Loan Portfolio Stress Test

Overview

CRM has conducted numerous Portfolio Stress Tests on behalf of its client banks. The Portfolio Stress Test estimates Potential Credit Losses in a portfolio under stressed market conditions, and then assesses the impact of those Losses on the bank's capital position.

Approach Similar to SCAP

CRM's Portfolio Stress Test addresses the same concerns as the Supervisory Capital Assessment Program (SCAP) test conducted in 2009 by the Federal Reserve and other Federal banking agencies on the 19 largest U.S. BHC's.

(See SCAP documents -- pdf document links will open in a new window:)

• The Supervisory Capital Assessment Program: Design and Implementation
• The Supervisory Capital Assessment Program: Overview and Results

Customized to take into account the unique circumstances of each bank, CRM's Portfolio Stress Test can provide more precise recommendations than a top down model such as SCAP

Portfolio Stress Test Methodology

Taking a forward looking approach, CRM's Portfolio Stress Test encompasses both formula losses and specific impairments, considering portfolio segments, risk grades, loss history, concentrations, and market conditions. Using data from the bank's loan flat file, Call Report, ALLL model, Loan Review, and Watch List (non-accrual, TDR, impaired), CRM models three scenarios of Potential Loss. The Medium case is a baseline that assumes both loan quality and the economy continue on a similar trend as today. The Low case assumes loan quality and the economy improve. The High case is a stressed scenario that assumes losses increase as the economy and loan quality decline, and more loans become impaired.

Portfolio Stress Test Results

After losses have been estimated under the three scenarios, CRM runs a Loss Distribution Model (LDM) to estimate the likelihood of Potential Credit Losses by plotting their frequencies of occurrence in a Monte Carlo simulation. The Probability of Default (PD) and Loss Give Default (LGD) variables used in the LDM are derived from CRM's analysis.

Finally, CRM runs the loss scenarios through a summary pro forma financial statement to assess capital adequacy. Any capital shortfall is quantified and alternatives to make up the shortfall are presented.

This approach produces more exact results than simply a top down model.

Ongoing Benefits of Portfolio Stress Testing

Once a Portfolio Stress Test has been developed, periodic updates can become routine. Annually, the Test can be back tested and assumptions validated. If the data is kept current, a Bank has the added benefit of being able to track default and loss history. This history can then be used to calculate a transition matrix and to back-test the accuracy of its risk grade system as a predictor of default.

Contact us to find out more.

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