The capital stress testing framework that we have developed is a dynamic way of looking at potential threats to capital in the context of the company’s ability to replace capital through its earnings power, the current level of capital, and plans for capital distribution. For traditional community banks, the primary threat to capital is the risk of loan losses.
We now have data on losses by loan category for two periods of severe financial stress, the recent financial crisis and the savings and loan crisis. One way to test whether community banks have enough capital to withstand stress would be to apply the level of losses generally experienced in a stressed environment to bank loan portfolios to estimate potential losses.