written by Jacob Hall
In 2012, bank regulators issued guidance on stress testing that encouraged community banks to stress test for more than just rising interest rates. The guidance from the OCC Bulletin 2012-33 seems especially prescient today as we enter the first year of a new presidential administration.
Insulate Your Bank
It wasn’t a big surprise when the Federal Reserve raised the Federal Funds rate a quarter of a percentage point in mid-December. With further rate increases expected this year, now is the time to assess your current interest rate position and protect your bank from the effects of rising rates.
The best way to do this is to stress test variable rate loans by adding 100, 200 and 300 basis points to their interest rate. What impact would this have on borrowers’ debt service capacity, their ability to produce necessary cash flow to service debt, and the value of collateral supporting the loan?
You should also perform similar interest rate stress testing on your aggregate portfolio. It’s better to find out now than later which borrowers will be hurt the most by rising rates so you can help them take proactive steps to deal with these impacts before rates go even higher.
As the OCC Bulletin 2012-33 makes clear, just stress testing for the impact of rising interest rates on debt service capacity isn’t enough. For income property borrowers, you should also stress test for:
- Higher operating expenses
- Higher capitalization rates
- Lower gross potential rent
- Rising vacancy rates
For non-income property borrowers, you should stress test for such factors as:
- Lower gross margins
- Falling revenue
- Higher operating expenses as a percentage of sales
Each of these potentially adverse factors should be stress tested to determine at what point a borrower no longer cash flows or collateral values fall below your underwriting guidelines.
Multi-family builders may be especially susceptible to a slowdown over the next year or two as in-town apartment rents soar beyond the average Millennial’s affordability and more Millennials start looking to settle down in single-family homes. If your bank has aggressively underwritten loans for multi-family construction, you could be looking at a significant rise in delinquencies with the triple whammy of rising interest rates, lower rents and higher vacancies.
So how do you decide which factors other than interest rates you should stress test for? Start by looking at your bank’s concentration risk. According to OCC 2012-33, you can conduct stress tests based on identified credit concentrations.
More specifically, your bank’s stress testing approach should match your strategy, size, loan types, composition, operations and management. If you have more questions about stress testing, please give us a call 417-881-0145.