Developing a Stress Test for Community Banks

 

Short Talks From The Hill” is a new podcast highlighting research and scholarly work across the University of Arkansas campus. Each segment features a university researcher discussing his or her work. In this episode, the second in a two-part series, Tim Yeager, professor of Finance in the Sam M. Walton College of Business, discusses a stress test he developed for community banks.

Tim Yeager

Matt McGowan: Hello, and welcome to Short Talks from the Hill.  A new podcast from the University of Arkansas.  My name is Matt McGowan.  In this episode, the second in a two-part series, Tim Yeager, professor of finance in the Sam M. Walton College of Business discusses his research, specifically the development of a so-called “stress test” for community banks. Your research also focuses on, recently especially, focuses on community banks.  I think most people have a good idea what a community banks is, but they may not have an exact definition in mind.  How do you define a community bank?

Tim Yeager: Philosophically, a community bank is one that is run based upon relationships.  And they make relationship loans to small businesses, they make relationship loans to many of their customers and they get to know their customers and their depositors very well.  In practice, the way I define a community bank is usually any bank that has less than $10 billion dollars in assets, which about 98% of all the banks in the United States. 

MM: Before we talk more about community banks, I’d like to focus just real quick on the big banks.  In reaction to the banking and financial crisis, the Federal Reserve as early as 2009 required banks to undergo something called “macro stress testing” as it’s standard method for accessing capital adequacy and the general health of the banks.  What exactly is “macro stress testing?”

TY:  Macro Stress Testing as applied to the banking system is where you look at the entire risk in the balance sheets of these banks.  What you’re asking is, “can these banks go through another very severe event like they went through with the financial crisis and have enough capital to survive?”  The Treasury Department announced that it is going to mandate stress tests for all the largest banks and it got those done very quickly, within a matter of about three months and released the results.  What is showed is that most of the banks were actually in better shape than the market thought they might be.  So what it did was it kind of cracked open the door, or peeled back the curtain and let the public and investors have a closer look as to what the real condition of those banks might be.  Now this of course was done after there was massive capital injections into these banks by the federal government.  So that certainly helped to stabilize them and prop them up.  But it was a way to remove a lot of the uncertainty that investors and the public about the conditions of the banks. 

MM: In reaction to the banking and financial crisis of 2007-2008, the Federal Reserve as early as 2009 started using macro stress testing as its standard method for accessing capital adequacy and the general health of large banks.  But the Fed did not specifically require community banks to run macro stress tests.  Why was this the case and how is this changing?

TY:  The thought was at first back in 2009 for example, that the large banks are the ones that hold the systemic risk.  The ones that if they fail, there is a domino effect in the economy and that’s one of the reasons these banks were bailed out in the first place.  The community banks don’t have that level of systemic risk, so the priority was placed on the largest banks.  Over time the stress testing has become a routine part of bank supervision now.  And it is cascading down in terms of the assets of the banks that must do stress tests.  Right now we’re at $10 billion.  Any bank that has $10 billion or more must do an annual stress test.  Community banks are exempt from this system-wide stress test but they still have to do stress tests on various other parts of their risk, including interest rate risk, let’s say or commercial real estate concentration.  So it’s not a big step to have even a community bank run these macro stress tests.  I think that they have some of the pieces in place and what I’ve done is I think is give them a tool to put the whole picture together. 

MM: Let’s talk about that.  What is your contribution to this change?  Can you talk about what you’ve created and explain how it works? 

TY:  Yes, I have created, essentially an excel spreadsheet, that banks right now can download from our University of Arkansas website, and they can download a template for their bank as of the year end 2014.  Here’s the way conceptually that works.  Just like you would get on a treadmill and walk very fast and the doctor is checking your heart condition, what this model does is it imposes very large losses bank’s loans.  And it looks back to the financial crisis years, 2008 through 2012 in particular, to give a reference point for how bad those loss rates can be.  So I take very extreme, severe conditions that I simulate on the bank’s balance sheets and give them really high real estate losses, really high consumer losses, whatever type of loan that they’re making they end up with very large losses and we see if the capital of that bank, the loss absorption capability is enough to withstand that very negative shock. 

MM: Music for Short Talks from the Hill was written and performed by Ben Harris, guitar instructor at the University of Arkansas.  For more information and additional podcasts, go to KUAF.com, or researchfrontiers.uark.edu, the home of research news at the University of Arkansas. 

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