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Stressing the Need for Stress Testing
Tuesday, April 18, 2017 6:35 AM

Mark DeBree, Vice President, ALM Services, Catalyst Strategic Solutions

Stress. It’s just one syllable, but it could have a disastrous effect on one’s mind, body, and soul. In the same vein, a stressed balance sheet could be just as detrimental to a credit union and its members.

In today’s improving economic climate, consumers are spending more, and credit union lending is on the rise. On the surface, this looks promising. But rising interest rates have the potential to drain available liquidity and place added stress on credit union balance sheets. Liquidity stress may result from:  

  • Reluctance to raise deposit rates
  • More competition and ease of transferring balances
  • Rise in loan volume
  • Slowing deposit growth
  • Increased consumer spending
  • Use of leverage/borrowings to boost returns
  • Wealth transfer to younger generations

To reduce and manage these stresses, credit unions must work to find the right balance between required funds and available liquid funds, without holding too much liquidity for an extended period. This requires a strong understanding of liquidity risk (a hot topic with examiners), liquidity sources and uses, as well as contingency funding plans. One way to ensure your credit union has sufficient liquidity and a viable contingency plan is to perform stress testing—ideally, before stress-inducing events occur.

Establishing effective contingency plans early is critical. But how does a credit union develop the right set of tests?

Liquidity Forecasting
Basic liquidity forecasts are often built off of the current business plan. By forecasting and tracking key liquidity metrics, you can set thresholds or triggers and identify potential red flags. But what happens when the future doesn’t go according to plan or extraordinary events occur?

Dynamic Stress Testing
Dynamic stress testing takes the traditional liquidity forecast a few steps further. It accounts for a variety of events, such as economic disruption, natural disasters, employer layoffs, deposit runoff, elevated credit losses, inability to sell assets, members drawing out more on their lines of credit, etc. Similar to the basic liquidity forecast, dynamic stress testing evaluates key ratios and triggers identified in liquidity risk policies. The goal with stress testing is to identify scenarios or a sequence of events that likely would result in elevated levels of liquidity stress. 

Choosing Scenarios
Above all else, stress scenarios must be meaningful and include a reasonable baseline: a mix of probable and plausible events, as well as extreme possibilities. Not all scenarios have to be likely. Standard scenarios include:

  • Traditional rate shock scenarios
  • Share runoff scenarios
  • Contingent liability funding (credit cards, LOCs, HELOCs, etc.)
  • Reduced/limited access to term funding
  • High/low probability events (employer layoffs, rising loan losses, etc.)

Stress testing is not an exercise to invoke fear. Instead, it is a prudent balance sheet management strategy that assures credit unions have an effective plan when—not if—challenges arise.

Catalyst Corporate is an endorsed five-star business partner of Credit Union Resources, Inc., a wholly owned subsidiary of Cornerstone Credit Union League.