Article by Roger Schlueter, MBA
What is a Loan Stress Test? The loan stress test can take many forms to address the risk inherent in any banks loan portfolio. This risk can be by company, industry or portfolio and can address all issues related to Risk the bank will face from many events or situations. The loan stress test we are addressing is, as it relates to a borrowers loans. The Stress Test for the borrowers loans is essentially adding an increased interest component to your loan or your loans in order to see if the borrower can Cash Flow (pay the loan interest and principle) the loan over the next year or several years. This test can be as simple as increasing the interest rate by one or more points or basis points (100 basis points equals one point in interest rate). The test can be expanded to add a stepped interest rate over the next year or a stepped interest rate over the next several years.
Many Banks will add a Stress Test to the loan when they present the loan on the Credit Memo or Loan Proposal. This Stress Test will be a simple interest rate increase to assess whether the borrower can Pay the Loan Interest Rate and Principle on the loan with all other factors held steady. The factors to be held steady are the Earnings and Cash Flow numbers. It is a measure to say that if everything remains the same and our interest rate goes up, will the borrower have the resources to pay the loan over the next year or several years. Some banks use this test on every Credit Memo and Loan Proposal that is presented by the loan officer. Other banks do not include this measure. Your loan officer would know if he will use this test on your loan write up to the credit committee.
The Bank Regulators do not care as much about a single loan but they do care about a borrower who has a number of loans with a particular bank or a borrower that has a number of loans and the bank has a portion of these loans. The regulator will look at all the loans that the borrower has on his books. They will usually look at the financial statement for Commercial Loans and at the Credit Report if the loans are in the individuals name. The bank will then ask the borrower to give information on these loans like:
1) current balance
2) monthly payment
3) Interest rate including Fixed or Floating Rates.
4) Term and maturity date
Of course the bank will know what loans the borrower has with their bank but most borrowers that have several loans may have many loans with several institutions.
The Bank Regulators will want the bank to do a Step Stress Test which will look at all the loans that the borrower currently has. These loans will be looked at and put on a spreadsheet to see what the impact of increasing interest rates have on these borrowers. This in itself may not be bad but these tests are done with all earnings and Cash Flow of the borrower at a stagnated amount, and this may not be an accurate way to look at a projection. The borrowers business under an increasing interest rate environment may be able to increase their Earnings or Cash Flow. This is not looked at and if the business is cutting the Cash Flow close, as for as debt service is concerned, may have some problems with their current lender with the availability of future loans and future accessability to credit.
If your business is asked to do a Stress Test you may want to know how the loans will be evaluated and do your own stress test to know if you should be worried about your borrowing future. There may be some changes you can make so that your Bank Stress Test has a more favorable outcome for your business and your future loan availability.
Please see my website at www.schlueterfinancial.com for any contact information.