Surveillance, Monitoring and Early Intervention

12th Asia-Pacific Regional Committee (APRC) Meeting and International Conference

24 April 2014, Kyoto, Japan

PDIC President Valentin A. Araneta

OutlineI. IntroductionII. Definition, Objectives and Approaches to Risk

Assessment of BanksIII. Risk Profile of Philippine BanksIV. Deposit Insurance Fund (DIF) LevelV. PDIC Mix of Assessment Tools

a) On-site Bank Examinationb) Off-site Bank Rating Model (OBRM)c) Financial/Statistical Models

Bank Failure Prediction ModelStress-Testing Model for Banks

V. Bank Resolution Measures

DEFINITION Based on BCBS Working Paper No. 4 (December 2000)

Authors: Ranjana Sahajwala & Paul Van den Berg

Early Warning System refers to methods and processes used byregulators for monitoring and assessing banks on an on-going basis.

Objectives

•Systematic assessment of banking institutions within a formalizedframework both at the time of on-site examination & in betweenexaminations through off-site monitoring;

•Identification of institutions & areas within institutions whereproblems exist or are likely to emerge;

•Prioritization of bank examinations for optimal allocation ofsupervisory resources & pre-examination planning;

•Initiation of warranted & timely action by the supervisor.

1. Supervisory bank rating systems (e.g. CAMELS Rating)Issue: Static/Backward looking.

2. Financial ratio & peer group analysis systems - banks grouped generally by asset size; financial ratio of bank compared (a) with its own past trend and; (b) trend of peers.

3. Comprehensive bank risk assessment systems - assigns rating to each unit of bank operation; require intensive on-site exam & special visits (6mos. to 3yrs to complete). Issues: Resource intensive & time consuming; most suitable for large and complex institutions.

4. Statistical Models - considered “true early warning models”; focus is on the future direction of bank performance; Types: a) Rating estimation (mutinomial model); b) Failure or survival model (binary logit model); c) Expected loss model (expected loss on credit –impact on capital); d) Other Models. Issues: Models exclude factors such as management, controls, credit culture , and other qualitative factors; Not fully developed, i.e., not tested vs. all economic cycles.

BROAD APPROACHES TO RISK ASSESSMENT OF BANKSBased on Survey of BCBS

Profile of Philippine Banks & PDIC EWS ToolsAmounts are in Billion Pesos, as of December 31, 2013

Bank Type

No. of Banks

Total Deposits

(TD)

PDIC Exposure (Est. Insured

Deposits or EID) EID/TDPDIC EWS Tools

Rear-View Forward-LookingTotals 673 7,600.25 1,793.06 24% CAMELS

Rating SytemFinancial/

Statistical Models

KB 36 90% 85% 22%Off-site Bank Rating Model

Bank Stress-Testing & Bank Failure Prediction Models

TB 71 8% 10% 29%

RB 566 2% 5% 63%

KB or Commercial Bank represent the largest group, resource-wise, of financial institutions in the country. They offerthe widest variety of banking services among financial institutions.

TB or Thrift Bank caters to small-and-medium enterprises and individuals. They provide short-term working capitaland medium- and long-term financing to businesses engaged in agriculture, services, industry and housing, anddiversified financial and allied services.

RB or Rural Bank sector is made up of cooperative, microfinance-oriented, and regular rural banks, mostly family-owned, promoting and expanding the rural economy by providing the people in the countryside with basicfinancial services .

Deposit Insurance Fund (DIF)Capital account of PDIC

Represents overall capacity of PDIC to cover anticipated and unanticpated losses arising from bank failures Composed of:

-Permanent Insurance Fund-Estimated Insurance Losses-Retained Earnings

Determination of Adequate Level of DIFRatio of DIF to Insurance Reserves Target (IRT)Ratio of DIF to the Estimated Insured Deposits (EID)

Deposit Insurance Fund Level

Ratio of DIF to Insurance Reserves Target (IRT)

Ratio represents potential charges to the DIF arising from anticipated and unanticipated lossesIRT is the sum of:

anticipated loss = 100% x EID of Banks atRisk (BAR)*

unancticipated loss = 2.5% of EID of non-BARbanks*

* BAR or non- BAR banks are determinedusing the Offsite Bank Rating Model

Indicators of DIF Adequacy

Ratio of DIF to EID - target of 5%

A strategic long-term targetCompares DIF to the EID of the whole banking industryMethodology recommended by the World Bank/ First Initiative consultantThe study showed that 5% target is:

- Sufficient to cover actual cases of failed banks for the worst two contiguous years.

- Able to absorb losses of at least one large bank under ordinary market condition (not systemic)

- Provides additional margin for unanticipated risks

Indicators of DIF Adequacy

1. On-site Bank Examination - may be done jointly or independently of the Central Bank.

2. Off-site Bank Rating Model (OBRM) – quarterly assessment of banks on the basis of bank-submitted reports, on-site exam reports, and other information available to PDIC where banks are assigned CAMELS rating.

3. Financial/Statistical Models (Early Warning System) –a. Failure Prediction Model - assess probability of failure within

the next 12 months.b. Bank Stress Testing Model – using hypothetical scenarios/

sensitivity analysis, assess financial soundness of banks over the next 12 periods, usually quarterly

PDIC Mix of Assessment Tools

Bank Failure Prediction Model

Stress-Testing Model for Banks

PDIC EWS Tools

Both models developed by World Bank under theFinancial Sector Reform and Strengthening (FIRST)Initiative; in collaboration with PDIC.The objective is to enhance PDIC’s ability to manage theDeposit Insurance Fund (DIF) and ensure its adequacythru improving analytical tools for estimating future losses

Improve PDIC’s surveillance and oversight capabilities aswell as mitigate risks.Project was completed in 2013 and fully implemented in2014.

Sources of InformationQUANTITATIVE

• Financial Reporting Package (FRP), a set of financial statements for prudential reporting purposes composed of the Balance Sheet, Income Statement and Supporting Schedules, designed to align with the provisions of the Philippine Financial Reporting Standards (PFRS)/ Philippine Accounting Standards (PAS) and Basel Accords Capital Adequacy Framework.

• Risk-Based Capital Adequacy Report, i.e. BASEL requirements

QUALITATIVE• PDIC Bank Examination

Report (BER)

• Available Central Bank Information

All Banks, net of closures after cut‐off

OBRM Rating = 1, 2, 3

EID > P50M 

PDIC has not examined bank w/in past 12 months

POOL OF BANKS FOR EXAM

Framework for Choosing Pool of Banks for Exam

Authority of PDIC to Examine Banks:PDIC authority to examine banks is provided underits Charter

Conduct of examination needs prior PDIC Board and CB approval.

PDIC to observe 12-month interval from closing date of CB examination.PDIC may conduct special examination if there is a threatened

or impending bank closure (TIBC). In case of special examination, there is no need for CB

approval but appropriate coordination should be done.PDIC may inquire into or examine deposit accounts in case

there is finding of unsafe and unsound (U&U) banking practice.

The Off-Site Bank Rating Model (OBRM) is a tool used byPDIC in assessing/rating banks performance and conditionaccording to CAMELS, based on bank-submitted reports(Balance Sheet, Income Statement, etc.), examinationreports and compliance with selected PDIC regulations:

Capital AdequacyAsset QualityManagement/Governance EarningsLiquidity, andSensitivity to Market Risk BANK

PDIC EWS Tools: Offsite Supervisory Bank Rating System

•Risk Category 5•Risk Category 4•Risk Category 3

Non-BAR

•Risk Category 2•Risk Category 1

Bank-At-Risk (BAR) 1

The Off-site Bank Rating Model Process

CAMELS Risk Rating

OTHER MARKET

INFO

BANK SUBMITTED REPORTS

CB-SHARED REPORTS / INFO

Risk CLASS

Capital AdequacyAsset QualityManagement/

GovernanceEarningsLiquiditySensitivity to

Market Risk

1 These are banks requiring stricter surveillance/monitoring given poor condition and adverse findings.

Features & ImplementationComprised of 3 models with bank “failure” defined as — (1) bank closings, (2) capitalization less than 2%, and (3) both closings and/or capitalization<2%.

Uses 5 bank condition and performance indicators/ratios representing CAEL as follows:

Gross Problematic Assets-to-Unimpaired Capital, Past Due Loans-to-Gross Loans, Net Interest Income-to Ave. Interest Earning Assets, Profit (Loss) after taxes-to-Ave. Assets (ROA), and Quick Assets-to-Total Assets.

Excel based, simple and user-friendlyFamiliar structure for data entry using PDIC financial ratios1-year forecast horizon

PDIC EWS Tools: BANK FAILURE PREDICTION

Screenshot of Model Results/

Template

The Stress Testing Model is an excel based projection modelprincipally designed to evaluate large banks and monitorproblematic banks in a forward-looking manner.

It simulates the potential impact of assumed stressvariables/set of assumptions on a bank’s capital adequacy,profitability, assets, liabilities and liquidity over a chosenprojection horizon.

Projection horizon of 12 periods may be monthly or quarterly

PDIC EWS Tools: STRESS TESTING MODEL

Features

Provides financial soundness indicators (e.g. stressed Tier 1,Tier 2, CAR levels; financial ratios; recapitalizationrequirements)

Allows for stress testing to be applied on a single bank orgroups of banks.

Allows for combining all the banks and applying stress testingon a system wide basis.

PDIC EWS Tools: STRESS TESTING MODEL

Applications

Assess sustainability of mergers and acquisitions going forward.

Financial projections may be generated reflecting bank’s business plans; launching/offering new product lines; unloading portfolios.

Other Application being Developed:

Estimation of cost of closure

PDIC EWS Tools: STRESS TESTING MODEL

Applications

Stress Testing Model -StructureIMPLEMENTATIONSINPUT OUTPUTMAPPING AND

ASSUMPTIONS

Though inspired by real bank practices, certainsimplifications were assumed which may not capture theentire breadth and depth of potential effects of shockvariables.Projections are linear though some feedback loops areembedded.There are no econometric analysis. The Model does notmeasure coefficients between macro indicators and riskindicators. Neither are the correlations between assetclasses or liabilities to risk factors assessed.Assessment is done for the entire bank. No divisional norcross-divisional stress testing may be done.

PDIC EWS Tools: STRESS TESTING MODELLimitations

Prompt Corrective Action

Bank Resolution

Financial Assistance (FA)(Stand‐alone/Regular FA)

Merger and Consolidation (M&C) andPurchase & Assumption (P&A)

Assisted M&C, P&A

Unassisted M&C, P&A Payout Rehabilitation

LiquidationCommercial, Thrift Rural & Coop Banks

Thrift, Rural & Coop Banks

Receivership(Appointment given by the MB/CB to PDIC)

CB Relief & Incentives

CFIEP SPCB

Investor‐Investee 

Help Desk*

PDIC BANK RESOLUTION FRAMEWORK

* Applies to all banks and non-banks

Legend:CB undertakingPDIC undertakingJoint CB-PDIC undertaking

SPRB Plus

Bank Strengthening

Programs

SPCBSPRB/

SPRB Plus

CFIEP Module III

Investor-Investee Helpdesk

Investor-Investee Helpdesk, facilitate MCAs by providing a “market place” where investors interested in merging with or acquiring banks, can meet banks looking for buyers.Countryside Financial Institutions Enhancement Program (CFIEP), Module 3: provides incentive to MCAs of CFIs involving at least one (1) undercapitalized CFI in order to prevent closures, attain economies of scale, achieve higher lending capacities, diversify risks, and improve the quality of banking services. Strengthening Program for Rural Banks (SPRB) Plus, expands the original SPRB to include strong and well-managed TBs and KBs as among eligible Strategic Third Party Investor (STPI) or so-called “white knights” entitled to incentives when investing in problematic country-side based banks.Strengthening Program for Cooperative Banks (SPCB) , Basically similar to SPRB Plus above, except that the players are limited to cooperative banks and non-bank institutions majority owned by cooperatives.

Other Bank Strengthening Programs

Surveillance and Early Intervention Challenges

Reliability of data submitted, particularly those by small banks;