In today’s economic environment, financial institutions are concerned about potential losses in their loan portfolios. To help customers during the pandemic, many community financial institutions modified loan agreements to include a deferral of payments. These lenders might wonder: what will happen when the payment deferral period ends, and what losses can they expect as a result? The general economic outlook raises potential concerns about credit quality.
In an attempt to understand potential losses that may occur within loan portfolios, many financial institutions perform a credit stress evaluation of their loan portfolios. Credit stress analysis or stress testing is a modeling process that forecasts future losses in a credit portfolio based on stressed economic scenarios or stressed factors that are inherent in the specific loan portfolio. This type of testing can be completed through a variety of methods, with the common approach focusing on specific portfolio segments that share a similar risk profile (e.g., commercial and industrial, construction, commercial real estate and residential real estate loans). Such defined segments are then stressed under various scenario forecasting analyses to determine expected losses.