We keep hearing words like “unprecedented” and “unpredictable” in reference to this pandemic. That can be really overwhelming to a credit union looking to complete stress testing with a future so volatile. So, I’ve compiled some answers here to frequently asked questions—and questions I want you to be asking at your institution—about stress testing processes, challenges, best practices and more.
Q: What advice do you have for keeping our institution focused and aligned while setting out on the first steps of stress testing?
A: Stress testing and loan underwriting foundations are built on risk assessments. In order to do either well, you need current risk data such as loan-to-value (LTV) or FICO at the date of underwriting and at the time of applying stress. All institutions need to understand the credit risk data they have and apply that knowledge to the risk analysis process. Take your time to understand what your data is telling you, update your data if possible, and apply consistent logic.
Q: Beyond the impacts of COVID, what other socioeconomic factors should our credit unions be considering as we perform stress testing for the next 3–5 years?
A: I believe there are many future issues to pay attention to. Two predominant things to watch out for:
Commercial real estate values after COVID-19. Companies will probably use less office/retail space and more people will work from home, thus having effects on available space and possible reduction in collateral values.
Generational wage disparities. It is forecast that 12,000 Baby Boomers are retiring each day between now and 2030. The labor participation rate of younger people (under 30, specifically) needs to increase dramatically; more young people need to be employed as fewer high-paid Baby Boomers are in the workforce. The wage disparity between these groups may also become a consumer spending issue as well. In general, these younger workers entering the labor force earn less.
Q: Are there any macroeconomic variables we should be talking about within those factors, too?
A: These are the factors we are paying close attention to because they tend to have higher correlation to credit risk in our clients’ data historically:
- Labor participation rate
- Consumer price index (CPI)
- Inflation rate
- Commercial real estate value indexes
- Housing Prices
Q: How can we predict if our allowance is overstated? Or if we need additional allowances for COVID-19? Does this also support additional allowances?
A: Yes. However, you must understand your current risk profile. This means you need to have credit quality indicators such as current FICO for consumer loans, LTV for real estate loans and debt service coverage ratio (DSCR) for commercial loans. You also need to understand which loans have additional risk because of forbearances or by industry type. Without this, you really are guessing. We recommend you create a baseline of your allowance based on current loan risk factors and then stress those factors. Many institutions have kept the allowance high before the Covid crisis and for many, not much additional allowance is necessary. Creating a baseline gives you a good starting point for your analysis.
Q: What about loan growth and interest rates? How should our credit union account for the new loans?
A: In a time such as this, all underwritings should be viewed differently. Because of the uncertainty, reducing your overall risk may be wise. But it can be difficult. Take the current residential real estate market: rates are low, and demand is high. The average price of a home has increased dramatically over the past year. Home prices in most areas are way above the peak in 2008; can prices still go up without additional risk to your institution? In the short run no, but in the long run, probably.
Q: What is your advice on extending current loans? What are the risks associated with these extensions as far as loan losses and income?
A: I think institutions should do everything they can within reason. However, all extensions and modifications need to fit what the borrower can actually pay, or they will not work in the long run. Regulator guidance requires institutions to be pragmatic in this decision.
Q: How will higher risk loan portfolio segments, and larger loans that were modified during the pandemic, need to be supplemented now?
A: Large loans need to each be treated individually. Some may recover quickly, and some may take a significant amount of time. Obtaining updated quarterly financial information will be important. Any modifications should require information from the borrower. Higher risk segments, where many smaller loans were modified, will need to be tracked more diligently by separating the pool into modified and non-modified loans.
Q: What things should we consider when documenting the composition of our loan portfolio, and segmenting it appropriately?
A: Segmenting should be a function of risk and should evolve with significant changes in your risk profile. Segmenting COVID-modified loans from non-modified may be necessary. Using credit quality factors as part of your segment structure can also be very effective. Most institutions use static pools; however, risk migrated pools provide better analysis and more precise allowances. If you want to prove your allowance changes to the auditors and regulators, I recommend using migrated analysis.
Q: And once the portfolio is properly segmented, any tips for analyzing the correlation between historical losses and current economic factors, like unemployment rates?
A: The best way—and the way we perform this task—is by using statistical regression modeling. We utilize regression modeling in determining segment structures as well as identifying external factors under the current expected credit loss (CECL) standard. Regression modeling works best because it allows you to determine rates of change between external factors such as housing prices or unemployment and charge offs, prepayments and default statistics. However, performing this assessment requires more data historically.
Q: What are the next steps for our institution after we obtain the results from our stress testing?
A: Once your analysis is complete, the results should also affect the following other parts of your accounting, policies and underwriting:
- Adjustments to your current allowance or qualitative factors based on the results of the test, and new information gleaned from the analysis. What changes in risk were found?
- Understanding changes in prepayments that may affect your other models such as ALM.
- Updating your underwriting or loan pricing based on results or changes since last test.
Stress testing is instrumental to a financially healthy institution. Hopefully these insights will help your credit union approach your stress testing with more confidence and preparedness. While current socioeconomic factors may be overwhelming and relatively unpredictable, you can set your credit union up for success in the years to come by relying on your data and knowing how to put it to work for you.