credit cycle. Alternatively, a weaker bank may determine that considering a sale or capital raise during a peak in the cycle is the optimal path forward. If the weaker bank elects to raise capital, a stress test will help to assess how much capital may be needed to survive and thrive during a severe economic environment. Beyond the strategic benefits, estimating loan losses embedded within a sound stress test can also provide a bank with a head start on the pending shift in loan loss reserve accounting from the current “incurred loss” model to the more forward-looking approach proposed in FASB’s CECL (Current Expected Credit Loss) model.

Top Down Stress Testing

In order to have a better understanding of the stress testing process, consider a hypothetical “top-down” portfolio-level stress test. While not prescriptive in regards to the particular stress testing methods, OCC Supervisory Guidance noted, “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.” The basic steps of a top-down stress test include determining the appropriate economic scenarios, segmenting the loan portfolio and estimating losses, estimating the impact of stress on earnings, and estimating the stress on capital.

While the first step of determining a stressed scenario to consider varies depending upon a variety of factors, one way to determine your bank’s stressed economic scenario could be to consider the supervisory scenarios announced by the Federal Reserve in February 2017. While the more global economic conditions detailed in the supervisory scenarios may not be applicable to community banks, certain detail related to domestic variables within the scenarios could be useful when determining the economic scenarios to model at your bank. The domestic variables include six measures of real economic activity and inflation, six measures of interest rates, and four measures of asset prices.

The 2017 severely adverse scenario includes a severe global recession, accompanied by heightened corporate financial stress (real GDP contraction, rising unemployment, and declining asset values). Some have characterized the 2017 “severe” scenario as less severe than the 2016 scenario (given a relatively higher disposable income growth forecast and a lack of negative short-term yields, which were included in the 2016 economic scenarios). However, CRE prices were forecast to decline more in the 2017 scenario, and those banks more focused on CRE or corporate lending may find the 2017 scenarios more negatively impact their capital and earnings forecasts.

For community banks facing more unique risks that are under greater regulatory scrutiny, such as those with significant concentrations in commercial real estate lending or a business model concentrated in particular niche segments, a top-down stress test can serve as a starting point to build their stress testing process. The current environment may be an opportune time for these banks to plan ahead.

While credit concerns in recent quarters have been minimal and provisions and non-performing asset levels have trended lower for the banking sector as a whole, certain loan segments have shown some signs that the credit pendulum may have reached its apex and reversed course by swinging back in the other direction. REITs were net sellers of property in 2016 for the first time since 2009, and a rising rate environment could pressure capitalization rates higher and underlying commercial real estate asset values lower. Furthermore, banks with longer duration fixed rate loans could face a combination of margin pressure and credit quality concerns as rates rise.

Conclusion

Regulatory guidance suggests a wide range of effective stress testing methods depending on the bank’s complexity and portfolio risk–ranging from “top-down” to “bottom-up” stress testing. The guidance also notes that stress testing can be applied at various levels of the organization including transactional level stress testing, portfolio level stress testing, enterprise-wide level stress testing, and reverse stress testing.

We acknowledge that community bank stress testing can be a complex exercise as it requires the bank to essentially perform the role of both doctor and patient. For example, the bank must administer the test, determine and analyze the outputs of its performance, and provide support for key assumptions/results. There is also a variety of potential stress testing methods and economic scenarios for a bank to consider when setting up their test. In addition, the qualitative, written support for the test and its results is often as important as the results themselves. For all of these reasons, it is important that bank management begin building their stress testing expertise sooner rather than later.

In order to assist community bankers with this complex and often time-consuming exercise, we offer several solutions, including preparing custom stress tests or reviewing ones prepared by banks internally, to make the process as efficient and valuable for the bank as possible.

To discuss your stress testing needs in confidence, please do not hesitate to contact us. For more information about stress testing, click here.

This article originally appeared in Mercer Capital's Bank Watch, March 2017.

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Jay D. Wilson, Jr.

Senior Vice President

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Bank Watch: April 2026

The Community Bank Scale Tax: Three Questions for Boards in 2026

Community banks came into 2026 in better shape than many expected. Margins and earnings improved, deposits were growing again, loan growth held up, and unrealized losses on securities moved lower. On the surface, the story looks better than a year ago. But that does not mean the pressure is gone.For many community banks, the next big issue is not only rates or loan growth. It is whether the bank is big enough, focused enough, and efficient enough to carry the higher cost of being a modern bank. That cost includes more than salaries and branches. It also includes technology, cybersecurity, vendor management, fraud tools, compliance, and the people needed to run it well. The FDIC’s Quarterly Banking Profile shows that despite better net interest margins, the largest drag on earnings is the cost of running a modern bank.That is where many board conversations should be headed now. The challenge is simple to describe: banking keeps getting more expensive, the cost base is harder to flex, and smaller banks do not always have enough scale to spread those costs out. This does not mean every bank needs to sell but it does mean every bank needs to be honest about what it costs to stay independent.1. Which costs are truly fixed, and which ones are self-inflicted?Every bank has unavoidable costs for non-revenue generating activities, such as for risk management, compliance, and cybersecurity. But not every cost deserves the same treatment.Some banks are carrying real fixed costs. Others are carrying years of built-up complexity: too many vendors, too many products, too many exceptions, too many legacy processes, and too many branches doing less work than they used to.The distinction between real fixed costs and the just-as-real complexity costs matters. If management treats every expense as untouchable, the bank usually ends up protecting complexity instead of protecting value. Boards should push on that point. Which costs are now part of the price of doing business? And which costs are there because nobody has made the harder cleanup decisions? Those are two very different problems.2. Are we big enough, or focused enough, to make the model work?Scale matters in banking, which is not a new point. The part that often gets missed is that scale does not always have to come from simply getting bigger. Scale can come from size. It can also come from focus.A bank with a strong niche, an efficient branch footprint, a manageable product set, and good expense discipline can often perform better than a larger bank carrying too much overhead. Bigger is not always better if the added size comes with added complexity.That is an important point for community bank boards. The question is not just, “Do we need to grow?” The better question is, “Do we have a business model that can carry the cost structure we have today?” If the answer is no, the bank has a few options: it can grow, it can simplify, it can narrow its focus, it can outsource more of what does not set it apart, or it can decide that another partner may be better positioned to carry the platform going forward.Recent examples show the range of choices. Community Bank used a branch purchase from Santander to build scale in a target market; Five Star Bank’s parent chose to wind down BaaS and refocus on its core franchise; Mechanics Bank exited indirect auto and later outsourced servicing of the run-off portfolio; and Susquehanna chose to partner with C&N for greater scale, resiliency, and efficiency. In sum, there are plenty of proven options and choices.But doing nothing is also a choice. And in many cases, it is the most expensive one.3. How much does the expense base hurt shareholder value?This is where strategy turns into valuation. A bank is not credited just for spending money on technology, compliance, or infrastructure. It gets credited when those investments lead to better performance, better returns, better customer retention, better growth, and better risk control.If the bank carries a heavy cost base without a clear payoff, that usually shows up in weaker earnings and lower returns. Over time, it can also show up in a lower valuation, which matters even if the board has no near-term interest in selling. Valuation is not just about a sale; it is a scorecard on the strength of the franchise. A bank with strong returns and a clear strategy usually has more flexibility. A bank with weaker returns and too much complexity usually has fewer options.Timing matters. Banks have more breathing room now than they did a few years ago when interest rates increased sharply, with strong earnings and clean asset quality, and that is a good time to revisit strategic and technological plans.The issue in 2026 is not simply whether a community bank can remain independent. The issue is whether it can earn that independence after paying the ever-growing cost of being a modern bank.The banks that will stand out are not necessarily the biggest banks. They are the ones that know what they do well, run a cleaner model, and make sure their cost base supports the franchise instead of weighing it down. For some institutions, that will support long-term independence. For others, it may lead to a different conclusion.Either way, the discussion should start with a hard look at the expense base. In a lot of cases, the pressure to sell does not begin with a buyer showing up. It begins when the math stops working.About Mercer CapitalMercer Capital is a nationally recognized valuation and advisory firm serving financial institutions including banks, credit unions, fintech companies, insurance companies, investment management firms, financial sponsors, and other specialty finance firms. Mercer Capital regularly assists these clients with significant corporate valuation requirements, transactional advisory services, and other strategic decisions.

Bank Watch: March 2026

Capital Allocation: The Strategic Decision in a Slower Growth Environment

Following several years of balance sheet volatility and margin pressure, the operating environment for banks improved in 2025 as most posted higher earnings on expanded net interest margins. The outlook for 2026, at least prior to the outbreak of the U.S./Israel-Iran war, reflects(ed) a relatively stable operating environment.Stability, however, introduces a different challenge. Loan growth has moderated across much of the industry, and the benefit from asset repricing has largely been realized. In this environment, earnings growth is less dependent on external tailwinds and more dependent on internal discipline. As a result, capital allocation has moved to the center of strategic decision-making.The Expanding Capital Allocation ToolkitCapital allocation discussions are often framed around dividends and, to a lesser extent, share repurchases. In practice, the range of capital deployment decisions is broader and more interconnected. Banks today are balancing:Organic balance sheet growthTechnology and infrastructure investmentDividendsShare repurchasesM&ABalance sheet repositioningRetained capital for flexibilityEach alternative carries different implications for risk, return, and long-term franchise value.Organic growth often is the preferred use for internally generated capital when the risk-adjusted returns exceed the cost of equity. However, competitive loan pricing and a tough environment to grow low cost deposits have narrowed spreads, reducing the margin for error. Similarly, technology investments may improve efficiency over time but require upfront capital with uncertain timing of returns.Returns, Valuation, and Market DisciplinePublic market valuations provide a useful lens for evaluating capital allocation decisions. As shown in Figure 1(on the next page), banks that generate higher returns on tangible common equity (ROTCE) tend to command higher price-to-tangible book value multiples. This can also be expressed algebraically, at least on paper, whereby P/E x ROTCE = P/TBV, while P/Es reflect investor assessments about growth and risk.This relationship reflects a straightforward principle: capital should be deployed where it earns returns in excess of the cost of equity. When internal opportunities meet that threshold, reinvestment should be appropriate. When returns are below the threshold, returning capital to shareholders through special dividends or repurchases may create greater per-share value.Share repurchases, in particular, can be an effective tool when executed below intrinsic value and when capital levels remain sufficient to support strategic flexibility. However, repurchases that do not improve per-share metrics or are offset by dilution from other sources may have limited impact.Figure 1: Publicly Traded Banks with Assets $1 to $5 BillionBalance Sheet Repositioning as Capital AllocationIn some cases, capital allocation decisions are embedded within the balance sheet itself. One example is securities portfolio repositioning.Many banks continue to hold securities originated during the low-rate environment of 2020 and 2021. While unrealized losses associated with these portfolios have moderated, the yield on these assets often remains well below current market rates.Repositioning the portfolio, by realizing losses and reinvesting at higher yields, represents a tradeoff between near-term capital impact and longer-term earnings improvement. In effect, this decision can be evaluated similarly to other capital deployment alternatives, with management weighing the upfront reduction in Tier 1 Capital against the expected lift to net interest income and returns over time.As with M&A, the concept of an “earnback period” can be applied. Institutions that approach repositioning with a clear understanding of the payback dynamics are better positioned to evaluate whether the strategy enhances long-term shareholder value. We offer the caveat that institutions who evaluate restructuring transactions should compare the expected return from realizing losses (i.e., reducing regulatory capital) with instead holding the securities and repurchasing shares. If the bank’s shares are sufficiently cheap, then it could make sense to continue to hold the underwater bonds until the shares rise sufficiently.M&A and Capital FlexibilityM&A remains a viable capital deployment option, particularly for institutions seeking scale or improved operating efficiency. However, transaction activity continues to be constrained by pricing discipline, tangible book value dilution, and investor expectations around earnback periods.Public market valuations ultimately serve as a governor on deal pricing, reinforcing the importance of aligning capital deployment decisions with shareholder return expectations.Conclusion: Discipline Drives OutcomesIn a slower growth environment, capital allocation is not a secondary consideration; it is a core driver of performance. While banks cannot control market multiples, they can control how capital is deployed across competing opportunities.Institutions that consistently allocate capital with a clear focus on risk-adjusted returns, strategic alignment, and per-share value creation are more likely to generate sustainable growth in earnings and tangible book value. In the current environment, disciplined execution may prove more valuable than more aggressive but less certain alternatives.

The Tariff Hangover: How a Year of Trade Volatility Is Reshaping Transportation

The past year has been defined by a series of rapid and often unpredictable shifts in trade policy. New tariffs, temporary pauses, retaliatory measures, and evolving global supply chains have left a measurable impact on the transportation and logistics industry. These developments have influenced freight volumes, pricing dynamics, capital allocation, and ultimately the valuation of transportation companies.

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