Stress Testing - The Banking Environment

Stress Testing - The Bank’s Responsibility

Stress Testing - Bank Directors Responsibility

Stress Testing - CEO and Senior Executive Responsibility

The Invictus ICAM™ Methodology – Helping Banks Define Solutions

 

Stress Testing - The Banking Environment

The banking system has undergone a series of never seen before financial shockwaves and stresses, which have significantly reduced regulatory capital at many banks, and which will continue to reshape the financial infrastructure and regulatory environment. The stress factors in the economy continue have an overhang effect on asset quality, pressuring capital reserves and, in some cases, threatening a bank’s sustainability. Traditional planning and forecasting systems are inadequate and do not provide clear and reliable planning tools.

Banks are left with difficult decisions — to maximize profitability, capital should be maintained at minimum required levels. However, at minimum capital levels the bank is susceptible to unforeseen stress within the economy and balance sheet assets. To maximize profitability AND insure future sustainability, a bank must balance capital reserves and future anticipated stress factors.

In today’s environment, banks need new analytical tools to help them analyze risk, identify potential transactional solutions, and ensure their ability to satisfy the requirements of regulators, shareholders, the investment community, insurers, and other key stakeholders.

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Stress Testing - The Bank’s Responsibility

Stress testing is the new generation of measurement tools that bank examiners have begun to utilize to determine the future adequacy of a bank’s financial position and sustainability. The banking examiners do not expect a bank’s stress testing program to follow a regulatory mandate, because there is not a specific established blue print for stress testing. However, the examiners do expect that a bank can demonstrate that it takes stress testing seriously and utilizes the stress test results for strategic planning purposes.

What does taking stress testing seriously mean? That the bank:

• Has a stress testing policy in place that was approved by the Board
• Has put serious thought into the underlying assumptions and that the assumptions are defensible
• Can demonstrate completeness that the entire spectrum of risk has been identified and evaluated
  (both on balance sheet and off balance sheet)
• Can show that the stress test is truly being used as a strategic planning tool not just a compliance exercise.

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Stress Testing - Bank Directors Responsibility

It is imperative that bank directors take an active role to ensure that a stress testing policy is in place and that the policy is an integral part of the strategic planning process. A stress testing policy should include the following information:

• A statement of purpose
• Clear accountability of procedure
• Frequency of the stress test and how and when reported to the Board
• Clear design and layout of the street test output and reports
• Description of the stress test process
• Definition of both the quantitative and qualitative aspects of the stress test
• Discussion of the technology, resources and personnel committed to the stress test
• Accountability of the Boards role in reviewing the policy
• Description of how the Board reviews and or sets the stress testing objectives – inclusion in Board minutes
• Discussion of the various scenarios used in the stress testing modeling and rational for each scenario

Invictus can support the Directors and Senior Executives in developing and maintaining a prudent and comprehensive stress test policy which is reflective of the size, complexity and makeup of the bank’s assets. Working closely with the Directors and Senior Executives, Invictus will provide quarterly compliance with the policy and review the underlying assumptions and suggest modifications as warranted by the economic and regulatory environment.

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Stress Testing - CEO and Senior Executive Responsibility

While stress testing is the next generation of measurement tool by examiners there are a number of threshold issue to overcome. There has been a regulatory reluctance to set best practices for stress testing, so where does a bank start? The examiners reluctance has been in part because of the vast differences in the banking landscape and in this case one size does not fit all. While banks are similar in their basic operation – gather deposits and provide lending to individuals and businesses, there are significant differences in all other aspects of their operations. From the size of the institution, to the markets that they serve, to the make-up of the assets mix, no two banks are the same. These differences are what have lead regulators to rely upon the banks senior executive to define and create a stress test that reflects the risks for the institution. Executives should take this opportunity to craft their own stress testing policy and program. Executives must start using stress testing as a serious planning tool as they move toward a forward looking planning process. The banks that stop viewing stress testing as a regulatory compliance item and move forward will have the opportunity for real revenue enhancement and growth.

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The Invictus ICAM™ Methodology – Helping Banks Define Solutions

The ICAM Methodology provides the bank with an effective analytical framework beginning with a robust stress testing capability. By focusing on the balance sheet, Invictus assists the bank in reviewing and analyzing, on a forward looking stress basis, all asset areas. The ICAM Methodology stress test identifies the timing of capital degradation, giving management the tools to address two critically important issues: The timing of capital regulatory adequacy concerns and what can be done to alter and offset the capital decline.

Banks are coming under increasing pressure from examiners and state regulators. Regulators are increasing regulatory capital minimums when many banks are facing significant capital constraints. The free flow of capital is generally available only for the largest banks, leaving many community banks with few options.

Using the ICAM Methodology as a foundation, Invictus provides a series of realistic, practical solutions and stress scenarios. These options consider how to repair or prevent projected capital shortfall and when these steps must be undertaken to be effective. A typical engagement with a bank provides a complete and detailed analysis of the factors contributing to the reduction of regulatory capital, the point at which regulatory capital is likely to reach its lowest point (the Point of Maximum Stress), and in cases where the degree of stress is likely to impair capital below regulatory minimums, the bank’s "Point of No Return." This timely, realistic stress analysis allows the bank to identify capital solutions, in time, that are likely to insure its own sustainability and compliance with regulatory mandates.

Typical solutions include the following considerations:

• Improved Information Flow to Directors, Senior Executives and Regulators: The ICAM Methodology provides forward looking stress testing that identifies the potential stress events that could affect the bank’s capital position. This information provides strategic planning for senior executives and directors as well as supporting the bank’s decisions and strategic planning with regulators.
• Asset Shifting: The illiquid nature of the loan assets on a bank’s balance sheet, make it very difficult to materially change the composition of assets in the short term. This results in difficulty in changing the bank’s capital position without some significant asset changes such as asset divestitures or acquisitions. The ICAM Methodology can quickly analyze and model strategic asset acquisitions or divestitures and the impact on the bank’s capital position.
• Funding Strategies: The illiquidity of existing capital markets, especially for community banks, generally limits the options for changing and strengthening the liability/capital of a bank’s balance sheet. The ICAM methodology is a primary tool in assisting a bank in providing potential investors the adequacy and sustainability of their regulatory capital position.
• Mergers and Acquisitions: The ICAM Methodology, using public data, can quickly and effectively screen potential merger or acquisition targets. Should merger or acquisition discussion move forward the ICAM modeling can be customized to provide a top down review of a target, allowing the limited due diligence time to focus on the targets stress areas and resulting analysis and questioning. Invictus also will analyze and evaluate the risk profile, stress profile and sustainability of the consolidated entity.

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