Building Blocks for Loan Portfolio Stress Testing

©2015 RSM US LLP. All Rights Reserved. ©2015 RSM US LLP. All Rights Reserved.

BUILDING BLOCKS FOR EFFECTIVE LOAN PORTFOLIO STRESS TESTINGJohn P. Behringer, CPA

Partner

November 17, 2015

©2015 RSM US LLP. All Rights Reserved.

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1


About Sageworks

• Financial information company that provides credit and risk

management software solutions to thousands of financial

institutions

− Stress Testing, ALLL, Credit Analysis, Loan Administration, Workflow,

Risk Rating, TDR, Loan Pricing, Accounting for Purchased Loans

• Awards

− Named to Inc. 500 list of fastest growing privately held companies in

the U.S.

− Named to Deloitte’s Technology Fast 500

− NC Tech Awards: Excellence in Customer Service

2


About RSM

• After 50 years of operating as a member of the RSM International network, our firm (formerly McGladreyLLP) united with these fellow firms, effective October 26, 2015, under a common name and global brand: RSM.

• RSM US LLP is the leading provider of audit, tax and consulting services focused on the middle market, with more than 8,000 people in 80 offices nationwide. We are a licensed CPA firm and the U.S. member of RSM International, a global network of independent audit, tax and consulting firms with more than 37,000 people in over 110 countries. RSM uses its deep understanding of the needs and aspirations of clients to help them succeed.

3


About the Presenter

− Great Lakes Financial Institutions Practice Leader

− National Leader for Credit Risk Services

− Over 15 years experience providing Risk and Advisory Services to Financial Institutions

− Experience assisting clients implement loan portfolio stress testing methodology

• Model selection

• Governance

• Reporting

John P. Behringer

Risk Advisory Partner

4


Agenda

• Business Case for Stress Testing

• Regulatory Expectations

• Stress Testing Methodology Basics

• Basic Stress Testing Example

• Stress Testing Governance Considerations

• Open Discussion

5


Polling Question

In your opinion how strong is your institution’s

current loan portfolio stress testing program?

• Best in class

• Overall effective but could be enhanced

• Work in progress

• What’s loan portfolio stress testing?

6


Common Attitudes Toward Stress Testing

• Why bother?

• We ran the stress test but now what?

• We implemented a model but these results do

not make any sense.

• How do I use the results in an effective manner?

• We do it at the loan level in credit presentations.

7


Can you answer these questions?

• How does a 100 or 200 BPS rate shock impact your borrowers ability to repay?

• Drop in commodity prices impact on marginal borrowers debt service ability?

• How does a negative change in capitalization rates on multi-family or non-owner occupied CRE impact NOI for your borrowers?

• Are we effectively monitoring concentrations and how a negative event in any one industry or vertical may impact the asset quality of our loan portfolio?

• How would a stress event impact the aggregate loan portfolio and in turn how does that impact capital?

8


Stress Testing Benefits

• Early warning on potential problem loans

• Broader perspective on overall level of loan portfolio credit risk

• More precise scenarios for use in capital stress testing

• Assist in eventual implementation of CECL

• Data point for consideration in ALLL adequacy analysis

• Provides Board of Directors ability to establish and monitor portfolio risk against established risk appetite (think ALCO)

• Comply with regulatory expectations

9


Polling Question

Did we convince you why stress testing is

important and beneficial for your institution?

• Yes I’m on board let’s keep the train moving!

• Maybe but would like to know specific regulatory

expectations.

• Not sure . . . . Keep going . . . .

• Nope I’m just here for the CPE

10


REGULATORY EXPECTATIONS


Regulatory Expectations

• FDIC – Supervisory Insights Summer 2012

− Stress testing expectations are more limited and discrete for banks under $1 billion

− Existing guidance requires banks with CRE or subprime concentrations should perform portfolio-level or sensitivity analysis to evaluate impact on asset quality, capital and earnings

− No specific method recommended and expectations for larger institutions not expected of community banks

− Extent and depth of stress testing should be consistent with the organization’s risks, i.e. portfolio size, concentrations and type of lending

• OCC – Bulletin 2012-33− Considers some form of stress

testing or sensitivity analysis on at least an annual basis of the loan portfolio necessary to maintain a sound risk management program

− No specific method recommended

− Effective elements in a stress test identified include:

• Consider plausible “what-if” questions about vulnerabilities

• Provide reasonable (i.e. directionally consistent) results regarding impact on earnings and capital from stress event

• Incorporate results into overall risk management (i.e. ERM) activities – ALCO, Capital Stress-test/planning, etc.

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Regulatory Expectations

• Supervisory Guidance on Model Risk Management− Stress test methodology should be developed consistent with regulatory

guidance on Model Risk Management

− Stress test model should be identified and captured in model universe

− Key areas that require consideration based on guidance• Model Development, Implementation and Use

− Model selection and methodology

− Appropriate use of model and results

• Model Validation

− Independent from model users

− Three keys

• Evaluate conceptual soundness of model

• On-going monitoring

• Outcomes analysis – includes back-testing

• Governance, Policies and Controls

− Policies and procedures

− Roles and responsibilities

− Model inventory

− Remediation monitoring

− Vendor management

− Internal Audit role13


STRESS TESTING METHODOLOGY BASICS


Stress Testing Methodology Basics

• Stress testing methodologies− Transactional sensitivity analysis/Transaction stress testing

• Considers impact of adverse event at loan level

• Typically completed during underwriting and annual review process

• Usually tailored to specific borrower

− Stressed portfolio loss rates/Portfolio stress testing• Utilizes various adverse scenarios at the portfolio level to evaluate impact on

earnings and capital

• Identifies potential problem loans under different scenarios

− Scenario analysis• Similar to Stressed portfolio loss rates/Portfolio stress testing

• Focuses on portfolio segment based on industry/vertical, concentration, etc.

− Enterprise-level stress testing• Integrated approach to stress testing

• Considers multiple variables in scenario to provide a more precise result

− Loan migration analysis• Focuses on estimated impact to earnings from downward migration in risk ratings

− Reverse stress testing

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• Community Banks

− Two methods most common and beneficial

• Transactional

• Portfolio level

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• Transactional − Assumptions stressed as part of adverse scenario

should be credit specific • CRE Non-Owner Occupied example

− Loss of key tenant

− Increase in real estate taxes

− Change in Cap Rate

− Promotes consistency in sensitivity analysis completed for both underwriting and on-going monitoring

• Constant assumptions to consider regardless of borrower

− Increase in interest rates

− Decline in collateral value

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• Portfolio

− Need to segment portfolio

• CALL report categories

• Concentrations

• ALLL segments

− Assumptions

• Will vary by segment

• Consider data points available

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• Probability of Default

(PD)

− Key assumptions

• Interest rate

• Net operating income

(NOI)

− Revenues

− Expenses

• Loss Given Default

(LGD)

− Key assumptions

• Cap rate

• Collateral value

• Coverage ratios

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• Key Data Points

− PD

• Revenue

• Expenses

• NOI

• DSC

• Interest rate

− LGD

• Collateral value

• Note balance

• LTV

20


Basic Stress Testing Example

21

Commercial Real Estate Revenue Expenses NOI Change in NOI

Non-owner occcupied Base -10 -20 -30 Base -10 -20 -30 Base -10 -20 -30 Base -10 -20 -30

Owner occupied Base -10 -20 -30 Base -10 -20 -30 Base -10 -20 -30 Base -10 -20 -30

Commercial and Industrial Revenue Expenses NOI Change in NOI

Lines of credit Base -10 -20 -30 Base -10 -20 -30 Base -10 -20 -30 Base -10 -20 -30

Equipment Base -10 -20 -30 Base -10 -20 -30 Base -10 -20 -30 Base -10 -20 -30

Floor plans Base -10 -20 -30 Base -10 -20 -30 Base -10 -20 -30 Base -10 -20 -30

BPS Change BPS Change Change in Debt Service Coverage

BPS Change BPS Change Change in Debt Service Coverage

Basic PD Analysis - Commercial

Commercial Real Estate Collateral Value LTV

Non-owner occcupied Base -10 -20 -30 Base -10 -20 -30

Owner occupied Base -10 -20 -30 Base -10 -20 -30

Commercial and Industrial Collateral Value LTV

Lines of credit Base -10 -20 -30 Base -10 -20 -30

Equipment Base -10 -20 -30 Base -10 -20 -30

Floor plans Base -10 -20 -30 Base -10 -20 -30

BPS Change

BPS Change

Change in LTV

Change in LTV

Basic LGD Analysis – Commercial

Residential Real Estate Payment Collateral

ARMs Base +50 +100 +200 Base -10 -20 -30 +50 +100 +200 +50 +100 +200 -10 -20 -30

HELOCs Base +50 +100 +200 Base -10 -20 -30 +50 +100 +200 +50 +100 +200 -10 -20 -30

Change in LTVInterest Rate Change BPS Change in Collateral Change in payment Change in DTI

Basic Residential Analysis


Corporate Governance Considerations

• Who owns the model and process?

− Risk Management Function

• How are the results utilized and how are they

reported?

− Parameters established consistent with risk appetite

− Actionable items and on-going monitoring if out of

tolerance

• Third party model

− How is model risk management addressed?

− Vendor management activities?

22


Polling Question

Do you feel prepared to discuss stress testing

with key stakeholders?

• Yes – this was excellent and I’m now a stress

testing expert.

• Maybe – could benefit from some examples

specific to my institution.

• No – Still not going to do any stress testing at

the portfolio level.

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Polling Questions

Learn more about Sageworks Stress Testing?

Learn more about RSM?

25

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• Increases consistency in pricing decisions• Ensures the institution meets performance targets (e.g., ROE,

ROA, NIM)• Accounts for cost of funds, risk premiums and other expenses • Builds justification/documentation for prices• Can be as simple or complex as the bank needs• Allows for multiple scenario comparisons to find the optimum

loan agreements• Offers pricing benchmarks from proprietary Sageworks

database• Integrates with other Sageworks solutions for data efficiency

BENEFITS OF THE SOLUTION


Contact Information, Additional Resources

John BehringerPartner, Great Lakes Region Financial

Institutions Practice Leader

RSM US LLP

312.634.5905

[email protected]

Additional Resources

• www.sageworksanalyst.com

− CECL Countdown Webinar on Thursday

− web.sageworks.com/CECL-Countdown-webinar/

• www.rsmus.com

27

Billy BurnetMarketing Manager

Sageworks

984.242.2619

[email protected]


This document contains general information, may be based on authorities that are subject to change, and is not a substitute for professional

advice or services. This document does not constitute audit, tax, consulting, business, financial, investment, legal or other professional

advice, and you should consult a qualified professional advisor before taking any action based on the information herein. RSM US LLP, its

affiliates and related entities are not responsible for any loss resulting from or relating to reliance on this document by any person.

RSM US LLP is a limited liability partnership and the U.S. member firm of RSM International, a global network of independent audit, tax and

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entities that cannot obligate each other. Each member firm is responsible only for its own acts and omissions, and not those of any other

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RSM® and the RSM logo are registered trademarks of RSM International Association. The power of being understood® is a registered

trademark of RSM US LLP.

© 2015 RSM US LLP. All Rights Reserved.

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Building Blocks for Loan Portfolio Stress Testing

Economy & Finance