6 Key Components of Effective Credit Stress Testing

August 25, 2023

When your financial institution is conducting a credit risk stress test, it’s imperative that your test has several key components for effective testing. As your trusted financial guide, at Young & Associates, we’ll walk you through the process. In this blog post, we’ll explore the key components of effective credit stress testing.  

1. Comprehensive scenario design 

This is the single most important component in creating an effective credit stress test. They say that success is 90% planning and 10% perspiration. While the exact percentages may vary, the message still stands. Planning is important! When you’re designing your credit stress scenario, be sure that you have taken into account the following:  

  • Interest rates 
  • Economic growth
  • Industry-specific risks such as collateral value of special use property 

2. High-quality data

The quality of a statistical model is only as good as the data it’s built upon. So, when you’re collecting your data, do your due diligence to ensure that it’s:  

Complete and accurate: Missing data or incorrect data will create skewed outcomes that lead to inaccurate results 

Uniform: When you’re consolidating data from several sources, it’s important to ensure that the format and measurements are uniform over time. Be sure to test at least a few samples of the data for accuracy. 

Timely: When you’re forecasting credit stress, it’s preferable to use data from within the past 3-6 months. The economy is affected by many things, so data that is more current will more accurately reflect the current situation.  

Unique: If you’re combining data sets, it’s all too easy to get duplicates. Be sure to review the data sets to ensure that the data is not replicated elsewhere. Duplicate data can skew the results and lead to inaccurate assumptions. Examples would include property collateralizing multiple loans. It is best to consolidate these loans into one for collateral and NOI purposes. 

Relevance: Is the data that is included in the credit stress test actually relevant to the test? You may be familiar with Karl Pearson’s famous phrase, “correlation does not imply causation.” It’s good to have a working knowledge of economics so that you can draw accurate conclusions from the data and the causes for the outcome. 

3. Robust models and methodologies 

If financial institutions want to test their credit stress with integrity, it’s important that they use robust models and methodologies to measure the risk under various circumstances.  To achieve this, be sure the model you are using bases its testing on consistent data and data that is relevant to current or future economic outcomes.  

4. Adequate portfolio selection 

To obtain an accurate credit risk stress test for a specific loan portfolio (we recommend doing this), then it’s important to include a representative sample size for each segment of your portfolio (bottoms-up approach). However, if the sample size is small, Young & Associates will use call report data to back-fill the rest of the portfolio and use industry standards to stress the portfolio of loans not individually stressed (top-down approach). By including “the rest of the portfolio” Young & Associates can cover the entire portfolio without the financial institution having to gather all that data on smaller loans and accurately reflect the credit risk of your financial institution.  

5. Credit stress scenario and sensitivity 

By now, you are familiar with the preparation for a credit stress test, but another key component is the execution. What are the metrics that you’re measuring to indicate the credit risk of your bank or credit union? Credit stress tests measure several specific metrics, including credit losses, capital requirements and default rates  and the sensitivity to those risks. This highlights the metrics that heavily influence the results and can indicate the robustness of the model.

6. Risk aggregation and reporting 

Like any work, the communication of that data is just as important as the data itself. After the calculations are made, gather the outcomes and associated risks, while adding your insights for how to improve those risks. Young & Associates will go through the stress test report in detail with you and indicate issues in the report including specific borrowers that show greater risk. Young & Associates is also able to present the findings of the report to your board audit committee, and senior management if desired.   

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Credit stress testing can sometimes feel overwhelming. We understand. Financial institutions exist to create stability for others, so when your bank or credit union is required to document the stress on your system, it can feel daunting. That’s where Young & Associates comes in. With unmatched expertise, you can trust us to guide your financial institution even when the future may seem unclear. Contact us today to learn more about our consulting and educational services.  

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