There was a story making the rounds yesterday that highlighted the fact that the National Football League had asked team owners to perform stress tests. The goal was to see how NFL team revenue streams might be impacted, in the event players decide to strike in 2011. Given the NFL is the world's richest professional sports league in annual revenues and an extremely popular sport, we would have to say this move makes it official that stress testing has become a major analytical tool to assess risk in this country and around the world. Look no further than the 2,000+ pages of the sweeping financial regulation law recently passed, to find numerous references where banks will have to do more stress testing.
We don't have to tell any community banker that stress testing is prevalent in the industry (given how many times the term is referenced in various regulatory documents), but while it is required by regulators, perhaps equally worthy of discussion is what stress testing should be doing for you beyond that.
Indirectly, stress testing is a great tool because it allows management and the board to test and understand not only the business plan, but also the underlying factors that drive that plan. By stressing the plan under various scenarios, executives and board members can see where things begin to fall apart, understand key drivers and where risks exist that may not be obvious at first blush. Understanding the impact of supply and demand on the bank, where weak areas are and peeling back concentrations ultimately help bankers make better decisions that protect earnings and capital.
Another valuable way to use any good stress testing program is to understand the limitations your own geographic market may place on the bank. It is simply a fact that certain geographies have inherent concentrations and as such, banks operating in those areas will have concentrated and compounded risk. For instance, consider that a bank operating in Las Vegas will be highly concentrated in gaming and real estate; while a bank in Silicon Valley will be concentrated in technology. As such, banks operating in these areas in general, are going to be automatically concentrated in these sectors simply because they operate in the area. No matter what the lending class diversification of an individual bank may be, all banks in Las Vegas for example, are impacted by how well developers, contractors, building material suppliers and others are doing. Stress testing the impact of a slowdown in such sectors gives banks a way to determine any potential impact (and take steps to protect the franchise) before the whistle blows and there is a penalty flag on the field.
Finally, what stress testing reveals is that banking is really all about cashflow first and then collateral value. Understanding the business your customers are in, where difficulties may arise and how the cash flows through the business is critical to ensuring it continues to flow up to you to service the loan. While collateral value is a good backstop to a potentially dire situation (the business stopped cash flowing so the collateral can be liquidated), not getting there in the first place serves as a better way to reduce stress in the bank. Having a good handle on historical and projected cash flow for each potential borrower and then stressing those loans to see how the portfolio performs over time is a great practice to incorporate.
To properly stress any business you need to know what drives it at a baseline level. Otherwise, when you encounter a gap in such understanding, you can be left standing in the middle of the field as your opponent scores. No matter which NFL team you are rooting for this season, focusing your efforts at the bank to help everyone see the drivers and risk clearly, are a great way to coach your own community bank through the toughest games.