portfolio stress testing one size doesn’t fit all

Portfolio Stress TestingOne Size Doesn’t Fit All

Panel:Bob Koch

Dave Kampff

History & background

• Initial focus on CRE

• Reg. requirements emerge with issuance of 2006 guidelines

• Obtain current valuation data by portfolio segment

• Request updated financials, P&L’s, Schedule E’s, etc.

• Obtain debt service data (or NOI) by portfolio segment

Data requirements

• Consider valuation sources other than appraisals

• Update financial info for C&I/SBA

• Update credit reports for consumers

• Update NOI data for multi-family borrowers

• Update appraisals where appropriate

Data requirements

Consider a high level segmentation

• Multi-family residential

• Land & construction

• Consumer mortgages & HELOC’s

• SBA owner occupied business properties

• Commercial real estate

High level portfolio segmentation

• Type of property

• Loan type

• Industry

• Ownership/occupancy

• Property location

Examine the demographics…

• Valuation and LTV (e.g., cap rates, etc.)

• Impacts on debt service requirement (e.g., interest rates, etc.)

• Impacts on NOI/Debt service capacity (e.g. rents, op exp, etc.)

Possible stress points

• Economic conditions, trends

• Consider the portfolio’s stressed performance as it affects bank earnings and capital

• Stressed portfolio trends based on prior stress tests – Ratings migration analysis

Other considerations…

• Quantifies risk levels under changing market conditions

• Provides critical analysis for capital and strategic planning

• Encourages management’s focus on a range of possible future scenarios

How stress testing benefits the Bank

Develop & run stress test(s)Develop & run stress test(s)

Impact on strategic plansImpact on strategic plans

Impact on nonaccrualsImpact on nonaccruals

Impact on Interest IncomeImpact on Interest Income

Impact on debt service capacity

Impact on debt service capacity

Impact on loan (risk) gradesImpact on loan (risk) grades

Impact on profitabilityImpact on profitability

Impact on capitalImpact on capital

Impact on DSC, LTVImpact on DSC, LTV

ALLL impactALLL impact

The process

The Bank’s corporate culture

Current Management Information Systems

• Perception that the portfolio is sound

Hurdles

• Too complex, requires staffing and expertise you don’t have

• Systems don’t support the ability to work on aggregated/disaggregated data

Start simple

Breaking down the barriers

• What are the Bank’s primary concerns

Create simple models• Thinking about the issues may be as important

as the actual stress models • Stress one or two variables to start

Create the methods and practices to be used• Establish the portfolio segments to stress

Getting started

• Decide which variables to stress• Create relevant scenarios – BC, WC, MLC

• Decide which variables to stress

• Implement systems so you can repeat and improve the process

• Establish a framework to analyze results

Determining the factors to stress

Macroeconomic Microeconomic• Interest rates • NOI• Unemployment • Vacancy rates

• Changes in cap rates • Appraised value

Evaluate Macro influences at the Micro level

Stress testing fundamentals

Each variable stressed can & likely will result in a number of measurable impacts

For example…

Stressing a variety of changes in cap rates will yield insight into changes in property value, LTV and more

For example…

Whereas stressing Gross Rents yields other insights…

Stressing entities vs. portfolios

Models should work at the entity and portfolio levels

Design models to stress independent variables to determine impacts on dependent variables

• To stress the CRE portfolio, models need to support stressing individual properties/projects

• Stress Rents for impact on NOI, Cap Rates for impact on LTV, Interest Rates for impact on DSC…

Stressing “single” variables

Stressing a single variable simplifies testing a broad range of possible outcomes:

• For C&I deals, evaluate how a 5%, 10%, 15%, 20% reduction in revenue affects profit, EBITDA, UCA Cash Flow, etc.• For CRE deals, evaluate how a 5%, 10%, 15%, 20%

increase in vacancies affects NOI, DSC, etc.

Stress testing fundamentals

Stress tests should be constructed to consider a range of possible future outcomes

Single variable entity stress testing

Analyze the full range of outcomes at the property, business or individual level

CRE Example

Single variable portfolio testing

Stress portfolio segments that operate in a similar space to enhance the test’s relevance

Stressing multiple variables

Concurrently stressing several variables enhances the ability to test combined impacts on performance• For CRE, concurrently stress changes in Rents, Op

Exp, Interest and Cap Rates to determine impacts on NOI, DSC, LTV and more• For C&I, stress changes in Revenues, Margins,

Op Exp, etc. to determine impacts on Profits, EBITDA, UCA Cash Flow and more

Stressing multiple variables

C&I Example

Stressing multiple variables

Assess the impact of changes in interrelated drivers on performance.

C&I “Entity” Example

Stressing multiple variables

C&I Portfolio Example

Anticipate the impact of changes in key areas affect the capacity of the portfolio or any segment of it.

In the final analysis…

• More effective capital planning• Better risk management

• Improved portfolio performance

Effective stress testing at the entity and portfolio level provides substantial benefits: