We all knew an economic contraction was around the corner. It had to be, right? The U.S. was in unchartered territory as it relates to consecutive months of economic expansion, but I don’t think anybody anticipated an overnight, screeching halt to the U.S. economy like we have experienced due to the COVID-19 crisis. Fortunately, financial institutions still have the opportunity to respond proactively to help struggling and/or at-risk borrowers through this period of time. One of the best ways to identify potential problem loans is through loan portfolio stress testing.
No matter how big or small your financial institution, loan portfolio stress testing is no easy task. Here are a few points to consider when performing a loan portfolio stress test to identify potential problem loans.
There is no doubt that the COVID-19 crisis has impacted all industries in some form or fashion, but we know there are some industries that have been hit harder than others.
The following is a list of industries we know have already been significantly impacted by the COVID-19 crisis:
• Travel and hospitality – airlines and hotels
• Tourism and entertainment
• Oil and gas
• Commercial real estate
• Dental practices
What other sectors can we anticipate will be impacted by COVID-19?
• Office space after the crisis passes
Scope and Coverage
Management will need to determine the scope and coverage of the stress test. There are many different ways to slice and dice portfolios – even loan portfolio segments. Within the industries listed above, the financial institution may have several types of concentrations and segments that need to be analyzed. Focus on the areas of greatest risk first and if time permits or additional resources become available add other lower-risk areas to the scope. The primary purpose behind a loan portfolio stress test is to identify potential problem loans and the overall impact to the financial institution if these loans become problem loans; therefore, the more data we can include in the stress test, the better and more useful the stress test results will be.
Stress Test Approach
Based on the information we need about specific borrowers a bottom-up loan portfolio stress test is most applicable. This method helps identify current and emerging risks and vulnerabilities within the loan portfolio by assessing the impact of changing economic conditions on borrower performance, identifying credit concentrations, measuring the resulting change in overall portfolio credit quality, and ultimately determining the potential financial impact on earnings and capital.
Stress Test Factors
Choose stress test factors that best apply to the COVID-19 crisis. For example, interest rates are a common stress test factor; however, we are not in a rising rate environment. Therefore, interest rates may not be the best stress test factor to include. Consider focusing on income and collateral. Many industry sectors are facing significant declines in commerce, and income will be impacted. Management should consider a more aggressive discount to income. Discounts to collateral may not need to be as aggressive as income, but if our economy does not recover as quickly as expected after the COVID-19 crisis passes we may see a sharp decline in collateral values.
Analyzing Stress Test Results
Typically there are three scenarios in the stress test: base, mild, and severe. Borrowers that fail the base scenario are probably already on management’s radar. Focus on those that failed the mild stress test scenario. They would be considered the higher risk of potential problem loans. These are the borrowers we are most concerned with communicating and getting in front of. These borrowers more than likely have been impacted by COVID-19. Borrowers that failed the severe stress test scenario would be second on the list to contact, as they appear to have the financial resources to pass the mild stress test scenario, but if economic conditions worsen and the COVID-19 crisis is extended these borrowers may experience cash flow problems and lack the financial resources to adequately service their debt.
There is still an opportunity for your financial institution to respond proactively to this crisis. Performing a bottom-up stress test will help in identifying potential problem loans and give management the opportunity to help borrowers that have been or will be impacted by COVID-19.
We can help
Please visit our COVID-19 Resource Page for more information.
The information provided in this communication is of a general nature and should not be considered professional advice. You should not act upon the information provided without obtaining specific professional advice. The information above is subject to change as a result of rapidly evolving legislative developments and government guidance.