Lecture Materials LOAN PORTFOLIO MANAGEMENT YEAR 1

Transcription

1 Lecture Materials LOAN PORTFOLIO MANAGEMENT YEAR 1 Rob Newberry SVP & Client Management Specialist FARIN Financial Risk Management Madison, Wisconsin rnewberry@farin.com August 8, 2017

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3 STRESS TESTING THE LOAN PORTFOLIO Rob Newberry

4 Credit Risk Management Three Main Components I. Loan Grading II. Stress Testing III. Reserve Calculations Loan Grading Credit Risk Mgmt. ALLL Reserve Stress Testing

5 The Three Inherent Risks to all Financial Intermediaries All financial intermediaries rent money from depositors (Liabilities) who then expect it back on demand or at maturity dates rarely more than a few years in the future. Banks then lend or invest that money in variety of instruments (Assets) with maturity dates as long as 30 years. 1. Credit Risk The obligation to pay back depositors regardless of whether loans are repaid 2. Interest Rate Risk The timing and size of changes in the rates that they receive from their Assets rarely match the timing and size of rate changes for their Liabilities 3. Liquidity Risk Not enough cash will be generated from Assets to meet deposit withdrawals or contractual loan fundings

6 Should the Financial Manager Care?

7 Loan Grading System Interagency Policy Statement on the Allowance for Loan and Lease Losses srletters/2006/sr0617 Loan Classification or Credit Grading Systems The foundation for any loan review system is accurate and timely loan classification or credit grading, which involves an assessment of credit quality and leads to the identification of problem loans. An effective loan classification or credit grading system provides important information on the collectability of the portfolio for use in the determination of an appropriate level for the ALLL

8 Continued Loan Grading System srletters/2006/sr0617 Because accurate and timely loan classification or credit grading is a critical component of an effective loan review system, each institution should ensure that its loan review system includes the following attributes: 1. To promptly identify loans with potential credit weaknesses. 2. To appropriately grade or adversely classify loans, especially those with well-defined credit weaknesses that jeopardize repayment, so that timely action can be taken and credit losses can be minimized. 3. To provide management with accurate and timely credit quality information for financial and regulatory reporting purposes, including the determination of an appropriate ALLL

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

10 Loan Grading System Understanding Pay vs Save Strategies Pay Strategies assess the borrowers ability to make the agreed upon loan obligations Save Strategies try to limit losses if the borrower stops making payments

11 Loan Grading System Loan Quality Death Spiral Self Actualization: Perceived Property Values dropped below amount owed, customers lost motivation to pay and walked away. Created excessive shadow inventory, dropped all property values via comparables. Based on tighter guidelines, customers couldn t qualify to refinance to lower interest rates. Further degrading loan portfolio quality. More Losses - Higher Reserves Required

12 Loan Grading System Why do we spread financials?

13 Loan Grading System Global Cash Flows Understanding related entities How does risk from one participant impact total Entity?

14 Loan Grading System Turning the 5c s into a science What factors should be used : I. Objective Analysis II. Comparative Analysis Objective Analysis Subjective Analysis III. Subjective Analysis Comparative Analysis Dual Loan Grading System

15 Loan Grading System Objective Analysis

16 Loan Grading System Objective Analysis Objective Measurements include 1. Current/Quick Ratios 2. Debt to Net Worth 3. Debt Service Coverage 4. LTV 5. Credit Scores How to weigh ratios?

17 Loan Grading System Objective Analysis Ratio's Assigned Grade Weighting Risk Grade Current Ratio % 0.63 Quick Ratio % 0.50 Debt to Net Income % 0.45 EBITA % 1.00 LTV % 1.00 Credit Score % % 3.88 Can use different ratios and weightings for different industries/loan types

18 Loan Grading System Subjective Analysis Subjective Measurements might include 1. Strength of Guarantors 2. Management Evaluation 3. Other Credit Quality Adjustments (5c s)

19 Loan Grading System Subjective Analysis What is the true value of a guarantee?

20 Loan Grading System Subjective Analysis Management/Customer Evaluation Character is the general impression you make on the prospective lender or investor. The lender will form a subjective opinion as to whether or not you are sufficiently trustworthy to repay the loan or generate a return on funds invested in your company. Your educational background and experience in business and in your industry will be considered. The quality of your references and the background and experience levels of your employees will also be reviewed

21 Loan Grading System Key Finding the balance Objective Subjective Black Box Flexibility

22 Loan Grading System Things to consider when developing a Loan Grading System How to pick a loan grading scale Diminishing returns Requires Split Classifications Typically includes a Pass/Watch Category Examiners are looking for more definition in the quality of the loan portfolio

23 Loan Grading System Impact of a compressed scale Can you identify the Top 1/3, Middle 1/3, and Bottom 1/3 of these cans?

24 Loan Grading System 1. Pass - Extremely high quality, excellent financial condition and collateral coverage. No identifiable risk of loss. 2. Pass - Very strong quality, excellent financial condition, no identifiable risk of loss but lower in one or two aspects than loans graded as Pass - Mid-Grade loans showing good financial condition with few, if any, below average characteristics. Most loans in this category, if measured purely on a risk-of-loss basis, would be considered above average. 4. Pass - Mid-Grade loans showing average financial condition. Most loans in this category, if measured purely on a risk-of-loss basis, would be considered above average. This is due to average financial condition but strong collateral coverage. 5. Pass/Watch - Mid-Grade loans showing average financial condition but may be susceptible to changing economic conditions that would raise risk to a minor concern. Normal comfort levels can be achieved through monitoring financial statements & collateral coverage

25 Loan Grading System Regulatory Classified Loan Definitions: A uniform agreement on the classification of assets and appraisal of securities in bank examinations was issued jointly on June 15, 2004, by the Office of the Comptroller of the Currency, the FDIC, the Federal Reserve Board, and the Office of Thrift Supervision. 6.Special Mention - A Special Mention asset has potential weaknesses that deserve management's close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects. Special Mention assets are not adversely classified and do not expose an institution to sufficient risk to warrant adverse classification. 7. Substandard - Substandard loans are inadequately protected by the current sound worth and repayment capacity of the obligor or the collateral pledged. Loans so classified must have a well-defined weakness or weaknesses that jeopardize liquidation of the debt. They are characterized by the distinct possibility that the bank will sustain some loss if the deficiencies are not corrected. 8.Doubtful - Loans classified Doubtful possess all of the weaknesses inherent in those classified Substandard with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently known facts, conditions and values, highly questionable and improbable. 9. Loss - Loans classified Loss are considered uncollectible and of such little value that continuance as bankable assets is not warranted. This classification does not mean that the loan has absolutely no recovery or salvage value but rather it is not practical or desirable to defer writing off this asset even though partial recovery may be effected in the future

26 Loan Grading System Portfolio Grade Curve Shifted to Left Pass

27 Loan Grading System Lenders mitigate credit risk using several methods: 1. Risk Based Pricing Models Charging higher interest rates to customers more likely to default 2. Covenants Stipulations on the borrower that are written into the loan agreements 3. Tightening Reducing the amount of credit extended 4. Diversification Expanding the borrower pool to mitigate concentration risks

28 Defining Stress Testing I. Loan Grading II. Stress Testing III. Reserve Calculations Loan Grading Loan Portfolio Mgmt. ALLL Reserve Stress Testing

29 Wikipedia Definition: Defining Stress Testing Instead of doing financial projection on a "best estimate" basis, a company may do stress testing where they look at how robust a financial instrument is in certain crashes, a form of scenario analysis. They may test the instrument under, for example, the following stresses: 1.What happens if equity markets crash by more than x% this year? 2.What happens if interest rates go up by at least y%? 3.What if half the instruments in the portfolio terminate their contracts in the fifth year? 4.What happens if oil prices rise by 200%? This type of analysis has become increasingly widespread, and has been taken up by various governmental bodies (such as the FSA in the UK) as a regulatory requirement on certain financial institutions to ensure adequate capital allocation levels to cover potential losses incurred during extreme, but plausible, events. This emphasis on adequate, risk adjusted determination of capital has been further enhanced by modifications to banking regulations such as Basel II. Stress testing models typically allow not only the testing of individual stressors, but also combinations of different events. Text is available under the Creative Commons Attribution-ShareAlike License; additional terms may apply. See Terms of Use for details. Wikipedia is a registered trademark of the Wikimedia Foundation, Inc., a non-profit organization

30 Stress test definition: Defining Stress Testing The term stress testing describes a range of techniques used to assess the vulnerability of a portfolio to major changes in the economic environment or to exceptional but plausible events. Stress tests make risks more transparent by estimating the potential losses on a portfolio in abnormal markets. (1) A simplified definition would be: Stress testing is a way to perform sensitivity analysis using What if alternative scenarios (1) Blaschke, Jones, Majnoni, and Peria, 2001, "Stress Testing of Financial Systems: An Overview of Issues, Methodologies, and FSAP Experiences," IMF Working Paper WP/01/

31 Preparing for Mayhem Stress Tests

32 Defining Stress Testing What is the risk if you are wrong or slip up What is your margin for error

33 Defining Stress Testing - Mayhem Defining Stress Testing We can mitigate risk that we see and identify, it is what we don t see coming that gets us

34 Defining Stress Testing - Mayhem Defining Stress Testing

35 Defining Stress Testing Credit Quality Rates Liquidity sources Funding sources & costs Asset Growth & Mix Base forecast assumes multiple planning variables but tends to assume 100% compliance/performance What is the cost of being wrong?

36 Defining Stress Testing Its all about connecting Silos, not tearing them down

37 Defining Stress Testing Guidelines Issued to Community banks on Stress Testing Dodd Frank Act Signed July 21, 2010 SR 12-7 Statement to Clarify Stress Testing by Community Banks 5/14/2012 FIL Annual Stress-Test Reporting Template 10/21/2013 Basel III November 2010 OCC Supervisory Guidance Community Bank Stress Testing 10/18/

38 Stress Testing and Capital Planning Regulatory Landscape The OCC expects every bank, regardless of size or risk profile, to have an effective internal process to (1) assess its capital adequacy in relation to its overall risks, and (2) to plan for maintaining appropriate capital levels. Stress testing can be a prudent way for a community bank to identify its key vulnerabilities to market forces and assess how to effectively manage those risks should they emerge. If the results of a stress test indicate that capital ratios could fall below the level needed to adequately support the bank s overall risk profile, the bank s board and management should take appropriate steps to protect the bank from such an occurrence. This may include establishing a plan that requires closer monitoring of market information, adjusting strategic and capital plans to mitigate risk, changing risk appetite and risk tolerance levels, limiting or stopping loan growth or adjusting the portfolio mix, adjusting underwriting standards, raising more capital, and selling or hedging loans to reduce the potential impact from such stress events. John C. Lyons Jr. Senior Deputy Comptroller and Chief National Bank Examiner

39 Regulatory Landscape 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. 1 Well-managed community banks routinely conduct interest rate risk sensitivity analysis to understand and manage the risk from changes in interest rates. Many community banks, however, do not have similar processes in place to quantify risk in loan portfolios, which often are the largest, riskiest, and highest earning assets. The OCC, however, does consider some form of stress testing or sensitivity analysis of loan portfolios on at least an annual basis to be a key part of sound risk management for community banks. Community banks that have incorporated such concepts and analyses into their credit risk management and strategic and capital planning processes have demonstrated the ability to minimize the impact of negative market developments more effectively than those that did not use stress testing

40 The Changing Regulatory Landscape Regulatory Landscape New Guidance on Stress Testing 10/18/2012 Stress Testing Methods and Approaches 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. Portfolio stress testing is a method that helps identify current and emerging risks and vulnerabilities within the loan portfolio by assessing the impact of changing economic 9 conditions on borrower performance, identifying credit concentrations, measuring the resulting change in overall portfolio credit quality, and ultimately determining the potential financial impact on earnings and capital

41 Regulatory Landscape New Guidance on Stress Testing 10/18/2012 Stress Testing Methods and Approaches Enterprise-level stress testing is a method that considers multiple types of risk and their interrelated effects on the overall financial impact under a given economic scenario. These risks include, but are not limited to, credit risk within loan and security portfolios, counterparty credit risk, interest rate risk, and changes in the bank s liquidity position. Reverse stress testing is a method under which the bank assumes a specific adverse outcome, such as suffering credit losses sufficient to cause a breach in regulatory capital ratios, and then deduces the types of events that could lead to such an outcome. This type of analysis (e.g. a break the bank scenario) can help a bank consider scenarios beyond normal business expectations and challenge common assumptions about performance and risk mitigation strategies

42 Regulatory Landscape New Guidance on Stress Testing 10/18/2012 Regardless of the testing method used, an effective stress test has common elements that a community bank should consider. These include asking plausible what if questions about key vulnerabilities; making a reasonable determination of how much impact the stress event or factor might have on earnings and capital; and incorporating the resulting analysis into the bank s overall risk management process, asset/liability strategies, and strategic and capital planning processes

43 Regulatory Landscape New Guidance on Stress Testing 10/18/2012 Appendix B - Constructing a Basic Portfolio Level Stress Test into three sections: Section 1 Estimated Loan Portfolio Stress Losses Objective: This section estimates the potential loan losses over a two-year stress test horizon for the entire loan portfolio. There are four components in this section. Loan Portfolio Categories Quarter-End Loan Portfolio Balances Stress Period Loss Rates Stress Period Losses

44 Regulatory Landscape New Guidance on Stress Testing 10/18/2012 Section 2 Estimated Impact on Earnings Objective: This section estimates the potential impact to net income from the stress scenario over the two-year period. There are five components in this section. Pre-provision Net Income Provision Expense to Cover Stress Losses Provision to Maintain an Adequate ALLL Income Tax Expense (Benefit) Net Income

45 Regulatory Landscape New Guidance on Stress Testing 10/18/2012 Section 3 Estimated Impact of Stress on Capital Objective: This section estimates the hypothetical impact on capital of the stressed environment. The example uses Tier 1 capital and the Tier 1 leverage ratios to help analyze the potential change in capital caused by a stress scenario. Banks can also review the changes in other relevant capital measures, such as the potential change in the common equity ratio, to assess the results of the stress test. This section has five components. Tier 1 Capital Net Change in Tier 1 Capital Adjusted Tier 1 Capital Quarterly Average Assets Tier 1 Leverage Ratio

46 1. Estimated Loan Portfolio Stress Losses Loan Portfolios from Call Report Schedule RC-G Quarter End as of Date $ Balances Two Year Stress Period Loss Rate % Two Year Stress Period $ Losses Loans Secured by type of Real Estate a. Construction and Development % 20 b. Farmland 50 8% 4 c. 1 4 Family Housing 100 4% 4 d. Multifamily Housing 75 16% 12 e. Nonfarm Nonresidential Property 100 8% 8 Agriculture Production and Farmer Loans 40 6% 2.4 Consumer Loans 60 14% 8.4 Commercial and Industrial 50 4% 2 All Other Loans 25 4% 1 Total

47 2. Estimated Impact of Stress on Earnings Descriptions Previous Two Years Actual Pro Forma Stress Period Pre-Provision Net Income Less Provision to Cover Two-Year Losses Less Provision to Maintain Adequate ALLL 0 10 Income Tax Expenses (Benefit) 5.5 (14.6) 3. Estimated Impact of Stress on Capital Net Income 16.5 (27.2) Descriptions Previous Two Years Actual Pro Forma Stress Period Tier 1 Capital $ Net Change in Tier 1 Capital from Stress Period (Net Income from Step 2) N/A (27.2) Adjusted Tier 1 Capital $ Quarterly Average Assets $ Tier 1 Leverage Ratio % 11% 8.2%

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49 Why should I care about DFAST Scenarios? Focus on what is keeping you up at night

50 Using the DFAST ingredients Your unique flavoring To create your own stress testing recipes

51 Scenario - DFAST Example Dodd-Frank Act Stress Test = DFAST Quarterly required stress tests for $10-$50 billion banks Projects multiple variables GDP Interest rates Housing growth Employment Sets baseline forecast for comparison Establishes 2 potential stress events Adverse event Severely adverse event

52 Baseline Scenario: Scenario - DFAST Example Moderate expansion in economic activity. Real GDP growth accelerates while the unemployment rate edges down to 5.25% by the fourth quarter of CPI inflation averages just over 2% per year. Short term Treasury rates begin to increase in the second quarter of 2015 and rise steadily thereafter reaching over 3% by year-end Both equity and property prices would appreciate, albeit at a modest rate, through Equity prices, nominal house prices, and commercial property prices all rise steadily throughout the scenario. The outlook for international variables features an expansion in activity, albeit one that proceeds at different rates across the four countries or country blocks being considered

53 Scenario - DFAST Example Adverse Scenario: Weakening in economic activity combined with an increase in U.S. inflationary pressures that cause rapid increase in both short- and longterm U.S. Treasury rates. Bank funding costs react strongly to rising short-term rates. Commercial deposits should be viewed as being unusually drawn to institutional money funds, which re-price promptly. Consumer deposits should also be assumed to be drawn to higher-yielding alternatives. House prices and commercial real estate prices decline by approximately 13% and 16%, respectively to their level in the third quarter of

54 Severely Adverse Scenario: Scenario - DFAST Example Substantial weakening in economic activity, characterized by a deep and prolonged recession Unemployment rate increases by 4% from its level in third quarter 2014 peaking at 10% in the middle of Short-term interest rates remain near zero through 2017; long-term Treasury yields drop to 1% in fourth quarter of 2014 and then edge up slowly over the remainder of the scenario period Significant reversal of recent improvements to the U.S. housing market. House prices decline by 25% during the scenario period relative to their level in the third quarter of 2014, while commercial real estate prices are more than 30% lower during the scenario period Corporate financial conditions tighten significantly in 2015 and the yield on investment grade corporate bonds is higher than the baseline until the fourth quarter of U.S. corporate credit quality deteriorates sharply

55 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. Scenario Analysis: 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

56 Credit Factors Liquidity Factors Interest Rate Factors Debt service coverage Large depositor runoff Non-maturity deposit repricing betas Portfolio loss rates Loss of wholesale\non-core funding Higher levels of surge balances Geographic valuation changes Reduction in loan repayments Changes in loan prepayments Credit score changes Devaluation of investment portfolio Parallel vs. Twisting yield curves Portfolio loan rates vs. market rates Freezing of markets (loan sales) Early withdrawal of CDs Credit migration Loan growth > Deposit growth Changes in asset mix What factors have highest impact on results - sensitivity testing purpose! Develop your list of top 5-6 assumptions by impact risk area Take highest impact factors and model in base plan with 1-2 standard deviations from original assumption. Compare results to goals

57 Sample Credit Risk Sensitivity Test Historcial Losses by Category Calculated Input Jun an Portfolios Current Balance 2 Yr Avg Balance 3 Yr Avg Balance Net Losses Prev 8 Qtrs Net Losses Prev 12 Qtrs Losses Prev 8 Qtr % Losses Prev 12 Qtr % Current ALLL % Stress Adj 1 Loans Secured by type of Real Estate $ 110,674 $ 101,946 $ 97,423 $ - $ % 0.00% 0.50% 100% a. Construction Loans $ 3,537 $ 7,240 $ 6,953 $ - $ % 0.00% 0.50% 100% 1-4 Construction Loans $ 983 $ 437 $ 313 $ - $ % 0.00% 0.50% 100% Oth Con, Dev, & Land Loans $ 2,554 $ 6,804 $ 6,641 $ - $ % 0.00% 0.50% 100% b. Farmland $ 12,197 $ 9,862 $ 9,483 $ - $ % 0.00% 0.50% 100% c. 1-4 Family Housing $ 56,579 $ 55,145 $ 54,425 $ 39 $ % 0.37% 1.00% 100% HE Lines $ 2,148 $ 2,111 $ 2,136 $ (18) $ % 0.56% 1.75% 100% Cl-end First Lien $ 53,653 $ 52,044 $ 51,187 $ 45 $ % 0.34% 0.75% 100% Cl-end Jr Lien $ 778 $ 990 $ 1,102 $ 12 $ % 1.09% 1.00% 100% d. Multifamily Housing $ 2,253 $ 2,366 $ 2,451 $ - $ % 0.00% 1.00% 100% e. Nonfarm Nonresidential Property $ 36,108 $ 27,333 $ 24,111 $ (50) $ % 0.07% 2.25% 100% Owner Occupied RE $ 8,942 $ 6,411 $ 6,159 $ (44) $ (4) -0.69% -0.06% 2.25% 100% Other Property Loans $ 27,166 $ 20,922 $ 17,952 $ (6) $ % 0.12% 2.25% 100% 2 Loans to Depository $ - $ - $ - $ - $ % 0.00% 0.00% 100% 3 Agriculture Production and Farmer loans $ 5,541 $ 3,353 $ 2,973 $ - $ % 0.00% 0.75% 100% 4 Commercial and Industrial $ 6,674 $ 5,603 $ 5,097 $ (6) $ (9) -0.11% -0.18% 1.25% 100% 6 Consumer Loans $ 2,367 $ 2,102 $ 1,900 $ 2 $ (13) 0.10% -0.68% 1.50% 100% 8 State & Political $ - $ 2 $ 5 $ - $ % 0.00% 0.00% 100% 9 All Other Loans $ 20 $ 15 $ 11 $ - $ % 0.00% 1.36% 100% $ 125,276 $ 113,020 $ 107,409 $ (15) $ % 0.18%

58 Sample Credit Risk Sensitivity Test Historcial Losses by Category To Base Line Scenario Jun Current Rolling 8 Rolling 12 Based on Base an Portfolios Adverse Severly Balance Qtrs Qtrs ALLL ASC Line Adverse 1 Loans Secured by type of Real Estate $ 110, % 0.00% 0.50% 0.00% 0.00% 0.00% a. Construction Loans $ 3, % 0.00% 0.50% 5.00% 10.00% 20.00% 1-4 Construction Loans $ % 0.00% 0.50% 0.00% 0.00% 0.00% Oth Con, Dev, & Land Loans $ 2, % 0.00% 0.50% 0.00% 0.00% 0.00% b. Farmland $ 12, % 0.00% 0.50% 0.00% 0.00% 0.00% c. 1-4 Family Housing $ 56, % 0.37% 1.00% 0.07% 0.14% 0.28% HE Lines $ 2, % 0.56% 1.75% -0.85% -1.71% -3.41% Cl-end First Lien $ 53, % 0.34% 0.75% 0.09% 0.17% 0.35% Cl-end Jr Lien $ % 1.09% 1.00% 1.21% 2.43% 4.85% d. Multifamily Housing $ 2, % 0.00% 1.00% 0.00% 0.00% 0.00% e. Nonfarm Nonresidential Property $ 36, % 0.07% 2.25% -0.18% -0.37% -0.73% Owner Occupied RE $ 8, % -0.06% 2.25% -0.69% -1.37% -2.75% Other Property Loans $ 27, % 0.12% 2.25% -0.03% -0.06% -0.11% 2 Loans to Depository $ % 0.00% 0.00% 0.00% 0.00% 0.00% 3 Agriculture Production and Farmer loans $ 5, % 0.00% 0.75% 0.00% 0.00% 0.00% 4 Commercial and Industrial $ 6, % -0.18% 1.25% -0.11% -0.21% -0.43% 6 Consumer Loans $ 2, % -0.68% 1.50% 0.10% 0.19% 0.38% 8 State & Political $ % 0.00% 0.00% 0.00% 0.00% 0.00% 9 All Other Loans $ % 0.00% 1.36% 0.00% 0.00% 0.00% $ 125,276 Copy Copy Copy 2 Yr Projected Losses Stress Test Scenario 2017 Sensitivity assumptions! 56

59 Sample Credit Risk Sensitivity Test Projected Balances by Category 1Year 2 Year Baseline Growth Rate % 3.00% 3.00% Adverse Growth Adj % 1.50% 1.50% Severely Adverse Growth Adj % 0.00% 1.00% Jun-15 BaseLine Adverse Severely Adv Loan Portfolios Current Balance Projected Balance 1 yr Projected Balance 2yr Projected Balance 1 yr Projected Balance 2yr Projected Balance 1 yr Projected Balance 2yr 1 Loans Secured by type of Real Estate $ 110,674 $ 113,994 $ 117,414 $ 112,334 $ 114,019 $ 110,674 $ 111,781 This should align with forecast assumptions in budget/interest rate risk modeling Sensitivity assumptions! a. Construction Loans $ 3,537 $ 3,643 $ 3,752 $ 3,590 $ 3,644 $ 3,537 $ 3, Construction Loans $ 983 $ 1,012 $ 1,043 $ 998 $ 1,013 $ 983 $ 993 Oth Con, Dev, & Land Loans $ 2,554 $ 2,631 $ 2,710 $ 2,592 $ 2,631 $ 2,554 $ 2,580 b. Farmland $ 12,197 $ 12,563 $ 12,940 $ 12,380 $ 12,566 $ 12,197 $ 12,319 c. 1-4 Family Housing $ 56,579 $ 58,276 $ 60,025 $ 57,428 $ 58,289 $ 56,579 $ 57,145 HE Lines $ 2,148 $ 2,212 $ 2,279 $ 2,180 $ 2,213 $ 2,148 $ 2,169 Cl-end First Lien $ 53,653 $ 55,263 $ 56,920 $ 54,458 $ 55,275 $ 53,653 $ 54,190 Cl-end Jr Lien $ 778 $ 801 $ 825 $ 790 $ 802 $ 778 $ 786 d. Multifamily Housing $ 2,253 $ 2,321 $ 2,390 $ 2,287 $ 2,321 $ 2,253 $ 2,276 e. Nonfarm Nonresidential Property $ 36,108 $ 37,191 $ 38,307 $ 36,650 $ 37,199 $ 36,108 $ 36,469 Owner Occupied RE $ 8,942 $ 9,210 $ 9,487 $ 9,076 $ 9,212 $ 8,942 $ 9,031 Other Property Loans $ 27,166 $ 27,981 $ 28,820 $ 27,573 $ 27,987 $ 27,166 $ 27,438 2 Loans to Depository $ - $ - $ - $ - $ - $ - $ - 3 Agriculture Production and Farmer loans $ 5,541 $ 5,707 $ 5,878 $ 5,624 $ 5,708 $ 5,541 $ 5,596 4 Commercial and Industrial $ 6,674 $ 6,874 $ 7,080 $ 6,774 $ 6,876 $ 6,674 $ 6,741 6 Consumer Loans $ 2,367 $ 2,438 $ 2,511 $ 2,403 $ 2,439 $ 2,367 $ 2,391 8 State & Political $ - $ - $ - $ - $ - $ - $ - 9 All Other Loans $ 20 $ 21 $ 21 $ 20 $ 21 $ 20 $ 20 $ 125,276 $ 129,034 $ 132,905 $ 127,155 $ 129,062 $ 125,276 $ 126,

60 Sample Credit Risk Sensitivity Test Projected Income Impact Income 75.0% 50.0% Provisions 150.0% 300.0% Sensitivity assumptions! Previous 2 Year Actuals Base Line Adverse Severely Adv Pre-Provision Net Income $ 1,114 $ 1,715 $ 1,286 $ 858 Less Provision to Cover Two-Year Losses $ - Less Provision to Maintain Adequate ALLL $ 28 $ 245 $ 368 $ 735 Income Tax Expense (Benefit) $ 1 Tier 1 Capital $ 16,614 Tier 2 Capital $ 1,536 LESS: Deductions for Total Risk-based Capita $ - Total Risk-Based Capital $ 18,150 Average Assets for Leverage Capital Purposes $ 199,438 Risk Wieghted Assets $ 121,455 Projection Source options ALM model with changes in mix/growth Guess Actuals Forecast Base Policy(ALM) yr Actual Total Total Interest Income $ 6,073 $ 6,267 $ 12,340 $ 6,170 $ 6,640 $ 7,304 $ 13,944 Total Interest Expense $ 1,174 $ 1,050 $ 2,224 $ 1,112 $ 1,084 $ 1,100 $ 2,184 Net Income before provisions $ 4,899 $ 5,217 $ 10,116 $ 5,058 $ 5,556 $ 6,204 $ 11,760 Provision Expense $ - $ 28 $ 28 $ 14 $ 120 $ 125 $ 245 Net Income after Provisions $ 4,899 $ 5,189 $ 10,088 $ 5,044 $ 5,436 $ 6,079 $ 11,515 Total Non-Interest Income $ 993 $ 1,019 $ 2,012 $ 1,006 $ 882 $ 900 $ 1,782 Total Non-Interest Expense $ 5,336 $ 5,678 $ 11,014 $ 5,507 $ 5,632 $ 6,195 $ 11,827 Net Income before Taxes $ 556 $ 530 $ 1,086 $ 543 $ 686 $ 784 $ 1,470 Taxes $ 1 $ - $ 1 $ 1 $ - $ 274 $ 274 $ 555 $ 530 $ 1,085 $ 543 $ 686 $ 510 $ 1,

61 Sample Credit Risk Sensitivity Test Step 1. Estimated Loan Portfolio Stress Losses (Dollar Amounts in Thousands) Dynamic Loan Porfolios from Call Report Schedule RC-C 2 Yr Stress Losses Baseline Est Balance 2 Yr Stress Losses Adverse % $ Est Balance % $ Est Balance % $ Loans Secured by type of Real Estate $117,414 $114,019 $111,781 a. Construction Loans $3,752 $3,644 $3, Construction Lns $1, % 0.0 $1, % 0.0 $ % 0.0 Other Con, Dev, & Land Lns $2, % 0.0 $2, % 0.0 $2, % 0.0 b. Farmland $12, % 0.0 $12, % 0.0 $12, % 0.0 c. 1-4 Family Housing $56,579 $58,289 $57,145 HE Lines $2, % (19.4) $2, % (37.7) $2, % Cl-end First Lien $56, % 49.2 $55, % 95.6 $54, % Cl-end Jr Lien $ % 10.0 $ % 19.4 $ % 38.1 d. Multifamily Housing $2, % 0.0 $2, % 0.0 $2, % 0.0 e. Nonfarm Nonresidential Propert $38,307 $37,199 $36,469 2 Yr Stress Losses Severely Adverse Owner Occupied RE $9, % (65.1) $9, % (126.5) $9, % Other Property Loans $28, % (8.3) $0-0.06% 0.0 $27, % Agriculture Production and Farmer loa $5, % 0.0 $5, % 0.0 $5, % 0.0 Commercial and Industrial $7, % (7.6) $6, % (14.7) $6, % Consumer Loans $2, % 2.4 $2, % 4.6 $2, % 9.1 State & Political $0 0.00% 0.0 $0 0.00% 0.0 $0 0.00% 0.0 All Other Loans $ % 0.0 $ % 0.0 $ % 0.0 Totals $132, $38.8 $101, $59.3 $126, $

62 Sample Credit Risk Sensitivity Test Step 2. Estimated Impact of Stress on Earnings Descriptions 2 Yr Actual Pro forma Baseline Pro forma Adverse Pro forma Severely Adverse Pre-Provision Net Income 1, , , Less Provision to Cover Two-Year Losse 0.0 (38.8) (59.3) (147.7) Less Provision to Maintain Adequate A Net Income before Tax 1, , Income Tax Expense (Benefit) Net Income after Taxes 1, Step 3. Estimated Impact of Stress on Capital Descriptions 2 Yr Actual Pro forma Baseline Pro forma Adverse Pro forma Severely Adverse Tier 1 Capital $ 16, , , ,614.0 Net Change in Tier 1 Capital - (NI F NA Adjusted Tier 1 Capital $ 16, , , ,789.6 Tier 2 Capital $ 1, , , ,536.0 Total Risk-Based Capital 18, , , ,325.6 Quarterly Avg Assets $ - (Less Losses S 199, , , ,585.7 Risk Wieghted Assets - (Less Losses S 121, , , ,602.7 Tier 1 Leverage Ratio % 8.33% 8.82% 8.65% 8.41% Tier 1 Risk Based Capital Ratio 13.68% 14.48% 14.20% 13.81% Total Risk Based Capital Ratio 14.94% 15.75% 15.46% 15.07%

63 Understanding available data and data sources Normalizing data into useable format Capture/update missing data Define Scenario variables Data System Create and document What if scenarios. Adjust grading inputs with scenario changes Grade portfolio based on new criteria Reports generated that highlight differences Analyze and incorporate results into processes Proactively manage loan portfolio Results 2017

64 Objective Grading Model Subjective OCC Model Industry Verticals Objective Risk Score Model Accuracy

65 ALLL Methodology Building the Reserve I. Loan Grading II. Stress Testing III. Reserve Calculations Loan Grading Loan Portfolio Mgmt. ALLL Reserve Stress Testing

66 ALLL Methodology / Impact of CECL? What did you do for Y2K?

67 ALLL Methodology / Impact of CECL? Assigned at Loan Pool level Qualitative Factors 1. Economic/External Conditions a. Local / National Economic conditions b. Collateral Valuation c. Impact of Competition / Legal 2. Portfolio Performance a. Impacts/Effects of Concentrations b. Changes in Loan Quality, PDs, NPAs c. Change in Portfolio Volume or Nature 3. Internal Processes a. Changes in Lending/Underwriting Policies b. Changes in Loan Review Process c. Changes in Staff Depth/Experience PV Future Losses 1. Loan Pool Performance 2. Projected Loan Performance a. Economic Conditions b. Borrower Financials 3. Time Value of Money a. Discounted Cash Flow b. Fair Market Value of Collateral Rolling Loss History Current Baseline Forecast of PV of Future Losses ASC 450 (FAS 5) ASC 310 (FAS 114) New Supportable Forecasting Requirement CECL Method

68 ALLL Methodology / Impact of CECL? What have you heard?

69 ALLL Methodology / Impact of CECL? Common Loan Practices Impacting CECL Model Mitigate Interest Rate Risk by Variable rate products Short term balloons Avoiding any longer term fixed products Maximize Profitability Incorporating pricing floors Tightened credit standards to minimize charge offs

70 ALLL Methodology / Impact of CECL? Additional data that need to be captured for CECL model: 1. Loan Grade Dimensions 2. Loan Age Dimensions 3. Loan Level History/ Charge off Dates and Amounts 4. Loan Terms 5. Loan Pricing compared to Market Rates

71 ALLL Methodology / Impact of CECL? C&I $ Balances Accomodation and Food Services Age of Loan in Months Grand Risk Grade < 6 6 < < < < < < < 48 > 48 Totals 1 Pass Pass - 200, , ,000 3 Pass 500, , , , , , , , ,000 3,775,000 4 Pass 125, , , , , , , ,000 2,775,000 5 Special Mention , , ,000 1,050,000 6 Substandard , , ,000 7 Doubtful , , ,000 8 Loss Totals 625, , ,000 1,000,000 1,350, , ,000 1,125,000 2,425,000 9,425,000 C&I $ Losses C&I Loss Rate Accomodation and Food Services Age of Loan in Months Grand Risk Grade < 6 6 < < < < < < < 48 > 48 Totals 1 Pass % % % % % % % % % - 2 Pass % % % % % % % % % - 3 Pass % % % % % % % % % 1.325% 4 Pass % % % % % % % % % 1.441% 5 Special Mention % % % % % % % % % 0.952% 6 Substandard % % % % % % % % % 1.765% 7 Doubtful % % % % % % % % % - 8 Loss % % % % % % % % % - Totals % % % % % % % % % 1.220% Accomodation and Food Services Age of Loan in Months Grand Risk Grade < 6 6 < < < < < < < 48 > 48 Totals 1 Pass Pass Pass , ,000 4 Pass , ,000 40,000 5 Special Mention ,000 10,000 6 Substandard ,000 15,000 7 Doubtful Loss Totals ,000-50, , ,

72 ALLL Methodology / Impact of CECL? Vintage Prepayment & Loan Migration Analysis Understanding how loans are behaving parked loans vs loans in the money Concentration Analysis Can drive marketing strategy. Natural hedging allows organic changes in product mix and industry concentrations. Pooling Methodologies Can be leveraged to mitigate increases in reserve requirements based on new CECL guidelines

73 ALLL Methodology / Impact of CECL? Good Credits Bad Credits Good credits evaporate out of your portfolio Look for best deal structure, can move anywhere, anytime Bad credits stick in your portfolio like gum on your shoe

74 Loan Portfolio Stress Testing Intersession Project Data Sources need to complete OCC Stress Testing Model GSB Student Website OCC Stress Test Model (Excel Version) SNL Data Sources (Calculating 2 & 3 Yr Loss Rates) Summary Income Statement RI-B Charge Off and Recoveries RC-C Loans and Leases RC-R Capital Ratios Data you need from CFO Current ALLL Reserve Asset Liability Forecast (Two year forecast of Income / Loan Balances)