With adequate stress testing, you can prepare your bank for whatever potential risks may be in your portfolio and how they impact liquidity and capital.
In the complex world of banking, scenario-based stress tests provide a familiar framework for risk assessment. However, amidst today’s higher interest rates and the ever-changing economy, pinpointing the scenario that encapsulates all uncertainties can be daunting. To aid in this endeavor, we offer our top six stress testing tips tailored to the needs of community banks.
- Sensitivity Testing: Market downturns, interest rate fluctuations and liquidity issues underscore the importance of sensitivity testing alongside scenario testing. Rather than attempting to capture every stressor, focus on assessing your portfolio’s resilience against deviations from your typical baseline. Additionally, consider sensitivity back-testing to document past actions and their effectiveness in mitigating sudden market fluctuations. These insights are invaluable for future planning, board education and employee training.
- Collateral Location: While major urban centers often dominate headlines, several secondary markets are witnessing increased vacancies in commercial real estate (CRE) and multifamily properties. Scrutinize the geographical distribution of your collateral and consider introducing additional loan groupings to address heightened risks in these markets. Tailoring stress assumptions to local economic conditions enhances risk assessment accuracy.
- Rollover Risk: With interest rates surpassing recent historical averages, shorter-term borrowers face increased rollover risk. Assess loan structures, particularly balloons nearing maturity, to anticipate refinancing challenges. Understanding the proportion of loans reaching maturation and borrowers’ ability to qualify for refinancing is crucial for managing rollover risk and preserving portfolio stability.
- Dig Deeper: Beyond surface-level analysis, delve into the intricacies of revenue sources, economic uncertainties and your customer base. Investigate how urban migration impacts residential landlords and associated cash flows, and assess the sensitivity of your customers’ business models to higher interest rates. Comprehensive analysis enables proactive risk mitigation and strategic decision-making.
- Earnings Challenges: When assessing credit stress, keep earnings forecasts in perspective, considering the industry’s evolving landscape. Rising deposit costs coupled with softer commercial loan demand pose challenges to net interest margins. While interest income on loans may increase, higher costs on Federal Home Loan Bank (FHLB) advances and overnight borrowings offset these gains. Anticipating earnings challenges allows for proactive measures to maintain profitability.
- Liquidity: Amidst credit risk considerations, liquidity management is paramount, particularly in turbulent market conditions. Many businesses face unexpectedly higher expenses, inflationary pressures and competition for workers. Developing a plan to protect liquidity against the potential movement of funds between institutions and market uncertainty will help increase financial stability during challenging times.
In conclusion, proactive stress testing enables community banks to navigate market fluctuations and safeguard their capital and liquidity. With adequate stress testing, you can prepare your bank for whatever potential risks may be in your portfolio and how they impact liquidity and capital.
To continue this discussion or for more information, please contact Jay Kenney at jkenney@pcbb.com or visit pcbb.com.
Dedicated to serving the needs of community banks, PCBB’s comprehensive and robust set of solutions includes cash management services such as Settlement and Liquidity for the FedNow Service, international services, lending solutions and risk management advisory services.
