Time for Stress Testing? Experts Say This Tool, Carefully Applied, Can Improve Bank Financial Management

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What do the space shuttle program a speech in Switzerland have in common?

The first represents a major edit concentration--albeit a far-from-obvious one that many lenders may not have considered. But now that the Shuttle program has ended, NASA will lay off 8,000 on Florida's east coast. Many of those employees have borrowed money, or are customers of businesses that have borrowed from banks.

Compound this with the potential loss of deposits and other banking relationships, and the grounding of U.S. space efforts takes on a very earthbound cast, notes risk management consultant Michelle Lucci of Bankers Toolbox. Lucci wonders how many lenders took NASA's future into account, and if they know what impact it will have on their banks.

And Switzerland? The city of Bern lies far beyond the radar of American community banks, yet what New York Federal Reserve Bank President William Dudley told a meeting of the Group of 30 there in late May was of more than academic interest.

Dudley discussed American regulators' experience with stress tests. These tests have loomed large three times in the recent past in the U.S., most recently in the Dodd-Frank Act. Each time, the government imposed them on parts of the industry.

Some now say that community bankers ought to consider doing stress tests voluntarily, as a means of improving management of the bank and looking at every letter in CAMELS, in a forward-looking way. Dodd-Frank's imposition of mandatory stress testing on large banks may have trickle-down impact, possibly sooner than in "normal" times.

Why stress over stress?

Bankers are tired of jumping through hoops for examiners. But with voluntary stress testing "you wouldn't be doing it for the regulators," says banking consultant Don Musso of FinPro, Inc. "You'd be doing it for your shareholders."

Musso says that community banks do a good job managing risk. But too often they look at risk management in "silos," not recognizing in a structural way that stresses on the bank, and their impact on its risk profile, know no boundaries and can have multiple impacts.

But while many bankers have recognized the need to step up risk management, stress testing remains far from a common practice.

"In general, the community bank world has not bought into the whole concept of stress testing," says Lucci, a former bank examiner and author of the blog "Stress Is Good."

The term "stress test" first began to be used in the wake of the controversial guidance on commercial real estate concentrations published near the end of 2006. The term has also been much used in the context of European banking problems. But in the wake of Dodd-Frank, talk about stress tests has picked up. ABA's Corporation for American Banking, for example, recently endorsed Crest, a commercial real estate stress-testing system from Banker's Toolbox.

Because of the recent history of stress testing, it can have a "big bank" air to it. But Musso says that's misleading.

"The regulators don't expect community banks to have a Citigroup model in place," Musso explains. "But you shouldn't do nothing."

Consultant Jay Brew of Seifried & Brew, LLC, notes that many community banks had enough capital on hand to survive the worst of the crisis.

"Look at what we just came through," says Brew. "It's pretty amazing, the resiliency of those banks that came through OK."

However, those banks that failed, and some where independence or any future at all remains an open issue, serve as an endorsement of how stress testing might have helped, says Brew. Among community banks that failed in the recent period, commercial real estate averaged 32% of their portfolios.

"That's just ridiculous," says Brew of such heavy concentrations, although some bankers would maintain otherwise.

Voluntary test, mandatory results? …

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