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Protect Your Bank’s Capital with Stress Tests

By: Michelle Lucci

On May 17, Federal Reserve Bank of Chicago Senior Vice President Cathy Lemieux testified before Congress that overexposed commercial real estate loan concentrations are still a significant problem for the nation’s community banks.

“Since the financial crisis began, 35 Illinois institutions have failed, accounting for nearly 14 percent of the U.S. total,” Lemieux said during her testimony. “Most of the failed banks held much larger-than-average concentrations in CRE, which, when the economy slowed, had a quick and adverse impact on bank earnings and capital.”

And bank closings are on track to blow past the damage done in 2009. Last year, the FDIC closed down 140 banks. Through June 2010, 86 banks had already been closed, many of them for overexposure in their CRE loans.

Regulators are placing more attention on the 2006 Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices guidance, which requires that banks with a 300 percent ratio of CRE loans to risk-based capital, or a 100 percent ratio of construction loans to risk-based capital, stress test their portfolios. Even banks without high concentrations, however, should apply the guidelines to their portfolios, because CRE evaluations will vary from bank to bank and are based on risk, not portfolio size.

There are three steps to satisfying regulator demands and determining the appropriate level of capital:

Segmenting the Portfolio

Segmentation is the first, and one of the most important steps, in conducting a CRE review. When banks fail, or receive orders from the regulators, most of them are cited for needing better management of CRE concentrations.

When it comes to segmenting the portfolio, traditional methods include sorting based on geography, industry, property types and single borrower or relationship status. The key is to group properties by common characteristics. This sometimes includes relationships that may need to be more specific than “retail,” such as hotels, food services or recreational.

If the initial data reveals a large group of loans labeled “unidentified” or “other,” the bank should also dig deeper to assign a category to every loan.

Remember that concentration segment analysis could include the type of credit offered. Many banks originate CRE loans using a balloon payment structure with a fixed rate and three- to five-year maturity. If the institution had an influx of new loans in a short time frame, it would be beneficial to know the impact on the debt-service coverage ratio when these loans are set to mature and renew.

Know the Current Value

The second step is to review the collateral value of CRE holdings. The appraisal regulation is fairly straightforward. For existing loans, a new appraisal is triggered by a transaction where the property is experiencing an “obvious and material change in market conditions.” The Moody’s/REAL Commercial Property Price Indices indicates that the market is constantly changing. Its April report showed that February prices were still 26 percent below their 2009 rates, and 42 percent below the market peak in 2007.

Regulators, however, have shown flexibility in recognizing the expense and limitations of new appraisals. If a new appraisal is not required, banks should scrutinize the collateral’s performance metrics using updated rent rolls, obtaining new lease rates and knowing upcoming lease expirations.

Just as banks should know the value of all CRE holdings, they should also know the value of the borrowers. Are they still financially solvent? Review tax returns to ensure that all entities are accounted for in the financial statements. If the documents don’t correlate, their validity will be questioned.

Banks should also know their borrowers’ total financial position, including other liabilities and contingent liabilities. A loan can be technically performing but still classified because the asset may still be risky if there is evidence that the long-term capacity for payments is shaky.

Stress Test the Portfolio

The goal of a CRE portfolio stress test is to see where weaknesses lie in the portfolio and then to take appropriate measures to mitigate the risk. Unlike applying stress factors to an individual loan, this exercise should examine the entire portfolio and measure the aggregate impact of various stressors on the institution’s earnings and capital.

Ultimately, stress testing should be able to answer:

A stress test is essentially an evaluation of how individual segments, as well as the total portfolio, will respond to changes in projected gross income, collateral value and interest rates. The key is to test for the realistic worst-case scenario.

A healthy loan portfolio should be able to withstand a realistic worst-case scenario. Otherwise, the bank may want to reconsider its loan reserves or diversify its portfolio. Banks should also use stress testing to ensure that they are not setting aside too much of a reserve, because restricting too much capital provides fewer funds for making more loans and generating additional income.

Tools Available for Stress Testing

How can banks begin performing their stress tests? There are currently three methods available in the marketplace for reviewing portfolios.

The first, and oldest, method is manually using spreadsheets. This method has typically been performed on a loan-by-loan basis, and the Office of the Comptroller of the Currency has distributed a spreadsheet that stress tests a loan under two different scenarios. The biggest benefit to spreadsheets is cost. All banks have a spreadsheet program installed. However, the spreadsheet requires the manual entry of all loan-related information, as well as the stress factor scenarios. While a spreadsheet can be useful for testing individual loans, the time and programming complexity of evaluating a full portfolio would be a monumental task.

Some banks also use report writers, usually provided by an outside consultant who requires the bank to manually gather all the data needed to perform the stress test up front. This required data includes the loan information, net operating income, capitalization rate, loan-to-value ratios and DSCR. While this method will eventually produce a report, the major concerns are privacy and time.

On the privacy front, banks will need to ensure all customer data is protected when sending files to a consultant. On the time front, determine how long it will take to pull the needed data and format it for the consultant. How long will the report take to be finalized once data is submitted? The data uploaded will also be static, and banks risk the analysis being out-of-date just a few months after the initial test.

The newest approach is to automate stress testing with technology that integrates with the loan system to upload loan data that is provided to the regulators. This file contains pertinent loan information such as the loan amount, interest rate, maturity and collateral value, among other data points. Automated models will then apply current capitalization rates to the current collateral value to calculate the net operating income for the property.

This approach is the most accurate and requires the least amount of time dedicated to data entry. Today’s systems can assist in obtaining current collateral values and enable the bank to apply the stressors to the entire portfolio, individual segments or individual loans. Automated systems also provide robust reporting tools to clearly communicate the findings and analysis for internal use and external reviews.

Armed with the early knowledge of what is in the portfolio and the effects of potential stressors, bankers can work with at-risk borrowers and devise strategies to strengthen the loans. Banks can also justify their capital decisions, outline where weaknesses may be found, along with the plan of action to correct those weaknesses and possibly avoid an adverse classification and a write down.  

Michelle Lucci is a risk management consultant for Austin, Texas-based Banker’s Toolbox. She can be reached at 813-374-0843 or michellel(at)

Copyright © August 2010 BankNews Media