Western Independent Bankers Executive Development ProgramDay_1)… · 1. Disclaimer This...

Washington Bankers2020 Executive Development ProgramAsset/Liability managementDave Koch

Managing Director, Advisory Services

[email protected]

608.661.4217

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DisclaimerThis presentation may include statements that constitute “forward-looking statements” relative to publicly available industry data. Forward-looking statements often contain words such as “believe,” “expect,” “plans,” “project,” “target,” “anticipate,” “will,” “should,” “see,” “guidance,” “confident” and similar terms. There can be no assurance that any of the future events discussed will occur as anticipated, if at all, or that actual results on the industry will be as expected. Abrigo is not responsible for the accuracy or validity of this publicly available industry data, or the outcome of the use of this data relative to business or investment decisions made by the recipients of this data. Abrigo disclaims all representations and warranties, express or implied. Risks and uncertainties include risks related to the effect of economic conditions and financial market conditions; fluctuation in commodity prices, interest rates and foreign currency exchange rates. No Abrigo employee is authorized to make recommendations or give advice as to any course of action that should be made as an outcome of this data. The forward-looking statements and data speak only as of the date of this presentation and we undertake no obligation to update or revise this information as of a later date.

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Our DNA

Today’s Presenter

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Dave Koch

Managing [email protected]

Bio:www.abrigo.com/people/dave-koch/

http://www.abrigo.com/people/dave-koch/

Agenda1

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ALM Overview

Defining Interest Rate RiskEarnings and Value at Risk

Role of Capital Planning in ALM

Please review the UBPR Report for your bank, or the bank you are using for analysis and discuss the trends in the following ratios between the periods 1/1/2016 - 3/31/2020 in comparison to your peers and the general market conditions

• Summary Ratios Page• Growth Rates Section

• Asset • Tier 1 capital• Net Loans and Leases

• Capitalization• What is the level of total tier 1 leverage and total capital vs. peers?

• Margin Section• Trend in earning assets to average assets.

• Earnings & Profitability Section• Net Interest Income (TE)• Non-Interest Income• Non-interest Expense• Prov. For Loan Loss• Net Income

Homework Assignment Part 1:

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Nuts & Bolts of Asset/Liability Management?

• Connecting how your FI generates sustainable earnings to achieve financial results.• Capital levels• Growth rates• Shareholder returns

• Asset/liability management (ALM) is not a REPORT it is a PROCESS• Meet financial goals • Manage risks • Maintain safety & soundness

• Primary risks of ALM process• Credit risk• Impact of interest rate movements• Liquidity levels

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Asset/Liability Defined – More Practically

• Asset-liability management• Controlling the balance sheet to sustain earnings and value as market interest rates change

• The process• How do we make decisions about what assets\liabilities to offer & at what rate(price)

• Goal:• Generate required financial performance levels• Managing risks to board established acceptable levels• Keep within regulatory expectations

• Capital• Earnings• Concentrations

This is NOT a regulatory appeasement tool!

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Asset/Liability – Simply Put

• How do you manage the balance sheet to maximize income without having that income be too volatile in different market conditions

• Examples of causes of volatile earnings• Fixed rate earnings funded by variable rate funding• Large amount of income generated from transactions like mortgage origination volumes• Reliance on less stable funding sources• Too many variable rate assets without floor protection

• Key outputs we measure for ALM • Net interest income (margin)• ROA• Sensitivity/volatility of earnings (EAR/IAR)• Net economic value of equity (EVE/NEV)

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Financial Goals

• Earnings (ROE, ROA, Net Interest Margin)• No earnings, no survival.• Earnings provide engine to grow

• Capital (Real and Regulatory)• Measure of solvency• Balancing act between regulatory need and shareholder return

• Too little in reserve may cause failure in unforeseen events• Too much in reserve costs shareholders money

• Growth• What is the tradeoff of growth in assets vs. capital\earnings

• Managing goals requires the ability to project cash flows and future plans for assets and liabilities.

• Financial risks develop from changes in actual versus expected cash flows

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Looking Back

Pre-pandemic Community Banking Trends

• Average community FI in UBPR peer 5: $300 million - $1 billion

Financial Trends 2006 2009 2011 2015 2019Avg Assets 466,021$ 530,961$ 420,139$ 436,942$ 638,199$ Avg Loans 283,607$ 326,255$ 257,195$ 281,660$ 363,145$ Avg Deposits 308,004$ 343,396$ 290,354$ 305,678$ 446,542$ Ttl Equity Capital 44,937$ 47,831$ 41,422$ 51,126$ 63,153$ Tangible Equity N/A 10.20% 10.15% 10.65% 11.15%RB Capital N/A 16.10% 16.87% 16.33% 18.80%

Total assets declined post crisis, now recovered…what about this time?

Pre-pandemic Community Banking Concerns

• Average community FI in UBPR peer 5: $300 million - $1 billion

Financial Trends 2006 2009 2011 2015 2019Asset Growth 4.73% 2.72% 2.16% 2.33% 2.00%Loan Growth 7.98% 2.06% 1.40% 2.67% 1.45%Deposit Growth 11.98% 3.66% 2.57% 2.48% 2.26%Equity Growth 2.93% 0.20% 0.71% 1.07% 1.86%Loan\Deposit 81.37% 84.17% 94.37% 83.43% 81.47%Loan\Asset 66.35% 66.33% 62.20% 65.90% 68.55%

Asset growth year over year – pretty consistent but slow….Loan\Deposit vs. Loan\Asset – What does this say?

Pre-pandemic Community Banking Concerns

• Average community FI in UBPR peer 5: $300 million - $1 billionFinancial Trends 2006 2009 2011 2015 2019Loan Yield (TE) 8.04% 6.27% 6.15% 5.17% 5.53%Cost of IB Deposits 3.64% 1.77% 1.00% 0.52% 1.16%NIM (TE) N/A 4.04% 4.17% 3.90% 3.92%Non-Int Income 1.20% 1.01% 1.06% 1.23% 1.10%Non-Int Expense 3.69% 3.43% 3.36% 3.30% 3.07%Net Overhead 2.49% 2.42% 2.30% 2.07% 1.97%Efficiency Ratio 79.74% 79.45% 76.20% 70.22% 66.19%ROA (Sub S adj) N/A 0.05% 0.50% 0.80% 0.88%ROE N/A -0.43% 3.48% 7.03% 7.41%

Peer Group 5 Trends – 2004-2019

• Net interest margin has been declining• 3.83% in 2019 vs. 4.30% in 2004

• -0.47 of a decline of 10.9%• Is your margin sustainable for another 5

years?• Impact of another 10% decline = 3.45%

• What’s the offset to manage ROA?• What changed in the last 10 years?

• How is the market valuing community banks in M&A markets?

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Polling Slide

• Do the trends on the prior slides generally represent your institution over the past decade?

• Yes• No

Q1 2020 FDIC Results

• All size banks saw declines in Q1 ROA• Banks >$10 billion saw a larger decline

• Note overall ROA levels between 2015-2018

• Rising interest rate cycle shows nominal increase in overall ROA levels

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Q1 2020 FDIC Results – Net Interest Margin

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• Net Interest Margins hovering at same levels as pre-2009 crisis except for larger banks

• Rising rates in 2016-18 produced short-term increase that reverted as rates fell

• Highly asset sensitive and highly reactive

• NIM shows declines since 2018• Q1 NIM levels fell by an average of

Q1 2020 FDIC Results – Yield/Cost

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Avg COF increased 60bp as rates rose 300 bp = 20-25% beta


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• Note the sharp decline in Q1 on smaller bank Noninterest Income

• Some asset growth due to pandemic?

• Expecting Q2 & Q3 levels to increase• PPP Income• Mortgage refinance activity

• However, excess liquidity raising total assets diluting ratio


• Size continues to bring significant operational efficiencies

• Some progress over the past decade

• Square this against capital levels…

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Larger banks make 2x ROA by increasing leverage and consistent growth


• Larger banks drove decrease in earnings (ROA) through increased Provision Expense

• Was this CECL related?

• Look at similarity to 2008-09

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Elements of a Successful ALM Process

1. Agreed upon financial goals & capital plan2. Right tools to identify existing financial risk levels 3. Clear idea of what risks you want to managed in order make money4. A way to assess new or changing strategies and plans (dynamic process)5. Ongoing tracking of performance and new strategies\ideas vs. goals\plan

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Breakout Topic #1

• Using your historical data and the information we discussed regarding overall market trends, discuss the following:

• What do the trends at your bank say about how net interest margin and net income have performed over time?

• What happened when rates went UP from 2016-2018?• What happened after 2019? How was that like 2011-16?

• Summarize your groups general findings and thoughts for discussion

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Risk Appetite

How Do I Make Money?

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Understanding Financial Risks

• What financial risks impact core earnings?• Credit risk: will the borrower of funds repay the committed amount? • Liquidity risk: will we have enough funds to meet the demands for loans or deposit

withdrawals? • Interest rate risk: to what extent will the core earnings change if market interest rates

change?

• Factors in measuring risks• Must be able to project cash flows (principal & interest)• Must understand what may cause changes in flows

• Embedded options• Pricing/member behavior

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How Much ROA Should You Make?

• Many institutions underperform potential earnings• Lack of risk taking• Concern over market conditions

• Most agree with concept of risk\return • what’s missing from the “trade-off” talk is the notion of an expected or optimal return.

• Would you be happy earning 3% if you knew that 5% was possible with your situation?

• “Optimal earnings frontier” sets out the target for the highest potential return given a defined level of risk

• The expected level of risk for expected return

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What Can You Really Expect to Earn?

• “Efficient earnings frontier” • Concept of risk vs return concept is well accepted• What’s missing in the “trade-off” talk is concept of maximum return.• “Efficient earnings frontier” defines highest potential return for a defined

amount of risk• Returns are limited by amount of risk accepted• Is THE target for evaluating risk\return trade-offs• Returns are not infinite unless risk can be expanded!• Think about all your “policy limits”

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Optimal Earning Asset Combinations

• Mapping each “mix” vs. earnings volatility helps show risk\return options

• Most often higher returns mean higher volatility

• What strategy has higher earnings potential and less “risk”

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Where is your current and projected performance vs. actual?Given your “risk appetite” what is your “domain” of optimal return?

Mea

sure

of R

etur

n (R

OE/

NII/

ROA)

Level of potential volatility

What’s The Difference?Risk Tolerance• Given an appetite for a

particular risk sector, how much exposure are we willing to extend?

• Example: Concentration limits, EVE limits, etc. help define tolerance

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Remember, earnings come from managing risk, not avoiding it.

What CAN you manage? What WILL you manage?

Enterprise Risk Management (ERM)

• Definition:• An integrated approach to identifying, assessing, managing, and monitoring risk in a way

that maximizes business success.

• Requires• Risk Management Systems to Assess “What Could Go Wrong”, as well as,• Understanding of what must go right to be successful

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ERM and the ALCO

• ERM is a fancy name for an “integrated” or “dynamic” ALCO process

• Requires a straddle of old approaches and new ideas to be meaningful

• “This is a growing process…there are no right answers…”• Comments from the former OCC Deputy Director.

• Capital plan drives it all…

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Polling Slide

• In thinking about my financial institution, I would say we make our money by primarily managing:

o Interest Rate Risko Credit Risko Liquidity Risk

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Capital Planning

Capital Planning Defined

• “Capital planning is a dynamic and ongoing process that, in order to be effective, is forward-looking in incorporating changes in a bank’s strategic focus, risk tolerance levels, business plans, operating environment, or other factors that materially affect capital adequacy.”

• The most effective capital planning considers both short- and longer-term capital needs and is coordinated with a bank’s overall strategy and planning cycles, usually with a forecast horizon of at least two years.

• From OCC 2012-16

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Defining Regulatory Capital – BASEL III

Common Equity Tier 1 Capital• Common stockholder’s equity,• Plus Qualifying noncumulative

perpetual preferred stock (including related surplus), and

• Plus Minority interest in the equity accounts of consolidated subsidiaries;

• Plus outstanding cumulative preferredperpetual stock;

• Minus all intangible assets except mortgage servicing rights that are included in tier 1 capital.

Tangible Equity• Subset of equity that is not

“preferred” and not “intangible”.• Critically undercapitalized shops are

those with this ratio below 2% • Will normally be closed within 90 days

So what is that list then?• Common Stockholder equity• Minority interests in equity of

consolidated subsidiaries• Mortgage servicing rights

This definition is important later…

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Defining Regulatory Capital – BASEL III

Additional Tier 1 Capital• Qualifying perpetual preferred

stock• Bank-issued small business

lending fund (SBLF) and TARP• Qualifying tier 1 minority

interests• Note total tier 1 capital is sum of

common equity and other tier 1 amounts

Tier 2 Capital• Allowance for loan and lease loss

(capped at 1.25% of risk weighted assets)

• Qualifying preferred stock• Subordinated debt• Qualifying tier 2 minority

interests• Less deductions in tier 2

unconsolidated subsidiaries38

Risk Weighted Assets – 2 Approaches

• Standard Filing Approach• All balance sheet (and off-balance sheet) exposures fall into one of four risk weight

categories• 0%• 20%• 50%• 100%

• Generally used by community banks

• Advanced Approach• Used by larger banks (or those smaller banks that opt in)• Additional categories for certain assets

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How Risk Weights Work

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Risk Based Requirements Denominator• Common Equity RBC• Tier 1 RBC• Total RBC

Leverage Requirements Denominator• Tier 1 Leverage Ratio• Tangible Capital Ratio

Risk Asset Definitions - Banks

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Exposure Risk Weight

Gov’t Sponsored Entities (GSEs) 20% for non-equity exposure100% for preferred stock

Depositories & CUs (insured) 20%

Public Sector Entities (Muni bonds) 20% for general obligations50% for domestic revenue obligations

Corporate exposures 100% including security firm exposures

Residential Mortgages 50%100%

Presold construction loans50%100% if contract cancelled or not meeting criteria

Multi-family loans 50% for most100% for others


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Highly volatile CRE 150%

Consumer loans 100%

Past due exposures 150% for the non-guaranteed (unsecured)portion

All other assets 100%


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Off balance sheet exposures Subject to a “conversion factor” assumesamount that moves on balance sheet

Commitments that are unconditionally cancellable by bank 0%

Unused commitments with original maturity <=1 Yr and not unconditionallycancellable

20%

Self-liquidating trade-related contingency items 20%

Unused commitments w commitment > 1 Yr not cancellable 50%


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Transaction-related items (performance bonds, bid bonds, warranties, standby letters of credit) 50%

Guarantees, repurchase agreements, securities lending borrowing transactions, financial Letters of credit, forward agreements

100%

Derivative contracts

Convert to on balance sheet based on current and potential future exposures. No risk weight cap

Community Bank Leverage Ratio

• Community Bank Leverage Ratio (CBLR)• Designed to lower burden on smaller, well-capitalized banks• Open to banks with

• Leverage ratio > 9.0%• total consolidated assets <$10 billion, and• Trading assets + trading liabilities <5% total consolidated assets• NOT filing the “advanced approach”

• CBLR Calculation• Tier 1 capital/ Average total consolidated assets

• Tangible equity capital is total bank or holding company equity capital, prior to minority interests, excluding AOCI, DTAs, goodwill, and other intangible assets (other than mtg servicing rights)

• If CBLR > 9%, all other capital requirements are waived• Examiner judgement of risk can restrict if high risk levels are deemed to be present

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Community Bank Leverage Ratio

• Maintain CBLR > 9.0%

• If CBLR declines to <9.0% but > 8.0%, bank has 2 quarter “grace period” to either:

• Raise the ratio to > 9.0% or,• Adopt the BASEL III regulatory capital standards

• If CBLR declines to level < 8.0%, no grace period• Must file BASEL III reports immediately

• Note: No grace periods in case of merger or acquisition

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Capital Adequacy – The C in CAMELS

• Less Than Adequately Capitalized• fail to meet minimum capital ratios are often subject to capital directives or other formal

enforcement action by the FDIC to increase capital.

• Fundamentally Sound and Well-Managed• applies to those banks evidencing a level of risk, which is no greater than that normally

associated with a Composite rating of 1 or 2

• Problem Banks• a level of risk at least as great as that normally associated with a Composite rating of 3, 4,

or 5 will be required to maintain capital higher than the minimum regulatory requirement and at a level deemed appropriate in relation to the degree of risk within the institution

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Capital Adequacy – The C in CAMELS

Ratings• A rating of 1 indicates a strong capital level relative to the risk profile.• A rating of 2 indicates a satisfactory capital level relative to the risk profile. • A rating of 3 indicates a less than satisfactory level of capital that does not fully

support the risk profile. The rating indicates a need for improvement, even if capital level exceeds minimum regulatory and statutory requirements.

• A rating of 4 indicates a deficient level of capital. In light of the institution’s risk profile, viability of the institution may be threatened. Assistance from shareholders or other external sources of financial support may be required.

• A rating of 5 indicates a critically deficient level of capital such that viability is threatened. Immediate assistance from shareholders or other external sources of financial support is required.

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Compliance Targets – The denominator matters!

• Tier 1 Leverage Ratio: Total consolidated assets (not risk based)

• Common Equity Tier 1 Risk Based Capital Ratio: Total Risk Based Assets

• Tier 1 Risk Based Capital Ratio: Total Risk Based Assets

• Total Risk Based Capital Ratio: Total Risk Based Assets

• Tangible Equity: total consolidated assets (not risk based)

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Compliance Targets – CBLR Yes/No?

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Maintain CBLR > 9.0%

Choosing CBLR or BASEL III

Consider this situation• $500 million Community Bank with

10.5% Tangible Equity• $52.5 million total equity

• 85% Loan\ Total Asset ratio• Majority of loans in CRE with 100% risk

weight• 10% Investments & Cash \ Total Assets

• Investments primarily in 20% risk weights•

• Total risk weighted assets• (500 *.85 * 100%) + (500 * .10 * .20) + (500

* .05 * 100%)• $460 million in risk-based assets (425 + 10 +

25)• Tier 1 Capital = 11.41%

• $52.5 / $460

• What benefit does the RBC ratio offer?• 2.41% capital buffer before BASEL III kicks in

• BASEL III buffer• Total Risk Based Capital Buffer = 1.41%• Tier 1 buffer = 6.41%

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Defining Capital & Risk Appetite

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Regulatory requirement

Risk

App

etite

Strategic risk buffer

Available Tier 1 Capital

Current risk needs

Excess capital

14.0%

5.0%

8.0%

11.0%Based on a balance sheet with full risk

Based on a current levels of risk

Your definition of regulatory minimum levels

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ROE = ROA * Leverage• Return on Equity: Net Income/Average Equity

• Measure of return on stockholder investment

• Return on Assets: Net Income/Average Assets• Measure of return on the resources of the bank

• Leverage: Average Assets/Average Tangible Equity• How many assets are we putting to work for each $1 of equity?

Effective Capital Planning Process

oSet your planning horizono 2 year minimumo Ideally 3 to 5 year

Step 1 – Set long-range goals• Balance equation of earnings,

capitalization, & growth• Include desired balance sheet mix

• Loans, investments, Non-earning assets• Core deposits, borrowing levels, other

liabilities, capital• This sets up discussion on risk appetite

Step 2 – Set annual goals• Determine annual steps towards goals

• Think of training for a marathon if you have never run?

• What is the plan that leads us to the desired financial goals?

• Helps set risk tolerance• Provide framework for drilling down in

greater detailStep 3 – Model the base plan

• Determine if the plan can be achieved Step 4 – Stress test the plan

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Setting Achievable Financial Goals

• Step 1: Assess Goals• 30% dividend payout ratio• Goal to increase capital 1% from 8% to 9%• Grow assets 5% per year• ROA Requirement = 2.02%!• Historical ROA 1.0%

• Is this a realistic set of goals? What can we “give up” to meet everyone’s wishes?

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ROA Required to Reach a Desired Capital Ratio

Beginning Assets

Total Capital

Target Capital Ratio

Annual Asset

Growth

Additional Capital Needed

% of NI Divided Payout $ Dividend

Required ROA

200,000$ 16,000$ 9.00% 0.00% 2,000$ 30.00% 857$ 1.43%200,000$ 16,000$ 9.00% 5.00% 2,900$ 30.00% 1,243$ 2.02%200,000$ 16,000$ 9.00% 10.00% 3,800$ 30.00% 1,629$ 2.59%200,000$ 16,000$ 9.00% 15.00% 4,700$ 30.00% 2,014$ 3.12%

ALM Financial Goals

• Balancing Earnings, Growth & Capital• No earnings, no survival.• Earnings provide engine to grow• Grow too fast, capital and earnings pressure• Regulatory pressure to grow capital forces

trade-off• Make more net income• Slow growth or shrink

• Set PRIORITY on specific goals!

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What happens in this game if 3 teams pull together?

Think about growth, earnings, capital & risk

Prioritized Goals

• Sample Goals in Priority Order:• Grow capital ratio to 9%• Earnings – (0.5%, 0.75% ROA), • Dividends – 30% payout ratio• 5% Asset growth rate

• Main variable for plan• Manage growth rates to achieve to goals

• Increase Loan/Assets from 72% to 80% over 3 years

• Maintain current loan mix• No major changes in credit underwriting or

product offerings

• List Your FI’s Goals in Priority Order1. _____________________________

2. _____________________________

3. _____________________________

4. _____________________________

5. _____________________________

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Capital Goal Setting

Step 2: Move from Macro View (Step 1) to Annual Goals

• Set Year by Year goals for• Capital/Asset• Growth• Earnings• Dividend Payout

• Establish a Priority for goals• Does Capital win over earnings or growth? • Is it time now to grow and let capital drop

for a while?• Board establishes priority and risk limits

Step 3: ALCO and Management uses ALM model to determine viability and required actions necessary to hit annual goals

• Does our existing plan meet the goals?• What combination of product\price

would achieve results?• Are these inside our established policy

limits?• Are we able to execute?• May involve more risks but can be

measured against established limits

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Setting Achievable Financial Goals

Stepping into Goals• Slowed growth rate of assets and planned capital target• Dividend payout stays at 30%• ROA returns to manageable levels

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YearBeginning

Assets Total Capital

Start Capital Ratio

Targeted Capital Ratio

Annual Asset

GrowthAssets After

Growth

Additional Capital Needed

% of NI Divided Payout

Required Net

Income ROA

Current 200,000$ 16,000$ 8.00% 8.25% 0.00% 200,000$ 500$ 30.00% 714$ 0.36%Year 2 200,000$ 16,500$ 8.25% 8.35% 3.00% 206,000$ 701$ 30.00% 1,001$ 0.49%Year 3 206,000$ 17,201$ 8.35% 8.45% 4.00% 214,240$ 902$ 30.00% 1,289$ 0.61%Year 4 214,240$ 18,103$ 8.45% 8.50% 5.00% 224,952$ 1,018$ 30.00% 1,454$ 0.66%Year 5 224,952$ 19,121$ 8.50% 8.50% 5.00% 236,200$ 956$ 30.00% 1,366$ 0.59%

5 Year Capital Planning Model

Example of Prioritized Goals

• 5 Year Capital Plan Prioritized Goals1. Grow capital ratio from 8.0% to 8.5% over 5 years 2. Sustain & grow ROA from 0.4% to 0.7% in the next 3 years 3. Maintain Dividends- 30% of NI4. Increase Loan/Assets to 80% over 3 years,

• Shift from RE to CRE in loan mix5. Manage Asset growth rate as the variable for plan

• Manage growth rates to achieve to goals6. Grow retail funding to meet growth needs

• Use wholesale or brokered funds to supplement within reason

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ALCO’s Primary Responsibilities

• Manage the level of net interest income/net income• Management of balance sheet structure

• Loan/investment & deposit/borrowing mix • Growth rates• Controlled through loan & deposit pricing• Investment portfolio management

• Earnings impact• Liquidity needs

• Wholesale funding • Capital utilization

• Risk measurement and management• Interest rate risk• Liquidity risk• Credit risk• Regulatory risk

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So with a set of prioritized goals established, ALCO can now determine how best to meet these goals and what risks are inherent in hitting the targets.

Breakout Topic #2

• Please discuss the following:• Discuss what your bank manages most to generate earnings• What are some of the challenges you see in that in the next 3 years?• What do you believe are the top 2 priorities in your "capital plan"?


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Overview

Measuring Interest Rate Risk

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What Is Interest Rate Risk?

• Interest Rate Risk is the risk that an institution’s earnings AND market value will change as market interest rate change.

• Measures the amount of change in earnings or value under different rates.• The earnings at risk portion measures short-term changes to the income statement.• The market value at risk element measures long-term risks to earnings and relative value

of assets & liabilities.• Both measures indicate the impact on earnings capacity – only difference is the horizon

evaluated.

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Key Interest Rate Risk Question• If market rates move, will our earnings change?

• Why do we care?• Profitability for Shareholder Distribution

• Dividends• Stock Buy Back

• Capital/Asset Levels• Earnings Feed Capital• Growth in Earnings LESS than Asset Growth reduces “safety” of the bank

• Stock Price• Stock prices based on sustainable earnings• Investors do not like volatile earnings!

• How do we traditionally measure this risk?• Test the impact of a change in market rates on net interest margin levels

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Interest Rate Risk Sources

• Financial Instruments Reprice for Four Reasons• Maturity

• Example: 90-day CD with P&I due at maturity• Amortization

• Example: 30-year fixed rate mortgage reprices gradually as the principal and interest payments are received.

• Prepayment• Example: 6% fixed rate mortgage with market rates of 3%. It reprices when owner refinances to

obtain a better rate.• Contractual repricing terms on arm or variable rate loan

• Example: 30-year ARM with annual resets.

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Cash Flow

Joint Agency Policy on IRR

• First Adopted in 1996 • Added the S component to CAMEL Rating• Developed Qualitative Assessment process for Examination

• No Uniform Supervisory Measure

• Major Components• Board & Senior Management Oversight Roles• Risk Management Processes

• Controls & Limits• Identification & Measurement• Monitoring & Reporting• Internal Audit & Review

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Joint Agency Policy Statement: 5 Areas of Risk

1. Repricing Risk: Impact of mismatch of repricing timing or amount on earnings/capital

2. Basis Risk: How different balance sheet components respond to market rate movements due to driver response• Example: Libor vs. Prime movements

3. Yield Curve Risk: Recognition that Yield Curves do not move the same amounts for all maturities (non-parallel movements)

4. Price Risk: Changes in market values of financial instruments and the impact on the market value of capital.

5. Option Risk: Changes to cash flows resulting from rate movements

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2010 FFIEC IRR Guidance

• 2010-1A IRR Regulatory Guidance• Issued December 2009

• Restatement of 1996 Joint Agency Policy Statement on Interest Rate Risk• FIL-52-96 Joint Agency Policy Statement: Interest Rate Risk• http://www.fdic.gov/news/news/financial/1996/fil9652.html

• 3 Major Issues:• Effective Policies & Governance• Effective Measurements• Meaningful & Adequate Reporting

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2010 FFIEC IRR Guidance

• What to Measure• To obtain “Well Managed” rating, must measure both earnings & economic value at risk• Must extend simulation of Income at Risk to minimum of 2 years.• If you are using dynamic balance sheet modeling, you must also run a static balance

sheet.• Why? Minimize Assumption Risk• Must be able to prove your model is effective at measuring real risks

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Interest Rate Risk Redefined

• Income Portion of Definition• Reinvestment risk is the risk that as one instrument matures and is replaced with

another, the funds being reinvested will carry a different interest rate than the funds in the original instrument.

• Example - a customer’s $10,000 90-day CD yielding 6% is about to mature. Tomorrow we’ll pay her $10,150 P&I. If we wish to continue to fund the asset supported by the CD, we’ll have to replace the $10,000. In order to do so we’ll have to pay prevailing market rates, which might mean something other than 6%. At that point the $10,000 reprices. Our cost of funds may rise or fall.

• Reinvestment risk is not a problem as long as it’s occurring at approximately the same speed on both assets and liabilities.

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Institutional ALCO ApproachesRegulatory Approach

• Run For Regulatory Compliance• Income at Risk - Static• Value at Risk - Historical• Maybe some Liquidity Testing

• Often outsourced• Cost/Time Savings• Duplicated Effort for Budgeting

• May Use Same Tool for Budget & Board Reports

Management Approach

• Used to assess risk/return trade offs

• Run dynamic models of budgets/business plans

• Regular update and roll of plan• Combine with regulatory analysis

• Usually in-house or high-end outsource

• May split functions

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Key Interest Rate Risk Question

• If Market Rates Move, How much will Bank Earnings Change?• Why do we care?

• Profitability for Shareholder Distribution• Dividends• Stock Buy Back

• Capital/Asset Levels• Earnings Feed Capital• Growth in Earnings LESS than Asset Growth reduces “safety” of the bank

• Stock Price• Stock prices based on sustainable earnings• Investors do not like volatile earnings!

• How do we traditionally measure this risk?• Test the impact of an immediate rise or fall in market rates (shocks)

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Historical Rate ComparisonSince 1986, has there ever been an immediate and parallel rate shock?This graphs explains both yield curve and basis risk management!

Bank Margin Performance – Changing Rates

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04-07 performanceMargin drops 50 bp-10.3%

16-19 performanceMargin increases 0.20 bp

Bank Margin Performance – Changing Rates• 2018 Return on Assets = 1.02%, ROE = 9.78%• Net Interest Income in 2018 = 3.59%

• What if we see a 20% decline in margin due to rates changing? • 3.59% * 80% = 2.872%

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Bank Margin Performance – Changing Rates• Return on Assets drops to 0.25%, • ROE declines to 2.2%

• A 20% decline in margin impacts ROA and ROE by 77%

Changed to 2.87%

Earnings (Income) at Risk


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IRR Measurement Techniques

Picking the Right Tool to match the job…• Gap Analysis

• Measures dollar volume difference between rate sensitive (repricing) assets and liabilities

• Income Simulation • Measures impact of interest rate changes on earnings

• Economic Value of Equity (EVE)• Present value of all asset, liability, and financial derivative cash flows

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Measurement System Requirements

1. Able to show size and direction of interest rate exposure under variety of interest rate scenarios

2. Capture all relevant data impacting cash flow and repricing• Proper modeling of underlying cash flows• Key options like caps, floors, balloon dates, prepayment penalties, etc.

3. Clearly show impact of key variables on overall exposure levels• How do these key variables impact results

4. Must be “dynamic”! • Must be able to easily assess new offerings, changes in key plan assumptions, etc.

5. Must be able to show impact of changing rates will impact each product differently

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Income Simulation

• Modeling tool to assess projected future earnings of FI

• Base projection uses most likely set of assumptions

• Market interest rates• Desired growth & mix of balance sheet• Planned non-interest income\expense

levels• Any capital actions

• Combines current balance sheet with planned future offerings

• Goal of Income Simulation• Option 1: Measure sensitivity of

earnings without concern to actual earnings levels

• Option 2: Measure both expected overall earnings AND sensitivity

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4 Requirements for Income Simulation

1. Develop your “Base Case”• “Static” balance sheet• “Most likely” change in mix forecast• “Budget/plan” as “base case”

2. Time horizon to model• 2-year minimum requirement per FFIEC• Measure each year individually or in

total?• Longer horizons lead to more variance

and less reliable results

3. Rate changes to model• Immediate interest rate shocks• Gradual interest rate “ramps”• Economic rate projections

4. Changes in business conditions• How will balance sheet performance

change in different economic environments?

• Fixed\variable loans• Deposit preferences• Liquidity levels

82Must have answers to 1-3 in order to run a useful income simulation

Static vs. Dynamic IRR Measurement

• Static Systems• Measure IRR in Existing Balance Sheet• Fail To Consider Institution Strategy• Can’t Be Used to Evaluate Risk/Return

Tradeoffs• Regulatory Systems Are Static• IAR Examples - Gap, Constant BS

Income at Risk• VAR Examples - Duration, Current VAR,

• Dynamic Systems• Measure IRR in Future Balance Sheet• Consider Institution Strategy• Evaluate Risk/Return Tradeoffs• IAR Example – Dynamic BS Income at

risk, • VAR Example – Running VAR on

projected balance sheets under projected interest rate scenarios

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Implications on ALM Results – Static vs. Dynamic

Static forecast shows bank as slightly liability sensitive

Dynamic forecast shows bank as asset sensitive

Which one is right?

Shocks

Shocks

Polling Slide

• At my financial institution we run the following balance sheet projections for earnings(income) at risk:

o Static onlyo Dynamic only o Static & Dynamic but report policy on statico Static & Dynamic but report policy on dynamico I don’t know

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Historical Rate Comparison

What Interest Rates Do We Care About?

• Modeling parallel movements in rates misstates earnings, period!• Does not matter if the rate moves are parallel or immediate shocks• Many models do not consider “basis” risk so changing yield curve shapes does not impact

results

• Did it make sense during the inverted yield curve to assume the inverted curve would move up 300 basis points?

• What are you modeling now?

What Interest Rates Do We Care About?

Implications on ALM Results

Note that shocks and ramps indicate +2-6% increase in net interest income as rates riseBut in any realistic scenario where the curve does not move in parallel fashion, margin is very sticky

Shocks

Ramps

Economic

Polling Slide

• At my financial institution we use the following rate projections for measuring policy compliance for earnings(income) at risk:

o Immediate, permanent and parallel shockso Gradual & parallel rampso Economic interest rate projectionso All of the aboveo I don’t know

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Breakout Topic #3



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Value at Risk


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Interest Rate Risk

• Market Value Portion of Definition• Market value risk is the risk that a change in market interest rates will raise or lower the

market value of instruments in an institution’s portfolio.• Example: you just purchased a new five year treasury yielding 5%. Immediately after purchase, 5 year

treasury rates move to 6%. Because A potential purchaser would expect to earn 6% and your treasury pays 5%, you would need to make up the difference of 1%. That’s 1% per year for 5 years or a discount on sale of approximately 5%.

• Market value risk is not a problem as long as the market value of both assets and liabilities is moving in the same direction and at approximately the same speed.

Value at Risk Concept

• Consider 401K or Personal Investments

• Value of Bonds goes UP when Rates go DOWN…why?

• Bonds are fixed rates that will earn More as compared to new rates, creating “Market Value” greater than “Book Value”

• Only real value if you SELL the asset

• Aren’t the financial instruments on a balance sheet the same as your 401K investments?

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PriceRates

Measuring Value at Risk

• Value at Risk is defined by:• The present value of net cash flows from all assets• Minus the present value of net cash flows from liabilities• Plus the present value of net cash flows from any off-balance sheet activities.

• Market value of capital is a derived value and does not necessarily correlate to book value of capital

• Present value is the current worth of a future sum of money or stream of cash flows given a specified rate of return.

• In essence, market value represents a long-term income statement view.

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Measuring Value at Risk Levels

Approach #1: Level of overall EVE & potential change in value• This measurement approach allows the risk

level to change with the level of overall EVE levels

• Higher EVE levels allow for more risk• Lower EVE levels restrict risk taking

Approach #2: Measure the % change in overall EVE levels & restrict to “reasonable levels”• Most common approach in industry• But, what change are we measuring

the change in EVE ratio or the $ value of EVE?

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Measuring EVE Risk – Option 1

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EVE\NPV Ratio after 200 bp shock

Interest Sensitivity Measure0-100 bp 100-200 bp 200-400 bp Over 400 bp

Over 12% Minimal (1) Minimal (1) Minimal (1) Moderate (2)

8% to 12% Minimal (1) Minimal (1) Moderate (2) Significant (3)

4% to 8% Minimal (1) Moderate (2) Significant (3) High (4)

Below 4% Moderate (2) Significant (3) High (4) High (4)

71 bp decline

Measuring EVE Risk – Option 2

• In example above, EVE $ amount drops by $51,155 in the +200 bp shock or 13.62% of the level of EVE in Flat (no change) scenario

• But, when we measure the % change in EVE ratio we see that it declines by only 9.93%

• Why is that the case?

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Using EVE as a Decision Making Tool

• EVE is a point in time tool• Any changes in EVE position requires a change in the future balance sheet

• Sell\Buy changes• Changes in product offerings• Changes in funding sources

• All changes in future balance sheet levels will change projected level of earnings at risk

• New level of baseline earnings vs. old “plan”• Resulting structure carries different “repricing” risks

• Use EVE as an indicator of rising future risks and assess impact of changes plans on both future earnings and future EVE levels

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Market Value (EVE/NEV/NPV) Choices

• Current/historical EVE/NEV• Run analysis on prior quarter end balance

sheet position• Run sensitivity testing on key variable• Assess long-run risks to earrings/capital

growth• What is the action we take based on

results?

• Forecast EVE/NEV• Run dynamic balance sheet forecast • Change assumptions on balance sheet to

meet economic and rate expectations• Use ending projected interest rates and

balance sheet levels as “current” and shock like a current EVE analysis

• Provides a look at how your plan is impacting long-term viability of margin

• “would this strategy be OK if I implement it and rates/economy went against me?”

• Repeat this process for difference “scenarios” for growth and mix based on rate and economic projections

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EVE Summary

• EVE/NEV is a critical measurement for ALCO to incorporate• Captures full horizon of risk• Expected by examiners more than ever• Provides a long-term view of income statement performance

• Use EVE/NEV as a decision-making tool on potential strategies• Acts as an early warning indicator• Helps weed out “Quick Fix” ideas

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OCC Standard Limits

• Earnings @ Risk Limits• % change in Net Interest Income• 12 & 24 month time frames?• Limits on each rate scenario?

• Shocks or Scenarios?

• Typical Limits• 400 bp > -20%• 200 bp > -20%• 100 bp > -10%• - 100 bp > -15%?

• Value @ Risk Limits• % change in EVE

• $ amount or ratio• Does this make sense?

• Do I need limits on each shock?• Field says YES• Reality?

• Example• +300/-300 -40%• +200/-200 -30%• +100/-100 -20%

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OCC National Statistics – Industry Limits

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• 2015

• 2017

Risk Levels – All Banks - 2017

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Risk Levels – Banks < $100 million 2017

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Risk Levels – Banks $100 - 250 million

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Risk Levels – Banks $250-500 million

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Risk Levels – Banks $500 mil - $1 billion

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Risk Levels – Banks $1 - $10 Billion

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Risk Levels – Banks > $10 Billion

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Breakout Topic #4



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Don’t be upset with the results you didn’t get from the work you didn’t do.

Abrigo\FARIN Resources

• Advisory Services• From education to strategy we can

recharge your approach to ALCO• Capital Planning

• Capital plan development• Integrated stress testing• Capital buffer calculations

• Asset/Liability Management• Institution managed• Outsourced

• Core Deposit Analysis• Vintage analysis• Sensitivity testing

• Credit Services• CECL ready ALLL calculation• Dual loan grading & migration• Credit stress testing• Customer management & tracking

• Loan & Deposit Pricing• Integrate CFO analytics with needs of the

front-line• Strategy development

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