Stress Testing. Webinar: Dodd Frank Act Stress Test (DFAST) for $10-$50 billion banks. John Lankenau Vice President, Product Management

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1 Stress Testing Webinar: Dodd Frank Act Stress Test (DFAST) for $10-$50 billion banks John Lankenau Vice President, Product Management

2 John Lankenau Vice President of Product Management, Primatics Financial John is currently the product head for valuation and accounting solutions in Evolv. He has extensive financial services industry experience, with an emphasis on the implementation, testing and use of complex models for financial reporting and business purposes. Prior to joining Primatics Financial, John was a Director of Financial Engineering at Fannie Mae where he was the business owner of the application used to determine the fair value of Fannie Mae s guaranty business, as well as the impairment amounts for loans under FAS 114 and SOP John holds his MS from the University of Michigan, Ann Arbor in Industrial and Operations Engineering (Operations Research), and his BA from Carleton College in Mathematics and Economics.

3 Agenda 1. Stress Testing Background: History of CCAR / CapPR / DFAST Regulatory Definitions of Stress Testing Dodd-Frank Requirements 2. Stress Testing Challenges: Common Bank challenges Template Requirements Meeting needs of Dodd Frank stress tests Importance of the Right Models 3. Primatics Stress Testing Approach: Recommended Approach Dry Run Evolv product demo 4. Q & A 3

4 History of CCAR / CapPR / Dodd Frank Stress Tests Supervisory Capital Assessment Program (SCAP) early 2009 done by regulators for very biggest banks to calm markets. Led to mandated capital increases of about $75 billion Comprehensive Capital Plan and Review (CCAR) and Capital Plan Review (CapPR) review of capital plan for banks above $50 billion in assets; includes a stress test Dodd Frank Mandated Stress Tests banks above $50 billion had to do last year, upcoming is first time for banks from $10-$50 billion 4

5 Definition of Stress Testing Stress testing refers to exercises used to conduct a forward-looking assessment of the potential impact of various adverse events and circumstances on a banking organization. A stress test is: a process to assess the potential impact of economic and financial conditions (scenarios) on the consolidated earnings, losses and capital of the company over a set planning horizon taking into account the current condition of the company and the company s risks, exposures, business strategies, and activities. The accounting view has become a necessary component of stress testing for banks >$10 B 5

6 Spectrum of Stress Testing General Requirements Dodd Frank ($10b-$50b) CCAR & Dodd Frank (>$50b) Complexity Stress Testing Complexity Curve $1B $10B $50B Bank Size 6

7 Dodd-Frank Requirements for $10-$50 Billion banks Required to fill in OCC form DFAST (quantitative templates) and/or Fed template FR Y-16 and provide: 1) GAAP-compliant income statement for base and 2 adverse scenarios for 9 quarters 2) GAAP-compliant balance sheet for base and 2 adverse scenarios for 9 quarters 3) Capital ratios derived from forecast balance sheets and capital plans 4) Qualitative report explaining risks included in the stress test, methodology, and an explanation of most significant causes of change in capital ratios 7

8 Common Pain Points at Banks Based on our experience working with leading banks, we have discovered the following challenges and questions that need to be addressed for Enterprise Wide Stress Tests. A Data Difficult to aggregate data found in various source systems Integrating the data into a normal business process Key challenges: 1) Stress loan portfolios 2) Portfolio exposures 3) Pro-forma Financials B C D Integration Interpretation of Results Capital Adequacy Integrating accounting and valuation views Keeping all the teams working towards the same goal together Transparency: comparing two runs against each other Creating board-ready deliverables in a format they can understand Generating GAAP-compliant forecasted results (forecasted balance sheet and income statement) E Struggle for Growth Making the process repeatable / automated / controlled Spending more time analyzing vs. processing the execution Scaling through the process 8

9 Functions Challenged by Stress Testing at Bank The assessment of credit risk in enterprise wide capital stress testing requires coordination of forecasting, accounting and credit assessment groups. Each of these groups is asked to leave its comfort zone. Forecasting Capital Adequacy Stress Test Accounting Typically a business planning exercise. Taking performance in a stress macroeconomy into account can be challenging. Credit Most comfortable with assessment of risks in valuation context. Outside historical comfort zone when accounting is layered on. Most comfortable with actual events on actual loans. Increasing familiarity with expected cash flows. Finds challenging and lacks system capabilities to assess accounting impact on forecasts of future loans. 9

10 DFAST: Template Requirements for 2014 Requirements Income Statement 1. Forecast of loan charge-offs, by segment 2. Net interest income 3. Non-interest income and expense 4. Provision for loan and lease losses 5. Realized gains (losses) on HTM securities 6. Realized gains (losses) on HFS securities 7. All other gains (losses) 8. Taxes 9. Memo item: Net gains (losses) on OREO 10. Memo item: Total OTTI losses Requirements Balance Sheet 1. Forecast loan balances, by segment (break out FDIC loss share) 2. ALLL 3. HTM securities by type 4. AFS securities by type 5. Retail funding (core deposits) 6. Wholesale funding 7. Trading liabilities 8. Other liabilities 9. Forecast equity capital components 10. Memo item: 11. Memo item: Forecast cash dividends on stock 12. Memo item: TDR balances 13. Memo item: loans in foreclosure 14. Memo items: Avg. rates on loans, deposits, funding, securities, liabilities 10

11 DFAST Activities / Output Income Statement DFAST Template Requirements (Income Statement) Not Complex Less Complex Highly Complex Non-interest income and expense All other gains (losses) Taxes Memo item: Net gains (losses) on OREO Memo item: Total OTTI losses Net interest income Realized gains (losses) on HTM securities Realized gains (losses) on HFS securities Forecast of loan charge-offs, by segment Net interest income Provision for loan and lease losses Spreadsheets Typical ALM Capability Specialized Solutions Complexity Curve 11

12 DFAST Activities / Output Balance Sheet DFAST Template Requirements (Balance Sheet) Not Complex Less Complex Highly Complex Other liabilities Forecast equity capital components Memo item Memo item: Forecast cash dividends on stock Memo item: TDR balances Memo item: loans in foreclosure HTM securities by type AFS securities by type Retail funding (core deposits) Wholesale funding Trading liabilities Memo items: Avg rates on loans, deposits, funding, securities, liabilities Forecast loan balances, by segment (break out FDIC loss share) ALLL Memo items: Avg rates on loans, deposits, funding, securities, liabilities Spreadsheets Typical ALM Capability Specialized Solutions Complexity Curve 12

13 Loan Modeling Approaches for a Stress Test Stress test requires evaluating impact of adverse conditions on loan performance. Institutions often have and want to apply for stress testing: Historical roll rates/moving averages Not sufficient Adjusting roll rates/moving averages using management intuition Usually not sufficient and only as good as management intuition and cannot be validated / difficult to defend Real, Forward-Looking Models are Required 13

14 Modeling Approaches for a Stress Test Top Down Portfolio / Asset Class Level Bottom Up Detailed loan level build up Can be pushed down to more granular levels Regulators Likely sufficient for entire portfolio for banks below the CCAR threshold Expect demands to increase as bank asset size increases Regulators More common with CCAR banks, although some do still leverage top down for part of their portfolio 14

15 How to Apply Models in Dodd Frank Stress Test All Loans Must be Stressed Regardless of whether top down models or more granular models are used, they should reflect the national macroeconomic conditions provided. This is not an exercise to figure out concentrations or perform granular risk management. This is an institution-level exercise to show regulators you can survive an adverse economy. The regulatory exercise here is not to stress different books (industry / geography) separately. 15

16 Stress Testing for Risk Management Beyond Dodd Frank Useful risk management exercises use stress testing to answer more complex risk management questions (these can be part of the multiple approaches the regulators expect). For a bank with multiple identifiable books, (different regions or industries) what happens if the economic shock causes one book to be very bad while others do ok and perhaps others are not stressed? For a bank that is booming due to regional conditions (oil a classic example), identify and stress oil-related loans. Have you bet your bank on a regional boom? 16

17 Are you prepared? Some aspects of the DFAST process are relatively easy to produce, via spreadsheets and/or ALM tools Several components are very complex to produce, and require specialty solutions We recommend performing a Dry Run of the stress testing process; use the dry run to identify gaps and/or process improvement needs Primatics can perform a dry run on the loan portfolio within 4-6 weeks, while offering a platform that can be a long-term sustainable solution 17

18 Stress Testing in Evolv Evolv Demonstration 18

19 Q&A 19

20 Contact John Lankenau Vice President, Product Management 8401 Greensboro Drive, Suite 300 McLean, VA (703) This document is protected under the copyright laws of the US and other countries as an unpublished work. This document contains information that is proprietary and confidential to Primatics Financial LLC, and by accepting receipt of this document the recipient agrees not to disclose, or to otherwise duplicate or use, this document or its contents in whole or in part for any purpose other than in connection with services or deliverables to be delivered by Primatics Financial LLC. Any use or disclosure in whole or in part of this information without the express written permission of Primatics Financial LLC is prohibited Primatics Financial LLC All rights reserved. 20