Why do we stress test? If we have commercial real estate in our portfolio, we stress test because the regulators require it. We also stress test the entire loan portfolio so we can establish policy limits and strategies. And finally, we stress test to quantify the variability of risk under changing conditions.
What are we supposed to stress test? If we have concentrations in commercial real estate, we have to stress test that portfolio. But again, we must look at the entire loan portfolio to assess our capital adequacy and to evaluate risk arising from specific concentrations.
The biggest hurdle to stress testing is that, for many, it's a new concept that has a learning curve. There are few experts or tools available to facilitate training, so working through the learning curve is extremely tough. Another large hurdle is the lack of meaningful data. A likely outcome of the credit crisis is that regulators will push financial institutions to maintain data in a more organized fashion, which should put pressure on core system providers to beef up their systems. We also lack historical information that helps us correlate some of the data points.
Static and Dynamic Stress Testing
There are two ways you can apply stress testing--by using a static view or a dynamic view.
A static view helps quantify volatility in a portfolio. Simply put, the application boils down to looking at your loan portfolio, trying to understand or quantify the overall default probability, and mapping the default probability to one of the nationally recognized rating-agency scales. Then, for example, you go through that portfolio and stress everything from a BBB level down to either a B or a BB level.
Meanwhile, a dynamic view helps us understand not only where we are today, but also where we might drift over time given current or expected conditions. When applying a dynamic view, we need to run a simulation to understand expected losses. The simulation should incorporate some of the components of the Five Cs of Credit. We need to see what drives the debt coverage ratio up or down. How do interest rates affect debt service? In effect, what are the moving pieces relative to stress testing?
Approaches to Stress Testing
There are a variety of approaches to stress testing a loan portfolio. For a real estate loan portfolio, whether it's commercial or residential, a collateral-based or loan-to-value approach is often used. A second approach uses a grade/ migration view. Third is the underwriting-based approach, which gets back to the Five Cs of Credit. The fourth approach is the historical or industry overlay view, in which we glean past information to help us understand where we are today.
The collateral approach is appropriate for real estate loans, but not as applicable to other sectors of the portfolio. It helps us get a better handle on the loss given default rate, but provides little insight into how the odds are migrating or changing within the portfolio. Statistics prove that level of collateralization is a poor indicator of default potential. Also, the collateral approach relies on collateral values that typically get stale in a loan portfolio. Finally, if you have a portfolio containing collateral-dependent loans, whether construction or …