"Net income ROA is a worthless measure,” writes researcher Mike Higgins in this report. And that's not the only sacred...
Mar 17 2016
The Usefulness of Effective Credit Union Stress Testing
In the broadest sense, stress testing is a tool to quantify the impacts that severe but plausible shocks could have on the integrity of a structure or system. Stress testing has a variety of practical applications. To a doctor, it can involve having a patient walk or run on a treadmill, hooked up to an electrocardiogram machine to monitor the performance of his or her heart and blood pressure while experiencing increasingly intense levels of exertion. An automotive engineer will deliberately crash a driverless car into a wall to measure the ability of the vehicle to protect its occupants at various speeds. And to a credit union, the primary objective of stress testing is for the board and management to assess the adequacy of the institution’s capital to absorb significant and out-of-the-ordinary, but plausible, economic stresses.
No financial institution is immune from failure. There is always some scenario, some “black swan,” unseen but imaginable, whose risks can trigger a collapse of public confidence. And risk comes in many forms: We need not be reminded that many credit unions are seeking merger partners to avoid going out of business due to obsolete business models, a classic representation of strategic risk. The intent of this report is to provide a basic introduction to this increasingly important topic so that North American credit unions can gain a better understanding of the role of stress testing as well as its challenges and benefits, and perhaps ideas on how to start, grow, or accelerate this important risk management practice in their own institutions.
Based on surveys of four leading credit unions—three in Canada, one in the United States—that are relatively far along in the stress testing process, the report’s author offers advice for credit unions just getting into the area.
Some of this advice includes:
- Look beyond stress testing as merely a regulatory requirement. Articulate a solid understanding of how stress testing can and should be used in a strategic manner by the board and senior management.
- Do not be daunted by the scope of the project that lies ahead. Launching a complex, fully developed stress testing program in one implementation is an unreasonable goal. Make a multiyear commitment to a multiyear program.
- Develop a strong governance framework, including a board-approved policy that appropriately reflects the stress testing program. Controls, model validation, effectiveness testing, and challenge protocols need to be robust. Make certain that the process has the necessary oversight and controls framework to ensure its effectiveness.
- Start thinking early about how to organize data to satisfy the needs of stress testing. Be prepared for the challenges of getting the data to do the job properly. This can be particularly difficult for credit unions that have multiple legacy IT systems resulting from a series of amalgamations. For example, if the system’s record-keeping system for delinquencies and charge-offs is set up to meet accounting and reporting conventions, will it line up with the assumptions needed to drive the stress testing model?
Filene thanks its generous partners for making this important research possible:
Report Number 396