Pub. 9 2020 Issue 2

15 s u mm e r | 2020 F E A T U R E 2. Stress Test Approach Based on the information we need about specific borrow - ers, a bottom-up loan portfolio stress test is most applicable. This method helps identify current and emerging risks and vulnerabilities within the loan portfolio by assessing the impact of changing economic conditions on borrower performance, identifying credit concentrations, measuring the resulting change in overall portfolio credit quality, and ultimately determining the potential financial impact on earn - ings and capital. 3. Stress Test Factors Choose stress test factors that best apply to the COVID-19 crisis. For example, interest rates are a common stress test fac- tor; however, we are not in a rising rate environment. Therefore, interest rates may not be the best stress test factor to include. Consider focusing on income and collateral. Many industry sectors are facing significant declines in commerce and income will be impacted. Management should consider a more aggres- sive discount-to-income. Discounts to collateral may not need to be as aggressive as income, but if our economy does not recover as quickly as expected after the COVID-19 crisis passes, we may see a sharp decline in collateral values. 4. Analyzing Stress Test Results Typically there are three scenarios in the stress test: base, mild and severe. Borrowers that fail the base scenario are probably already on management’s radar. Focus on those that failed the mild stress test scenario. They would be consid- ered a higher risk of potential problem loans. These are the borrowers we are most concerned with communicating and getting in front of. These borrowers more than likely have been impacted by COVID-19. Borrowers that failed the severe stress test scenario would be second on the list to contact, as they appear to have the financial resources to pass the mild stress test scenario, but if economic conditions worsen and the COVID-19 crisis is extended, these borrowers may experience cash flow problems and lack the financial resources to service their debt adequately. Conclusion In conclusion, there is still an opportunity for your finan - cial institution to respond proactively to this crisis. Perform- ing a bottom-up stress test will help in identifying potential problem loans and allow management to help borrowers that have been or will be impacted by COVID-19.