COVID-19 Stress Testing: An Essential Tool to Guide Banks through the Crisis and Beyond

The financial fallout from the coronavirus is not going away anytime soon. Now that the all-hands-on-deck efforts to secure federal Paycheck Protection Program loans has passed, community bank executives need to get a sense of how their banks will handle the rocky road ahead.

They must know which loans need to be watched, at what point their bank’s capital safety net might be in jeopardy, and when to develop contingency plans. Bankers also need help calculating their allowance for loan and lease losses (ALLL). And they will want to know if it makes strategic sense to seize opportunities that may emerge.

One essential tool is stress testing. There is no other way for CEOs and boards to get an inside look at how their banks will handle the potential downturn, while gaining a roadmap for strategic decision-making that will determine the future.

But stress testing models created prior to the pandemic will not help. Only models that have been specifically calibrated to reflect the coronavirus economy will have any use to bank executives. Invictus Group CEO Adam Mustafa recommends that banks repeat their stress tests often to ensure that they are staying on top of an ever-changing situation – and to position their banks to take advantage of opportunities at the right time.

While no one knows exactly how the economy will change and when, proper stress tests that rely on loan-level data will give a directional guide to bankers. “Precision is a waste of time. You need direction. Speed matters. Repetition wins,” Mustafa said.

The concept of stress testing is not new. “Community banks, regardless of size, should have the capacity to analyze the potential impact of adverse outcomes on their financial conditions,” the Office of the Comptroller of the Currency declared in 2012 guidance on using stress testing. The OCC recommended that community banks use stress testing “to identify and quantify risk in loan portfolios and help establish effective strategic and capital planning processes.”

While not required for banks under $10 billion, regulators have embraced capital stress testing as a risk management best practice. “If your institution has not yet ventured into this arena, now is the time to begin,” advises Cynthia Brzeski, CPA, at Wipfli LLP, in an article about why COVID-19 increases the need for stress testing.

Reverse stress tests, which prior to the pandemic were rarely used, can also be helpful. It is essential for tests to be forward-looking, while analyzing the most vulnerable loans in a bank’s portfolio.

Stress tests became an essential risk management tool after the 2008 financial crisis to help bankers understand their risks in a down economy. There is no more important time than now to adopt a stress testing policy at your bank. This Bank Insights issue will help guide bankers through COVID-19 stress testing and how it should be used.