New threats to the global economy emerge almost daily, making robust credit risk stress testing processes critical. But where should you begin?
Institutions that establish well-rounded credit risk stress testing processes not only have a stronger understanding of their true risk profiles, but they can also more prudently allocate capital under any environment – stressful or otherwise.
These three steps can help you begin to strengthen your institution’s risk management process and navigate uncertainty more confidently.
1. Take Inventory
It’s not uncommon for there to be a lack of clarity around credit department risk management practices – there may be well-rounded processes in place or, in some cases, something more rudimentary. Regardless, the starting point for any institution is to assess current practices and evaluate the current state.
For example, a well-rounded approach may include some or all of:
Stress testing loan pools based on credit characteristics such as Loan-to-Values (LTV), FICO scores, and Debt Service Coverage Ratios. By shocking these factors, institutions can better understand how credit risk ratings might shift under adverse conditions.
Annual credit reviews requiring updated financial statements from borrowers. These are typically conducted for larger credits due to their time-intensive nature.
Using macroeconomic statistical models to correlate economic conditions with loan losses. Unlike CECL, which is built on reasonable and supportable economic forecasts, these models simulate moderate and severe scenarios, providing insights into how a downturn may impact a portfolio.
2. Identify Blind Spots
It is essential to recognize the limitations of current practices. Does a program cover all the potential risks management needs to be aware of? The only way to know is to look at a program through different and diverse lenses.
Potential blind spots in the above examples may include:
Stress Testing LTV: Shocking LTVs in a mortgage portfolio can help assess the potential loss given default of a pool of loans. But the analysis is incomplete without understanding the economic triggers behind those shocks: What conditions would drive LTVs higher? At what level will defaults spike?
Annual Reviews: Annual reviews of large credits are useful for identifying potential changes to a borrower’s financial position. These assessments enable institutions to act quickly during periods of stress. However, they often fall short in projecting the potential impacts of systemic events, like a recession, on overall loan losses.
Macro-Economic Models: Top-down models, which look at total loan portfolios, are invaluable for estimating a range of potential loan loss outcomes under different economic conditions. While they can’t predict which specific loans will default, combining them with loan-level or segmented analysis can strengthen the overall credit risk management process. The challenge? Most institutions lack in-house expertise to perform this type of analysis effectively.
3. Educate Stakeholders and the Board
Stress testing is about more than predicting losses; it’s about understanding how those losses could impact an institution’s broader financial health. Prudent risk managers (and examiners) focus on:
Liquidity: How would rising loan losses impact cash flow and collateral values?
Earnings: What would a drop in interest income mean for profitability?
Capital: Are capital buffers strong enough to absorb losses while supporting long-term goals?
Loan loss projections significantly influence these risk models, yet the impacts are often not forecasted through stress testing.
Never underestimate the opportunity cost of carrying excessively high capital or imposing unsupported concentration limits on certain loan types. Foregone earnings due to the lack of support for these policy guidelines can be material.
Make education a priority. Regularly share findings with management and the board, embedding stress testing into the institution’s culture. Be prepared to tell the story of your analysis and how you support strategic initiatives, whether it’s increasing concentrations or other lending directives or deploying capital in different ways. You may uncover meaningful strategic opportunities in the process.
The Unexpected Will Happen. Will You Be Ready?
A strong credit risk stress testing process is a critical defense, no matter the stage of the credit cycle. Take stock of your existing tools today, identify potential vulnerabilities, and implement solutions to eliminate blind spots. The information gained may reduce downside risk and even change your strategic direction. Finally, ensure all stakeholders are informed about the risks and opportunities your institution faces to enable proactive, strategic decision-making.
For more information about Credit Risk Stress Testing and how a forward-looking risk assessment can provide immediate feedback regarding capital adequacy, Contact DCG.
ABOUT THE AUTHOR
John Demeritt is a Managing Director at Darling Consulting Group, working directly with financial institution executives to improve the effectiveness of their asset liability management (ALM) process. In this capacity, he provides insight and education in managing interest rate risk, liquidity risk, credit risk and capital. John 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. John 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 to learn more about getting started with Credit Risk Stress Testing.
© 2025 Darling Consulting Group, Inc.
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