FINANCIAL STATEMENT ANALYSIS & RATIO ANALYSIS

Transcription

1 FINANCIAL STATEMENT ANALYSIS & RATIO ANALYSIS June 13, 2013 Presented By Mike Ensweiler Director of Business Development Agenda General duties of directors What questions should directors be able to answer about financial statements? Financial statements and financial statement analysis Key ratios Risk exposures 2

2 General Duties of Directors Be familiar with basic finance and accounting practices, and have basic financial skills needed to manage the size and complexity of the institution s balance sheet Be able to read and have a basic understanding of the balance sheet and income statement Have the ability to ask questions to management or auditors 3 Questions Directors Should Be Able to Answer What does this line item mean? How does this trend impact the financial institution? Why is this item important? What is the trend of the line item? Are there inherent risks in the line item? 4

3 Financial Statements Balance sheet Financial position at a point in time Income statement Financial performance over a period of time Statement of cash flows Sources and uses of cash 5 Balance Sheet Assets what the financial institution is financing Consumer and mortgage loans, investments, other assets Liabilities how the financial institution financing the assets Borrowings and other liabilities Equity what the members / shareholders own assets = liabilities + equity 6

4 7 Common Asset Types Cash and cash equivalents Cash on hand and investments with original maturities of 3 months or less Consumer loans Credit cards Auto loans Secured and unsecured 8

5 Mortgage Loans Member loans carried at cost which includes expenses for underwriting loans minus fees FAS 91 accounting 15 yr fixed rate mortgages 92,604, yr fixed rate mortgages 23,151, /1 ARMs 115,755, Real Estate Loans 231,511, Mortgage Loan Origination Costs 250, Amortized Mortgage Loan Orig Costs (149,579.49) Unamortized Mortgage Loan Fees (75,324.98) Total Costs / Fees 25, Total Real Estate Loans 231,537, Loans Purchased loans Participations or indirect loans Carried at cost and account for premium or discount paid Loans held for sale Carried at lower of cost or market Mortgages can either enter cash delivery or lock into 10 or 30 day commitments 10

6 Allowance for Loan Loss Management s estimate of probable loan losses Based on historical losses and analysis of loan products Allowance for loan loss (beginning of period) Minus Loans charged off Plus Recoveries of past loans charged off Plus Provision for loan loss Allowance for loan loss (end of period) 11 Investment Security Classifications Trading Intent is to hold only for the near term Available for sale (AFS) May consider selling before maturity to meet liquidity needs or respond to a change in market conditions Held to maturity (HTM) Intent and ability to hold from purchase to maturity date 12

7 Investment Reporting Balance Sheet Income Statement Trading Available for Sale Held to Maturity Fair Value Realized Gains / Losses Unrealized Gains / Losses Amortized Cost Unrealized Gains / Losses flow into Equity Realized Gains / Losses Amortized Cost Realized Gains / Losses Realized gain / loss is the gain or loss that results from selling a security Unrealized gain / loss is the gain or loss that results from a change in market value Amortized cost is the purchase price + / - premium or discount 13 Fixed and Other Assets Land Buildings and equipment Depreciation expense is contra account used to allocate the cost of the asset over the years of usage Other Assets Prepaid expenses operating cost paid for a service that will occur in the future NCUSIF / FDIC 14

8 Liabilities Deposits and borrowings Non-maturity deposits Time deposits FHLB advances Accrued expense an expense incurred but not paid Salaries Benefits 401K, life insurance 15 Equity Regular reserves Minimum required reserves each financial institution must retain Undivided earnings Cumulative net income that has not been distributed Other comprehensive income Unrealized gains / losses on AFS securities Gains and losses on derivatives used as hedges Actuarial gains and losses on defined benefit plans recognized 16

9 Income Statement Income Interest income Other income Expense Interest expense Other expense income expense = net income 17 Income Statement Equation Interest income - Interest expense. Net interest income - Provision for loan loss + Other income - Other expense. Net income 18

10 Income Sources Consumer and mortgage loan income Investment income Late fees Overdraft fees ATM fees Gain on sale fixed assets 19 Expense Sources Interest expense on non-maturity deposits and certificates Interest on borrowings Salaries Employee benefits Building expenses Taxes, cleaning fees, utilities Legal fees Operating fees Advertisements, postage Loan loss provision expense 20

11 Provision for Loan Loss Current period provision set aside for probable loan losses Used to transfer funds to the allowance for loan loss account on the balance sheet If asset quality declines and an increase in provision for loan loss is warranted, this will have a negative impact on net income 21 Financial Statement Analysis Financial statements Record the financial data Financial statement analysis Process of reviewing the financials (balance sheet and income statement) to gain an understanding of the financial stability of an institution 22

12 Points to Consider Ratio analysis Trends Time series trend Evaluate how the balance sheet changes over time Cross-sectional trend Compare the balance sheet ratios with your peers Is there an unusual or infrequent or extraordinary item that appears frequently? Gains or losses One time events do happen all the time 23 Key Ratios Capital adequacy Asset quality Earning and operating Liquidity 24

13 Capital Adequacy Ratio Net worth ratio = total net worth / total assets This ratio measures net worth in relation to total assets High versus low net worth ratio Institution A Institution B 12.67% 7.20% 25 26

14 Asset Quality Ratios Delinquency ratio = (Delinquent loans / total loans) x 100 Delinquent loans are over 60 days past due Indicates potential loan losses or loan quality Low ratio could indicate too restrictive underwriting standards An increasing ratio could be an indication of a future impact to earnings Coverage ratio = Allowance for loan loss / delinquent loans Delinquent loans are over 60 past due How much does the allowance for loan loss cover the current delinquent loans? 27 Asset Quality Ratios Charge off ratio= Net charge offs / average loans x 100 Net charge offs are total charge offs minus loan recoveries Annualize by multiplying the charge off ratio by 12 and divide by the months reported Measures net charge offs in relation to average loans Indicates the effectiveness of lending / collection practices or a change in liquidated asset value The lower the ratio, the lower the amount of loan losses were realized on loans 28

15 Earnings Ratios Return on assets (ROA) = Net income / total average assets x 100 Annualize by multiplying ROA by 12 and divide by the months reported How efficiently is the institution operating? How much income is balance sheet generating from each dollar worth of assets? 29 30

16 Earnings Ratios Total yield on earning assets = Interest income / average interest-earning assets This calculation can be used for loans and investments Keep in mind the loan and investment portfolio composition Will be impacted by the market rate environment 31 32

17 33 Earnings Ratios Total cost of funding = Interest expense / average interest-bearing liabilities Keep in mind the following: Deposit Composition Rate Environment Deposit Specials 34

18 35 Earnings Ratios Net interest spread Total yield on earning assets total cost of funding Critical to manage this spread A wider spread allows management to operate with more flexibility Net interest margin (NIM) Net interest income / average interest-earning assets Indicative of lending, investing and deposit cost strategies 36

19 37 Operating Ratios Efficiency ratio Net interest expense / (net interest income + non-interest income) Measures the cost to generate each dollar of income Operating expenses to average assets How efficiently is the financial institution using funds to provide services 38

20 Liquidity Ratios Loans-to-assets This measures total loans outstanding as a percentage of assets Loans-to-deposits This is the ratio of total loans outstanding to total non-maturity and time deposits If deposits are increasing faster than loans, this ratio would decline Cash + short term investments / assets Cash on deposit at other financial institutions Short term investments is the sum of investment cash flows in the next 12 months 39 40

21 Gauging Ratios Is it Good or Bad? Trends Are the ratios over time increasing or decreasing? Peer groups NCUA / FDIC website Software available 41 Common Size Balance Sheet Divide each balance sheet account by total assets Assets FY 2012 % TA Total Cash on Hand 3, % New Vehicle Loans 45, % Used Vehicles 80, % Credit Card Loans 16, % Unsecured Loans 23, % Secured Loans 41, % HELOCs 62, % Home Equity Fixed 55, % 10 Year Mortgages 52, % 15 Year Mortgages 83, % 30 Year Mortgages 121, % Total Loans 581, % Allowance for Loan Losses -6, % Net Loans 575, % 42

22 Impact of Specific Activities What interest income or expenses are tied to these activities? Equally important, what risks accompany these activities? Associated risks: Credit Liquidity Interest rate Reputation How are these risks managed? Internal controls Policy limits 43 Conclusion Basic financial skills will enable a Director to be positioned to fully represent the best interests of the financial institution, and therefore the institution s members The regulator s intent is NOT to increase examiner scrutiny of board members but to ensure adequate training and policies are implemented 44

23 BREAK 45 UNDERSTANDING NII AND GAP ANALYSES June 13, 2013 Presented By Travis Goodman, CFA Senior Financial Advisor

24 Agenda Define interest rate risk (IRR) Measurement tools Gap Types, assumptions, and examples Interpreting and utilizing results Net interest income (NII) Scenarios, assumptions, and outputs Interpreting and utilizing results 47 What is Risk? Possibility of an event occurring that will have an impact on the achievement of objectives Variance between outcome and expectation Interest rate risk The possibility of an increase or decrease in value and income resulting from a change in interest rates 48

25 Risk Measurement Tools Behavioral gap (typically referred to as just gap) Static cash flow perspective Net interest income simulation Earnings perspective 49 What is Gap? Gap is a method of attempting to quantify IRR by the mismatch between assets and liabilities repricing over relevant intervals Example: A higher positive gap will indicate that the financial institution is more sensitive to interest rate changes on the asset side of the balance sheet Assets Year 1 $100 million - Liabilities Year 1 $85 million = Mismatch Year 1 $15 million 50

26 Gap Analyses Behavioral gap (mentioned above) Incorporates behavioral characteristics to designate location of cash flows (i.e. includes repricing, prepayments) Assumptions Repricing buckets (the time frames of the intervals) Prepayment speeds Non-maturity deposit cash flows 51 Gap Results Running a gap analysis provides two measurements: Periodic Gap: The static mismatch of assets and liabilities within the one defined time period Cumulative Gap: The summation of all periodic gaps at that point, or the overall effect of periodic gaps across multiple time periods Results can be expressed in different forms: A nominal amount ($) A ratio (typically assets over liabilities in that period) A percentage (e.g. the nominal amount over total assets) 52

27 What Do The Gap Results Provide? A determination if the balance sheet in the base case is asset or liability sensitive Short-term risk measurement of asset and liability repricing Insight to short-run liquidity management 53 NCUA Guidelines Using the behavioral gap, the NCUA sets out parameters for the one-year cumulative gap Low risk +/- 10% Moderate risk +/- 10% to +/-20% High risk +/- 20% 54

28 Asset Sensitive Gap ($,000 omitted) First Year Repricing 0-3 mos 4-6 mos 7-12 mos ASSETS Consumer Loans 82,501 35,106 66,096 Auto Loans 26,893 26,328 49,619 Home Equity Loans 12,438 3,756 6,987 Mortgage Loans 19,404 19,605 30,405 Total Investments 9,239 6,142 7,321 CD Bank 2,149 3,623 2,546 Overnight 1, Total Rate-Sensitive Assets 111,144 60, ,823 LIABILITIES Total NMD 21,668 21,668 43,336 Savings Accounts 4,571 4,571 9,142 Checking Accounts 2,741 2,741 5,482 Money Markets 14,356 14,356 28,712 Total Time Deposits 73,129 37,507 45,673 Total Borrowings 1, Total Rate-Sensitive Funding 95,847 59,175 89,009 Periodic Gap 15,297 1,678 14,813 Gap Ratio Gap as Percent Assets 2.09% 0.23% 2.02% Cumulative Gap 15,297 16,976 31,789 Gap Ratio Gap as Percent Assets 2.09% 2.32% 4.34% 55 Liability Sensitive Gap ($,000 omitted) First Year Repricing 0-3 mos 4-6 mos 7-12 mos ASSETS Consumer Loans 26,579 24,367 43,822 Auto Loans 11,163 10,234 18,405 Home Equity Loans 10,100 9,259 16,652 Mortgage Loans 26,082 6,982 12,788 Total Investments 25,052 3,009 6,500 CD Bank 15,875 1,907 4,119 Overnight 1, Total Rate-Sensitive Assets 77,713 34,358 63,110 LIABILITIES Total NMD 58,966 51,490 69,051 Savings Accounts 42,845 34,029 36,412 Checking Accounts 1,765 3,105 3,927 Money Markets 14,356 14,356 28,712 Total Time Deposits 21,115 28,676 65,862 Total Borrowings 1, Total Rate-Sensitive Funding 81,131 80, ,913 Periodic Gap (3,418) (45,808) (71,803) Gap Ratio (0.96) Gap as Percent Assets -0.35% -4.73% -7.41% Cumulative Gap (3,418) (49,226) (121,029) Gap Ratio Gap as Percent Assets -0.35% -5.08% % 56

29 Full Gap Example ($,000 omitted) First Year Repricing Post First Year Total 0-3 mos 4-6 mos7-12 mos 1-2 yrs 2-3 yrs 3-5 yrs 5-10 yrs > 10 yrs Balance ASSETS Consumer Loans 82,501 35,106 66, ,501 72,012 73,419 47,127 26, ,755 Auto Loans 26,893 26,328 49,619 79,937 47,314 34,988 3, ,236 Home Equity Loans 12,438 3,756 6,987 12,099 9,861 14,498 16,938 4,485 81,062 Mortgage Loans 19,404 19,605 30,405 35,283 21,060 19,673 9, ,221 Total Investments 9,239 6,142 7,321 15,082 4,469 7,563 11,582 2,154 63,553 CD Bank 2,149 3,623 2,546 8,861 1,712 5, ,870 Overnight 1, ,107 Total Rate-Sensitive Assets 111,144 60, , ,865 97, ,655 68,609 30, ,528 LIABILITIES Total NMD 21,668 21,668 43,336 86,672 86,672 90,599 85, ,906 Savings Accounts 4,571 4,571 9,142 18,283 18,283 36,566 30, ,888 Checking Accounts 2,741 2,741 5,482 10,964 10,964 21,928 54, ,641 Money Markets 14,356 14,356 28,712 57,424 57,424 32, ,377 Total Time Deposits 73,129 37,507 45,673 50,022 19,345 25, ,524 Total Borrowings 1, ,050 Total Rate-Sensitive Funding 95,847 59,175 89, , , ,419 85, ,480 Periodic Gap 15,297 1,678 14,813 23,172 (8,475) (15,763) (16,711) 30,037 Gap Ratio Gap as Percent Assets 2.09% 0.23% 2.02% 3.16% -1.16% -2.15% -2.28% 4.10% Cumulative Gap 15,297 16,976 31,789 54,961 46,486 30,723 14,012 44,049 Gap Ratio Gap as Percent Assets 2.09% 2.32% 4.34% 7.50% 6.35% 4.19% 1.91% 6.01% 57 Gap Analysis Caution Don t put too much emphasis on gap NEV and NII analyses are much more robust This analysis by itself cannot properly capture the interest rate risk of the balance sheet 58

30 Gap Advantages and Disadvantages Advantages: Ease of use Intuitive Disadvantages: Ignores yield curve changes Ignores any option value Does not address economic value View is static and focuses on one period of measurement Does not capture income: the institution could have investments at 1.00% and funding at 3.00% 59 Income Statement Equation Interest income - Interest expense. Net interest income - Provision for loan loss + Other income - Other expense. Net income 60

31 Net Interest Income Analysis Remember the purpose of any analysis In the case of NII, the purpose is not budgetary That is, the primary goal is not to determine the projected income for the institution over a given time period To do so would require balance and rate projections The goal is to project the volatility of earnings in changing (rising / declining) interest rate environments NII is then compared in alternative scenarios in order to evaluate interest rate risk 61 NII Assumptions Rate Environment ramp and shock scenarios Horizon Period 12 to 24 months Balances are held constant Reinvestment Rates offering or market rates 62

32 NII Scenarios Declining Base Rising Shock Up basis points = 0.25% 100 basis points = 1.00% Scenarios include: Base scenario - rates are held constant Declining scenario - rates decrease 25 basis points per month for 12 months (resulting in a down 300 over 1 year) Rising scenario - rates increase 25 basis points per month for 12 months (resulting in an up 300 over 1 year) Shock up 300 scenario - rates shock immediately 300 basis points and hold at that level indefinitely 63 NII Projected Outputs Projected interest income Projected interest expense Projected NII and net income Percent change from base model Asset yields and costs of funding Net interest spread Net interest margin Return on assets 64

33 Earnings Simulation Steps Steps to produce the net interest income simulation Use actual loan level detail into a model Month end balance sheet is the starting point Over a 12 month period, the model takes all monthly cash flows (monthly principal received, any additional principal, maturities) and reinvest these cash flows back into the same asset / liability at current offering rates or market rates for investments Important: balance sheet is held constant 65 Reinvestment of Cash flows Example Current Offering Rate = 3.00% Month 1 Month 2 Month 3 $600K Principal $400K Principal $375K Principal Base 3.00% 3.00% 3.00% Declining 2.75% 2.50% 2.25% Rising 3.25% 3.50% 3.75% Shock Up % 6.00% 6.00% 66

34 NII Simulation Output: Income ($,000 omitted) Declining Base Rising Up 300 Difference ASSETS Consumer Loans 23,894 24,882 26,280 28,136 3,254 Mortgage Loans 7,615 7,713 8,151 8,747 1,034 Total Investments 1,245 1,312 1,542 1, Total Interest Income 32,754 33,907 35,973 38,608 4,701 LIABILITIES Total NMD 907 1,121 2,512 3,688 2,567 Total Time Deposits 2,223 2,665 3,725 5,289 2,624 Total Borrowings Total Interest Expense 3,130 3,809 6,366 9,194 5,386 Net Interest Income 29,624 30,098 29,607 29,413 (685) Net Interest Income Volatility -1.58% % -2.27% -2.27% Between base and shock 300 scenarios, interest income increases $4,700, but interest expenses increase $5,386 This results in a decrease in net interest income of $685 which is a reduction of 2.27% 67 NII Simulation Output: Yields ($,000 omitted) Declining Base Rising Up 300 Difference ASSETS Consumer Loans Mortgage Loans Fixed Mortgages Adjustable Mortgages Total Investments CD Bank Overnight Yield on Assets LIABILITIES Total NMD Savings Account Checking Account Money Markets Total Time Deposits Total Borrowings Yield on Liabilities Net Interest Spread (0.14) Net Interest Margin (0.09) Yield is the 12 month projected income (expense) divided by the average balance 68

35 NII Simulation Output: Low Volatility ($,000 omitted) Declining Base Rising Up 300 Difference ASSETS Consumer Loans 25,089 24,882 27,594 29,543 4,661 Mortgage Loans 7,995 7,713 8,558 9,185 1,472 Total Investments 1,308 1,312 1,619 1, Total Interest Income 34,392 33,907 37,771 40,538 6,631 LIABILITIES Total NMD 1,270 1,121 3,517 5,163 4,042 Total Time Deposits 3,112 2,665 5,216 7,405 4,739 Total Borrowings Total Interest Expense 4,382 3,809 8,913 12,872 9,063 Net Interest Income 30,009 30,098 28,859 27,666 (2,432) Net Interest Income Volatility -0.29% % -8.08% -8.08% 69 NII Simulation Output: High Volatility ($,000 omitted) Declining Base Rising Up 300 Difference ASSETS Consumer Loans 22,699 24,882 24,966 26,729 1,847 Mortgage Loans 7,234 7,713 7,743 8, Total Investments 1,183 1,312 1,465 1, Total Interest Income 31,116 33,907 34,174 36,677 2,771 LIABILITIES Total NMD 1,632 1,121 4,522 6,638 5,517 Total Time Deposits 4,001 2,665 6,706 9,520 6,855 Total Borrowings Total Interest Expense 5,635 3,809 11,459 16,550 12,741 Net Interest Income 25,482 30,098 22,715 20,127 (9,971) Net Interest Income Volatility % % % % 70

36 NCUA Guidelines Change in NII (shock up 300) Low risk > -20% Moderate risk -20% to -30% High risk < -30% Change in net income (shock up 300) Low risk > -40% Moderate risk -40% to -75% High risk < -75% 71 What do NII Results Provide? Earnings at risk due to changing interest rates Breakdown of interest income and interest expense by category type Potential balance sheet issues (both before and after interest rate changes) 72

37 NII Advantages and Disadvantages Advantages Intuitive sense Easy to interpret results Multiple scenarios (allows for comparison) Can capture optionality Disadvantages Set time period Lacks value perspective Like any model, assumptions are key 73 Conclusion Gap shows how assets and liabilities are repricing Allows for new volume planning NII shows projected interest income and interest expense Measures how interest rate changes affect the credit union s projected income stream Shows which accounts are most sensitive to interest rate changes from an income perspective 74

38 BREAK 75 UNDERSTANDING NET ECONOMIC VALUE ANALYSES June 13, 2013 Presented By Travis Goodman, CFA Senior Financial Advisor

39 Agenda What is economic value? Net economic value (NEV) Importance of the NEV analysis How to use the results of an NEV analysis Determining risk tolerance 77 Interest Rate Risk In finance, risk = volatility An income analysis measures the earnings volatility in various interest rate scenarios An economic value analysis measures the value volatility in various interest rate scenarios 78

40 What is Economic Value? Economic value The present value (PV) of the balance sheet Economic Value of Assets - Economic Value of Liabilities = NEV Objectives Understand risk Understand how to manage risk to maximize income while ensuring stability 79 Purposes of Calculating Economic Value Measuring interest rate risk to capital Understanding the trade-offs between risk and return Measuring the effective duration of assets and liabilities Conducting what-if analyses to test the balance sheet 80

41 Why Estimate Economic Value? Superior to cost accounting information Captures interest and principal cash flows Provides an analysis of options risk Allows for comparisons between different scenarios More complete than the income simulation Properly managing NEV can reduce the volatility of earnings and net worth 81 Economic Value Measurements Economic value percent change The projected net gain or loss of economic value assuming changes in interest rates, relative to the starting value The sensitivity of capital to changes in interest rates Economic value ratio A measurement of capital adequacy from an IRR perspective Calculated: economic value of equity / economic value of total assets 82

42 Calculating Prices Present value: The current worth of a future stream of cash flows given a specified rate of return Future cash flows are discounted at a discount rate (usually some kind of market rate); as such, the higher this rate, the lower the present value of the cash flows This discount rate will change in the model according to the interest rate scenario Prices, as opposed to market values or gains / losses, allow equal comparisons between all types and all sizes 83 Calculating Prices Example 1: Fixed mortgage portfolio Book value $166,269,000 Book rate 4.32% Market (discount) rate 2.83% Market value $173,302,000 Gain / (loss) $7,033,000 Price

43 Calculating Prices Example 2: Auto portfolio Book value $268,236,000 Book rate 4.53% Market (discount) rate 2.72% Market value $273,528,000 Gain / (loss) $5,292,000 Price Calculating Prices Comparison 30-year mortgage gain $7,033, year mortgage price Auto gain $5,292,000 Auto price Even though the auto rate is higher and its discount rate (i.e. the market rate) is lower, its price is lower Why? 86

44 Calculating Prices The discounted cash flow (DCF) approach takes into account the full term of the loan. The longer mortgage has a smaller premium over more time, rather than a higher premium over a shorter time. This results in a higher price: Mortgage Premium Auto Premium Cash flows A premium of 3 units over 10 units of time (30) is less than a premium of 2 units over 36 units of time (72) 87 Calculating Prices Economic values are calculated for all assets and liabilities in all scenarios The difference in the value of assets and liabilities results in the economic value of capital Example: Value of Assets $10 million - Value of Liabilities $8 million. = Value of Equity $2 million 88

45 Economic Value (Micro) Selected Asset Prices (Highlighted are the earlier examples) 89 Economic Value (Micro) Selected Asset Values (Highlighted are the earlier examples) 90

46 Economic Value (Micro) Selected Liability Prices We can see that the savings account is priced below par in the base case (which is a gain for the institution as it increases base case capital), whereas the checking account it priced above par in the base case (which is a detriment to the institution by reducing capital) 91 Economic Value (Micro) Selected Liability Values The full economic values, based on the prices, are shown 92

47 Economic Value (Macro) Taking into account all of the gains or losses from assets and subtracting out the gains or losses from liabilities results in the total gain or loss to capital Remember: Economic Value of Assets - Economic Value of Liabilities. = NEV 93 Economic Value (Macro) ($,000 omitted) INTEREST RATE SCENARIO (200) (100) Base CURRENT ANALYSIS Change in Economic Value of Assets 29,948 24,436 12,590-5,177-23,577-41,934 - Change in Economic Value of Liabilities 30,187 19,061 2,417-13,783-27,735-39,338 Change in Economic Value of Capital ,375 10,173 8,606 4,158-2,596 + Book Capital 72,255 72,255 72,255 72,255 72,255 72,255 Economic Value of Book Capital 72,016 77,630 82,428 80,861 76,413 69,659 NEV Dollar Change (10,412) (4,798) - (1,567) (6,015) (12,769) Effective Duration Mismatch -0.38% -0.85% -0.46% 0.16% 0.56% 0.90% NEV Ratio 9.06% 9.84% 10.60% 10.65% 10.31% 9.64% NEV Percentage Change % -5.82% 0.00% -1.90% -7.30% % 94

48 Economic Value Percent Change 10.0% 0.0% -10.0% Low Risk -20.0% -30.0% -40.0% -50.0% High Risk -60.0% Base Economic Value Ratio 10.0% 8.0% Low Risk 6.0% 4.0% 2.0% Base High Risk 96

49 Effective Duration Effective duration is the fundamental concept of interest rate risk This measures the price sensitivity of a stream of cash flows for a given change in interest rates Note: even though the name is duration, it is measured in percentage terms (a sensitivity) not in years (a length) Effective duration takes into account the fact that expected cash flows will change as interest rates move 97 Effective Duration Example Effective duration helps estimate performance in other scenarios: Effective Duration 2.00% PRICE Actual Price: Base Price: 100 Actual Price: Shock Down 100 Shock Up 100 LEVEL OF RATES 98

50 Effective Duration (Micro) The attributes of the account will impact its price sensitivity 99 Effective Duration (Macro) 100

51 Effective Duration Mismatch Effective duration mismatch is the difference between the ED of assets and the ED of liabilities The ED mismatch in the shock up 300 scenario compared to the ED mismatch in the base case scenario indicates how much interest rate risk is present in the balance sheet Managing effective duration also helps manage risk and earnings 101 Effective Duration Mismatch When the mismatch is 0.00%, that is the rate environment in which assets and liabilities would be equally sensitive to a change in interest rates When the mismatch is positive, assets are more sensitive, and when the mismatch is negative, liabilities are more sensitive 102

52 NEV Risk Tolerance NEV percent change in an up 300 shock Low risk > -25% Moderate risk -25% to -50% High risk < -50% NEV ratio in an up 300 shock Low risk > 6% Moderate risk 4% to 6% High risk < 4% 103 NEV Risk Tolerance Complete sensitivity Use the NEV percent change along with the NEV ratio to determine overall profile limits The credit union could have an aggressive NEV percent change, but a neutral or conservative NEV ratio Guideposts for either can be adjusted based on the direction of the board Those institutions with higher capital ratios can, in theory, afford more risk 104

53 NEV Risk Tolerance The negative impact to capital is only revealed if and when these adverse rate environments actually occur High NEV changes portend income changes in adverse environments; the NEV ratio floor or the NEV percent change floor may be secondary if income is critical 105 Analyses Comparison Gap and NII Use accounting-based measures of risk rather than marketbased measures Is forward looking, in the sense that it captures the next 12 months of changes But, it only measures that period of time NEV This approach attempts to capture the economic value, and not just the accounting (book) value It evaluates the impact of interest-rate changes on all future cash flows, and not just a defined short period of time Both are heavily influenced by assumptions 106

54 Conclusion The NEV analysis has benefits It analyzes all cash flows It includes relative value It includes optionality But there are also drawbacks It is measured at one point in time It is strongly influenced by the way NMDs are valued The static NEV is based on the current balance sheet only The board and ALCO should Understand the intent of the analysis and what the results show Understand the assumptions and how they impact the results Know about risk management strategies 107 BREAK 108

55 UNDERSTANDING ALM REPORTS June 13, 2013 Presented By Travis Goodman, CFA Senior Financial Advisor Agenda The story of an ALM report Report construction Table of contents Key pages How to interpret results 110

56 Report Construction ALM review Asset and liability allocation Macro summary of all three tests Net interest income (NII) and net income (NI) macro NII and NI micro Economic value (NEV) - macro NEV micro 111 Table of Contents 112

57 ALM Review ALM narrative change from previous should include: Discussion on economic value Discussion on NII Major changes in balance sheet structure Major influences to changing risk parameters Were financial institution influences the major reason risk changed? Were market influences the major reason risk changed? 113 ALM Review ALM results Important that your ALM results are detailed enough to provide meaningful information so that accurate decisions can be made ALM for practitioners cannot be accurately portrayed in 5 pages Should always be compared to previous analysis 114

58 Asset and Liability Allocation Sets expectation for what should happen to results Increase in risky balance sheet items risk should increase Decrease in risky balance sheet items risk should decrease 115 Asset and Liability Allocation BALANCE SHEET COMPOSITION - ASSETS September 30, 2012 TYPE 30-Jun Sep-12 Difference Consumer Loans 495, % 509, % 14, % Mortgage Loans 152, % 150, % (1,326) -0.39% Investments 72, % 65, % (7,363) -1.06% Other Assets 38, % 40, % 2, % Total Assets 757, % 766, % 8, % PREVIOUS MIX Other Assets 5% Investments 10% Mortgage Loans 20% Consumer Loans 65% CURRENT MIX Other Assets Investments 5% 8% Mortgage Loans 20% Consumer Loans 67% Consumer Loans Mortgage Loans Investments Other Assets 116

59 Trend Analysis ANALYTICAL MEASURES 30-Sep Jun Mar Dec Sep-11 NEV Percent Change Up % % % % % NEV Ratio Base 10.60% 10.47% 10.74% 10.29% 9.85% NEV Ratio Up % 9.39% 9.22% 8.31% 7.66% Shock-Up 300 Scenario NII Volatility -2.75% -2.27% -2.11% 0.61% -0.98% Rising Rate Scenario NII Volatility -1.38% -1.63% -1.18% -0.10% -0.13% Declining Rate Scenario NII Volatility -1.70% -1.58% -1.73% -1.78% -2.13% Base Case Return on Assets 0.40% 0.90% 0.70% 0.47% 0.42% Base Case Net Interest Margin 4.15% 4.14% 4.22% 4.07% 4.13% 1-Year Cumulative Gap 4.34% 3.91% 2.85% 4.61% 5.37% 117 ALM Overview NEV ANALYSIS (200) (100) Base NEV Ratio 9.84% 10.60% 10.65% 10.31% 9.64% 8.69% 7.72% NEV Percent Change % -5.82% 0.00% -1.90% -7.30% % % % Eff. Duration Mismatch -0.38% -0.85% -0.46% 0.16% 0.56% 0.90% 1.05% --- INCOME ANALYSIS Declining Base Rising Shock Up 300 Net Interest Income $29,634 $30,148 $29,731 $29,318 % Change from Base -1.70% 0.00% -1.38% -2.75% Net Income $2,582 $3,096 $2,679 $2,266 % Change from Base % 0.00% % % Return on Assets 0.34% 0.40% 0.35% 0.30% 11.00% 10.50% 10.00% 9.50% 9.00% 8.50% 8.00% NEV RATIO (200) (100) Base $30,400 $30,200 $30,000 $29,800 $29,600 $29,400 $29,200 $29,000 $28,800 NII AND ROA Declining Base Rising Shock Up % 0.40% 0.35% 0.30% 0.25% 0.20% 0.15% 0.10% 0.05% 0.00% 118

60 Net Interest Income Simulation Net interest income (NII) and net income (NI) Macro Summary of NII volatility Summary of NI volatility Interest income volatility Interest expense volatility Micro Individual loan and investment accounts Individual deposit accounts 119 Net Interest Income Simulation NII comparison report One of the most important income pages Income is an output that can only change if: Balances change Rates change Prepay speeds change Clearly explains how income has been generated or lost since the previous analysis 120

61 Net Interest Income Simulation CURRENT ANALYSIS Declining Base Rising Shock Up 300 Interest Income $ 32,684 $ 33,892 $ 35,971 $ 38,684 % Change from Base -3.57% 0.00% 6.13% 14.14% Interest Expense $ 3,050 $ 3,744 $ 6,239 $ 9,365 % Change from Base % 0.00% 66.64% % Net Interest Income $ 29,634 $ 30,148 $ 29,731 $ 29,318 % Change from Base -1.70% 0.00% -1.38% -2.75% Other Income $ 8,902 $ 8,902 $ 8,902 $ 8,902 Provision for Loan Loss $ 4,966 $ 4,966 $ 4,966 $ 4,966 Other Expenses $ 30,988 $ 30,988 $ 30,988 $ 30,988 Net Income $ 2,582 $ 3,096 $ 2,679 $ 2,266 % Change from Base % 0.00% % % Total Yield on Earning Assets 4.50% 4.67% 4.96% 5.33% Total Cost of Paying Liabilities 0.44% 0.54% 0.91% 1.36% Net Interest Spread 4.06% 4.12% 4.05% 3.97% Net Interest Margin 4.08% 4.15% 4.10% 4.04% Return on Assets 0.34% 0.40% 0.35% 0.30% 121 Net Interest Income Simulation Base Jun-12 Sep-12 Difference ($,000 omitted) Average Average Average Average Average Average Balance Rate Balance Rate Balance Rate Income Income Income ASSETS Consumer Loans 24, , , , ,728 (0.10) Auto Loans 9, , , , ,217 (0.08) Home Equity Loans 4,701 82, ,536 81, (164) (1,856) (0.07) Mortgage Loans 7, , , , (29) (1,326) 0.03 Fixed Mortgages 5, , , , (21) (1,845) 0.05 Adjustable Mortgages 1,722 31, ,715 32, (7) 627 (0.13) Total Investments 1,312 74, ,101 65, (211) (9,375) (0.07) CD Bank , , (76) (3,731) (0.07) CMOs 67 7, , (35) (1,061) (0.39) Overnight 13 6, , (7) (3,532) 0.00 Total Interest Income 33, , , , (15) 4,027 (0.03) LIABILITIES Total NMD 1, , , , , Savings , , Checking , , , Money Markets , , , Total Time Deposits 2, , , , (68) 8,676 (0.06) CDs 1, , , , (39) 10,095 (0.07) Total Borrowings 23 6, , (19) (5,450) (0.04) Total Interest Expense 3, , , , (65) 8,400 (0.02) Net Interest Income/Spread 30, , (0.01) Net Interest Margin (0.02) 122

62 Net Interest Income Simulation Jun-12 Sep-12 Difference ($,000 omitted) Shock Shock Shock Declining Base Rising Up 300 Declining Base Rising Up 300 Declining Base Rising Up 300 ASSETS Consumer Loans 23,894 24,882 26,280 28,136 24,076 25,107 26,560 28, Auto Loans 9,331 9,508 10,116 11,019 9,675 9,873 10,516 11, Home Equity Loans 4,473 4,701 4,902 5,167 4,313 4,536 4,734 4,993 (160) (164) (168) (174) Mortgage Loans 7,615 7,713 8,151 8,747 7,577 7,685 8,126 8,733 (37) (29) (25) (14) Fixed Mortgages 5,893 5,991 6,328 6,809 5,866 5,970 6,303 6,771 (27) (21) (25) (38) Adjustable Mortgages 1,722 1,722 1,823 1,939 1,712 1,715 1,824 1,962 (10) (7) 1 23 Total Investments 1,245 1,312 1,542 1,724 1,030 1,101 1,284 1,469 (215) (211) (258) (255) CD Bank (83) (76) (65) (18) CMOs (40) (35) (31) (34) Overnight (3) (1) (7) (72) (116) Total Interest Income 32,754 33,907 35,973 38,608 32,684 33,892 35,971 38,684 (70) (15) (2) 76 LIABILITIES Total NMD 907 1,121 2,512 3, ,143 2,557 3, Savings Checking Money Markets ,654 2, ,684 2, Total Time Deposits 2,223 2,665 3,725 5,289 2,123 2,597 3,661 5,587 (100) (68) (64) 298 CDs 1,499 1,843 2,678 3,905 1,426 1,804 2,667 4,235 (73) (39) (11) 330 Total Borrowings (0) (19) (108) (183) Total Interest Expense 3,130 3,809 6,366 9,194 3,050 3,744 6,239 9,365 (81) (65) (127) 171 Net Interest Income 29,624 30,098 29,607 29,413 29,634 30,148 29,731 29, (95) 123 Net Interest Income Simulation Jun-12 Sep-12 Difference (% omitted) Shock Shock Shock Declining Base Rising Up 300 Declining Base Rising Up 300 Declining Base Rising Up 300 ASSETS Consumer Loans (0.10) (0.10) (0.10) (0.10) Auto Loans (0.08) (0.08) (0.08) (0.08) Home Equity Loans (0.07) (0.07) (0.07) (0.07) Mortgage Loans Fixed Mortgages Adjustable Mortgages (0.14) (0.13) (0.11) (0.05) Total Investments (0.09) (0.07) (0.10) (0.05) CD Bank (0.11) (0.07) (0.00) 0.21 CMOs (0.48) (0.39) (0.30) (0.32) Overnight (0.05) (0.05) (0.00) 0.00 (0.01) 0.01 Yield on Interest-Bearing Assets (0.03) (0.03) (0.03) (0.02) LIABILITIES Total NMD Savings Checking Money Markets Total Time Deposits (0.07) (0.06) (0.08) 0.04 CDs (0.08) (0.07) (0.08) 0.06 Total Borrowings (0.00) (0.04) (0.03) (0.04) Yield on Interest-Bearing Liabilities (0.02) (0.02) (0.03) 0.01 Net Interest Spread (0.02) (0.01) 0.00 (0.03) Net Interest Margin (0.02) (0.02) (0.01) (0.04) 124

63 Net Interest Income Simulation Interest income and expense variability Two tests shown: % change from base (compared to the same account) % of total change from base (compared to total change in income) When compared to previous report, this can be a very powerful page 125 Net Interest Income Simulation Current % Change from Base Current % of Total Change from Base % of Total Shock Shock Earn Asset / Declining Rising Up 300 Declining Rising Up 300 Pay Liabilities ASSETS Consumer Loans -4.1% 5.8% 13.4% 85.3% 69.9% 70.4% 70.4% Auto Loans -2.0% 6.5% 16.1% 16.4% 30.9% 33.2% 37.0% Home Equity Loans -4.9% 4.3% 10.1% 18.5% 9.5% 9.5% 11.2% Mortgage Loans -1.4% 5.7% 13.6% 8.9% 21.2% 21.9% 20.8% Fixed Mortgages -1.7% 5.6% 13.4% 8.6% 16.0% 16.7% 17.1% Adjustable Mortgages -0.2% 6.4% 14.5% 0.3% 5.2% 5.2% 4.4% Total Investments -6.4% 16.7% 33.5% 5.8% 8.8% 7.7% 8.8% CD Bank -5.1% 14.9% 42.1% 1.6% 2.7% 3.3% 3.4% CMOs -40.9% 54.2% 80.0% 1.1% 0.8% 0.5% 0.9% Overnight % 839.4% % 0.6% 2.3% 1.3% 0.2% Total Interest Income -3.6% 6.1% 14.1% 100.0% 100.0% 100.0% 100.0% LIABILITIES Total NMD -19.0% 123.7% 227.4% 31.2% 56.7% 46.3% 63.3% Savings -38.1% 248.5% 457.0% 6.0% 11.0% 8.9% 16.2% Checking -10.3% 67.2% 123.5% 2.3% 8.6% 6.9% 15.1% Money Markets -19.2% 125.5% 230.7% 11.9% 45.1% 36.0% 28.2% Total Time Deposits -18.3% 41.0% 115.1% 68.3% 42.6% 53.2% 36.5% CDs -20.9% 47.8% 134.8% 54.4% 34.6% 43.3% 28.0% Total Borrowings -98.4% 526.3% 967.7% 0.5% 0.7% 0.6% 0.2% Notes Payable -98.4% 526.3% 967.7% 0.5% 0.7% 0.6% 0.2% Total Interest Expense -18.5% 66.6% 150.1% 100.0% 100.0% 100.0% 100.0% Net Interest Income -1.7% -1.4% -2.8% 126

64 Economic Value Most important sections of the entire analysis Show the impact on the economic value of capital due to a change in interest rates Also goes from macro to micro Review comparison to previous report 127 Economic Value NEV Macro Change in fair value of assets Change in fair value of liabilities NEV dollar change NEV % change and NEV ratio Micro Asset and liability values Asset and liability prices Asset and liability gain / loss 128

65 Economic Value ($,000 omitted) INTEREST RATE SCENARIO (200) (100) Base CURRENT ANALYSIS Change in Economic Value of Assets 29,948 24,436 12,590-5,177-23,577-41,934 - Change in Economic Value of Liabilities 30,187 19,061 2,417-13,783-27,735-39,338 Change in Economic Value of Capital ,375 10,173 8,606 4,158-2,596 + Book Capital 72,255 72,255 72,255 72,255 72,255 72,255 Economic Value of Book Capital 72,016 77,630 82,428 80,861 76,413 69,659 NEV Dollar Change (10,412) (4,798) - (1,567) (6,015) (12,769) Effective Duration Mismatch -0.38% -0.85% -0.46% 0.16% 0.56% 0.90% NEV Ratio 9.06% 9.84% 10.60% 10.65% 10.31% 9.64% NEV Percentage Change % -5.82% 0.00% -1.90% -7.30% % ($,000 omitted) INTEREST RATE SCENARIO (200) (100) Base CHANGE FROM PREVIOUS ANALYSIS Change in Economic Value of Assets 1, ,019 - Change in Economic Value of Liabilities ,253-1,405-1,328-1,242-1,141 Change in Economic Value of Capital 1,944 1,789 1,362 1,501 1,856 2,160 + Book Capital Economic Value of Book Capital 2,466 2,310 1,883 2,022 2,377 2,682 NEV Dollar Change Effective Duration Mismatch 0.04% 0.02% -0.04% -0.05% -0.05% NEV Ratio 0.21% 0.19% 0.13% 0.15% 0.20% 0.25% NEV Percentage Change 1.02% 0.67% 0.00% 0.22% 0.78% 1.35% 129 Economic Value NEV and effective duration comparison base and up 300 Identifies changes in: Prices Gain / loss Effective duration Changes in market rates are observed here Identifies reason for changes in first variable used to calculate NEV% change (base case NEV) 130

66 Economic Value - Base ($,000 / % omitted) Change In Jun-12 Sep-12 Difference Book Value Book Value Price G/L Eff Dur Price G/L Eff Dur Price G/L Eff Dur ASSETS Consumer Loans $509,930 $14, , , (0.03) Auto Loans $268,236 $15, , , (0.01) Home Equity Loans $81,062 -$1, (417) (464) 2.89 (0.07) (46) 0.06 Mortgage Loans $150,866 -$1, , , (0.33) (563) 0.12 Fixed Mortgages $124,076 -$1, , , (0.36) (576) 0.10 Adjustable Mortgages $32,145 $ (1,821) (1,808) Allowance for Loan Loss -$5,354 -$ Total Investments $63,553 -$7, , , (0.02) CD Bank $24,870 -$3, (0.34) CMOs $6,547 -$1, (0.76) (0.76) (0.12) (12) (0.00) Overnight $1,107 -$1, Other Assets $40,327 $2, Total Assets $764,676 $8, , , (0.02) (44) 0.00 Unrealized Gain/Loss $1,539 -$3 GAAP Assets $766,215 $8,245 LIABILITIES Total NMD $435,906 $5, , (0.25) (1,066) (0.01) Savings $111,649 $ (641) (1,001) 3.74 (0.32) (361) (0.03) Checking $109,641 $2, , , (0.44) (438) (0.02) Money Markets $204,377 $2, (0) (236) 2.09 (0.12) (236) 0.01 CDs $193,021 $10, , , (0.17) (239) (0.07) Notes Payable $1,050 -$5, Other Liabilities $3,941 -$ Total Liabilities $692,421 $7, , , (0.21) (1,405) (0.02) CAPITAL $72,255 $ ,811 (0.48) ,173 (0.46) , Unrealized Gain/Loss $1,539 -$3 GAAP Capital $73,794 $ Economic Value Up 300 ($,000 / % omitted) Change In Jun-12 Sep-12 Difference Book Value Book Value Price G/L Eff Dur Price G/L Eff Dur Price G/L Eff Dur ASSETS Consumer Loans $509,930 $14, (29,631) (29,667) (36) (0.03) Auto Loans $268,236 $15, (6,425) (6,918) 1.50 (0.04) (493) 0.01 Home Equity Loans $81,062 -$1, (7,914) (7,803) 2.92 (0.08) 112 (0.00) Mortgage Loans $150,866 -$1, (9,415) (9,124) (0.17) Fixed Mortgages $124,076 -$1, (5,778) (5,475) (0.18) Adjustable Mortgages $32,145 $ (3,637) (3,650) (13) 0.00 Allowance for Loan Loss -$5,354 -$ Total Investments $63,553 -$7, (3,907) (3,143) (0.07) CD Bank $24,870 -$3, (1,145) (752) (0.11) CMOs $6,547 -$1, (337) (229) (0.43) Overnight $1,107 -$1, Other Assets $40,327 $2, Total Assets $764,676 $8, (42,953) (41,934) ,019 (0.09) Unrealized Gain/Loss $1,539 -$3 GAAP Assets $766,215 $8,245 LIABILITIES Total NMD $435,906 $5, (32,457) (33,503) 1.99 (0.15) (1,046) (0.03) Savings $111,649 $ (11,016) (11,273) 2.50 (0.21) (257) (0.03) Checking $109,641 $2, (11,012) (11,554) 3.54 (0.28) (542) (0.03) Money Markets $204,377 $2, (9,488) (9,732) 0.93 (0.05) (243) (0.02) CDs $193,021 $10, (4,257) (4,292) (34) (0.09) Notes Payable $1,050 -$5, Other Liabilities $3,941 -$ Total Liabilities $692,421 $7, (38,197) (39,338) 1.62 (0.10) (1,141) (0.03) CAPITAL $72,255 $522 (0.10) (4,756) (2,596) ,160 (0.05) Unrealized Gain/Loss $1,539 -$3 GAAP Capital $73,794 $

67 Economic Value NEV comparison base and up 300 volatility Identifies the change in gain / loss between base and shock up 300 Identifies where NEV volatility is coming from Identifies changes in assumptions, cash flows, and balances Identifies reasons for change in second variable used to calculate NEV % change (up 300 $ change in NEV) 133 Economic Value - Volatility ($,000 omitted) Change In Jun-12 Sep-12 Difference Book Value Book Value Base Up 300 Difference Base Up 300 Difference Base Up 300 Difference ASSETS Consumer Loans $509,930 $14,728 3,662 (29,631) (33,293) 4,124 (29,667) (33,790) 461 (36) (497) Auto Loans $268,236 $15,217 5,013 (6,425) (11,439) 5,292 (6,918) (12,210) 278 (493) (771) Home Equity Loans $81,062 -$1,856 (417) (7,914) (7,497) (464) (7,803) (7,339) (46) Mortgage Loans $150,866 -$1,326 6,980 (9,415) (16,395) 6,416 (9,124) (15,541) (563) Fixed Mortgages $124,076 -$1,845 8,801 (5,778) (14,579) 8,225 (5,475) (13,699) (576) Adjustable Mortgages $32,145 $627 (1,821) (3,637) (1,816) (1,808) (3,650) (1,842) 13 (13) (26) Allowance for Loan Loss -$5,354 -$ Total Investments $63,553 -$7,361 1,992 (3,907) (5,899) 2,050 (3,143) (5,192) CD Bank $24,870 -$3, (1,145) (1,542) 511 (752) (1,263) CMOs $6,547 -$1, (337) (366) 18 (229) (247) (12) Overnight $1,107 -$1, Total Other Assets $40,327 $2, Other Assets $40,327 $2, Total Assets $764,676 $8,247 12,633 (42,953) (55,586) 12,590 (41,934) (54,523) (44) 1,019 1,063 Unrealized Gain/Loss $1,539 -$3 GAAP Assets $766,215 $8,245 LIABILITIES Total NMD $435,906 $5,174 1,354 (32,457) (33,811) 288 (33,503) (33,791) (1,066) (1,046) 20 Savings $111,649 $223 (641) (11,016) (10,375) (1,001) (11,273) (10,272) (361) (257) 104 Checking $109,641 $2,252 1,960 (11,012) (12,972) 1,521 (11,554) (13,076) (438) (542) (104) Money Markets $204,377 $2,882 (0) (9,488) (9,488) (236) (9,732) (9,496) (236) (243) (8) CDs $193,021 $10,156 1,600 (4,257) (5,857) 1,361 (4,292) (5,652) (239) (34) 205 Notes Payable $1,050 -$5, Other Liabilities $3,941 -$ Total Liabilities $692,421 $7,726 3,822 (38,197) (42,019) 2,417 (39,338) (41,755) (1,405) (1,141) 264 CAPITAL $72,255 $522 8,811 (4,756) (13,568) 10,173 (2,596) (12,769) 1,362 2, Unrealized Gain/Loss $1,539 -$3 GAAP Capital $73,794 $

68 Economic Value ($,000 omitted) INTEREST RATE SCENARIO (200) (100) Base CHANGE FROM PREVIOUS ANALYSIS Change in Economic Value of Assets 1, ,019 - Change in Economic Value of Liabilities ,253-1,405-1,328-1,242-1,141 Change in Economic Value of Capital 1,944 1,789 1,362 1,501 1,856 2,160 + Book Capital Economic Value of Book Capital 2,466 2,310 1,883 2,022 2,377 2,682 NEV Dollar Change Effective Duration Mismatch 0.04% 0.02% -0.04% -0.05% -0.05% NEV Ratio 0.21% 0.19% 0.13% 0.15% 0.20% 0.25% NEV Percentage Change 1.02% 0.67% 0.00% 0.22% 0.78% 1.35% LIABILITIES Total NMD 1,354 (32,457) (33,811) 288 (33,503) (33,791) (1,066) (1,046) 20 Savings (641) (11,016) (10,375) (1,001) (11,273) (10,272) (361) (257) 104 Checking 1,960 (11,012) (12,972) 1,521 (11,554) (13,076) (438) (542) (104) Money Markets (0) (9,488) (9,488) (236) (9,732) (9,496) (236) (243) (8) Total Time Deposits 2,468 (5,740) (8,208) 2,129 (5,834) (7,963) (339) (95) 245 CDs 1,600 (4,257) (5,857) 1,361 (4,292) (5,652) (239) (34) 205 IRA CDs 868 (1,482) (2,351) 768 (1,543) (2,311) (100) (60) 40 Notes Payable Other Liabilities Total Liabilities 3,822 (38,197) (42,019) 2,417 (39,338) (41,755) (1,405) (1,141) 264 CAPITAL 8,811 (4,756) (13,568) 10,173 (2,596) (12,769) 1,362 2, Unrealized Gain/Loss GAAP Capital 135 Economic Value Highest 7 accounts shown ASSETS Percent % Economic Previous % NEV Base Case NEV Up 300 Difference Allocation Change-Up 300 Change-Up 300 Major Asset Accounts: Fixed Mortgages 132, ,601 (13,699) 17.8% 25.1% 26.2% Auto Loans 273, ,318 (12,210) 36.8% 22.4% 20.6% Business Loans 49,023 40,955 (8,068) 6.6% 14.8% 14.6% Home Equity Loans 80,598 73,259 (7,339) 10.8% 13.5% 13.5% Other Loans 74,911 68,903 (6,008) 10.1% 11.0% 11.0% Municipals 11,640 9,156 (2,484) 1.6% 4.6% 4.6% Adjustable Mortgages 30,336 28,495 (1,842) 4.1% 3.4% 3.3% Total Interest-Earning Assets 744, ,488 (54,523) 100.0% 100.0% 100.0% Total Loans 742, ,017 (54,523) 99.8% 100.0% 100.0% Total Investments 1,471 1, % 0.0% 0.0% 40.0% 35.0% 30.0% 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% ASSET ALLOCATION VERSUS ECONOMIC VALUE CHANGE UP 300 Allocation Volatility 136

69 Key Assumptions Valuation methodology Book rate Reinvestment rate Rate Source Market rate Rate Source Prepayment Table Source 137 Key Assumptions Book Reinvestment Discount Prepayment Speeds Rate Rate Source Rate Source Description Table Source Total Consumer Loans Auto Loans Offer Broker Average Swaps Auto Auto ABS Home Equity Loans Offer Broker Average Swaps Home Equity HE ABS Business Loans Offer Broker Average Swaps Auto Auto ABS Unsecured Loans Offer Offer - Consumer ALM First Total Mortgage Loans Fixed Mortgages Offer 3.05 FHLMC 30-Day Price Mortgage ZMDesk Adjustable Mortgages Offer 2.87 FHLMC 30-Day Price Mortgage ZMDesk Total Investments CD Bank IDC 0.00 Suncorp CD Term Structure None None CMOs IDC 0.23 IDC Price Mortgage ZM Desk Overnight Market None None Total NMD Savings Offer FHLB Dallas Term Advances None None Checking Offer FHLB Dallas Term Advances None None Money Markets Offer FHLB Dallas Term Advances None None Total Time Deposits CDs Offer FHLB Dallas Term Advances None None Total Borrowings Notes Payable FHLB FHLB Dallas Term Advances None None 138

70 Key Assumptions 30-Jun Sep-12 Difference 30-Jun Sep-12 Difference Index Rates Dallas FHLB Curve Prime Month Fed Funds Month Month Treasury Curve 1 Year Month Year Month Year Month Year Year Year Year Year Year Year Year Futures Curve Spot LIBOR/Swap Curve 3 Month Month Month Month Month Month Month Year Month Year Month Year Month Year Month Year Month Year Month Year Month Year Month Year Month Year Month Key Assumptions 30-Jun Sep-12 Difference 30-Jun Sep-12 Difference Auto ABS Spreads FHLMC Offers New Auto Year Fixed 2.50% Used Auto Year Fixed 2.75% Year Fixed 3.00% Year Fixed 3.25% Credit Card Spreads Fixed Year Fixed 3.50% Floating Year Fixed 3.75% Year Fixed 4.00% Year Fixed 4.25% Home Equity Spreads Fixed /1 ARM 2.50% Floating /1 ARM 2.75% /1 ARM 3.00% /1 ARM 3.25% Commercial Spreads 3-Year Mortgage /1 ARM 2.50% Year Mortgage /1 ARM 2.75% Year Mortgage /1 ARM 3.00% Variable Mortgage /1 ARM 3.25% Nonconforming Spreads 7/1 ARM 2.50% Year Fixed Mortgage /1 ARM 2.75% Year Fixed Mortgage /1 ARM 3.00% ARMs /1 ARM 3.25%

71 Key Assumptions INTEREST RATE SCENARIO 30-Jun Sep-12 Difference Table Name Coupon DN 300 Base UP 300 DN 300 Base UP 300 DN 300 Base UP 300 Constant Speeds All Auto, Aged 1 Year All Auto, Aged 2 Years All Auto, Aged 3 Years All Auto, Aged 4 Years All Home Equity Loans All Year Fixed Mortgages 2.75% Year Fixed Mortgages 3.00% /1 ARMs 2.50% /1 ARMs 2.50% Member Mortgages 3.00% CUNA Mortgages 3.00% CMO Fixed 2.50% MBS Fixed 2.00% ARMs 1.75% Key Assumptions INTEREST RATE SCENARIO (200) (100) Base Savings Total Cost 1.39% 1.39% 1.49% 1.64% 1.79% 1.94% 2.09% Decay Rate 12.00% 14.00% 15.00% 16.00% 17.00% 18.00% 20.00% Maturity WAL X-Coefficient 0.15% 0.15% 0.15% 0.15% 0.15% 0.15% 0.15% IRA Shares Total Cost 1.39% 1.44% 1.59% 1.74% 1.89% 2.04% 2.19% Decay Rate 12.00% 14.00% 15.00% 16.00% 17.00% 18.00% 20.00% Maturity WAL X-Coefficient 0.15% 0.15% 0.15% 0.15% 0.15% 0.15% 0.15% Checking Total Cost 1.84% 1.94% 2.04% 2.14% 2.24% 2.34% 2.44% Decay Rate 10.00% 10.00% 10.00% 11.00% 12.00% 13.00% 14.00% Maturity WAL X-Coefficient 0.10% 0.10% 0.10% 0.10% 0.10% 0.10% 0.10% Money Markets Total Cost 0.86% 0.94% 1.23% 1.51% 1.79% 2.07% 2.35% Decay Rate 25.00% 25.00% 25.00% 27.00% 30.00% 35.00% 40.00% Maturity WAL X-Coefficient 0.28% 0.28% 0.28% 0.28% 0.28% 0.28% 0.28% 142

72 Conclusion Comprehension of your report story requires your reports to be sufficiently detailed Detailed reports allow managers to dig deeper into output Dissection of results allow managers to make better decisions Understanding key assumptions is vital to all ALM analyses BREAK 144

73 ALCO BEST PRACTICES June 13, 2013 Presented By Travis Goodman, CFA Senior Financial Advisor Agenda Type one ALCO strategic Risk measurement Assumptions What-ifs Type two ALCO operational Underperforming ALCOs Validations 146

74 Risk versus Reward You can t broad brush risk. You should not overlook all means of serving members, earning incremental income, and enhancing capital just because failures have occurred. Totally avoiding risk does not guarantee survival. It would be difficult for any institution to maintain profitability without some degree of risk. Risk should not be avoided but managed and through that process, education of the staff, board members and most importantly, the regulators is paramount. 147 Strategic ALCO All departments should be represented: Finance Wholesale / Investments Lending Marketing Operations / Branches A representative from the Board 148

75 Strategic ALCO Agenda is focused; objectives are clear Emphasis on the future and not the past Do not emphasize individual member issues that are irrelevant to ALCO material Primary focus on strategic development and decision making Education of the Board 149 Strategic ALCO Sample agenda Review of the balance sheet Economy direction of interest rates Action plans Strategies 150

76 Review of Balance Sheet Review of balance sheet Earnings Liquidity ALM reports Net interest income simulation Economic value analysis Trends Annual review of policies 151 Review of Balance Sheet Reporting package is clear and concise Written summary of overall position Make sure committee members understand the report Make sure that members involved understand the underlying assumptions 152

77 Review of Balance Sheet Reports to use Summary report Trend analysis Report showing policy / regulatory guidelines to actual numbers Duration Strategy formulation 153 Review of Balance Sheet Policies Clean and understood by the ALCO and Board Limits should be in policy, not current guidelines Should reflect the financial institution s philosophies 154

78 Action Plans Recommended strategies / actions Implementation: timetable and responsibilities Optimizing the balance sheet Analyzing true loan yields Loan pricing, products and product development Investment strategy 155 Strategy Formulation Brief description of progress from previous report Objectives Maintain a moderate amount of interest rate risk Maintain XXX amount of net interest margin Interest rate environment Strategy 156

79 NCUA Risk Measurement Guidelines Basis of Measurement Low Moderate High Gap - 12 Month +/- 10% +/- 10% to +/- 20% >+/- 20% Net Interest Income - 12 Month >- 20% -20% to -30% < -30% Net Income - 12 Month > -40% -40% to -75% < -75% Net Economic Value - % Change > -25% -25% to -50% < -50% NEV Ratio > 6% 4% - 6% < 4% Risk Measurement ANALYTICAL MEASURES 31-Dec Sep Jun Mar Dec-08 1-Year Cumulative Gap -8.47% -5.49% -8.40% -5.59% % Declining Rate Scenario NII Volatility 0.18% 0.54% 0.58% -0.05% 0.89% Rising Rate Scenario NII Volatility 1.37% 1.17% 0.76% 1.14% -0.75% Shock-Up 300 Scenario NII Volatility % -9.35% % -7.72% % Base Case Return on Assets 0.30% 0.61% 0.11% 0.54% 1.57% Base Case Net Interest Margin 4.53% 4.57% 4.46% 4.45% 4.90% NEV Percent Change Up % % % 23.82% -3.76% NEV Ratio Base 7.88% 6.68% 1.24% % % NEV Ratio Up % 7.31% 2.97% 4.56% 5.54% NEV Ratio Up % 8.92% 4.45% 1.94% 4.60% Low Moderate High 158

80 OTS Risk Management Table INTEREST RATE SENSITIVITY MEASURE Up 300 bps Post-Shock Economic Value Ratio Under 100bp bp bp bp Above 400bp Over 10% Minimal Minimal Minimal Minimal Moderate 6% to 10% Minimal Minimal Minimal Moderate Significant 5% to 6% Minimal Minimal Moderate Significant High 4% to 5% Minimal Moderate Significant High High 3% to 4% Moderate Significant High High High Below 3% High High High High High 159 Economic Value Ratio INTEREST RATE SCENARIO (200) (100) Base Effective Duration of the Assets Effective Duration of the Liabilities Effective Duration Mismatch Equity Duration Economic Value Ratio 7.95% 7.84% 7.58% 7.26% 6.85% 6.28% Change between base and up 200 is 73 basis points. 160

81 Risk Measurement ANALYTICAL MEASURES 31-Dec Sep Jun Mar Dec-08 1-Year Cumulative Gap -8.47% -5.49% -8.40% -5.59% % Declining Rate Scenario NII Volatility 0.18% 0.54% 0.58% -0.05% 0.89% Rising Rate Scenario NII Volatility 1.37% 1.17% 0.76% 1.14% -0.75% Shock-Up 300 Scenario NII Volatility % -9.35% % -7.72% % Base Case Return on Assets 0.30% 0.61% 0.11% 0.54% 1.57% Base Case Net Interest Margin 4.53% 4.57% 4.46% 4.45% 4.90% NEV Percent Change Up % % % 23.82% -3.76% NEV Ratio Base 7.88% 6.68% 1.24% % % NEV Ratio Up % 7.31% 2.97% 4.56% 5.54% NEV Ratio Up % 8.92% 4.45% 1.94% 4.60% Minimal Moderate High 161 Assumptions Should be updated every time an analysis is performed Prepayments Offering rates (for purposes of NII) Discount rates / market rates (for purposes of the economic value) 162

82 Assumptions Should be updated every two years Non-maturing deposit analysis Regression analysis for final maturities Correlation analysis for dividend payments Decay rates Non-interest expense ratios 163 Assumptions Make sure you use two sets of assumptions: Offering rates for the net interest income simulation Market rates for the economic value analysis Static balance sheets 164

83 What-if Analyses What-if analysis to formulate strategy Forward NEV analysis Analyses using historical spreads (back to normal) Changes in the shape of the yield curve 165 Operational ALCO Objectives are to carry out the decisions of the strategic ALCO and would include: ALCO implications effecting daily operations Emphasis on the details Emphasis on operations 166

84 Operational ALCO Comprised of management staff Branches / Operational Lending / Indirect Collections / Delinquency Accounting / Finance Mortgage and Commercial Executive staff Meet monthly 167 Operational ALCO Sample agenda Review financials Identify reporting requirements Rate setting Monitoring of major loan programs, including delinquency Monitoring of task items of the action plans Product profitability Cash management Promotions 168

85 Review Financials Loan mix strategy where are we today and where do we want to be; what are we doing to achieve the mix change, etc Deposit mix strategy Investment strategy Loan / deposit targets Operational expense ratio s or operating income ratio s Actual versus budget 169 Identify Reporting Requirements Branches report on production and significant branch budget variations. Collections report on delinquency: By credit score, loan officer, origination date, regulatory at 61 days, 31 days +, by loan type. Review repo s, deficiency balances and trends Review bankruptcies and trends Review the ALL calculation for current and prior month loan production reports, i.e. indirect by score Review product profitability to monitor true yields, i.e. Indirect loans by paper grade start with gross yield, net dealer fees, net charge-off s for net yield before staff and operational expenses Review rates versus competition Discuss promotions where to focus, rates, effect 170

86 Minutes Make sure that minutes are complete and include: Discussions during the ALCO What-if scenarios of strategies discussed Who was in attendance Evidence of the ALCO evaluating IRR exposure and comparing results to policy limits Evidence that contingency plans were developed when risk thresholds are approached / exceeded Determination on whether the current risk measurement system adequately evaluated IRR and liquidity risk exposure 171 Frequency of Reporting Quarterly reports are adequate for strategies Policy reviews every year Validations every two years (only for larger financial institutions) Income verifications every year 172

87 Underperforming ALCO Fear of change Focusing on the minutia Lack of future focus Do not let the board use the ALCO for personal agendas 173 What is a Validation? A validation includes a review of the ALM model s calculations and processes. Validations can be viewed more as an audit of the ALM process ensuring accuracy and the strength of internal controls. It is a review of the logical and conceptual soundness of a financial institution s ALM model. 174

88 What is a Validation? Validation should not be thought of as a purely mathematical exercise performed by quantitative specialists. It encompasses any activity that assesses how effective a model is operating. Validation procedures focus not only on confirming the appropriateness of model theory and accuracy of program, code, but also tests the integrity of model input, outputs, and reporting. * *FDIC Supervisory Insights-Compliance Examinations 175 When Does a Financial Institution Need a Validation? It depends on what you mean by validation Validation work should be performed by parties completely independent from the model s design and use Could be an independent model validation group within the financial institution, internal audit, staff with model expertise from other areas of the financial institution, or an external vendor 176

89 When Does a Financial Institution Need a Validation? Third-party validations Large, complex financial institutions where the risk profile is high Financial institutions that have a high amount of embedded options (i.e., mortgage exposure, especially innovative type mortgages or complex investments) 177 When Does a Financial Institution Need a Validation? Third-party validations can be costly Financial institutions that GENERALLY DO NOT need third party validations: Small financial institutions (less than $150 million) Financial institutions with very high capital Financial institutions that fall in the low risk category and do not have a complex balance sheet 178

90 Validation ALM process review The process review is patterned after guidelines for model validation as described in OCC Bulletin ALM parallel analysis An ALM run independent of the financial institution s report Full ALM validation Both an ALM parallel analysis and a process review 179 Conclusion An effective way of conducting ALCO meetings is to separate the committees between strategic and operational Any financial institution unsure of ALCO reports and results should consider a validation 180

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