Crafting a CRE Stress Testing Policy: A Simple Outline

Historically, writing a policy for your bank can be as easy as downloading one from the internet or borrowing one from a trusted friend at a neighboring bank. After obtaining a policy in this manner, remember to modify the policy to fit the particulars of your bank. This is a very important step because regulators hate to read a board approved policy that names another bank and details the other bank’s specific information in the policy. Bankers can do this for just about every bank regulation and issue out there. However, stress testing is a fairly new concept and policies are not readily available. When a bank commits to stress testing, a formal policy is needed and will be expected by your regulators.

The following are some suggestions when crafting the policy for your bank:

I. Opening Statement – For stress testing to be a successful exercise in your bank, the Board of Directors and Senior Management must “buy in” to the concept and recognize the value that can be derived. An opening statement should express the level of commitment by this group and individuals. For example, “The Board of Directors at Anytown Bank and Trust are committed to operating the institution in a safe and conservative manner and as such has decided to employ stress testing techniques to the CRE portfolio (or total loan portfolio).

II. General Purpose Statement and Information - This statement or paragraph should clearly detail why the bank is undertaking this exercise and what the expected value will be. For example, “The Board and Senior Management recognize that undertaking risk is an embedded part of the banking process and that it is the bank’s duty to originate safe and sound loans within the market or assessment area. During uncertain or downturns in the economic cycle these assets can decrease in value, often without any fault or neglect on the part of our customer. Part of management’s responsibility is to effectively manage these risks and concentrations to protect the bank’s capital base and ensure the long-term viability of this institution. With the information derived from the stress testing exercises, we will be able to assess the adequacy of the capital base under various stress scenarios and develop contingency planning, should the need arise.”

III. Responsibility and Independency – The policy should designate two individuals, one with primary authority and another with secondary authority, who are responsible for this exercise. The primary individual should have officer level authority and responsibility within the institution and have access to loan files, records, and information needed to ensure the success of this exercise. It would also be best for this individual to not have a vested interest from a compensatory standpoint, i.e. commissions or bonuses based on originations, in the results of this exercise.

IV. Reporting and Frequency – How often and in what format will the results be conveyed to senior management and the board of directors? The bank should decide upon the proper format for the reporting. Should a summary document be prepared? How much information from the output of software or spreadsheets should go to the board?

V. Scope – The policy should require the report to clearly define the scope of the stress testing. For example, “The stress test encompasses all CRE loans as defined in the 2006 Interagency Guidance which includes construction, multifamily, and commercial real estate for investment purposes only. The pool of loans consists of 150 loans totaling $7,500,432. Please note that loans secured by farms, 1-4 family residential properties, and owner-occupied properties are not included”.

VI. Assumptions and Scenarios - Any assumptions made during this process should be detailed in the summary document. These assumptions can include management’s lending focus, underwriting standards, and growth/no growth objectives for these loan products. Bankers should then decide how many stress test scenarios are needed and name them accordingly. If the institution is small and low-risk, it is possible that only two scenarios would be needed. Some possibilities include mild, moderate, severe, and extreme. What components will these scenarios actually stress? The Federal Reserve has committed to maintaining low interest rates for the foreseeable future but it would be wise to stress customer’s debt payments to interest rate shocks to predict possible cash flow shortfalls when monetary policy changes course. Interest rates have declined in a steep and quick manner but they can also rise with a vengeance. It’s better to be prepared. Other components to stress include changes or declines in Net Operating Income as well as collateral value decreases.

VII. Thresholds and Limits - The stress test policy should detail threshold levels for Loan-to-Value as well as Debt Service Coverage. If the stress scenarios result in loans exceeding these thresholds, what is your course of action? Some recommendations include downgrading the internal loan grade, allocating more funds into the ALLL, and devising a possible workout plan. You can reference the newly issued Interagency Policy on Prudent CRE Loan Workouts (http://www.fdic.gov/news/news/financial/2009/fil09061.html) for guidance.

VIII. Capital Levels - The goal of the stress test is a forward-looking capital assessment of how much is needed today to maintain a “well capitalized” status if the economy were to mirror the stress scenarios. With that in mind the report should detail the effect on the bank’s capital ratios if management had to offset credit losses under the stress scenarios. There are really only two capital positions for a bank, “Well Capitalized” and “Not Well Capitalized.” Projecting that your bank’s capital position will still be in the former category under reasonable stress scenarios would be the ultimate objective of this exercise.

IX. Contingency Planning – If the stress test reveals lower capital levels than recommended, the policy should detail possible courses of action management can take to mitigate the risk and achieve the higher capital status. Can the institution be successful with a public stock offering? Will the directors increase their investment in the institution? Does the institution have a strong holding company that can provide additional support?

These are just some suggestions to create a detailed stress testing policy for your institution. After writing the document and making the final adjustments, don’t forget to present the document to your full board of directors for their approval and document the approval in the board minutes.