CEOs Need to Start Prepping for the Worst-Case Scenario

CEOs Need to Start Prepping for the Worst-Case Scenario

By Adam Mustafa  Invictus Group Chief Executive Officer

The coronavirus chaos and its cascading impact on the financial markets has obliterated the existing strategic plan for every community bank virtually overnight.  Bank CEOs must now shift gears and focus on getting ready for a broader economic downturn that is increasing with probability by the day. Big strategic initiatives will likely be put on hold until operational challenges can be contained, and the economy, markets and the interest rate environments stabilize. Throw in the fact that it’s an election year, and the uncertainty multiplies.

CEOs need to quickly start understanding which segments of their loan portfolio will be the most affected and the impact on capital from potential losses. Clearly, banks with direct exposure to sectors on the front lines such as hospitality, oil and gas, retail, restaurant, health care and manufacturing need to get in front of any problems.

Many of the borrowers in these industries are already having immediate cash flow problems, but there will be a lag between now and when these problems rise to the surface. Many borrowers are not due to submit financials for many months. Some will continue to service their debt despite their cash flow problems, but they will eventually run out of runway. And by the time you find out you have a real problem, either in the form of ugly financial statements or even worse, missed payments, your options are severely limited. You cannot wait for all of this to happen. But what’s the next step?

Stress Testing Needs to Be at the Top of the CEO’s Priority List

Most community bank CEOs have viewed stress testing as either a check-the-box or a risk management exercise, not a strategic one. CEOs were content knowing that regulators and directors were happy the bank could survive a recession. It was a “no news is good news” mentality.

This mindset must change immediately. The coronavirus chaos has forced stress testing to become a strategic priority, as it is for the big banks. CEOs deserve a proper diagnosis of how their bank will handle possible adverse economic scenarios. The proper stress test will help CEOs identify the segments of the portfolio that are most vulnerable so they can focus the attention of their team on the larger credits within that group. It will also help them fully grasp the bank’s capital situation to determine if contingency plans such as de-leveraging, cost cutting, or changes to the dividend policy need to be pursued.

CEOs need a strong stress test that will inform them in real time whether their decisions will keep problems contained. And they will certainly need to use the stress test as a communication vehicle to show regulators they are able to recognize, quantify and address any problems they find.

Questions to Ask

Most community banks have been doing stress testing, but most of the tests do not give them what they need. Most CEOs don’t realize this because they aren’t — and shouldn’t be — involved in the weeds and details of every risk management tool at their disposal. But each CEO must now ask the person who is responsible for stress testing the following 5 questions:

  1. Can we stress test all our loans and not just our CRE or Ag loans?
  2. Is our stress test driven by loan-level risk characteristics as opposed to historical losses?
  3. Are we able to properly model the impact of stress on our balance sheet, P&L, and capital?
  4. Are we able to overlay what-if strategic scenarios onto our stress tests to measure the impact of plans I am considering?
  5. Can you tell me, by using the stress tests, how much of our capital needs to be reserved as a buffer for stress and how much of our capital is excess?

If the answer to ANY of these questions is “NO,” then you do not have what you need. However, this is not your team’s fault. Clearly what they have been using was perfectly fine for the last few years when it was more of a compliance exercise. But now that the world has clearly changed, you need a much better tool. Think of stress testing as a flashlight. If the answer to some or all the above questions is indeed “NO,” then your existing flashlight is not powerful enough. You are actually in the dark and your tests may mislead you on where to go. You need a new and better flashlight.

Speed Matters

Without the proper stress test, most CEOs will ultimately be okay. Even without the right information, their instincts should take the bank in the right direction.

But with the right flashlight, CEOs can move much faster. Speed matters. The sooner problems are identified, the more flexibility you have in solving them. More importantly, the sooner you escape the darkness, you will see the daylight.

Massive uncertainty also means massive opportunities. Economic downturns create more opportunities for banks to gain or expand their competitive positioning than any other time. Most of today’s highest performing and valued community banks took advantage of the fallout from the 2008 Financial Crisis by taking market share, strategically growing when competitors were shrinking, and pursuing mergers and acquisitions that created the platform for rampant growth and profitability. They did this while their competitors were de-leveraging, cutting costs, rolling back capital expenditures, and avoiding acquisitions.

Similar changes in competitive positioning for community banks occurred during previous disruptions. It’s these types of environments where the best bankers roll up their sleeves and make moves to position their banks to be the winners in the next cycle. But you can’t start taking advantage of opportunities until you shore up your own vulnerabilities first.

Playing Defense – and Offense

Stress testing matters now – and not just to deal with regulators. It will not only help you play defense against what might be coming, it will allow you to start playing offense much faster. Just make sure you grab the right flashlight.