Capital is the core of an institution’s ability to grow and succeed. This is especially true in the current environment as depositories of all sizes consider the potential impacts of COVID-19, cybersecurity failures, recessions and other risks. Yet answering the question: “How much capital does my institution really need?” remains a challenge for many leaders.
Now is the time to develop or refine your strategic road map to include capital adequacy and identify potential risks. Understanding how operational and credit risks could impact the balance sheet and income statement will enable your depository to determine the appropriate amount of capital. This is critical for your business, whether it is a regulatory requirement or not.
Prioritizing a Strategic Net Worth Analysis
How can busy executives ensure the most effective use of their time? Categorizing their priorities. Most of us follow some form of this useful practice: Make a list of projects and initiatives that we “must do,” “might consider doing” and “don’t need to do.” For many, stress testing net worth often falls into the second category. While the largest credit unions must regularly perform capital stress testing, many who don’t fall into that class wonder about the tradeoff between the time and value of this task.
Financial regulators require capital stress testing for institutions with more than $10 billion in assets, but we’ve found it to be an important exercise for financial institutions of any size. Regular stress tests aim to ensure financial depositories have enough capital to withstand a severe economic downturn, including the ability to quickly adjust their balance sheets. Institutions do not need to follow the same rigorous mandate required for $10 billion institutions in order to inform appropriate levels of capital.
Why Conduct Stress Tests?
Stress testing offers key insights about the credit union’s financial position that exceed regulatory requirements, making them a good idea for all depositories; a comprehensive examination of the balance sheet and various potential risks forces the credit union to take a hard look at its current position and how that would change under various scenarios.
| Here are some of the benefits derived from a detailed stress testing analysis:· |
· Assurance that your credit union has adequate capital to survive a market downturn
· Verification of the adequacy of the allowance for loan and lease losses
· Ability to isolate possible future problems, such as an over-concentration in a specific asset type
· Better decision-making as management and the board see the need to set risk-tolerance levels
· Improved capital and asset planning by verifying risk-reward assumptions
How to Conduct Stress Tests
Although establishing and executing a capital stress testing process takes time to establish, credit unions can potentially benefit by developing an organized approach that helps keep the program moving smoothly. Here are some points to consider:
1. Data collection and organization – Before the advent of capital stress testing requirements, many depositories didn’t keep the necessary critical data on their loan originations – often the biggest challenge to adequate testing. Results from an analysis will be far less meaningful if the appropriate data isn’t available – as the IT expression goes, “garbage in, garbage out.” Creating and developing a process to collect and organize data is essential to evaluate your credit union’s profitability, value, and overall balance-sheet trends. Knowing that the input data is accurate allows management and the board to be confident in the results of analyses, permitting them to plan strategies more effectively for future success.
2. Scenarios – Scenario simulations are a beneficial exercise for all institutions. As part of stress testing, the Fed issues scenarios that incorporate a baseline status, as well as those assuming adverse and severely adverse economic environments. The resulting analyses determine how well the depository will perform in the face of a deteriorating market. By definition, risk involves unknown factors that can occur and affect the value of each product. Reviewing the portfolio under different scenarios may allow financial managers to more accurately price and invest in risk, ensuring the credit union is fairly compensated.
For the best insight, scenario testing should include more than balance-sheet risk and valuation. Because liquid, short-term liabilities fund long-term assets, they carry liquidity risk and the possibility that funding could quickly dry up. We believe this makes it imperative to perform periodic stress testing of liquidity funding. The testing scenarios should include local economic actions, like increases in competition or a decrease in skilled workforce, as well as global economic events, like changes in market rates, and other random risks, like security breaches.
3. Loss and recovery assumptions. A cornerstone of capital stress testing is determining the assumption of principal losses and severities. After the Fed issues economic changes that form the basis of testing scenarios, the depository should make assumptions about the loan portfolio’s default tendencies. To ensure assumptions are appropriately designed for the balance sheet, delinquency and charge-off information should be captured across all collateral types. By understanding the depository’s performance in a typical environment, it will be easier to predict results under adverse market conditions. Also, knowing the delinquency rate of various features of the portfolio helps estimate the recovery lag for the different collateral types. If a model assumes immediate recovery, it won’t show a true picture of the credit union’s practices. Knowing the cost to foreclose on properties or repossess collateral is critical to making strategic decisions about risk-based pricing and product offerings.
4. Analyses – Conducting regression analyses on performance and changes in macroeconomic variables will help credit unions understand their sensitivity to economic factors. To be most helpful, these analyses should incorporate unique scenarios unrelated to market performance, as they wouldn’t be included in the model projections. Develop scenarios to measure performance in case an inherent, but unexpected, risk was to occur. Further, random probability simulators can project the probability of a natural disaster, or other negative local events, and how it would potentially affect operations.
5. Reporting – One of the greatest values of capital stress testing comes from the information it provides to management and the board. To help in strategic planning and auditing, testing and capital planning methods should be transparent and well-documented for easy auditing. This should include highlighting key variables, assumptions and the credit union’s sensitivity to particular changes. Finally, to maximize effectiveness, credit-monitoring reports should be available during planning sessions, liquidity discussions and profitability analyses.
Not Ready for Annual Stress Tests?
An initial strategic net worth analysis will provide many insights and may shine a light on the value of regular stress testing for credit union decision makers. It’s a highly beneficial practice for all institutions. Incorporating the necessary data-gathering and reporting into existing analytical procedures provides critical information. Developing customized stress-testing procedures that match a credit union’s level of complexity and recognizing the risks it faces can potentially help management and the board more effectively plan for future success – required or not.
Thomas Griswold joined ALM First Financial Advisors in 2013. As the Managing Director for Advisory Services, Thomas oversees the Advisory Services department, which is responsible for implementing actionable and effective ALM and investment strategies for client financial institutions. In addition, Thomas performs merger and acquisition analyses, and ALM model validations. He also assists with interest rate hedging strategies, and values loan pools to guide trading decisions. Prior to joining ALM First, he worked as an analyst underwriting commercial credits with PlainsCapital Bank. Thomas holds a bachelor’s degree in finance from the University of Notre Dame, as well as the Chartered Financial Analyst (CFA) designation. He assists with Junior Achievement Dallas mentoring students on a variety of topics including sound financial planning and career guidance and planning.
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