The Stress Test Waterfall Analyzing Inter-Relationships of Credit, Interest Rate, and Liquidity Stress Events

Transcription

1 The Stress Test Waterfall Analyzing Inter-Relationships of Credit, Interest Rate, and Liquidity Stress Events Tuesday, June 18, :30 AM 12:30 PM Presented by: Ryan Henley, CFA Managing Director Sterne, Agee & Leach, Inc. 800 Shades Creek Parkway, Ste. 775 Birmingham, AL (205)

2 Background Credit Risk Components Liquidity and Interest Rate Risk Historically Analyzed Independently Conceptual Relationships Credit Risk Analysis Now Required Explore Quantitatively! Liquidity Risk Components Interest Rate slide 2

3 Agenda Credit Stress Testing Expectations and Regulatory Requirements Modeling Framework Lessons Learned Conclusions Drawn Credit Stress Test Effects on Interest Rate Risk Net Interest Income (NII) and Economic Value of Equity (EVE) Credit Stress Test Effects on Liquidity Risk Stress Amount Case Study Funding Considerations Rate Shock Considerations Liquidity Stress Test Effects on Interest Rate Risk New Balance Sheet Composition Practical Management Considerations slide 3

4 Credit Stress Testing slide 4

5 Credit Stress Testing Credit Stress Testing Regulatory Timeline CCAR 11/22/2011 CapPR 11/9/2012 $10-50 Bill 10/9/2012 CCAR Comprehensive Capital Analysis and Review Federal Reserve and Institution Run Scenarios 19 Firms (Largest Institutions) CapPR Capital Plan Review Federal Reserve and Institution Run Scenarios 19 + Add l 11 Firms ($50+ Billion) $10-50 Billion Stress Test Interagency Guidance as a result of Section 165(i)(2) Dodd Frank Economic and Financial Market scenarios provided by Agencies Institution incorporates these variable forecasts into their own stress test model First analysis required using data as of Sept 30, 2013 slide 5

6 Credit Stress Testing DFAST Prescribed Scenarios Domestic * Suggested Independent Variables Historic and Forecasted Values slide 6 *

7 Credit Stress Testing DFAST Prescribed Scenarios Domestic * Baseline scenario closely tracks the consensus expectation of analysts with U.S. economic activity gaining strength over the projection period. This would be accompanied by a steadily declining unemployment rate. Interest rates would drift up over the period and both equity and property prices would appreciate, albeit at a modest rate, through Adverse scenario incorporates a milder U.S. recession, with economic activity declining beginning 2012 Q4 and continuing through 2013, coupled with a rise in domestic inflation. In this environment, interest rates would move significantly higher. Equity prices would decline but not as markedly as in the severely adverse scenario. Severely adverse scenario incorporates deep recessions in the U.S. and Europe along with a deceleration of growth in developing Asia. There would be a steep rise in the unemployment rate. This would be coupled by a drop in equity and home prices, while risk premia would rise for corporate borrowers. Equity prices would fall significantly. This scenario is fairly close to the one the Federal Reserve used for its 2012 CCAR exercise. slide 7 *

8 Credit Stress Testing Goals Forecasting includes credit detioration and view of capital under both tangible book values and regulatory perspectives Pre-tax Pre-Provision Loan Loss Provision OTTI Net Income Capital Levels slide 8

9 Credit Stress Testing Data The data for the net loan charge off was obtained from the FDIC SDI system. 1 This data was screened for institutions between 5 billion and 200 million in asset size and outlier observations were removed. Aggregate net charge off variables were then compiled using a weighted average by asset size. Data for the independent variables were taken from the Federal Reserves report on stress test scenarios, including the forecasts of macroeconomic variables used for each stress scenario. 2 The model Given the Federal Reserve provided independent variables, a multivariate model was developed in order to predict the level of net charge offs using the historical data set. Based upon the model over the historical period, a multi-step forecast was applied over the Federal Reserves prescribed stress test scenarios. The model was established for net loan charge offs as a % of Total Loans but then also per loan class. Each respective class may in fact have differing independent variables providing for greater explanatory value slide 9 1: 2:

10 Credit Stress Testing Assumption Sets (provided) Real GDP Growth Unemployment 8% 14% 6% 12% 4% 10% 2% 0% 8% -2% 6% -4% 4% -6% 2% -8% -10% 0% Historic Baseline Adverse Severe Adverse Historic Housing Price Index Baseline Adverse Severe Adverse BBB Corp Spread Historic Baseline Adverse Severe Adverse Historic slide 10 Baseline Adverse Severe Adverse Data Source: Federal Reserve

11 Credit Stress Testing Projected Net Charge offs Total Net Charge offs Historic Model Baseline Adverse 1-4 Family Net Charge offs Commercial and Industrial Net Charge offs Historic Model Baseline Adverse Severe Adverse Historic Severe Adverse slide 11 Model Baseline Adverse Severe Adverse Data Sources: Federal Reserve FDIC

12 Credit Stress Testing Sample Analysis This hypothetical institution was created in order to explore the effects of the charge off assumptions across the baseline, adverse, and severely adverse scenarios. Key attributes are introduced below: slide 12

13 Credit Stress Testing Baseline Adverse Severe slide 13

14 Credit Stress Testing Baseline Adverse Severe slide 14

15 Credit Stress Testing Multivariate approach Top down approach Aggregated data sets facilitates analysis Application across individual institution s chargeoff history Ability to focus on geographic and loan type concentrations Factor Model Bottom up approach Loan level analysis DSCR and LTV Performance across forecasted economic scenarios slide 15 1: 2:

16 Credit Stress Testing Effects on Interest Rate Risk slide 16

17 Credit Stress Testing Interest Rate Risk Effects Charge-offs result in deterioration of book value of capital More capital/adds asset sensitivity Less capital/adds liability sensitivity Impaired loan values result in deterioration of Economic Value of Equity Net Interest Income and Net Income more a function of Delinquents/Nonaccruals slide 17

18 Credit Stress Testing Effects on Liquidity Risk slide 18

19 Liquidity Stress Testing Wachovia Case Study Facing these and other growing concerns, Wachovia raised additional capital. Then, in April, Wachovia announced a loss of $350 million for the first three months of the year. Depositors withdrew about $15 billion in the following weeks, and lenders reduced their exposure to the bank, shortening terms, increasing rates, and reducing loan amounts. 1 Wachovia Funding Structure 3/31/2008 Average Core Deposits Q1 $394.5 billion Average low-cost core deposits (excludes consumer cd s) Q1 $270.9 billion Low-cost core deposit outflow 5.5% in the following weeks Purchased unsecured funds $104 billion slide 19 1: FCIC.pdf

20 Liquidity Stress Testing Liquidity Stress Scenarios 5% Adverse 25% Cut of Borrowing Capacity (FHLB, FF, etc.) 10% Adverse 50% Cut of Borrowing Capacity (FHLB, FF, etc.) slide 20

21 Liquidity Stress Testing Liquidity Stress Effects Deposit outflow stresses funding position Institutions more heavily reliant upon wholesale funding at risk Wachovia case study Liquid assets immediately utilized Rate shocks adversely effect in two ways: Asset cash flows extend / liability cash flows (decay amounts) accelerate Collateral values deteriorate Market value on investments decline» Pledgeable collateral adjusts accordingly Loan market/fair value declines» Blanket lien haircuts reduced» Collateralize prepay penalties» Audit issues slide 21

22 Liquidity Stress Testing Effects on Interest Rate Risk slide 22

23 Liquidity Stress Testing Interest Rate Implications Deposit outflow reduces cash position Assuming sufficient outflow, could also require wholesale funding replacement Wholesale funding terms likely shortened Eg. Secured funding permissible maturities now 30 days and in (only) Net Effect Weighted average asset duration lengthens Cash and Fed Funds sold exhausted Weighted average liability duration shortens Core deposit duration (eg. 3 year duration) replaced by short term wholesale funding slide 23

24 Liquidity Stress Testing Net Interest Income Simulation Clearly results in added liability sensitivity slide 24

25 Liquidity Stress Testing Economic Value of Equity Clearly results in added liability sensitivity slide 25

26 Practical Management Considerations slide 26

27 Practical Management Considerations Conclusions Credit Stress in isolation adds liability sensitivity Impaired Assets Reduced Base Case EVE Delinquent/Nonaccrual Credit stress leads to liquidity stress Liquidity stress adds liability sensitivity Cash/FF sold exhausted Core deposit runoff replaced by short term secured wholesale funding Liquidity Stress Credit Stress Added Liability Sensitivity slide 27

28 Practical Management Considerations Credit Events and Associated Historic Rate Movements Severe stress and potential and absolute rates? Total Net Charge offs and Treasury Securities mo T-Bill 10 Year Treasury Total Net Charge Offs slide 28 Data Sources: Federal Reserve FDIC

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