Liz Williams, Managing Director, CEIS Review

Mike Lubansky, Director of Consulting Services, Sageworks

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An Independent consulting firm serving lending institutions regarding their loan portfolios since 1989

Experience providing the following services:

◦ Loan Review Programs

◦ Loan Loss Reserve Methodology Validation or Refinement

◦ Loan Portfolio Stress Testing

◦ Consulting Credit Risk Process Review Loan Policy Maintenance Loan and Credit Seminars

Financial information company that provides credit and risk management solutions to financial institutions

Data and applications used by thousands of financial institutions and accounting firms across North America

Provides banking industry resources including whitepapers, webinars, templates and videos on SageworksAnalyst.com

Awards

◦ Named to Inc. 500 list of fastest growing privately held companies

◦ Named to Deloitte’s Technology Fast 500

Elizabeth (Liz) Williams Elizabeth is Managing Director of Special Projects & “Complex”

Reviews at CEIS Review, Inc., where she is responsible for various projects for clients involving “complex” portfolios, process and procedure, loan loss reserve methodology, stress testing and other specific needs.

Mike Lubansky Mike is a director of consulting services at Sageworks, where he

oversees product development, research and implementation in the banking market. He often presents on risk management, most recently to the FFIEC on stress testing methodologies.

Does your institution currently perform any of the following stress tests?

When evaluating capital adequacy, have examiners cited your stress testing results?

What is Stress Testing

Stress Testing & Capital Adequacy Regulations

CRE Stress Tests

Top Down Stress Tests

Expected Thresholds

Basel III Implications

Perform loan-, portfolio- or institution-level analysis

Develop scenarios of stressed environments: baseline, adverse and severely adverse

Apply stress scenarios and calculate estimated impairment

View potential impact on the financial institution’s earnings and capital

Determine complexity of stress tests according to bank size, loan portfolio characteristics and risk appetite

“Bottom up” Analysis

1. Apply set of assumptions to a sample of individual transactions

2. Determine impact on key ratios for each transaction

3. Aggregate results at the portfolio level

4. Extrapolate results across portfolio (depending on sample size)

“Top down” Analysis

1. Segment the portfolio into homogeneous pools

2. Evaluate impact of a scenario(s) on each pool

3. Aggregate results for each pool at total portfolio

Individual Transactional Analysis

o Typically performed at underwriting / approval

o Sensitize cash flow or other indicators

o Assess impact on risk of migration to criticized / classified /default

o Not focus of today’s discussion

2006

• Interagency Guidance on CRE Concentrations • Portfolio stress testing key “in establishing a risk management framework that

effectively identifies, monitors and controls CRE concentration risk.”

• “…sophistication …should be consistent with the size, complexity, and risk characteristics of its [the bank’s] CRE loan portfolio.”

• Primarily describes “bottom-up” analysis

2009

• CCAR Requirements for 19 Largest Banks • Annual “top down” analysis - assess capital adequacy under adverse economic

conditions

2011

• Dodd-Frank – Requirements for Banks > $10 Billion in assets

• Expands CCAR-like “top down” process to larger number of banks

• Implementation deferred to 2013 ($10 billion to $50 billion in assets)

2011

• OCC Comptroller’s Handbook - “Concentrations of Credit” – Update • “Banks of all sizes will benefit by supplementing stress testing of significant

individual loans with portfolio and firm-wide stress testing. The overall goal is to quantify loss potential and the impact on earnings and capital adequacy.”

• Combination of “bottom-up” and “top-down” analysis

2012

• Interagency Expectations for Stress Testing by Community Banks • Confirmed that Dodd-Frank and CCAR requirements would not apply

• Reiterated that “all banking organizations, regardless of size, should have the capacity to analyze the potential impact of adverse outcomes on their financial condition….The agencies note that such existing guidance, including that covering interest rate risk management, commercial real estate concentrations, and funding and liquidity management (among others), continues to apply.”

• Combination of “bottom-up” and “top down” analysis

2012

• Other Agency-Specific Publications

• FDIC –Supervisory Insights – “Stress Testing Credit Risk at Community Banks”

• OCC – “New Stress Testing Guidance and CRE Stress Test Tool”

• More specific comments regarding processes

Bottom up stress tests typically focus on CRE portfolio, using one or a combination of these factors: o „ debt-service coverage

o „ loan-to-value ratios and capitalization rates

o „ property net operating income

o „ collateral value depreciation (regional and local)

o „ CRE sector performance

o „ interest-rate levels on variable-rate loans

o „ contractual terms that may introduce refinancing or repayment risk

o „ occupancy status and„ lease rates

o „ unit absorption rates for real estate developments

o „ economic factors such as changes in local employment and house prices

234 Loans in sample as of

1/31/2012

65% of Pass-rated CRE,

Multifamily & Construction

C&I loans with real estate

collateral treated as CRE

Includes loans reviewed

between Dec. 2010 and March

2012

Coverage increases every

quarter

Income properties (263 loans,

84% of exposure):

o 154 Multifamily

o 23 Retail

o 22 Industrial

o 35 Office & Other

Construction

9% Owner-

Occupied

4% Guarantor

3%

Income - MF

(State 1)

25%

Income - MF

(State 2)

17%

Income - MF

(Elsewhere)

11%

Other Income

Properties 31%

(Retail 11%;

Industrial

10%;

Office & Other

9%)

Stress Segments (% Total Exposure)

Grade Migration Assumptions

Assumed Migration Depends on Recourse, LTV and DSCR

Full Recourse

Grade LTV < Benchmark % LTV ≥ Benchmark %

Pass

(Appropriate DSCR Thresholds) (Appropriate DSCR Thresholds)

Marginal Pass

Special Mention

Classified (Substandard or Doubtful)

Less Than Full Recourse

Grade LTV < Benchmark % LTV ≥ Benchmark %

Pass

(Appropriate DSCR Thresholds) (Appropriate DSCR Thresholds) Marginal Pass

Special Mention

Classified (Substandard or Doubtful)

DSC recalculated with higher

rates

Up to +300 bps by 50 bps steps

Apply standard grade migration

assumptions to adjusted DSC

and current LTV

122 loans maturing or resetting

by 3/31/17 treated as interest

sensitive

53% of exposure (26 loans)

reset after 2014

93% of exposure (101 loans)

remain Pass up to +150 bps

Falls to 63% Pass (70 loans) at

+300 bps

Over half the migration is to

Special Mention rather than

Classified

No potential impairments

estimated

+50 bps+100

bps

+150

bps

+200

bps

+250

bps

+300

bps

Classified 0% 0% 2% 6% 9% 17%

SM 2% 2% 4% 7% 9% 21%

Pass 98% 97% 93% 88% 81% 63%

40%

60%

80%

100%

Scenario I - Interest Rate Sensitivity

Potential Grade Migration

Flexible scenario

Impact at loan and summary level

Capital levels

“For most community banks, a simple stressed loss-rate analysis based on call report categories may provide an acceptable foundation to determine if additional analysis is necessary.”

OCC Supervisory Guidance– Community Bank Stress Testing– 10/18/2012

Segment the portfolio into pools with similar risk characteristics

Develop “stressed” loss rates for each segment; consider: ◦ Bank’s historical loss rates over several stress periods

◦ Peer / market loss rates over several stress periods

◦ Results of any “bottom up” stress testing

Calculate Stress Period Loss amounts (2-year timeframe)

Estimate Earnings impact, apply to Tier 1 Capital ratios

1. Estimate Portfolio Losses Over the Stress-Test Horizon

Stress Period Loss Rates, Two Yrs Stress Period Losses, Two Yrs

Est. Portfolio

Balances, in $

Moderate Case

Stress

Severe Case

Stress

Moderate Case

Stress, in $

Severe Case

Stress, in $

Construction & Development 124 14.0% 25.0% 17 31

Commercial Real Estate 22 2.5% 5.0% 1 1

Residential Mortgage 372 2.9% 6.5% 11 24

Other Loans 125 5.0% 10.0% 6 13

Totals 643 35 69

2. Estimate Revenues and Impact of Stress on Earnings

Moderate Case

Stress, in $

Severe Case

Stress, in $

Pre-provision net revenue (over two years) 31 25

Less Provisions 35 69

Less Tax Expense (Benefit) -1 -13

Net After-Tax Income -3 -31

3. Estimate Impact of Stress on Capital

Moderate Case

Stress, in $

Severe Case

Stress, in $

Beginning Tier 1 Capital 88 88

Net Change in Tier 1 Capital -3 -31

Ending Tier 1 Capital 85 57

Estimated Average Assets 850 816

Estimated Tier 1 Leverage Ratio 10% 7%

Capital levels

Easier to pull together a top down stress test, requires little loan-level data

Requires market data to assess possible range of loss rates loan type

Could consider Reverse Stress Test Institution back-solves to see what loss rates scenarios cause the

institution to breach capital thresholds

Management considers how likely those conditions are, makes contingency plans, or takes other steps to mitigate the identified risks

Current Minimum Well

Capitalized Adequately Capitalized

Under-capitalized

Significantly Under-

capitalized

Tier 1 capital ratio

4.0% ≥ 6.0% ≥ 4.0% < 4.0% < 3.0%

Total capital ratio

8.0% ≥ 10.0% ≥ 8.0% < 8.0% < 6.0%

With capital levels under stress calculated, the institution can estimate appropriate ratios Tier 1 capital ratio = (Total Equity - Revaluation Reserves) / Risk Based

Assets

Total capital ratio = (Tier 1 Capital + Tier 2 Capital) / Risk Based Assets

If stress tests indicate capital ratios could fall below thresholds, the institution would have to make a plan that might include: 1. closer monitoring of market information,

2. adjusting strategic and capital plans to mitigate risk,

3. changing risk appetite and risk tolerance levels,

4. limiting or stopping loan growth or adjusting the portfolio mix,

5. adjusting underwriting standards,

6. raising more capital,

7. selling or hedging loans to reduce the potential impact from such stress events.

“The Basel Committee is raising the resilience of the banking sector by strengthening the regulatory capital framework…

The reforms raise both the quality and quantity of the regulatory capital base and enhance the risk coverage of the capital framework. They are underpinned by a leverage ratio that serves as a backstop to the risk-based capital measures, is intended to constrain excess leverage in the banking system and provide an extra layer of protection against model risk and measurement error.”

Basel III: A global regulatory framework for more resilient banks and banking systems

Community banks will start transitioning on January 1, 2015

Year (as of Jan 1) Now 2015 2016 2017 2018 2019

Minimum common equity tier 1 capital ratio N/A 4.5% 4.5% 4.5% 4.5% 4.5%

Common equity tier 1 capital conservation buffer

N/A N/A 0.625

% 1.25%

1.875%

2.5%

Minimum common equity tier 1 capital ratio plus capital conservation buffer

N/A 4.5% 5.125

% 5.75%

6.375%

7.0%

Phase-in of most deductions from common equity tier 1 (including 10 percent & 15 percent common equity tier 1 threshold deduction items that are over the limits)

N/A 40% 60% 80% 100% 100%

Minimum tier 1 capital ratio 4.0% 6.0% 6.0% 6.0% 6.0% 6.0%

Minimum tier 1 capital ratio plus capital conservation buffer

N/A N/A 6.625

% 7.25%

7.875%

8.5%

Minimum total capital ratio 8.0% 8.0% 8.0% 8.0% 8.0% 8.0%

Minimum total capital ratio plus conservation buffer

N/A N/A 8.625

% 9.25%

9.875%

10.5%

Leverage ratio 4.0% 4.0% 4.0% 4.0% 4.0% 4.0%

Liz Williams Managing Director-Special Projects, CEIS Review, Inc.

888-967-7380

lwilliams@ceisreview.com

http://ceisreview.com/

Mike Lubansky Director of Consulting Services, Sageworks

866.603.7029 ext. 651

mike.lubansky@sageworks.com

www.sageworksanalyst.com