If Credit Risk Is Inherent In Your Balance Sheet, Stress Testing Interest Rate Risk Isn’t Going To Help



Stress tests play an important role in identifying and analyzing interest rate
risk outliers for credit unions. However, if your CU has a high amount of
credit risk, such analyses are not going to alter your risk category.
Learn why selecting the appropriate factors to stress is key.

Financial institutions face three types of financial risk: interest rate risk; credit risk and liquidity risk. Generally the net economic value (NEV) and net interest income (NII) simulation analyses test interest rate risk. Additional stress tests in the form of altering the shape of the yield curve, non-maturity deposit assumptions, volatility, etc. are critical to identify and analyze outliers of interest rate risk. But will these analyses help if a financial institution has a high amount of credit risk? The answer is no.

Stress Testing
Stress testing has been a hot topic over the last couple of years. Generally, stress testing is a forward-looking quantitative evaluation of adverse macroeconomic environments that could impact a banking institution’s financial condition and capital adequacy. These risk assessments are based on assumptions related to potential adverse external events, such as changes in real estate or capital market prices or unanticipated deterioration in a borrower’s repayment capacity. These stress tests are used to evaluate credit risk and can also be used to ensure capital is sufficient to withstand an economic downturn.

Regulatory Guidelines
The Supervisory Capital Assessment Program, its successor the Comprehensive Capital Adequacy Review (CCAR) and the stress testing requirements of Section 165 of the Dodd-Frank Wall Street Reform and Consumer Protection Act are, collectively, an important set of supervisory expectations for banking organizations with greater than $10 billion in assets. These large organizations are required to conduct stress tests in accordance with the Dodd-Frank Act Stress Testing (DFAST).
In its October 18, 2012 guidance, the OCC emphasized that national banks with assets well below $10 billion should begin their evaluations with a simple stress test of their loan portfolio. The OCC also suggested that such tests be conducted annually. In addition, the OCC recommended banks stress test at the individual loan level and on credit concentrations of concern, such as commercial real estate.

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