Capital Planning and Stress Testing
As the first round of NCUA supervisory stress tests are being completed, NCUA’s capital planning and stress testing rule for the largest credit unions might have you asking if you should be doing capital planning and stress testing too. Even if you are not a federally insured credit union with assets of $10 billion or more, it’s reasonable to ask if it’s a good practice.
Understanding risk exposures and being structured to survive a certain level of risk is key. All credit unions do some form of capital planning via their budgeting process (although not at the rule’s level), but stress testing is often lacking. If you’re interested in performing NCUA’s stress testing, they publish stress test scenarios for baseline, adverse and severely adverse scenarios. These are macro-economic scenarios that include the unemployment rate, market interest rates, GDP, etc., and must be translated into assumptions that affect the credit union’s projections.
NCUA is conducting the stress testing for the first three years and results aren’t public at this time. But the Federal Reserve’s approach to stress testing for banks, which NCUA’s stress tests were modeled after, shows that those macro-economic scenarios are turned into stress test assumptions by using the financial institution’s data, historical information and other regional and national data. If it’s overwhelming to think about creating assumptions for individual loans, step back to the bigger picture. The Federal Reserve’s emphasis is on how such assumptions should be justifiably tied to the economic stresses being modeled, rather than loan-level detail. In fact, banks commonly model portfolios segmented by such characteristics as product line, lien position and sometimes down to loan-to-value and credit score for material portfolios rather than at the individual loan level.
Whether you choose to follow NCUA’s stress scenarios or not, keep the bigger picture in mind. It’s not only about credit losses. Consider how high deposit growth and prolonged low loan demand continued to affect credit union profitability and net worth long after credit losses from the last recession subsided. Along with loan and deposit growth, assumptions for non-interest income and operating expense must also be constructed. How could regulatory changes affect fee income? What might be the cost of a security breach? What are the credit union’s unique risks?
It’s important to identify, quantify and aggregate key risks, recognizing that multiple risks can be realized at the same time. Ultimately, you want to know if the credit union can survive the identified risks and take appropriate action depending on the answer.
In capital planning and stress testing, as with any analysis, it is the process of thinking through the possibilities, causes and effects that yields good decision information. Credit unions can benefit from using a common-sense approach to stress testing with a level of sophistication that is supportable and which can be refined over time. The real value is when the results are understood by leadership and incorporated into business models, strategic planning and other areas of decision making.
