Signs of softening in consumer and commercial credit are flashing daily. Proactive institutions are prioritizing quantifying just how severe potential loan credit losses could become, what that may mean for capital adequacy, and whether it may impact achieving their strategic objectives.
It is more important now than perhaps ever before to perform credit and capital stress testing before the next crisis hits and options for remediation become even more limited. Here are three reasons to start now:
1. Consistent Volatility
In the Spring of 2023, bank failures seemingly came out of thin air. In August this year, the stock market experienced its worst day in almost two years. Every new data point and news story seems to whipsaw the yield curve like two kids trying to balance on a seesaw, and these unexpected events keep coming. While no one knows for sure what the future may bring, it is prudent to be prepared for future volatility, especially in the near term.
2. Credit Risk Is Elevated, Uncertainty Abounds
Losses are mounting in multiple loan asset classes (CRE, C&I, auto, and credit cards). Both the inverted yield curve and Sahm Rule (more than .50% increase in U.S. unemployment rate three-month average from 12-month low) are flashing the recession signal. JP Morgan has increased their recession probability to 35%[1] by the end of 2024 with a 45% chance by the end of 2025. Unemployment has risen[2] while job cuts are mounting (e.g., Paramount, UPS, Amazon).
What will the impact be on credit if the unemployment rate increases are exacerbated by layoffs? How high could unemployment get? What can we expect for potential loan losses?
3. Capital Is Expensive!
Institutions often struggle to balance how much capital may be required to absorb potential losses in the future while achieving their strategic growth goals today. If they need to raise capital, what options might they have? Importantly, what will those options look like if a recession brings interest rates all the way back down to 0%?
It is impossible to determine today’s prudent operating level of capital without knowing what loan credit losses might look like under different economic downturns (both moderate and severe). Using “gut feel” to set appropriate capital buffers (i.e., capital ratio policy limits) could result in undue risk, including the significant opportunity cost of leaving earnings on the table. Capital is too expensive to not understand precisely how much is needed.
The following components are crucial to a prudent capital forecasting/stress testing process:
Macro-economic trend correlations to potential losses
Loan loss projections under moderate and severe stress events
Capital forecast that includes credit losses, growth, earnings, and capital strategy impacts
Forecasts under a range of baseline to moderate to severe economic environments
Where Should Institutions Go from Here?
While predicting the ultimate economic outcome from here is an impossible task, combating uncertainty with a thoughtful analysis illustrating how macro-economic factor trends could impact loan losses and capital may provide valuable insight into what to do next.
Institutions that delay performing credit and capital stress testing may find themselves at a severe disadvantage, potentially missing out on strategic growth opportunities. Time is becoming limited. Perform credit and capital stress testing today and sleep better knowing how your institution may perform in the next downturn, regardless of severity.
[1] J.P. Morgan, “The probability of a recession now stands at 35%,” August 15, 2024
[2] U.S. Bureau of Labor Statistics, "The Employment Situation -- July 2024," August 2, 2024
For more information on how your institution can take advantage of Credit & Capital Stress Testing to enhance remediation options and strategic planning, contact DCG.
ABOUT THE AUTHOR
John Demeritt is a Managing Director at Darling Consulting Group. In this capacity, he works directly with financial institution executives to improve the effectiveness of their asset/liability management (ALM) process, providing insight and education on managing interest rate risk, liquidity risk, credit risk, and capital. He also advises on regulatory compliance, stress testing, and contingency planning.
John began his career with DCG in 2006 as a financial analyst and currently manages DCG’s Risk Analyzer Plus product and Loan Credit Loss Model solution. He is a graduate of the University of Massachusetts with a degree in finance and marketing.
Contact John Demeritt at jdemeritt@darlingconsulting.com or 978-499-8144.
© 2024 Darling Consulting Group, Inc.
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