The recent news about the European bank stress tests has us thinking about when a stress test isn’t a stress test.  By now, you may have heard that out of the banks tested, 7 out of 91 failed the “stress tests”.¹  That is a 92% pass rate, and should earn the European banking system an A grade, right?  As it turns out, there are many critics of these tests.  For example, only trading securities were subject to market devaluations, so all held-to-maturity securities were excluded from the tests.  Further, some of the economic “stresses” were little more stressful than the current environment.

For example, “The worst-case scenario envisioned…the overall euro-zone economy shrinking 0.2% this year and 0.6% the next year.   In some of the 20 countries that conducted the tests, regulators figured that property values would keep rising or hold steady in a worst-case economic scenario…”  In Austria, for example, properties under the stress test were assumed to increase 2% this year and 2.7% next year.²  Try telling a “sand state” credit union that a 2% increase in property values is a stress test.

Why this interest in Europe’s stress tests?  As regulators/governments publish the results, it could provide consumers with a sense of security and hope that may not be justified—ultimately adding more confusion to an already delicate environment.  We often find that appropriately managing expectations is nearly half the battle.

When you decide to conduct stress tests for your organization, don’t shortchange yourself by designing a test that can be easy to pass.  AND, don’t limit your stress tests to what is probable.  Again, nobody thought the cascading events that occurred over the last few years were probable.  It’s the improbable that is currently bringing long-standing organizations to their knees.

¹Cozy Stress Tests Fail Confidence Test, The Source, 07/26/10

²Europe’s Stress Tests Relied On Mild Assumptions, Wall Street Journal, 07/26/10

In risk analysis, it is important to make realistic assumptions about potential bad scenarios that could play out—large increases in interest rates and credit risk exceeding expectations are just a couple that come to mind.

While interest rates are at an all-time low, credit risk is at an all-time high for some credit unions. In preparing for your future, don’t mistake an all-time high with worst case.

For example: back in August 2007, the Associated Press reported that foreclosure filings had soared 93% from July 2006 to July 2007 and that the national foreclosure rate stood at 1 filing for every 693 households. Then in the first quarter 2008, CNN reported that, according to the Mortgage Bankers Association, the number of homes in foreclosure had topped 1 million.

Given this unprecedented level of foreclosure activity, it certainly felt like it couldn’t get any worse. However, according to RealtyTrac’s 2009 year-end report on foreclosures, there were over 2.8 million homes, or 1 in 45 households, with foreclosure filings in 2009 alone.

The bottom line is that, in risk planning, it can be very dangerous to assume that just because things are bad they can’t get any worse. It is important for your management team and board to understand the potential impact on your operations if things do get worse. It is likewise important for you to have well thought out plans—today—as to how you will pull your strategic levers to manage your credit union through even rougher times.

Hope for the best, but plan for the worst… or at least minimally prepare for the worst.