Stress Testing Commercial Real Estate Loans – No Time Like the Present (article)
Regulators and management teams alike benefit from stress tests of commercial real estate loan portfolios. Banks undergo the assessment of high-risk components of their loan portfolios to demonstrate to regulators that they are aware of the factors that affect portfolio liquidity. It can also help banks get a jump start on the new credit loss impairment accounting model, which takes effect in 2020 for public companies. A well-planned stress testing process should help management ensure that it has a defensible, forward-looking, capital planning process.
The current environment makes now a good time to conduct stress testing. Additional interest rate hikes are expected, and the next recession may be on the horizon. Banks will want to establish their financial position under these and other scenarios. The following approach may help banks perform their stress test analysis.
Setting the Stage
Once the bank selects the pools of loans to be stressed, the bank’s risk management team should ensure the reliability of the data within the model. In order to obtain relevant impairment estimates using this approach, it is imperative that the bank has sufficient current data at the individual loan level. This data includes financial statements on the borrowing entities, guarantors or both, and collateral values.
Loans that do not have the required data should be left out of the stress test so as not to skew the results. The loss rates calculated on the loans with sufficient data would then be applied to the entire population within that loan portion of the commercial real estate loan portfolio. Having at least 70% of the total outstanding balance of loans within each loan component would provide sufficient data to produce actionable results.
Determine the Stress Factors
Banks need to determine the various scenarios that would result in mild, moderate and severe stress on borrowers’ cash flow and underlying collateral. Stress factors should be designed so that the impacts are plausible for the bank’s markets and customers, based on economic and market analysis, and historical data for the bank or its peers. The various scenarios can include the following stressors placed on the individual loans:
- Interest rates
- The business entity’s net operating income
- The guarantors’ personal income
- Collateral values
- Vacancy rates
Run the Stress Tests
The stress factors selected for each scenario are applied to the selected loans in each loan component selected by the bank to determine how the stress might impact the borrower’s ability to repay or value the underlying collateral. Assumptions are made regarding the amount of stress a loan can take before considering it to be impaired and how the amount of impairment is to be calculated.
Analyze the Results
The impairment calculated for each loan is reviewed for reasonableness to detect any unusual amounts that may have been caused by incorrect loan data. Once corrections are made as necessary, an analysis of the stressed loans and estimated impairments is made. This analysis may reveal vulnerabilities about an entire segment of loans as well as certain loans within the segments. These vulnerabilities may influence management to reevaluate underwriting practices for certain portions of the portfolio or consider enhanced monitoring practices of certain properties should market conditions begin to show deterioration.
Estimate Impact on Earnings
Estimating the impact of the stress scenarios on the bank’s income provides valuable insights into the portfolio’s ability to absorb losses during an economic downturn. The effect of the stress scenarios on pre-provision, pre-tax net income (PPNI) is considered, taking into account loss of revenue due to higher non-performing assets, additional expenses (e.g., collection costs) and interest rate risk (i.e., net interest margin). The provision expense is then estimated by breaking it down into two components: the provision necessary to cover potential losses/charge-offs and the additional provision needed to maintain an adequate allowance for loan and lease losses (ALLL). Finally, the income tax expense or benefit arising from the estimate of pre-tax income is applied.
Estimate Impact on Capital
The possible impact on projected capital levels is estimated by applying the impact of the net loss to equity, capital, average assets and risk-weighted assets during the two-year stress period. Based on the impact, banks can consider enhancing their strategy to address the functions that could be hit the hardest.
Prepare Summary Report
The bank will document the results of the stress testing performed in the above steps in a narrative report with a summary of the analysis. Preparing a summary report can also assist with communicating information about the high-risk areas within portfolios with board and management teams. Summary reports can also provide regulators with evidence that portfolio liquidity is adequate to address the areas of highest risk.
Bill Siegenthaler is a financial and risk consultant in our Philadelphia office. If you have questions, feel free to contact Bill at email@example.com or 267-353-4141.