Stress testing and capital planning are important for financial institutions in good times. They are even more important in volatile times like these when the coronavirus and pressures on the energy sector result in a financial crisis.

Banks need to have an idea of what a recession might do to their allowance levels and capital ratios, and how those impacts could affect plans for dividends or other distributions. However, one challenge for financial institutions in 2020 is that the economy in recent years has been so strong that institutions’ processes for capital analysis haven’t faced a lot of pressure or scrutiny, according to Neekis Hammond, managing director of Advisory Services at Abrigo.

“There’s been virtually no realized credit risk or seemingly realizable credit risk to a financial institution. This has resulted in theoretical assumptions for capital planning. Now, the stressed inputs are very real and very realizable,” he said. Each year, the largest institutions must produce capital analysis and stress testing results for the Federal Reserve to show how they will fare during specific, simulated times of economic and financial stress, and to evaluate their capital adequacy assessment processes. Meanwhile, recognizing that other financial institutions are vital to their own communities, regulators also have a long history of requiring various stress tests on individual risk areas of other institutions. Institutions may regularly perform stress testing for strategic planning and managing capital ratios — the key performance indicators for a financial institution’s safety and soundness.

“Now, the question for a financial institution is, what are reasonable default and loss estimates for a prolonged economic impact due to the global pandemic?” Hammond said. “Many institutions would have a difficult time supporting economic-based stress testing assumptions on their own due to capacity or confidence constraints. Obviously, there’s a lot of uncertainty about how the economy will recover and how that might impact their dividend limits or even how to reflect that in models. We’re not claiming to know what will happen; rather, we support sensitivity to changing conditions and produce multiple scenarios. The goal is to provide internal and external parties with a range of expectations. From there, they can have contingency plans.”

Inspiring confidence through capital planning

In addition, Hammond noted, financial institutions already dealing with challenges associated with virtual staffing and the deluge of work associated with the Paycheck Protection Program must find the resources to manage heightened risk and incorporate uncertainty into risk models and budgeting.

“Every regulator is going to have elevated interest in credit risk in a prolonged downturn,” Hammond said. “Credit risk and the resulting impact is going to be a focus in every safety and soundness exam, and if you want to inspire confidence, your financial institution will already have conducted stressed capital planning.”

Financial institutions need to determine whether updated scenarios may affect capital ratios so that management and the board can have assurances they will remain within “well-capitalized” levels, within management targets, or within targets tied to future strategic planning. These ratios also affect the institution’s CAMELS (Capital adequacy, Asset quality, Management, Earnings, Liquidity, Sensitivity to market risk) rating, which can have multiple impacts on an institution and its plans.

Because of the limited capacity to develop new assumptions and conduct stressed capital assessments while handling day-to-day operations, many financial institutions are turning to external advisors for assistance.
“There are most certainly resource and staffing constraints,” Hammond said. “Right now, it’s like everyone’s anthill has been stepped on. Everyone’s managing the relationship, modifications and covenants, and they don’t have time to generate a legitimate capital plan and stress test under multiple scenarios.”

One model is key to accurate capital, allowance forecasts

When seeking assistance outside the financial institution, Hammond said, bank and credit union executives should consider utilizing the same advisor for any stress testing or credit-focused capital planning as they use for allowance of loan and lease losses to avoid producing irrational allowance estimates.

“Using the same model to produce estimates for your allowance and to produce results for stress tests is the best way to make sure your projections are meaningful,” he said. The alignment of critical assumptions and inputs is fundamental to developing accurate forecasts. Hammond said financial institutions working with an experienced advisor would be able to meet their needs for assessing capital this year while acquiring the tools to handle capital analysis and stress testing on their own in the future — even, as Hammond put it, “during stepped-on-anthill times.”