Portfolio Stress Testing One Size Doesn’t Fit All

Portfolio Stress Testing One Size Doesn’t Fit All Panel: Bob Koch Dave Kampff

History & background Initial focus on CRE • Reg. requirements emerge with issuance of 2006 guidelines

Obtain current valuation data by portfolio segment Data requirements • Obtain debt service data (or NOI) by portfolio segment • Request updated financials, P&L’s, Schedule E’s, etc.

Consider valuation sources other than appraisals Data requirements • Update appraisals where appropriate • Update NOI data for multi-family borrowers • Update financial info for C&I/SBA • Update credit reports for consumers

Consider a high level segmentation High level portfolio segmentation • Commercial real estate • SBA owner occupied business properties • Multi-family residential • Consumer mortgages & HELOC’s • Land & construction

Type of property Examine the demographics… • Property location • Ownership/occupancy • Loan type • Industry

Valuation and LTV (e.g., cap rates, etc.) Possible stress points • Impacts on NOI/Debt service capacity (e.g. rents, op exp, etc.) • Impacts on debt service requirement (e.g., interest rates, etc.)

Economic conditions, trends Other considerations… • Stressed portfolio trends based on prior stress tests – Ratings migration analysis • Consider the portfolio’s stressed performance as it affects bank earnings and capital

Quantifies risk levels under changing market conditions How stress testing benefits the Bank • Encourages management’s focus on a range of possible future scenarios • Provides critical analysis for capital and strategic planning

The process Develop & run stress test(s) Impact on DSC, LTV Impact on nonaccruals Impact on debt service capacity Impact on loan (risk) grades ALLL impact Impact on profitability Impact on Interest Income Impact on strategic plans Impact on capital

The Bank’s corporate culture Hurdles • Perception that the portfolio is sound • Too complex, requires staffing and expertise you don’t have Current Management Information Systems • Systems don’t support the ability to work on aggregated/disaggregated data

Start simple Breaking down the barriers • What are the Bank’s primary concerns • Create simple models • Thinking about the issues may be as important as the actual stress models • Stress one or two variables to start

Create the methods and practices to be used Getting started • Establish the portfolio segments to stress • Decide which variables to stress • Decide which variables to stress • Create relevant scenarios – BC, WC, MLC • Implement systems so you can repeat and improve the process • Establish a framework to analyze results

Determining the factors to stress • Microeconomic • Macroeconomic • NOI • Interest rates • Vacancy rates • Unemployment • Changes in cap rates • Appraised value • Evaluate Macro influences at the Micro level

Stress testing fundamentals • Each variable stressed can & likely will result in a number of measurable impacts

For example… • Stressing a variety of changes in cap rates will yield insight into changes in property value, LTV and more

For example… • Whereas stressing Gross Rents yields other insights…

Stressing entities vs. portfolios • Models should work at the entity and portfolio levels • To stress the CRE portfolio, models need to support stressing individual properties/projects • Design models to stress independent variables to determine impacts on dependent variables • Stress Rents for impact on NOI, Cap Rates for impact on LTV, Interest Rates for impact on DSC…

Stressing “single” variables • Stressing a single variable simplifies testing a broad range of possible outcomes: • For C&I deals, evaluate how a 5%, 10%, 15%, 20% reduction in revenue affects profit, EBITDA, UCA Cash Flow, etc. • For CRE deals, evaluate how a 5%, 10%, 15%, 20% increase in vacancies affects NOI, DSC, etc.

Stress testing fundamentals • Stress tests should be constructed to consider a range of possible future outcomes

Single variable entity stress testing CRE Example Analyze the full range of outcomes at the property, business or individual level

Single variable portfolio testing Stress portfolio segments that operate in a similar space to enhance the test’s relevance

Stressing multiple variables • Concurrently stressing several variables enhances the ability to test combined impacts on performance • For CRE, concurrently stress changes in Rents, Op Exp, Interest and Cap Rates to determine impacts on NOI, DSC, LTV and more • For C&I, stress changes in Revenues, Margins, Op Exp, etc. to determine impacts on Profits, EBITDA, UCA Cash Flow and more

Stressing multiple variables C&I Example

Stressing multiple variables C&I “Entity” Example Assess the impact of changes in interrelated drivers on performance.

Stressing multiple variables C&I Portfolio Example Anticipate the impact of changes in key areas affect the capacity of the portfolio or any segment of it.

In the final analysis… • Effective stress testing at the entity and portfolio level provides substantial benefits: • Improved portfolio performance • Better risk management • More effective capital planning

Portfolio Stress Testing One Size Doesn’t Fit All