Portfolio Stress Testing
Overview: Portfolio stress testing is important today because of the soft economy and because bank regulators are expecting lenders to be able to stress test their portfolios. We think that portfolio stress test should be able to assist in evaluating the impact that various changes will have on the quality of individual loans and the total portfolio.
Some of the parameters that should be stressed include:
- Higher interest rates for floating rate loans and refinancing rates for fixed rate loans.
- Cap rates for commercial real estate loans ï¿½ changes in cap rates will affect valuations.
- Collateral or business income
- Collateral or business valuations
Users should also be able to specify the Default Conditions that give rise to losses and the cost to collect defaulted loans. Losses should reflect the value of all collateral for the loan.
Stress tests should apply conditions on a loan by loan basis, showing the results for each loan and for the total portfolio. Going from simple to complex, stress test results may include:
- A simple ranking of loans by stressed Debt Service Coverage Ratios (DSCRs) and Loan to Value Ratios (LTVs)
- Estimated changes to Loan Ratings
- Estimated loan losses
- Estimated changes in the Allowance for Losses on Loans and Leases (ALLL)
Stress tests conditions and parameters should be easy to apply to the portfolio and facilitate the ability to perform ï¿½what ifï¿½ analysis, eventually ending up with parameter sets such as best case, expected case, and worst case.
Stress test can be applied to the portfolio as it stands right now, or by projecting scenarios into the future to see how conditions would change based on scenarios of future conditions. The time series analysis embodied in future projections can allow users to project forward recent trends to better understand their future consequences. But this analysis requires more data for the portfolio and more time developing and evaluating future scenarios.
Results also need to be in a format that supports presentations to senior management, directors and regulators. All assumptions should be noted on the document and other notes and analysis should be included as well.