Concentrations of credit, particularly those related to commercial real estate loans, have been a common factor in bank distress during economic downturns. Since the financial crisis, regulators have been laser focused on ensuring that the nation’s largest financial institutions – those with $10+ billion in assets – have sound stress testing and capital planning programs in place to ensure financial stability. The focus is trickling down to the community bank level and examiners are now asking smaller institutions to have appropriate programs in place. For many community bankers, there is uncertainty as to what examiners expect, as well as a lack of resources and expertise to comply. There is also a misconception about the value of stress testing, with attitudes ranging from “it’s a necessary evil” to “it is an integral part of our strategic planning process.” EDR, in partnership with sister company Trepp, is pleased to offer this complimentary webinar “Stress Testing 101 – Best Practices for the Community Banker.” Matthew Anderson, managing director at Trepp, will provide insight into the most recent regulatory guidance and the current state of stress testing. He will explore modeling techniques as well as the macroeconomics variables that should be considered. Attendees will gain a better understanding of what regulators require, how to develop a compliant program, and the role stress testing can play in mid- and long-term strategic planning. Webinar presenters: Matthew Anderson Managing Director Trepp, LLC Mike Benz Associate Vice President, Sales Trepp, LLC Attendees with get answers to some commonly asked questions, including: -What is a stress test? -What is capital adequacy stress testing? -What are the regulators’ expectations? -What are the larger banks doing? -What is the current state of stress testing? -What do stress testing results look like? -What macroeconomic variables go into projections?

1. © Copyright 2015, Trepp LLC
Introduction to Stress Testing
For Community Banks
EDR / Trepp Webinar
September 17, 2015

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Speakers
Matt Anderson
Managing Director
Applied Data & Research, Trepp
Mike Benz
Associate Vice President
Bank Solutions, Trepp

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Goals for Today
Introduction
to Stress
Testing
Look at
Some
Solutions

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 What is Stress Testing?

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Stress Testing
• Specific Applications
– Credit Loss / Loan Losses
– Interest Rate Sensitivity – Asset Liability Management
• Comprehensive
– Capital Adequacy
– Scenario-based, Regulator-defined
– Required for larger institutions (CCAR and DFAST)

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Regulators’ Definition
• Stress testing is a forward-looking quantitative
evaluation of stress scenarios that could impact
a banking institution’s financial condition and
capital adequacy.
– based on assumptions about potential adverse external events,
such as changes in real estate or capital markets prices
– most useful when it reflects the characteristics particular
to the institution and its market area
– can be used to evaluate credit risk in the overall loan
portfolio, segments of portfolios, or individual loans
Source: FDIC Supervisory Insights

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Regulators’ Definition
• Stress tests can be used to evaluate whether
existing financial (such as capital and liquidity)
and operational (such as staffing and internal
systems) resources are sufficient to withstand an
economic downturn or unexpected event.
Source: FDIC Supervisory Insights

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The Current State of Stress Testing
Macroeconomic
variables
Forward looking
Multiple
scenarios

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 Stress Testing Background

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Stress Testing Evolution
CCAR
Comprehensive
Capital
Analysis and
Review
- Began as SCAP
(2009), expanded
to CCAR (2011)
- Large Banks: over
$50bn
- Review of banks’
capital plans
(dividends)
DFAST
Dodd
Frank
Act
Stress Testing
- Banks over $10bn
- Enterprise-wide
capital adequacy
- Public reporting
requirement
CECL
Current
Expected
Credit
Loss
- FASB “life of loan”
loss standard
- Will change how
banks reserve for
future losses

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Stress Test Concepts
1998: OCC Loan
Portfolio Management
Handbook
1990s: Interagency
Statement on Interest
Rate Risk Issued
2006: Joint Guidance
on Concentrations in
CRE Lending, Sound
Risk Management
Practices
2010: Interagency
Statement Re-stated
Interagency Policy on
Funding and Liquidity
Risk Management
Stress Testing is NOT a new concept!
2011: Comptroller’s
Handbook
Concentrations of
Credit Booklet
2012-16: OCC
Bulletin, Guidance for
Evaluating Capital
Planning an Adequacy

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 What are Regulators’ Expectations?

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Regulator Expectations
1. Repeatable, defensible
• Won’t fly anymore: “We think using 1.5x our loss experience
during the downturn will be sufficient.”
2. Forward-looking, scenario-based forecasts tied to
macro-economic inputs
• Usually means quantitative/regression models
3. Management and Board buy-in
• Board is “ultimately responsible”
4. Documented and Tested
• Process is as important as the results
• If it’s not in writing, it doesn’t exist

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"... stress testing has fundamentally changed the way we think
about capital adequacy. The need to specify scenarios, loss
estimates, and revenue assumptions--and to apply these specifications
on a dynamic basis--has immeasurably advanced the regulation of
capital adequacy and, thus, the safety and soundness of our financial
system."
“… the single most important
advance in prudential regulation
since the crisis.”
The Regulator Perspective
Federal Reserve Governor Daniel K. Tarullo
"Stress Testing after Five Years" - June 25,
2014

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 Scenarios

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What Macroeconomic Variables Go into
the Projections?
Macroeconomic indicators:
• GDP growth (real, nominal)
• Disposable income growth
(real, nominal)
• Unemployment rate
• CPI inflation

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What Macroeconomic Variables Go into
the Projections?
Market Volatility Indices
• Dow Jones Total Stock Market Index
• Market Volatility Index (VIX)
• Home Price Index
• Commercial Real Estate Price Index

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Benchmark Yields
• 3-month Treasury Yield
• 5-year Treasury Yield
• 10-year Treasury Yield
• BBB Corporate Yield
• Mortgage Rate
• Prime Rate
What Macroeconomic Variables Go into
the Projections?

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Unemployment Rate
0.0
2.0
4.0
6.0
8.0
10.0
12.0
1Q05 1Q06 1Q07 1Q08 1Q09 1Q10 1Q11 1Q12 1Q13 1Q14 1Q15 1Q16 1Q17
Actual Baseline Adverse Severely Adv.

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Commercial Real Estate Price Index
100
120
140
160
180
200
220
240
260
280
300
1Q05 1Q06 1Q07 1Q08 1Q09 1Q10 1Q11 1Q12 1Q13 1Q14 1Q15 1Q16 1Q17
Actual Baseline Adverse Severely Adv.

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 Stress Testing Results

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What Do Stress Test Results Look Like?
Stress
Testing must
produce
information
that will:
Project
income (9
quarters
into the
future)
Project
balance
sheets (9
quarters into
the future)
Project Loan
Loss (9
quarters into
the future
for 15 loan
types)
Project
capital
Project
operational
risk

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What Do Stress Test Results Look Like?

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What Do Stress Test Results Look Like?

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15.5%
7.4%
-3.8%
-1.9%
-0.8%
0.0%
0.1%
-2.7%
13.9%
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
9/30/2014 PPNR NCO Change in
ALLL
Taxes Dividends Other RWA 12/31/2016
Capital Ratio Drivers - Tier 1 Capital Ratio
Stressed Capital Drivers

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Stress Testing Applications
1. Regulatory Compliance
2. Budgeting / Business Planning
3. Strategic Planning
4. Return Optimization
– Right-sizing the capital base to achieve higher ROE

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Stress Testing Value Goes Well Beyond
Compliance
Compliance
Review
Loss
Minimization
Risk
Measurement
Risk
Management
Strategic
Integration
Return
Optimization
Enterprise Risk Management evolves in organizations
Regulatory Compliance is just the first step
Risk Control Balance Sheet
Protection
Risk/Return
Optimization
Value Creation

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 Loan Modeling

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Credit Loss / Loan Modeling
Top Down
Portfolio Segmentation
Historical Loss
Rate Application
Bottom
Up
Probability of Default (PD)
Risk Rating
Migration
- Loss Given Default (LGD)
- Expected Loss (EL)

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Loan Models: PD, LGD, EL
• Probability of Default
– Likelihood ranging from 0% to 100%, over time
– Cumulative PD from 0% to 100%
• Loss Given Default
– Loss severity
– How large is the loss in the case of default
• Expected Loss
– PD * LGD * Outstanding Loan Balance, over time.

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PD vs LTV and DSCR

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Loan Data Input

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Loan Level Results

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Portfolio Summary

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Portfolio Summary

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Data download and interactivity allow for further analysis
Customized Output

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 CECL

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CECL: Current Expected Credit Loss Model
• FASB: Proposed Accounting Standards Update
(Subtopic 825-15), announcement expected in Q3 2015
• Transition period through January 2018
• Loss Reserve based on forward-looking, "life of loan"
assessment
• Acceptable methods include probabilities of default,
historical loss rate averages, discounted cash flows

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CECL Impacts
• Audit and disclosure needs will increase
• Preparation: Data collection and aggregation across
multiple platforms
• Implementation of a model or system that can account
for analytics, compliance, and reporting
• OCC has estimated ALLL increases of 30 to 50%
• Bankers tend to believe 50% increase

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 Getting Started

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How Do I Get Started?
Since regulators will be redefining stress
scenarios over time, you want your
solution to be flexible, allowing for a
wide range of scenarios and
assumptions
All capital adequacy models should be
treated as a long-term and integral part
of any strategic planning process
All capital adequacy models should be
aligned with bank management’s
forward looking business assumptions

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How Do I Get Started?
Make sure you have access
to your
internal data
If building your own models,
make sure you have access
to the right external data
What data do I need? Is the data reliable?

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• Time can be a resource or a constraint
• Starting early opens more options
• Determine needs
• Develop and stay within budget
When Should I Start?

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 Trepp Overview

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• Bank Navigator / T-CAST
• TreppDM Loan
Model
• CRE Data Feed
• TreppLoan
Trepp Products for Banks

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TreppDM – Loan Modeling

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CRE Data Feed
• Over 100,000 commercial and multifamily
mortgages
• Monthly loan data, quarterly property financials
• History to late-1990s
• More than 250 data elements per loan
• Uses include loan modeling and benchmarking /
score cards

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TreppLoan – Source Deals

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 Questions

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www.trepp.com
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