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Commercial Loan Stress Testing: The Rx for Maintaining a Healthy Portfolio

January 09, 2012

Leading up to the game-changing financial crisis in 2009, community banks dramatically increased participation in commercial real estate (CRE) secured lending, and regulators have taken notice. These loans, as well as all other commercial loans, can be significantly impacted by a number of external events, ranging from economic shifts and falling real estate values to rising interest rates or vacancy rates – transforming asset quality from good to bad and a stable portfolio into one that puts the institution at risk.

Benjamin Franklin said ‘An ounce of prevention is worth a pound of cure’ and this idiom should be applied to manage overall portfolio risk. Regulators are strongly encouraging, i.e. requiring, banks with high concentrations of CRE to implement a little preventative medicine of their own – in the form of monthly stress testing and portfolio testing.

Stress Testing Illustrates Situational Impact

Stress testing is actually scenario testing – a “what if” analysis that evaluates loan performance parameters, like loan-to-value ratios, under adverse market conditions. If interest rates shoot up, what impact does that have on a group of loans? How will the collateral value change? What can we, as an institution, do to mitigate risk? Instead of reacting to a credit crisis, stress testing gives institutions the opportunity to take proactive measures to protect their organization and customers.

Here’s an example to illustrate the kind of insight stress testing can provide.

Let’s assume real estate values decline by 20 percent, so Institution X performs a stress test on a three-year-old, $1 million loan on a $1.5 million property. At the time of the loan, the loan-to-value was 65 percent. If the value decreased to $1 million three years later, and the institution is still carrying a $900,000 loan, that loan-to-value is now 90 percent.

Stress testing takes all of these individual values and provides a comprehensive risk picture of an institution’s entire loan portfolio, so management can identify vulnerabilities and determine which scenarios have the greatest impact on the portfolio. This information enables institution leadership to take appropriate strategic action -- including adjusting lending practices or increasing capital reserves – if the specific stress incident comes to pass.

Portfolio Analysis Provides a Clearer Picture

While stress testing enables institutions to “try out” scenarios, portfolio analysis enables institutions to look at specific concentrations. How many CRE loans do you have in a particular industry sector? How many do you have in a particular county? For example, if your institution serves the state of Michigan, wouldn’t you want to know if 70 percent of your CRE loans are located in Detroit that has been hard-hit by the challenges facing the auto industry?

By slicing and dicing data and analyzing various concentrations, lenders can identify where they have risk on an ongoing basis.

Portfolio analysis also enables bank and credit union management to look at the types of loans their lending personnel are making. Are their portfolios diverse? Do specific loan officers have high concentrations in specific areas?

Using the information derived from ongoing portfolio analyses, institution leaders can set credit policies and more effectively monitor decisions. Combining this data with stress tests, institutions can identify individual at-risk loans earlier in the process, work with the borrowers toward resolution and ultimately optimize the composition and quality of the overall portfolio.

The idea is not to approve fewer loans, or increase foreclosures. Instead, a more effective portfolio analysis enables lenders to take action long before liquidation – requesting additional guarantees, business loan agreements or collateral adjustments. Using the results of ongoing portfolio and stress testing, institutions can better serve their customers; working with them before default, and mitigating their own risk levels in the process.

Automating the Process

Stress testing and portfolio analysis are not annual events. Regulators are encouraging institutions to perform these functions monthly. To be effective, the same analysis should be run on the portfolio each time, with stress tests fluctuating to reflect current market conditions.

Institutions can automate this process with the right solution, such as D+H’s CreditQuest® Portfolio Manager solution. Not only does this enable bank leadership to stay on top of risk on a more granular level, but will also prepare them for the inevitable regulations to come. It’s also more accurate, efficient and reliable than managing a myriad of spreadsheets.

Although stress tests are not yet required by law, more often than not, examiners are increasingly asking institutions about stress testing, from which tests they’re running to requesting documented details around portfolio concentration.

If your institution can’t produce this information, the examiner might do the stress test for you – and present you with some surprises that could impact your bank rating. The best defense is showing the examiners that you’re on top of things; proactively running your own stress tests and portfolio analysis to identify concentrations – and documenting the assumptions that went into the report.

It’s that ounce of prevention that could have a major impact on your institution’s stability tomorrow.

Author

Kimberly Songer
Vice President, Client Services, Lending & Compliance Solutions

Kimberly has over 18 years of experience in the commercial banking and software development fields. She currently serves as director of risk solutions for D+H where she is focused on developing a wide range of innovative products for the financial services industry. Kimberly leads a team of banking and industry subject matter experts, and provides overall product direction for D+H’s risk management offering within the U.S.