Credit Risk Management and the ALCO Process

Transcription

1 Credit Risk Management and the ALCO Process David Koch Chief Operating Officer x4217 1

2 Definition: Asset/Liability Management asset/liability management is the processes of acquiring and deploying funds to maximize the earnings, and value of the institution, while controlling financial risks. Key Issues: Set Direction to Meet Capital Plan Goals for Earnings, Growth and Capital Measure All Financial Risks to Plan Measure Risk based on Return! 2

3 Traditional ALCO Process ALCO Measures looked at various risks in silos little interaction was assumed between each risk area and each area had its own policy. Walls separate the results from one area versus the others. Earnings at Risk Value at Risk Liquidity Risk Credit Risk 3

4 Managing Concurrent Risks Excerpt from the January 2010 FFIEC Interest Rate Risk Advisory Policies and Procedures Institutions are expected to have comprehensive policies and procedures governing all aspects of their IRR management process. Such policies and procedures should ensure the IRR implications of significant new strategies, products and businesses are integrated into IRR management process. Policies and procedures also should document and provide for controls over permissible hedging strategies and hedging instruments. Institutions should ensure the assessment of IRR is appropriately incorporated in firm-wide risk management efforts so that the interrelationships between IRR and other risks are understood. 4

5 Interrelated Risks Credit Risk Liquidity Risk Interest Rate Risk ALCO and Board must recognize that efforts to control one risk have impact on other risks Reducing liquidity levels raises interest rate risk levels and may increase credit risks Reducing interest rate risk levels may increase liquidity and LOWER earnings So, what s the real driver for managing ALCO risks? 5

6 What is a Dynamic ALCO Dynamic refers to the plans and assumptions used to measure risks We aren t a static or No Change business, so why measure it? No regulations exist requiring static but has evolved over time given our approach to managing ALCO We have been complying with requirements, not ACTIVELY using ALCO to Manage Dynamic Requires You To Do More! More Discussion More Accountability More Integration of Plans with Actions that Change as Environment Changes This is NOT a course in how to appease regulators! 6

7 Credit Risk and the ALCO Credit Risk is defined as the risk of loss of principal and/or loss of interest due to a borrower's failure to repay a loan or otherwise meet a contractual obligation. Financial Institutions are compensated for assuming credit risk by way of interest payments from the borrower or issuer of a debt obligation. So how does Credit Risk fit into the ALCO Process? Changes in risk impacts earnings and capital growth Changes in risk effects liquidity of the bank 7

8 Mitigating Credit Risk How do institutions control credit risk? Rates/term on loans Risk based pricing Credit tightening Decreasing concentrations in product/risk classes Requiring credit insurance products for marginal borrowers PMI Credit Life/Disability 8

9 FDIC Credit Risk Supervisory Guidance Summer 2012 Financial institutions can create a variety of stress tests to evaluate credit portfolio risk and the potential impact on capital. These types of generalized stress tests can be used by community banks to meet supervisory expectations (e.g., expectations contained in the 2006 CRE Guidance) or by institutions seeking to complement and enhance their other risk management activities. As suggested by this list, there is no one right way to conduct stress tests. Existing supervisory guidance states that banks with significant concentrations in commercial real estate (CRE) or subprime lending should conduct portfolio stress tests of these exposures as part of their ongoing risk management activities 9

10 OCC Community Bank Stress Testing Issued 10/18/2012 Lays Out Supervisory Expectations Primarily focused on Credit Stress Testing Generally Stress Tests Should Lay Out Plausible What If Questions Assess Impact of What-If Incorporate Results into Institution Risk Management Process If Major Problems are Uncovered at the Basic Level, Additional Detailed Analysis May be Necessary 10

11 FDIC Stress Testing - Defined Stress testing is a forward-looking quantitative evaluation of stress scenarios that could impact a banking institution s financial condition and capital adequacy. These risk assessments are based on assumptions about potential adverse external events, such as changes in real estate or capital markets prices, or unanticipated deterioration in a borrower s repayment capacity. Stress tests are most useful when customized to reflect the characteristics particular to the institution and its market area, and can be used to evaluate credit risk in the overall loan portfolio, segments of portfolios, or individual loans. Stress tests also can be used to evaluate whether existing financial (such as capital and liquidity) and operational (such as staffing and internal systems) resources are sufficient to withstand an economic downturn or unexpected event. Focus of all Regulatory Documents is on CRE Lending though can be applied universally in Top Down Testing 11

12 5 Key Stress Testing Principles: 1. The framework should include activities and exercises that are tailored to and sufficiently capture the organization's material exposures, activities and risks. 2. An effective stress testing framework employs multiple conceptually sound stress testing activities and approaches 3. An effective stress testing framework is forward-looking and flexible 4. Stress test results should be clear, actionable, well supported, and inform decision-making. 5. Strong governance and effective internal controls help ensure that the framework contains core elements, from clearly defined stress testing objectives to recommended ones. 12

13 Credit Risk Stress Tests Types of Stress Tests Transaction Stress Testing Bottom up analysis beginning at loan level Portfolio Stress Testing Bottom Up Transaction Stress Tests Top Down Applying Loss Rates to Pools of Loans Enterprise Level Testing Incorporates Multiple Kinds of Risk (Integrated) Assumptions Derived from Same Economic Scenarios Future of ALCO Modeling? Reverse Stress Testing Assumes Specific Adverse Outcome (Capital Failure) then Deduces Kinds of Events Leading to This Outcome 13

14 Two Approaches to Stress Testing Scenario Analysis: a technique where you apply a historical or hypothetical scenario to assess the impact of various events and circumstances, including the most extreme situations. Examples include severe recession, failure of a major counterparty, loss of major clients, localized economic downturn, or a sudden change in interest rates brought about by unfavorable inflation developments. Can t we tie this into other ALCO risks we monitor? 14

15 Two Approaches to Stress Testing Sensitivity Analysis: refers to assessment of risk when certain variables, parameters, and inputs are "stressed" or "shocked." Unlike scenario analysis, this is performed without an explicit underlying reason or narrative in order to explore what occurs under a range of inputs and at extreme or highly adverse levels. The guidance state: "It can help to assess a combined impact on several variables, parameters, factors, or drivers. For example, an organization could better understand the impact on its credit losses from a combined increase in default rates and a decrease in collateral values...an organization can also explore the impact of highly adverse capitalization rates, declines in net operating income, and reductions in collateral when evaluating risk from CRE exposure." 15

16 Stress Test Objective Test whether an institution has sufficient capital to remain Well Capitalized after a severe stress Says to us: New capital regulations will set minimums Stress tests will define cushions Recently verbalized regulatory approach Stress tests not a requirement for community banks Simple enough to be done in a spreadsheet Excel or Lotus Maybe?? 16

17 Goal Example Tier 1 Leverage Example Capital Goal + 2% Established Through Stress Testing Capital Goal Answers the Question, How Much Capital Cushion Do I Need to Remain Well Capitalized After a Stress Test? 17

18 Capital Planning Objectives (OCC) Capital Plan to Assess Capital Adequacy in Relation to Overall Risks Plan for Maintaining Adequate Capital Levels If Analysis Shows Institution Falling Below Regulatory Minimums, Board and Management Should Take Some Combination of the Following Actions: Increase Monitoring of Market Information Adjusting Strategic and Capital Plans Changing Risk Appetite and Tolerance Levels Limiting or Stopping Loan Growth and Adjust Mix Adjusting Underwriting Standards Raising More Capital Selling or Hedging Loans 18

19 Are The BASEL II Proposed Capital Changes Really Just Proposed? Banks Already being enforced in the field Core Capital 8-9% (Currently 6% Minimum) Risk Based Requirement 12-14% (Currently 10%) Why so high? Adds capital buffer to existing standards more on this later Credit Unions NCUA announced in April 2013 likely to take a BASEL III Lite approach for RBNW Driven by Basel III which applies to everyone internationally Aimed at CU s with more diverse and risky assets CU s Capital sources are limited 19

20 Estimated Impact of Standardized Approach Example Before After After- Adjusted Risk-Based Capital $10 $10 $12 Risk-Based Assets $100 $120 $120 Risk Based Cap/Assets 10.00% 8.33% 10.00% Note: impact on your shop may be more or less based on your balance sheet composition and financial condition. 20

21 TRANSACTION STRESS TESTING 21

22 Can I Get Some Regulatory Relief? OCC Background and Supervisory Expectations Sound risk management practices should include an understanding of the key vulnerabilities facing banks. For several years, supervisors have used the term stress testing in guidance and handbooks to refer to and encourage banks to incorporate this practice. (References Comptrollers Handbook) Comptrollers Handbook Credit portfolio stress testing is a relatively new analytical tool and the OCC does not currently require banks to conduct stress tests or to develop or purchase computer models to perform such tests. Bankers are encouraged, however, to expand their capabilities. Banks of all sizes will benefit by supplementing stress testing of individual loans with portfolio stress testing. They may also want to consider credit modeling software as it becomes more refined and readily available for stress testing. OCC Comptroller s Handbook, Loan Portfolio Management Booklet, April 1998, Page 35 22

23 Definition Transaction stress testing is a method that estimates potential losses at the loan level by assessing the impact of changing economic conditions on a borrower s ability to service debt. Transaction level scenario stress testing can help in a bottom up analysis to gauge a borrower's vulnerability to default and loss, foster early problem loan identification and strategic decision making, and strengthen strategic decisions about key loans. Question: How do we apply in top down analysis? 23

24 Pre-Commitment Stress Tests Commonly Used in Commercial Real Estate, Agriculture and other Commercial Loans Testing changes in underlying conditions impacting the borrowers ability to repay. Commercial Real Estate Example Compare Rental Income At Various Vacancy Rate How Rate Changes Impact LTV & DSC Ratios What level of loan is supportable by the borrower Threshold level 24

25 Pre-Commitment Stress Tests Input Loan Structure Information 10 Yr 4% $2 million request $200k in rental income $60k in maintenance expense 10% vacancy rate $70k in operating expenses Creates net income of $164k per year Assuming a 7% Capitalization Rate, estimate loan value $2.3 million 25

26 Pre-Commitment Stress Tests Changes to parameters allow lender to recalculate DSC ratios and check compliance. Is there a real chance that this event might occur? 26

27 Pre-Commitment Stress Tests Allows for comparison of changes in multiple inputs to see test loan size 20 Yr. 5% with a 25% reduction in DSC means loan is too large for limits by $365k But a 10 Yr. with a 2X DSC position is profitable. Loan structure is heavily dependent on DSC position Question to solve: At what point are cash flows insufficient to pay the loan? How does it move across the classification process (sub-standard, classified etc.)? Focus is Borrower Specific, not Institutional 27

28 Portfolio Level Stress Test Loan Portfolio Categories Call Report or SIC? Begin with Quarter End Portfolio Balances Apply Stress Period Loss Rates At Portfolio Category Level Bank s Historical Experience a Starting Point Severity Should Consider Economic Scenario Impact Rolls Up to Economic Effect Minimum 2 Year Forecast Horizon Economic Effect Components Income Pre-Provision Net Income Provision to Cover Stress Losses Provision to Maintain Adequate ALLL Income Tax Effect Net Income Capital Focus on Effect on Tier 1 Capital and Tier 1 Leverage Likely to Change with Basel III to all 4 Ratios 28

29 OCC Example Sum of Losses Carries to Calculation for Stress Loss Rate This example groups by call report category. We believe this is too aggregated and should be set at SIC or NAICS code levels 29

30 OCC Example 2 Yr. Loss Provision from prior Stress Calculation PLL required for Maintaining Adequate ALLL based on loan growth and mix and should be a part of your ALM modeling assumptions already! 30

31 OCC Example Stress Test costs the bank 3.7% of tier 1 Capital Pre-stress tier 1 ratio: 88 / 738 = 11.9% Post-stress tier 1 ratio: 60.8 / 738 = 8.2% Credit buffer Requirement 3.7% above minimum capital levels 31

32 OCC Real Estate Stress Factors Factors in Loss Rate Projections Loan Types 32

33 ALLL Reserve Calculation Choosing a look back period Understanding the current environment When coming out of a economic boom cycle, like 2005 where loss experience was very low, the norm was to have long look back periods. After 2008, when loss experience was high examiners started to shorten the look back periods Most examiners recommend a rolling 12 quarter look back period for loss history, as the market recovers look for these periods to start extending again 33

34 ALLL Reserve Qualitative and Environmental Factors (Fas 5/ASC 450) The subjective components of reserve analysis 34

35 Forecast Reserves ALLL Reserve By forecasting loan growth by reserve pools, it enables a financial institution to forecast future provisions based on current reserve run rates and loss experience. Description Out Bal Forecast Historic Loss Reserve Amount Forecasted Res Net Charge Offs Capital Impact RE - Construction/Land Development 1-4 Family $ 2,000,000 $ 2,500, % $ 47,084 $ 58,856 $ 10,000 $ 21, family residential $ 27,500,000 $ 34,375, % $ 382,701 $ 478,376 $ 137,500 $ 233,175 Other construction loans $ 1,500,000 $ 1,875, % $ 38,225 $ 47,781 $ 7,500 $ 17,056 Secured by farmland $ 3,200,000 $ 4,000, % $ 29,545 $ 36,931 $ 16,000 $ 23,386 RE - Secured by 1-4 Family Residential Property $ - $ % $ - $ - $ - $ - Revolving, open-end loans $ - $ % $ - $ - $ - $ - Closed-end loans, secured by first lien $ 900,000 $ 1,125, % $ 7,776 $ 9,720 $ 4,500 $ 6,444 Closed-end loans, secured by junior lien $ - $ % $ - $ - $ - $ - Secured by multifamily $ 600,000 $ 750, % $ 12,668 $ 15,834 $ 3,000 $ 6,167 RE - Secured by nonfarm/non residential owner occupied $ - $ % $ - $ - $ - $ - Owner-occupied nonfarm nonresidential $ 13,440,000 $ 16,800, % $ 217,429 $ 271,786 $ 67,200 $ 121,557 Other nonfarm nonresidential $ 15,000,000 $ 18,750, % $ 227,400 $ 284,250 $ 75,000 $ 131,850 RE - Secured by nonfarm/non residential non-owner occu $ - $ % $ - $ - $ - $ - Loans to depository institutions $ - $ % $ - $ - $ - $ - Loans to finance agricultural production $ 1,937,863 $ 2,422, % $ 25,175 $ 31,468 $ 9,689 $ 15,983 Commercial and industrial loans $ 76,590,000 $ 95,737, % $ 977,671 $ 1,222,089 $ 382,950 $ 627,368 Credit cards $ - $ % $ - $ - $ - $ - Other revolving credit plans $ - $ % $ - $ - $ - $ - Other consumer loans $ 10,000 $ 12, % $ 86 $ 108 $ 50 $ 72 Tuition $ - $ % $ - $ - $ - $ - Loans to foreign governments and institutions $ - $ % $ - $ - $ - $ - Obligations of states and political subdivisions $ - $ % $ - $ - $ - $ - Other Loans $ - $ % $ - $ - $ - $ - Lease financing receivables $ - $ % $ - $ - $ - $ - Totals $ 142,677,863 $ 178,347,329 $ 1,965,760 $ 2,457,200 $ 713,389 $ 1,204,829 Impact of required ALLL and stress tests using top down on forecasted balance sheet 35

36 Enterprise Risk & Your ALM Model Ideally will incorporate Basel III Capital Regulation Calculations When Final Capable of Running All Three Kinds of Stress Tests Interest Rate Risk - Current Liquidity Risk Current Credit Risk Proposed Option for Top Down or Bottom Up Approach to Credit Risk Top Down Requires Factors to be set by scenario Bottom Up required integration with credit stress test model Enterprise Level Testing Specify Combinations of Stress Test Factors Measure Effect on Income, All 3 Forms of Regulatory Capital, and All 4 Basel III Ratios 36

37 Enterprise Risk & Your ALM Model Must Have Unstressed & Stressed Annual Charge Offs At Chart Level Detailed or Roll Up NAISC Code Level Detailed or Roll Up RMA Level Detailed or Roll Up NAISC/RMA data passed from External Model Ideally Capacity for Multiple Stressed Charge Offs Match to Interest Rate Risk and Liquidity Scenarios Integrated ALLL Calculations 37

38 Enterprise Risk & Your ALM Model Define Scenarios Pick Combinations of: Liquidity Stress IRR Stress Credit Stress Dynamic Built off Business Plan Ability to Play What If? Shows impact on income, all three forms of capital, all four Basel III capital ratios 38

39 Loan Portfolio Management What is the relationship between Underwriting and Loan Grading? 1. Approval 2. Covenants 3. Pricing Underwriting Risk Scoring Loan Grading 1. Performance 2. Reserves 39

40 Bottom Up Stress Testing Features Most Sophisticated Form Bottom Up Approach Losses at Loan Level Roll Up to Portfolios Identifies Individual Loans that May Be Problem Areas Allowing for: High Levels of Concentration Risk in Risky Loans Provides Loss Experience at Portfolio Level Disadvantages Very Data Intensive Expensive Long Lead Times Often Static Rather than Dynamic Overkill for Many Community Banks Not Universally Required by Regulators 40

41 Bottom Up Stress Testing Begins Before Origination How Do You Classify Your Loans for Granular Analysis? Call Report Code Too Aggregated Internal Type/Collateral Code Too Inconsistent NAISC Codes (Census Bureau Data) 20 Industry Sectors Numerous Detailed Business Types By Industry Industry Business Type Advantages of Using NAICS codes 1. Comparative Analysis 2. Concentration Analysis 3. Loan Portfolio Segmentation 4. Stress Testing 41

42 Bottom Up Stress Testing Building Loan Grading Systems Loan Grading Models Require Consistent Measures for all loans Consistent Weights/Factors for all Loans Types of Factors Objective Measures Current/Quick Ratios Debt to Net Worth Debt Service Coverage LTV Credit Scores Subjective Measures Strength of Guarantors Management Evaluation Other Credit Quality Adjustment Assign Weights to Each Factor to be used consistently for all loans 42

43 Example Loan Grading System Grade Assigned based on Borrower s raw score without Subjective factors Note the presence of a decimal in the grade How close to a B+ or A- is a real borrower. Note Ability to see the relative impact of each factor on the overall score 43

44 Example Loan Grading System Separating the Management Assessments Allows for Control Over Lending Activity and Approvals Back testing and holding managers accountable for subjective factors reduces fuzzy grade assignments 44

45 How Does Detail Impact Decisions Top Down Method Assigns Loss Factor to Entire Class of Loans No sub-classification No Credit grade Implication Example: Bank has 49% of Portfolio in C&I Loans Under Top Down Factor would apply to nearly 50% of the major earning assets. Consider the following 45

46 Distribution By NAISC Industry 26% of all C&I Loans are in Ag loans 10 total loans Are Ag Loan Factors difference from Real Estate, Restaurant, or Educational Services? Depending on your diversity in lending, industry difference can lead to major stress factor difference 46

47 Distribution By Credit Score & Industry 4 of 10 Ag Loan are Graded 3, remaining > 3 More risk? In order to quantify stress results, the change in grades are critical to ALLL/Charge- Off status 47

48 Incorporating Stress testing into Portfolio Management 9 stress points: 1. Increase in non-performing assets Concentrations by loan type or industry Securities portfolio (TRUPS, Fannie, Freddie) Economic slowdown Collateral depreciation 2. Contagion Weakness from one loan type spreading to another sector Downstream impact from the loss of a major employer or industry 3. Widespread deterioration in a portfolio due to a rouge or incompetent lender 4. Long-term effects from changes in underwriting practices 5. Changes in borrowing terms or collateral requirements 6. Stress in funding from reputational risk negative press, regulatory enforcement, etc. 7. Funding outflows in a stressed environment 8. Operational risk 9. Impact on the holding company from a stress event at the bank Can the holding company serve as a source of strength for the bank or will the stress at the bank spread to the holding company? 48

49 Bottom Up Example Loan Portfolio Management Incorporating Stress testing into Loan Level Portfolio Management By comparing actual results to what if scenarios results 49

50 Bottom Up Example Loan Portfolio Management 50

51 Putting Credit Risk Data To Work In ALCO, stress test results provide potential impact on: Earnings Loss Capital Growth Remember that these systems as shown are static systems Should incorporate stress tests into ALM model to capture changes in liquidity and earnings at risk under relevant scenarios Where Else Does This Data Fit? Loan Pricing 51

52 Inputs to Loan Pricing Rate & Fees Cash Flows Credit and Option Risk Benchmarks Investments Funding ROE ROA 52

53 Credit Risk Adjustment By Class Differential pricing on A, B, C credits should reflect both additional charge offs, and additional servicing costs due to legal and collection fees. 53

54 A Credit Auto 48 Months Which credit risk adjustment do we use? Capital requirement - Basel I Loan is well priced under all four measures 54

55 B Credit Auto 48 Months +50bp from A +30bp from A +20bp from A Capital requirement - Basel I Loan is as well priced under 3 Measures. 55

56 C Credit Auto 48 Months +100bp from A +65bp from A +40bp from A Capital requirement - Basel I Loan is as well priced under 3 measures. 56

57 C Credit Auto 48 Months Basel II Note change in capital requirement (Basel I à II - III) In order for the C credit Basel II - III to match C credit Basel I ROE, a 200 bp rate increase is required. 57

58 C Credit Auto 48 Months Basel II +300 bp from A Note change in capital requirement (Basel I à II - III) In order for the C credit Basel II - III to match C credit Basel I ROE, a 200 bp rate increase is required. Note that all other measures improve 58

59 Lessons from these Examples Situation A, B, & C loans all priced to approximately the same spread to benchmark given credit risk and servicing cost. Market values, spreads, and net incomes are nearly the same for all three loans as would be expected. Because of same Basel 1 capital requirements, RAROCs are roughly the same. Regulatory consolidation is likely to cause credit unions to be under the same capital standards as banks. Lessons Assuming Basil II-III applies differential capital standards to loans, based on credit worthiness of borrower Those against risk-based standards will need to increase spreads between A s B s and C s to equalize RAROC. Those not against RB capital requirements will price those that are out of the B & C markets Under the proposed Basel II rule making, big banks would have had lower capital requirements on A s than small institutions. Presumption was they had better credit underwriting. Sub prime mess has destroyed that myth. 59

60 ALM Models and Stress Tests Ideally, Incorporates Basel III Capital Regulation Calculations When Final Capable of Three Kinds of Stress Tests Interest Rate Risk - Current Liquidity Risk Current Credit Risk Proposed Credit Risk Tests Likely Built With Top Down Approach to Credit Risk Optional Integration with third party, Bottom Up Model 60

61 Move To Enterprise Stress Tests Define Scenarios Pick Combinations of: Liquidity Stress IRR Stress Credit Stress Dynamic Built off Business Plan Ability to Play What If? Shows impact on income, all three forms of capital, all four Basel III capital ratios 61

62 Scenario Comparisons Dashboard Comparisons Scenario to Scenario Factor in major risk & return elements Scenarios can be different What-if plans combined with stress tests Results show comparative pre-stress test to post stress test Buffer Requirement = to impact of combined stress events One risk may offset other, hedging costs Requires relationships between all stress tests Capital Risk Asset Quality Risk/Return Risk/Risk Decision Matrix Ratio Base Plan Base + Credit Stress Base + Credit + Liquidity Core capital Ratio 8.25% 5.07% 8.65% Tier 1 Leverage 11.90% 8.20% 8.65% Risk Based Capital 13.50% 11.33% 12.33% PLL/Avg.Assets 1.36% 9.72% 9.72% ALLL/Total Loans 1.55% 1.55% 1.55% Earnings ROA 1.60% % % Interest Rate Risk Liquidity Risk % Change in Net Int Margin % Change in Net Income % % % % % % Current EVE Minimal Minimal Minimal Forecast EVE Minimal Moderate Moderate Liquidity Gap Ratio - Base 18.38% 10.75% % LCR Ratio % % 98.75% Non- Core Funding/Assets 20.15% 25.75% 38.75% 62