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Want Stronger Capital?-Strengthen Your Stress Testing Process

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BY EMILY HOLLIS

At ALM First Financial Advisors, we’ve heard from a number of larger credit unions, asking about the value of capital stress testing. Although NCUA’s current capital stress testing guidance is directed to those with $10 billion or more in assets, we believe that these tests or scaled-down versions are also a valuable exercise for credit unions below this threshold. First of all, it helps determine if your credit union can weather a future market downturn. Beyond that, it gives the board and management a “heads up” to potential problem areas, like portfolio concentration. And finally, it’s very useful in capital planning, helping to determine if risk-reward assumptions need to be revised. Let’s take a deeper look:

Testing capital adequacy

Think about the challenging conditions auto manufacturers put their vehicles through to determine how much stress and damage they can withstand. It’s the same with capital stress testing, which analyzes a depository institution’s ability to absorb the impacts from negative financial or economic events. But different from ALM analyses, which primarily assess interest-rate risk, stress testing also incorporates credit factors. The requirements for sophisticated stress tests are part of regulations introduced in the past couple of years to evaluate various aspects of risk in a balance sheet:

All of us continue to carry the painful memory of the global economic crisis and its far-reaching repercussions within the financial industry. Depository institutions continue to struggle under the weight of more and tighter regulations, among other major impacts.

The joint supervisory guidance issued by the Basel Committee on Banking Supervision and U.S. regulators is a glaring example that calls for capital stress testing for institutions with $10 billion+ in assets. And under Dodd-Frank Act (the “Comprehensive Capital Analysis and Review and Dodd-Frank Act,”), stress tests are designed to gauge the capital adequacy of individual depository institutions and reassure investors. You may recall it was introduced by the Federal Reserve in 2009 to restore confidence in U.S. banks to measure the vulnerability of a portfolio, an institution or a financial system under hypothetical scenarios.

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