Introduction to Stress Testing For Community Banks

© Copyright 2015, Trepp LLC

Introduction to Stress TestingFor Community Banks

EDR / Trepp WebinarSeptember 17, 2015

© Copyright 2015, Trepp LLC2

Speakers

Matt AndersonManaging DirectorApplied Data & Research, Trepp

Mike BenzAssociate Vice PresidentBank Solutions, Trepp


Goals for Today

Introduction to Stress Testing

Look at Some

Solutions


What is Stress Testing?


Stress Testing

• Specific Applications– Credit Loss / Loan Losses– Interest Rate Sensitivity – Asset Liability Management

• Comprehensive– Capital Adequacy– Scenario-based, Regulator-defined– Required for larger institutions (CCAR and DFAST)


Regulators’ Definition

• Stress testing is a forward-looking quantitative evaluation of stress scenarios that could impact a banking institution’s financial condition and capital adequacy. – based on assumptions about potential adverse external events,

such as changes in real estate or capital markets prices– most useful when it reflects the characteristics particular

to the institution and its market area– can be used to evaluate credit risk in the overall loan

portfolio, segments of portfolios, or individual loans

Source: FDIC Supervisory Insights


Regulators’ Definition

• Stress tests can be used to evaluate whether existing financial (such as capital and liquidity) and operational (such as staffing and internal systems) resources are sufficient to withstand an economic downturn or unexpected event.

Source: FDIC Supervisory Insights

8 © Copyright 2015, Trepp LLC

The Current State of Stress Testing

Macroeconomic variables Forward looking Multiple

scenarios


Stress Testing Background


Stress Testing Evolution

CCARComprehensive CapitalAnalysis and Review

- Began as SCAP (2009), expanded to CCAR (2011)

- Large Banks: over $50bn

- Review of banks’ capital plans (dividends)

DFASTDoddFrank Act Stress Testing

- Banks over $10bn

- Enterprise-wide capital adequacy

- Public reporting requirement

CECLCurrentExpectedCreditLoss

- FASB “life of loan” loss standard

- Will change how banks reserve for future losses


Stress Test Concepts

1998: OCC Loan Portfolio Management Handbook

1990s: Interagency Statement on Interest Rate Risk Issued

2006: Joint Guidance on Concentrations in CRE Lending, Sound Risk Management Practices

2010: Interagency Statement Re-stated

Interagency Policy on Funding and Liquidity Risk Management

Stress Testing is NOT a new concept!

2011: Comptroller’s Handbook Concentrations of Credit Booklet

2012-16: OCC Bulletin, Guidance for Evaluating Capital Planning an Adequacy


What are Regulators’ Expectations?


Regulator Expectations

1. Repeatable, defensible• Won’t fly anymore: “We think using 1.5x our loss experience

during the downturn will be sufficient.”

2. Forward-looking, scenario-based forecasts tied to macro-economic inputs

• Usually means quantitative/regression models

3. Management and Board buy-in• Board is “ultimately responsible”

4. Documented and Tested• Process is as important as the results• If it’s not in writing, it doesn’t exist


"... stress testing has fundamentally changed the way we think about capital adequacy. The need to specify scenarios, loss estimates, and revenue assumptions--and to apply these specifications on a dynamic basis--has immeasurably advanced the regulation of capital adequacy and, thus, the safety and soundness of our financial system."

“… the single most important advance in prudential regulation since the crisis.”

The Regulator Perspective

Federal Reserve Governor Daniel K. Tarullo "Stress Testing after Five Years" - June 25, 2014


Scenarios


What Macroeconomic Variables Go into the Projections?

Macroeconomic indicators:• GDP growth (real, nominal)• Disposable income growth

(real, nominal)• Unemployment rate• CPI inflation



Market Volatility Indices• Dow Jones Total Stock Market Index • Market Volatility Index (VIX) • Home Price Index • Commercial Real Estate Price Index


Benchmark Yields• 3-month Treasury Yield• 5-year Treasury Yield• 10-year Treasury Yield• BBB Corporate Yield• Mortgage Rate• Prime Rate



Unemployment Rate

0.0

2.0

4.0

6.0

8.0

10.0

12.0

1Q05 1Q06 1Q07 1Q08 1Q09 1Q10 1Q11 1Q12 1Q13 1Q14 1Q15 1Q16 1Q17

Actual Baseline Adverse Severely Adv.


Commercial Real Estate Price Index

100120140160180200220240260280300

1Q05 1Q06 1Q07 1Q08 1Q09 1Q10 1Q11 1Q12 1Q13 1Q14 1Q15 1Q16 1Q17

Actual Baseline Adverse Severely Adv.


Stress Testing Results


What Do Stress Test Results Look Like?

Stress Testing must

produce information

that will:

Project income (9 quarters into the future)

Project balance

sheets (9 quarters into the future)

Project Loan Loss (9

quarters into the future for 15 loan

types)

Project capital

Project operational

risk


15.5%

7.4%

-3.8%

-1.9%-0.8%

0.0% 0.1%

-2.7%

13.9%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

9/30/2014 PPNR NCO Change inALLL

Taxes Dividends Other RWA 12/31/2016

Capital Ratio Drivers - Tier 1 Capital Ratio

Stressed Capital Drivers


Stress Testing Applications

1. Regulatory Compliance

2. Budgeting / Business Planning

3. Strategic Planning

4. Return Optimization– Right-sizing the capital base to achieve higher ROE


Stress Testing Value Goes Well Beyond Compliance

Compliance Review

Loss Minimization

Risk Measurement

Risk Management

Strategic Integration

Return Optimization

Enterprise Risk Management evolves in organizations

Regulatory Compliance is just the first step

Risk Control Balance Sheet Protection

Risk/ReturnOptimization

Value Creation


Loan Modeling


Credit Loss / Loan Modeling

Top Down

Portfolio Segmentation

Historical Loss Rate Application

Bottom Up

Probability of Default (PD)

Risk Rating Migration

- Loss Given Default (LGD) - Expected Loss (EL)


Loan Models: PD, LGD, EL

• Probability of Default– Likelihood ranging from 0% to 100%, over time– Cumulative PD from 0% to 100%

• Loss Given Default – Loss severity– How large is the loss in the case of default

• Expected Loss– PD * LGD * Outstanding Loan Balance, over time.


PD vs LTV and DSCR


Loan Data Input


Loan Level Results


Portfolio Summary


Data download and interactivity allow for further analysis

Customized Output


CECL


CECL: Current Expected Credit Loss Model

• FASB: Proposed Accounting Standards Update (Subtopic 825-15), announcement expected in Q3 2015

• Transition period through January 2018

• Loss Reserve based on forward-looking, "life of loan" assessment

• Acceptable methods include probabilities of default, historical loss rate averages, discounted cash flows


CECL Impacts

• Audit and disclosure needs will increase

• Preparation: Data collection and aggregation across multiple platforms

• Implementation of a model or system that can account for analytics, compliance, and reporting

• OCC has estimated ALLL increases of 30 to 50%

• Bankers tend to believe 50% increase


Getting Started


How Do I Get Started?

Since regulators will be redefining stress scenarios over time, you want your solution to be flexible, allowing for a wide range of scenarios and assumptions

All capital adequacy models should be treated as a long-term and integral part of any strategic planning process

All capital adequacy models should be aligned with bank management’s forward looking business assumptions


How Do I Get Started?

Make sure you have access to your

internal data

If building your own models, make sure you have access

to the right external data

What data do I need? Is the data reliable?


• Time can be a resource or a constraint

• Starting early opens more options

• Determine needs

• Develop and stay within budget

When Should I Start?


Trepp Overview


• Bank Navigator / T-CAST

• TreppDM Loan Model

• CRE Data Feed

• TreppLoan

Trepp Products for Banks


TreppDM – Loan Modeling


CRE Data Feed

• Over 100,000 commercial and multifamily mortgages

• Monthly loan data, quarterly property financials• History to late-1990s• More than 250 data elements per loan• Uses include loan modeling and benchmarking /

score cards


TreppLoan – Source Deals


Questions

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Introduction to Stress Testing For Community Banks

Economy & Finance

Transcript of Introduction to Stress Testing For Community Banks