FAQs About Stress Testing Expectations
The following Frequently Asked Questions (FAQs) provide brief answers to many common questions about FCA’s stress testing expectations. They are designed to answer the most common questions posed by examiners, as well as Farm Credit System (FCS or System) management and board members. For additional information on stress testing and FCA’s expectations of FCS lending institutions, see the FCA Informational Memorandum dated March 4, 2010. FCA will update these FAQs periodically based on feedback received.
1. What is stress testing?
Stress testing is an analytical procedure for subjecting an institution to a hypothetical, yet plausible adverse scenario. The purpose is to measure the impact of the potential adverse scenario on the condition and performance of the institution and to devise contingency plans for responding to and managing the risk identified in the stress testing exercise. Stress testing is an important risk management tool that is used by financial institutions as part of their internal risk management and capital adequacy framework. Stress testing alerts an institution’s management to adverse outcomes related to a variety of risks and provides an opportunity to prepare for them. An effective stress testing program also helps management determine how much capital might be needed to absorb losses should large shocks occur. Although stress tests provide an indication of the level of capital needed to manage through deteriorating economic conditions, an institution may also take other steps to help mitigate increasing levels of risk. Stress testing supplements other risk management approaches and measures.
2. Why is stress testing important?
Stress testing is important because it: (1) Helps senior management and the board develop more effective contingency plans; (2) Enables them to understand their institution’s risk profile more completely; and (3) Allows them to make better informed decisions about their risk tolerance levels, appropriate allowance and capital levels, loan pricing, underwriting and other risk management actions.
Stress testing is especially important after a long period of favorable economic and financial conditions that can lead to complacency and the under pricing of risk. It can also be an important risk management tool during periods of growth, when new products tend to grow rapidly and for which limited or no loss data is available.
Much of the material above draws from an excellent reference document that explains the importance and key facets of stress testing, Principles for sound stress testing practices and supervision (May 2009), published by the Basel Committee on Banking Supervision at the Bank for International Settlements. It can be found at www.bis.org/publ/bcbs155.pdf.
3. What type of models should be used to conduct portfolio stress testing?
The models used for stress testing should be appropriate for the complexity of the institution and enable it to address its key risks. It may be that more than one model is necessary for stress testing each of the important risks to the institution.
The institution may elect to use software designed for stress testing financial institutions, which is provided by vendors. Some institutions may wish to build in-house models tailored to their specific needs and risks.
Stress testing capabilities and expertise varies widely within the System. It is recommended that associations with little experience in stress testing consult with their funding bank, other associations with more experience, and/or outside consultants. They may be able to recommend stress testing tools available from vendors or alternative strategies for acquiring the necessary analytical tools and expertise.
4. What are some of the practical benefits of stress testing?
Stress testing is a critical component of an institution’s risk management and business planning processes.
Stress testing can provide insights into the potential impacts of specific, well-defined scenarios. For example, a stress testing program would enable the board and management to answer questions such as:
- What would be the impact of significant declines in farmland values (e.g., 10 to 15 percent per year for the next three years) in our territory? How would that affect our risk profile?
- How would a significant rise in interest rates (e.g., 200 to 300 basis points) affect the institution’s spreads, NIM, and ROA? What would such an event mean for credit risk?
- Do we know the potential impact of a sharp two-year decline in the profitability of producers of the commodity to which we have our greatest exposure? What would be the impact if such profitability declines occurred for commodities to which we have our top two or three exposures?
- If the unemployment rate in our territory remains at high levels for another two years, how would it affect our portfolio’s credit quality, earnings, and capital?
- How severe a downturn would it take to result in our financial ratios declining to the “3” range under FCA’s FIRS benchmark?
The answers to the types of questions above should lead to appropriate contingency plans to enable the institution to manage through a period of future severe adversity.
The outcome of the stress scenarios may reveal a higher than anticipated exposure to certain risks, leading the board and management to adjust the institution’s underwriting practices, loan pricing, allowances, capital levels, or utilize other balance sheet management plans.
Stress testing also provides a valuable tool for analyzing how new programs or loan or investment products might affect the risk profile of the institution.
5. What are some of the challenges encountered when implementing a stress testing program?
Data – Some institutions do not have current or relevant borrower financial data in their loan portfolio database. This is particularly true for mortgage loans that are performing and require little ongoing contact between the borrower and the loan officer. Nevertheless, without updated financials on performing loans, the institutions may not know if the borrower is under stress until the loan goes past due. If incomplete and/or stale borrower data on commercial and mortgage loans is too prevalent in the portfolio, the institution may be forced to make additional assumptions or use proxy data when conducting any loan portfolio management analyses, including stress testing. It may also be possible to incorporate credit scores into the stress testing analysis. In other words, meaningful stress tests can and should be completed even in the absence of borrower level financial data.
Institution size and complexity – Some associations are relatively small and have non-complex portfolios. The management and boards of these types of associations may feel that they have an intimate knowledge of their institution’s portfolio and its inherent risks. They may believe that stress testing is unnecessary for their institution. Indeed, such institutions may not require a sophisticated stress testing program, comparable to what is needed at a multi-billion dollar institution. Nevertheless, the economic and financial environment in which even small institutions operate has become very complex and extremely volatile. In such an environment, a stress testing program suited to the needs of a small, non-complex institution can greatly enhance its risk management and protect the interests of its stockholders.
Availability of models and modeling expertise – Institutions with little or no experience with portfolio stress testing may not know where to obtain the appropriate models and analytical tools needed for stress testing. Fortunately, there are vendor-supplied stress testing tools available. In addition, many associations have experience using these vendor-supplied models, as well as internally developed tools. Associations can get advice from their funding bank or other associations with experience stress testing their loan portfolios.
Some institutions may feel they do not have the modeling and/or analytical expertise to implement a stress testing program. Nevertheless, stress testing is an important enough function to warrant the implementation of strategies to acquire such expertise, whether by hiring staff with the appropriate expertise or contracting with outside consultants to enable the association to implement an appropriate stress testing program.
Cost of implementation – There are costs associated with implementing a stress testing program. These costs may seem high for some associations, particularly small to medium-sized institutions. However, the cost is justified by the potential loss mitigation and improved risk and capital management that will result from an effective stress testing program. A well-designed stress testing program will enable the institution to better understand its risk profile, improve its portfolio management practices, and avoid costly lending missteps in the future by adjusting key practices (e.g., loan pricing, underwriting) initiated due to risks revealed in the stress testing process. Improved business and capital planning, as well as earnings performance, are also potential positive outcomes of appropriately designed stress testing programs.
6. How does stress testing at Farm Credit System banks differ from associations?
Stress testing at banks is far more complicated than at associations due to their more complex balance sheets and the challenge of being able to effectively mine an association’s database. Banks should carry out ongoing stress testing of the various components of their balance sheets.
Retail loans (including participations and capital market loans) – This loan category should be stress tested in a manner similar to what is expected of associations. This category should be segmented into logical groups of commodities or other groups possessing common underwriting/risk characteristics. Stress testing should be based on borrower level information or proxy data and/or simulations reflecting management’s most up-to-date knowledge of its borrowers’ financial condition.
If an institution does not have the data needed to enable it to stress test its portfolio based on borrower-level stress scenarios, it can assume certain PD and LGD migration scenarios. These PD and LGD migration scenarios should be well supported by analyses explaining why certain economic stressors translate into a given PD/LGD migration. This, however, should not be considered a long-term solution to the institution’s data shortcomings.
Association Direct Loans – Direct loan stress testing should be rooted in the risk embedded in each association’s direct loan. Consequently, the direct loans’ performance under alternative stress scenarios ought to be reflective of each district association’s risk profile. Banks should utilize stress testing methodologies that reflect how each direct loan would likely perform under well-defined stress scenarios. Assessing the risk embodied in each direct loan may be aided by evaluating the stress testing completed by the district associations if viewed to be adequate, sound and comprehensive enough to judge the impact of potential risk to the portfolio. If an association’s stress testing practices are not sufficient to support a valid conclusion, then the bank should conduct stress analyses of that association’s direct loan based on other information available to the bank.
Investment Portfolio – Banks should conduct regular stress testing of their investment portfolio. Stress tests should consider alternative interest rate and credit-related scenarios. We understand that some banks rely on external parties and tools for stress testing this portion of their balance sheet.
Interest Rate Risk – Banks analyze the potential impact of alternative interest shocks and other interest rate scenarios on their market value of equity and net interest income. Their analyses enable them to fulfill reporting requirements to FCA and their board and asset-liability management committee.
Other Exposures – Other exposures, such as counterparties, should be stressed regularly and reflect potential events ranging from high probability-low impact to low probability-high impact scenarios.
Comprehensive Stress Testing – Comprehensive stress testing associated with the annual business planning process and/or an unusual or elevated risk environment should incorporate the entire balance sheet. Banks should develop well-defined stress scenarios, describing the underlying economic environment for each scenario. At least one scenario should constitute a severe stress, one that is unexpected, yet plausible. The entire balance sheet should be subjected to these stress scenarios in a consistent manner. The impact of the scenarios on the performance and condition of the bank should be projected over at least a 3 year time horizon.
7. What is the role of the board and senior management?
Both the board and senior management are expected to be actively engaged in the institution’s stress testing process. The stress testing program is expected to be an integral part of the institution’s overall risk management and business planning processes. The board should establish the policies related to stress testing and be actively involved in evaluating the results; providing input on or reaction to stress test scenarios and assumptions, and determining appropriate institution responses. Management should establish procedures and perform the actual stress testing analyses.
The stress testing results should provide the board and senior management valuable input into analyses related to assessing the sufficiency and appropriateness of the allowance for loan losses, underwriting standards, loan pricing, hold limits, earnings retention, capital adequacy, and patronage, etc.
8. How many scenarios should be performed? How should scenarios be documented?
The stress testing process should consider a range of scenarios to provide management and the board with a good understanding of the risk profile of the institution. At least one of the scenarios should be a severe stress, one that is unexpected, but plausible.
It is important that each scenario is well-documented with a description of the scenario, including key assumptions, related financial statements and supporting schedules. Each scenario should be internally consistent and defensible. That is, all the assumptions and the results must make sense when considered together. There should not be contradictory assumptions built into the scenario. For example, if it is assumed that corn prices are very low, one would not expect to see an assumption of high feed costs in the same scenario. Also, farmland prices are not likely to be rising sharply while grain prices are low and interest rates are high.
9. What should the output of the scenario analyses include?
Institutions may perform a variety of stress tests and sensitivity analyses throughout the year. These analyses focus on specific aspects of the institution’s operations. The output is dependent on the purposes and goals of those tests and analyses.
The results of the more comprehensive stress tests that are usually part of the business planning process are expected to flow through the institution’s financial statements and performance ratios. This stress testing analysis should be more than a set of risk rating/probability of default migration tables. The results of a baseline or most likely scenario should be compared to alternative stress scenarios by comparing key balance sheet and income statement items, as well as earnings, capital and liquidity ratios.
A complete discussion of the results, including potential management responses, should be included in the output analysis.
10. Should the institution have written policies and procedures related to its stress testing program?
The board and senior management should ensure that written policies and procedures be put into place to govern the institution’s stress testing program. Policies and procedures should address the frequency of stress testing, its role in the business planning process, and how the stress testing program is integrated into the overall risk management process. They should also specify a clear and central role for the board, or the appropriate committees of the board, and senior management.
11. What if the institution has inadequate data?
Some institutions may indicate that they have inadequate data to conduct credible stress tests of their institution. In some situations the data may not be up-to-date or the institution may not have access to the breadth of data needed for a stress test. If an institution has inadequate data for implementing a credible stress testing program, its management and board should evaluate the feasibility of acquiring the needed data. At a minimum, institutions should maintain sufficient data for assigning accurate risk ratings and performing other loan portfolio management analyses. Associations should also maintain data which can provide a credible basis for generating proxy data and/or simulated portfolios for use in stress testing.
If an institution does not have the data needed to enable it to stress test its portfolio based on borrower-level stress scenarios, it can assume certain PD and LGD migration scenarios. These PD and LGD migration scenarios should be well-supported by analyses explaining why certain economic stressors translate into a given PD/LGD migration. This, however, should not be considered a long-term solution to the institution’s data shortcomings.
Institutions may wish to consult with their funding bank, other associations with more robust databases, and/or outside consultants for advice and assistance.
For some portfolio segments, such as housing or consumer loans, it is not practical to collect updated borrower financial information. However, credit scores are generally available for these borrowers and stress tests can be devised to assess the impact of a changing risk environment on this portfolio segment.
It is important to distinguish between commercial loans (agricultural real estate and operating) and loans for part-time farms and rural housing when establishing policies associated with credit monitoring, portfolio management and related data requirements. Board policies should clearly specify the criteria (e.g., loan size, complexity) for maintaining up-to-date borrower financial information. (See FCA regulation § 614.4150: Lending policies and loan underwriting standards.)
Lack of complete data does not preclude stress testing, but the better the data the better the stress testing results and usefulness.
12. How often should stress testing be conducted?
Institutions may conduct various types of stress testing throughout the year to meet a variety of analytical needs. However, a comprehensive stress test that measures the impact of various stress scenarios on the institution’s balance sheet, income statement and performance ratios should be conducted at least once a year, usually during the annual business planning process. More frequent comprehensive stress testing is recommended during periods of adverse and/or volatile economic conditions.
13. How should stress testing models be tested and validated?
All stress testing models should be tested and validated consistent with the directions provided in the Informational Memorandum, Computer-Based Model Validation Expectations (June 17, 2002).
14. How does individual loan stress testing fit into an institution’s overall loan portfolio management program?
Stress testing principles should also be incorporated into loan underwriting practices. Stress testing individual loans provides insights into a borrower’s ability to withstand adversity, thereby facilitating more constructive underwriting and more accurate pricing commensurate with the risk. Decisions on loan originations and major servicing actions for large loans should be supported by loan specific stress testing analysis.
Individual loan stress tests should assess the borrower’s ability to withstand adversity from factors such as changes in commodity prices, input costs, interest rates, government payments, and production levels and yields. Items such as off-farm income and income from contracts (e.g., integrator/contract growers) should also be stressed if the borrower’s repayment capacity is reliant on this income.
On loans to borrowers in distressed industries, current prices and production costs already reflect highly stressed conditions. In these situations, stress testing may focus more on evaluating the effect of continued stress on collateral values and whether the borrower has the financial capacity (working capital and balance sheet equity) to justify continued financing until industry conditions improve.
The institution’s credit guidance should define when stress testing on individual loans is required as part of the credit analysis process. Criteria may include loan size/total borrower debt with the institution, type of credit action, and/or the commodity/industry being financed.
15. If I have additional questions, whom do I contact?
FCS institutions should contact their designated examiner-in-charge. You may also contact Doug Alford, Credit Specialist Program Manager, Office of Examination, (720) 213-0961, (firstname.lastname@example.org), or Stephen Gabriel, Chief Economist and Associate Director, Office of Regulatory Policy, (703) 883-4287, (email@example.com).