Stressing is Good
In an ever-evolving financial landscape, community banks and credit unions serve as the backbone of local economies. They provide essential financial services to individuals and small businesses. Accordingly, it is imperative to assure the long-term health of these institutions if local communities are to not just thrive but survive.
Stressing is Good
The current economic policy response to continued inflation is a threat to the viability and stability of our community banks and credit unions. I recently heard a business pundit state that there are only two basic principles for managers of financial institutions to understand to be successful. That would be risk (quality) and duration. While I think this may oversimplify the issues a bit, it is instructive on key areas of concern. Especially given a 500-basis point increase in interest rates in less than a year.
There is an important risk management practice that allows banks to assess the potential impact of adverse economic scenarios on their loan and securities portfolios. This is called stress testing. Yup, Stressing is Good! By subjecting their portfolios to rigorous stress tests, community banks can identify vulnerabilities. They can also enhance their risk management strategies, and safeguard the interests of their customers, communities, and shareholders.
What Portfolio Stress Testing Involves
In general, portfolio stress testing involves simulating adverse economic conditions. Items such as economic downturns, changes in interest rates, or industry-specific shocks, to evaluate the impact on loan portfolios. The stress testing approach should be adjusted to consider unique industry-related factors and the loan repricing schedule. As an example, non-owner-occupied investment real estate is certainly going to have higher risk issues than an owner-occupied wholesale operation. Loan decisions for an investment commercial real estate project that were made based upon lease and occupancy rates prior to 2020 (or perhaps 2021) are likely to be significantly lower in today’s market. When increased new interest rates are applied for loan renewal, cash flow coverage will be considerably less than the original financing. Further, increased interest rates will negatively impact cap rates, depressing the value of the underlying collateral.
What impact will this have on the borrower risk rating and how should a lender respond to increased risk within that specific relationship? Or, when thinking more broadly, what steps can be taken to identify, prioritize and mitigate risk related to entire segments of the portfolio most susceptible to changing market conditions? These are complicated but important questions – ones we will address again in next month’s feature as well.
In addition to impacts on the loan portfolio, interest rate increases are having a significant impact on the securities portfolio. While there may not be an immediate default risk, there certainly is a potential value risk. Further, the timing of repricing in the loan portfolio compared with the maturities in the securities portfolio may subject the institution to considerable compression in interest rate margins and/or liquidity needs. If the portfolio is marked to market under the new rate environment, there is potential for capital requirements to be violated. This analysis can not only provide valuable insights into the potential losses an institution may face under different stress scenarios. It can also assist in designing appropriate mitigation strategies.
A proactive approach allows community banks to make informed decisions. Everything regarding credit risk management, capital allocation, and liquidity planning. To mitigating the potential negative consequences of further interest rate increases and/or economic downturn safeguarding the financial well-being of their stakeholders.
Performing stress tests is certainly more than a casual analysis. Especially given the number of economic variables that are currently in flux. The team at Enlighten Financial can assist in developing a risk analysis program for your institution. Or conduct limited scope reviews into the most sensitive portions of your portfolio. In addition to identifying any regulatory compliance concerns, we can help identify vulnerabilities in loan and securities portfolios. We can also strengthen risk management practices, and foster confidence with customers, investors, and regulators.
Richard Rudolph is Senior Consultant at Enlighten Financial, a specialized consulting firm that focuses on loan review and risk management services to community banks and credit unions. Enlighten Financial has made it our business to shed light on the complex financial landscape. We lead clients in the right direction. We work with financial institutions and other providers to mitigate risk. To talk to Rick directly, please call: 920.445.8133.
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