Fathoming Future Risks

With lingering uncertainty, community banks incorporate stress-testing scenarios into their risk management routines

By Howard Schneider

Much-awaited guidance from the Office of the Comptroller of the Currency regarding stress-testing guidelines for community banks came out last fall. “The OCC encourages community banks to adopt a stress test method that fits their unique business strategy, size, products, sophistication and overall risk profile,” the agency’s Bulletin 2012-33 states.

Yet some community bankers remain uncertain about how this new regulatory initiative will be implemented over time.

As a safety-and-soundness risk management measure urged by regulators, stress testing attempts to estimate how adverse events could affect a community bank’s loan portfolio. For community banks, regulators say, forward-looking stress-testing exercises should attempt to forecast potential risks by modeling the effects of negative developments—such as rising interest rates—on loan performance, income, liquidity, investments and, most important, capital assets.

Based on such test results, community banks would then develop plans to cover their funding needs and mitigate potential risks should such scenarios indeed occur.

Large depository institutions are required under the Wall Street Reform legislation to set up stress-testing programs. Banks with $10 billion or more in assets must annually conduct these tests across all their business lines and report the results to regulators. The Wall Street Reform law doesn’t mandate stress testing for smaller depository institutions. Yet OCC Bulletin 2012-33 states that the regulatory body “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.”

Beyond capturing a snapshot at a given point in time, stress testing is generally considered to lead banks to more carefully and fully evaluate different potential dire scenarios—such as a recession in a particular industry or a natural disaster in their town or region—to help prepare for events. Banks with $10 billion in assets or more are also supposed to be using stress-testing scenarios across all of their business lines.

The OCC’s supervisory guidance statement also suggests acceptable stress-testing methodologies. Yet, community banks have different loan portfolios and face varying risks, making it hard to easily define what stress testing should entail in a specific situation. Community banks with high concentrations in particular kinds of lending areas, whether in commercial real estate or agriculture, should be conducting thorough internal assessments of how their portfolios would be affected by changing market circumstances. Such banks are expected to receive closer regulatory scrutiny over how well they understand, and not just document, different risk factors regarding their loan portfolios.

Therein lies the genesis of uncertainty for community banks—mainly what scenarios to examine that will satisfy regulators. Community bankers are voicing concerns about how much effort they’ll need to put into this process, and they’re wondering how their business plans will need to change because of stress-test results.

A common worry voiced by community bankers is that over time “regulators will take [stress testing] too far,” says Chris Cole, ICBA’s senior vice president and senior regulatory counsel. He’s concerned that eventually “everything will have to be stress-tested,” whether it becomes a formal or informal safety and soundness requirement or not.

Here to stay

Stress testing needs to be designed around each institution’s individual characteristics, says Robert Azarow, a law partner in the New York City offices of Arnold & Porter LLP. “No two community banks look alike in terms of risk profiles.

“I don’t think there’s a community bank in the country that can ignore this.”

He suggests that community banks consider the stress-testing demands on financial institutions slightly larger than they are—then expect many of those requirements eventually to “trickle down” over time.

However, performing stress tests “doesn’t have to be a complex, burdensome process,” emphasizes Darrin Benhart, an OCC deputy comptroller. Many community banks can use loan information on their call reports and incorporate risk factors available here.

Those stress factors are derived from previous recessions, Benhart adds. For most community banks, he says, performing that analysis on a spreadsheet will be all that’s necessary.

Being able to quantify potential risk factors—and seeing how they’re changing over time—can make it easier for community bankers and their examiners to foresee potential risks and discuss ways of mitigating potential problems, Benhart notes. He explains that the OCC and its examiners will provide “a lot of flexibility” as stress testing is formalized at community banks over the coming months.

Azarow agrees that the only certainty is that “stress testing is here to stay.” But he’s not certain this new regulatory expectation will be easy for community bankers to put into action.

“Boards should be asking management to get specific feedback from their regulator” regarding stress testing, asserts Azarow. Armed with that information, managers then can set up stress tests that they believe are suited to their institution’s assets, marketplace and overall risk profile. Talking with examiners early in the process lets community bankers have input into how these new policies are implemented at their institution. “Show examiners what you think is right,” Azarow says. “Show them you’re focused on the issue and have gone through a thoughtful process.”

Finally, adds Azarow, community bank boards of directors need to incorporate stress-test results into their capital management planning. Just doing the test and showing your examiner the results isn’t adequate; upper management needs to understand those test results and plan accordingly.

Stress strategies

Comprehensive stress testing should involve three steps, according to OCC Bulletin 2012-33. The first is “asking plausible ‘what-if’ questions about key vulnerabilities.”

Community bankers then must “make a reasonable determination of how much impact the stress event or factor might have on earnings and capital.” Managers subsequently should “incorporate the resulting analysis into the bank’s overall risk management process.”

Community banks will find that their size, the makeup of their loan portfolio and even their regulator will affect their approach to stress testing. Ann Hengel, executive vice president and chief risk officer at Bremer Financial Services Inc. in St. Paul, Minn., says she recently attended a conference where senior level representatives of the Federal Reserve and the FDIC “stated that they do not expect their organizations to come out with [stress-testing] guidance for banks with less than $10 billion in assets.”

Yet, many community bank managers are adopting the belief that stress testing has taken up a permanent position in the examination process. An ICBA member survey found that two out of three community banks performed at least one stress test in 2012—up from just 42 percent who stress tested their institution in 2009.

Stress testing is just one task performed by an 11-person compliance team at MidSouth Bank, a $1.4 billion-asset community bank in Lafayette, La. “The smaller the bank, the more pressure” regulatory compliance places on it, says C.R. “Rusty” Cloutier, MidSouth Bank’s president and CEO.

Cloutier wonders about the appropriateness of new regulatory burdens on a typical community bank, where bankers “know everyone in town.” Stress-testing simply as a means of regulatory compliance, Cloutier says, may not give them a better understanding of their risks. endmark


Howard Schneider is a financial writer in Ojai, Calif.