Frequently Asked Questions
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Stress testing expectations
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 probability of defautl (PD) and loss given default (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 use 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 three-year time horizon.
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, patronage, etc.
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, you 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.
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 with 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.
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.
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 that can provide a credible basis for generating proxy data and/or simulated portfolios for use in stress .
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 probability of default (PD) and loss given default (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.
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.
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).
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.
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, ([email protected]), or Stephen Gabriel, Chief Economist and Associate Director, Office of Regulatory Policy, (703) 883-4287, ([email protected]).