Most would agree that the recent financial industry woes have unfairly penalized community banks, resulting in an increasing scope of regulation and harsher regulatory enforcement.
Unfortunately, this situation has created a heightened sensitivity among many bankers, especially regarding stress testing.
I was dismayed to see the inference that the regulators are looking to apply "hypothetical stress-test results to determine supervisory ratings and/or required capital levels" of community banks, as stated in a recent viewpoint article "
Having worked with community banks on portfolio stress testing since the interagency guidance on commercial real estate was issued in late 2006, I can tell you that "stress testing" as a concept has been largely misunderstood by banks and regulators alike since then, and it continues to be a source of confusion and anxiety to most community bankers today.
Over the past few months this anxiety has seemingly reached a new level of hysteria — obscuring any value that forward thinking risk management suggestions from the government agencies about practices like stress testing might actually have for the industry.
For example, while as noted in the article the Conference of State Bank Supervisors did release a white paper in October of last year called "The Case for Stress Testing at Community Banks," but it never endorsed any concept leading to "regulators developing stress tests for smaller banks" that could result in downgrading a community bank's rating.
Quite the opposite, in fact. In the very first page of the white paper they state: "Stress testing should not be a regulatory model... a bank should not be subject to criticism for identifying its vulnerability."
The authors of "Mission Creep" may have heard regulators talk about the value they place on using the risk management practice of stress testing at a recent conference, but I doubt they actually heard any statement implying that it would be part of a new regulatory crackdown on community banks.
The recent release by the agencies of the "Proposed Guidance on Stress Testing for Banking Organizations with more than $10 Billion in Total Consolidated Assets" has further agitated the industry around stress testing, even though by it's very title this is clearly oriented to larger institutions for the foreseeable future.
The fact is that stress testing a valuable risk management practice that has been used in many different ways in banks of all sizes for decades, but usually at the individual credit level during underwriting or when looking at bank liquidity in the face of interest rate changes. It wasn't until the 2006 CRE guidance that the concept of "portfolio stress testing" was widely considered as a risk management exercise that banks of all sizes could and should perform for concentration and other credit portfolio management needs.
Instead of viewing new regulatory explanation of stress testing as a "burden" it should be viewed as a welcomed opportunity to bring clarity and context to how to best use the practice of stress testing to reduce risk for banks of all sizes.
The recent credit crisis has shown that relying exclusively on historical performance and lagging risk indicators results in an insufficient view of institutional risk, and stress testing, even in it's simplest form, can be a valuable forward looking practice that can be very helpful. Since the release of the CRE guidance stress testing has been explained as a simple modeling exercise for banks to use to try and identify potential risk in their loan portfolios based on market shifts — with emphasis on their CRE exposure.
The recent guidance explains that stress testing simply "refers to exercises used to conduct a forward looking assessment of the potential impact of various adverse events and circumstances on a banking organization."
What appears to cause much of the anxiety around the stress testing is it hasn't been well defined, and many bankers aren't sure exactly what it means and how to do it. This new guidance actually explains the ideas and methodologies to an extent (though it doesn't give specific step by step details). This information should help bankers in banks of all sizes understand what stress testing is, how it can be used and what kinds of programs the regulators are looking for.
It would certainly be onerous and imprudent for regulators to use stress testing or any model or risk management modeling tool alone to determine a bank's supervisory ratings and/or required capital levels, but that really doesn't appear to be what the regulators are suggesting. Stress testing is a modeling exercise that can bring banks of all sizes real value, if they understand what it is and how to use it.
Instead of more hue and cry linking the use of new credit management practices like stress testing to the extinction of community banking, why not view advocating and explaining the use of a forward looking risk tool like stress testing as an opportunity for all banks to improve their internal risk management processes?
Peter Cherpack is a director and principal of Ardmore Banking Advisors, Inc. He was previously vice president of the network services division at PNC Financial.
