Banks and credit unions that perform loan portfolio stress tests likely have a better understanding of credit risk that may reside in the portfolio within different concentrations. In this presentation, find out how to begin stress testing loans and the portfolio.

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BUILDING BLOCKS FOR EFFECTIVE
LOAN PORTFOLIO STRESS TESTING
John P. Behringer, CPA
Partner
November 17, 2015

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Housekeeping Items
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About Sageworks
• Financial information company that provides credit and risk
management software solutions to thousands of financial
institutions
− Stress Testing, ALLL, Credit Analysis, Loan Administration, Workflow,
Risk Rating, TDR, Loan Pricing, Accounting for Purchased Loans
• Awards
− Named to Inc. 500 list of fastest growing privately held companies in
the U.S.
− Named to Deloitte’s Technology Fast 500
− NC Tech Awards: Excellence in Customer Service
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About RSM
• After 50 years of operating as a
member of the RSM International
network, our firm (formerly McGladrey
LLP) united with these fellow firms,
effective October 26, 2015, under a
common name and global brand:
RSM.
• RSM US LLP is the leading provider of
audit, tax and consulting services
focused on the middle market, with
more than 8,000 people in 80 offices
nationwide. We are a licensed CPA
firm and the U.S. member of RSM
International, a global network of
independent audit, tax and consulting
firms with more than 37,000 people in
over 110 countries. RSM uses its deep
understanding of the needs and
aspirations of clients to help them
succeed.
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About the Presenter
− Great Lakes Financial Institutions Practice Leader
− National Leader for Credit Risk Services
− Over 15 years experience providing Risk and
Advisory Services to Financial Institutions
− Experience assisting clients implement loan portfolio
stress testing methodology
• Model selection
• Governance
• Reporting
John P. Behringer
Risk Advisory Partner
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Agenda
• Business Case for Stress Testing
• Regulatory Expectations
• Stress Testing Methodology Basics
• Basic Stress Testing Example
• Stress Testing Governance Considerations
• Open Discussion
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Polling Question
In your opinion how strong is your institution’s
current loan portfolio stress testing program?
• Best in class
• Overall effective but could be enhanced
• Work in progress
• What’s loan portfolio stress testing?
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Common Attitudes Toward Stress Testing
• Why bother?
• We ran the stress test but now what?
• We implemented a model but these results do
not make any sense.
• How do I use the results in an effective manner?
• We do it at the loan level in credit presentations.
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Can you answer these questions?
• How does a 100 or 200 BPS rate shock impact your
borrowers ability to repay?
• Drop in commodity prices impact on marginal borrowers
debt service ability?
• How does a negative change in capitalization rates on
multi-family or non-owner occupied CRE impact NOI for
your borrowers?
• Are we effectively monitoring concentrations and how a
negative event in any one industry or vertical may
impact the asset quality of our loan portfolio?
• How would a stress event impact the aggregate loan
portfolio and in turn how does that impact capital?
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Stress Testing Benefits
• Early warning on potential problem loans
• Broader perspective on overall level of loan portfolio
credit risk
• More precise scenarios for use in capital stress testing
• Assist in eventual implementation of CECL
• Data point for consideration in ALLL adequacy analysis
• Provides Board of Directors ability to establish and
monitor portfolio risk against established risk appetite
(think ALCO)
• Comply with regulatory expectations
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Polling Question
Did we convince you why stress testing is
important and beneficial for your institution?
• Yes I’m on board let’s keep the train moving!
• Maybe but would like to know specific regulatory
expectations.
• Not sure . . . . Keep going . . . .
• Nope I’m just here for the CPE
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REGULATORY
EXPECTATIONS

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Regulatory Expectations
• FDIC – Supervisory Insights
Summer 2012
− Stress testing expectations are
more limited and discrete for
banks under $1 billion
− Existing guidance requires banks
with CRE or subprime
concentrations should perform
portfolio-level or sensitivity
analysis to evaluate impact on
asset quality, capital and
earnings
− No specific method
recommended and expectations
for larger institutions not
expected of community banks
− Extent and depth of stress
testing should be consistent with
the organization’s risks, i.e.
portfolio size, concentrations and
type of lending
• OCC – Bulletin 2012-33
− Considers some form of stress
testing or sensitivity analysis
on at least an annual basis of
the loan portfolio necessary to
maintain a sound risk
management program
− No specific method
recommended
− Effective elements in a stress
test identified include:
• Consider plausible “what-if”
questions about vulnerabilities
• Provide reasonable (i.e.
directionally consistent) results
regarding impact on earnings
and capital from stress event
• Incorporate results into overall
risk management (i.e. ERM)
activities – ALCO, Capital
Stress-test/planning, etc.
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Regulatory Expectations
• Supervisory Guidance on Model Risk Management
− Stress test methodology should be developed consistent with regulatory
guidance on Model Risk Management
− Stress test model should be identified and captured in model universe
− Key areas that require consideration based on guidance
• Model Development, Implementation and Use
− Model selection and methodology
− Appropriate use of model and results
• Model Validation
− Independent from model users
− Three keys
• Evaluate conceptual soundness of model
• On-going monitoring
• Outcomes analysis – includes back-testing
• Governance, Policies and Controls
− Policies and procedures
− Roles and responsibilities
− Model inventory
− Remediation monitoring
− Vendor management
− Internal Audit role13

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STRESS TESTING
METHODOLOGY
BASICS

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Stress Testing Methodology Basics
• Stress testing methodologies
− Transactional sensitivity analysis/Transaction stress testing
• Considers impact of adverse event at loan level
• Typically completed during underwriting and annual review process
• Usually tailored to specific borrower
− Stressed portfolio loss rates/Portfolio stress testing
• Utilizes various adverse scenarios at the portfolio level to evaluate impact on
earnings and capital
• Identifies potential problem loans under different scenarios
− Scenario analysis
• Similar to Stressed portfolio loss rates/Portfolio stress testing
• Focuses on portfolio segment based on industry/vertical, concentration, etc.
− Enterprise-level stress testing
• Integrated approach to stress testing
• Considers multiple variables in scenario to provide a more precise result
− Loan migration analysis
• Focuses on estimated impact to earnings from downward migration in risk ratings
− Reverse stress testing
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Stress Testing Methodology Basics
• Community Banks
− Two methods most common and beneficial
• Transactional
• Portfolio level
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Stress Testing Methodology Basics
• Transactional
− Assumptions stressed as part of adverse scenario
should be credit specific
• CRE Non-Owner Occupied example
− Loss of key tenant
− Increase in real estate taxes
− Change in Cap Rate
− Promotes consistency in sensitivity analysis
completed for both underwriting and on-going
monitoring
• Constant assumptions to consider regardless of borrower
− Increase in interest rates
− Decline in collateral value
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Stress Testing Methodology Basics
• Portfolio
− Need to segment portfolio
• CALL report categories
• Concentrations
• ALLL segments
− Assumptions
• Will vary by segment
• Consider data points available
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Stress Testing Methodology Basics
• Probability of Default
(PD)
− Key assumptions
• Interest rate
• Net operating income
(NOI)
− Revenues
− Expenses
• Loss Given Default
(LGD)
− Key assumptions
• Cap rate
• Collateral value
• Coverage ratios
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Stress Testing Methodology Basics
• Key Data Points
− PD
• Revenue
• Expenses
• NOI
• DSC
• Interest rate
− LGD
• Collateral value
• Note balance
• LTV
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Basic Stress Testing Example
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Commercial Real Estate Revenue Expenses NOI Change in NOI
Non-owner occcupied Base -10 -20 -30 Base -10 -20 -30 Base -10 -20 -30 Base -10 -20 -30
Owner occupied Base -10 -20 -30 Base -10 -20 -30 Base -10 -20 -30 Base -10 -20 -30
Commercial and Industrial Revenue Expenses NOI Change in NOI
Lines of credit Base -10 -20 -30 Base -10 -20 -30 Base -10 -20 -30 Base -10 -20 -30
Equipment Base -10 -20 -30 Base -10 -20 -30 Base -10 -20 -30 Base -10 -20 -30
Floor plans Base -10 -20 -30 Base -10 -20 -30 Base -10 -20 -30 Base -10 -20 -30
BPS Change BPS Change Change in Debt Service Coverage
BPS Change BPS Change Change in Debt Service Coverage
Basic PD Analysis - Commercial
Commercial Real Estate Collateral Value LTV
Non-owner occcupied Base -10 -20 -30 Base -10 -20 -30
Owner occupied Base -10 -20 -30 Base -10 -20 -30
Commercial and Industrial Collateral Value LTV
Lines of credit Base -10 -20 -30 Base -10 -20 -30
Equipment Base -10 -20 -30 Base -10 -20 -30
Floor plans Base -10 -20 -30 Base -10 -20 -30
BPS Change
BPS Change
Change in LTV
Change in LTV
Basic LGD Analysis – Commercial
Residential Real Estate Payment Collateral
ARMs Base +50 +100 +200 Base -10 -20 -30 +50 +100 +200 +50 +100 +200 -10 -20 -30
HELOCs Base +50 +100 +200 Base -10 -20 -30 +50 +100 +200 +50 +100 +200 -10 -20 -30
Change in LTVInterest Rate Change BPS Change in Collateral Change in payment Change in DTI
Basic Residential Analysis

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Corporate Governance Considerations
• Who owns the model and process?
− Risk Management Function
• How are the results utilized and how are they
reported?
− Parameters established consistent with risk appetite
− Actionable items and on-going monitoring if out of
tolerance
• Third party model
− How is model risk management addressed?
− Vendor management activities?
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Polling Question
Do you feel prepared to discuss stress testing
with key stakeholders?
• Yes – this was excellent and I’m now a stress
testing expert.
• Maybe – could benefit from some examples
specific to my institution.
• No – Still not going to do any stress testing at
the portfolio level.
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Polling Questions
Learn more about Sageworks Stress Testing?
Learn more about RSM?
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• Increases consistency in pricing decisions
• Ensures the institution meets performance targets (e.g., ROE,
ROA, NIM)
• Accounts for cost of funds, risk premiums and other expenses
• Builds justification/documentation for prices
• Can be as simple or complex as the bank needs
• Allows for multiple scenario comparisons to find the optimum
loan agreements
• Offers pricing benchmarks from proprietary Sageworks
database
• Integrates with other Sageworks solutions for data efficiency
BENEFITS OF THE SOLUTION

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Contact Information, Additional Resources
John Behringer
Partner, Great Lakes Region Financial
Institutions Practice Leader
RSM US LLP
312.634.5905
john.behringer@rsmus.com
Additional Resources
• www.sageworksanalyst.com
− CECL Countdown Webinar on Thursday
− web.sageworks.com/CECL-Countdown-webinar/
• www.rsmus.com
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Billy Burnet
Marketing Manager
Sageworks
984.242.2619
billy.burnet@sageworks.com

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