External Credit Stress Testing

Transcription

1 External Credit Stress Testing What Community Banks Need to Know March 3, 2015

2 Introductions Greg Dingens EVP and Head of Investment Banking Monroe Financial Partners, Inc. 25 years experience in investment banking Former Managing Director and the head of the Chicago Investment Banking Advisory practice at both Merrill Lynch and Lehman Brothers Also: General Partner, Siena Capital Partners I, L.P. - private investment fund that invests in community banks Shawn O Brien President QwickRate Leads the strategy for the premier non-brokered CD marketplace and accompanying products Serves on the Board of Directors of National Bank of St. Anne (Illinois) Previously worked at HomeStar Bank & Trust in Manteno, Illinois Works closely with the ICBA as a Preferred Service Provider 2

3 What Is A Stress Test? Definition The results of conducting a series of what if scenarios to assess the vulnerability of your loan portfolio to exceptional but plausible credit stress. Stress Test for Community Banks? Can Mean Many Different Things 3

4 Today s Topic: Credit Stress Testing for community banks per Regulatory Agencies 4

5 Why Should You Care? 1 Stress Tests Are Coming! Clear regulatory mandate (the execution less clear) 2 Best Practices Demonstrate Risk Management Proactively get ahead of regulatory curve 3 You Might Learn Something Identify vulnerabilities; plan for BASEL III 5

6 Polling Questions: Answer from your smartphone or tablet. Type in your Browser: 6

7 Polling Question: Did you conduct a stress test in 2014? Poll 7

8 Background: Regulatory Framework A bank must have in place sound stress testing processes for use in the assessment of capital adequacy. Stress testing should involve identifying possible events or future changes in economic conditions that could have unfavorable effects on a bank s credit exposures and assessment of the bank s ability to withstand such changes. Basel Capital Accord FED Risk Types Credit risk Liquidity risk Market risk Operational risk Legal risk Reputation risk 8 OCC Risk Types Credit risk Liquidity risk Interest rate risk Price risk Transaction risk Compliance risk Strategic risk Reputation risk 8

9 The Big Bank Stress Tests Big Banks: EXPLICIT Mandatory Testing Dodd-Frank Act Requirements Federal Reserve to provide at least three different scenarios for firms to stress test against Exhaustively detailed set of assumptions, variables and outputs Federal Reserve to do annual stress test on bank holding companies over $50 billion in assets and non-bank financial firms under Federal Reserve supervision And firms above required to do their own semi-annual stress tests All other banks with assets greater than $10 billion required to do annual stress test 9

10 The DFAST Bank Testing For Banks $10 billion to $50 billion: 19 pages of instructions 27 different macroeconomic variables Mandatory templates with over 100 line item outputs 10

11 Divining Regulatory Expectations Statement to Clarify Supervisory Expectations for Stress Testing by Community Banks Issued Jointly By the Federal Reserve, OCC and FDIC May 14, 2012 Community banks are not required or expected to conduct the types of stress testing specifically articulated in the initiatives directed at larger organizations. In particular, community banks are not required or expected to conduct the enterprise-wide stress tests required of larger organizations under the Dodd- Frank Act 11

12 Divining Regulatory Expectations Statement to Clarify Supervisory Expectations for Stress Testing by Community Banks Issued Jointly By the Federal Reserve, OCC and FDIC May 14, 2012 The agencies continue to emphasize that all banking organizations, regardless of size, should have the capacity to analyze the potential impact of adverse outcomes on their financial condition. 12

13 Divining Regulatory Expectations OCC Guidance Comptrollers Handbook, December 2011 While institutions with large and complex portfolios may use sophisticated financial models, institutions with less complex portfolios can use less sophisticated techniques. It is critical to ask the what if questions and incorporate the answers into the risk management process. Lenders may conduct less complex stress tests by evaluating borrower what ifs The lender can then aggregate the results at the portfolio and firm-wide levels. As the bank s knowledge of stress testing grows, it should strive to make the analysis more robust by simultaneously stressing a number of related variables. 13

14 Divining Regulatory Expectations Stress Testing and Capital Planning 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. 14

15 Divining Regulatory Expectations Stress Testing and Capital Planning 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 October

16 Punchline! Regardless of the testing method used, an effective stress test has common elements that a community bank should include: Asking plausible what if questions about key vulnerabilities (primarily loan losses for community banks); Making a reasonable determination of how much impact the stress event or factor might have on earnings and capital; and OCC Supervisory Guidance October 18, 2012 Incorporating the resulting analysis into the bank s overall risk management process, asset/liability strategies, and strategic and capital planning processes. 16

17 Polling Question: Has your regulator asked to review your stress test? Poll 17

18 Stress Test Methods Method Description Community Banks? Transaction stress testing Enterprise-level stress testing Individual loan level analysis, borrower ability to pay analysis Multiple variable, environmental risk No No Portfolio stress testing Loan category analysis against peer and historical loss experiences YES Reverse stress testing What stress level of losses breaks the bank? YES 18

19 Stress Test Methods Test Should Reflect Community Bank A community bank s approach to stress testing should fit its unique loan portfolio strategy, size, loan types, composition, operations and management. Given the smaller scale and lesser complexity of most community banks, assessing portfolio risk and capital vulnerability can be relatively simple. Concentration, Especially in CRE, May Merit Further Analysis In some cases, a bottom-up, loan-by-loan analysis may help... For more complex portfolios management may link commercial mortgages to debt service coverage and long-to-value ratios to project potential loss under possible adverse circumstances. Construction loans may be sensitive to particular variables such as selling rates, leasing activity, or oversupply. OCC Supervisory Guidance October 18,

20 Beyond The Portfolio Test? The regulators have NOT provided guidance around WHEN a bank may need more sophisticated, transaction-level analyses. However, reading the tea leaves If your bank has very high concentrations in certain loan categories E.g. 300% Investor CRE / capital If your bank has experienced loan losses well above your peers in certain loan categories E.g. in the 80th percentile of your peer group If you are a larger, more sophisticated bank E.g. trending closer to the $10 billion Dodd-Frank limit 20

21 The Regulators 3 Tests Test 1 Test 2 Test 3 Peer Group Loss Experience The bank s Peer Group Loss Experience has been gathered, evaluated and applied to the subject bank s loan portfolio under varying scenarios of stress. Bank Historical Loss Experience The bank s actual Historical Loss Experience has been gathered, evaluated and applied to the bank s current loan portfolio under varying scenarios of stress. Reverse Stress Test The Reverse Stress Test has been applied to the bank s own balance sheet, calculating the losses required to reduce the bank s capital to critically undercapitalized levels. 21

22 Basic Portfolio Stress Test Framework Step 1: Estimate Loan Portfolio Losses Calculate potential stressed losses over 2-year period for entire portfolio 1. Loan Categories 2. Period End Balances 3. Stress Loss Rates 4. Stress Losses Step 2: Estimate Earnings Offset / Impact Calculate earnings available to fund losses 1. Core Operating Earnings (PTPC) 2. Provisions required to (a) fund losses and (b) maintain ALLL levels 3. Taxes and other items 4. Net Income Step 3: Estimate Impact on Capital Levels Apply net impact to capital levels 1. PF Impact to Tier 1 & Total Capital 2. Calculate and compare relevant capital ratios 22

23 Determining Loss Rates UBPR Peer Analysis to Establish Benchmarks PEER GROUP 3: $300 mm to $1 billion 90th Percentile WORST Net Losses by Type of LN&LS AVG 2 YEARS Real Estate Loans Construction & Land Development Family C onstruction Other Construction & Land Secured by Farmland Single & Multifamily Mortgage Home Equity Loans Family Non-Revolving Multifamily Loans Non-Farm Non-Residential Mtg Owner Occupied Nonfarm Nonresidential Other Nonfarm Nonresidential Agricultural Loans C ommercial and Industrial Loans Loans to Individuals All Other Loans & Leases

24 Polling Question: Do you track & compare peer credit data? Poll 24

25 Peer Credit Stress Test Example Example: $800 million bank with $615 million in loans and $75 million in Tier 1 Capital Key Assumptions: 2-year Loss Rates? Gather Data & Create a Range: Bank s actual experience UBPR PG experience Sort by geography, size, etc. 25

26 Peer Credit Stress Test Example Example: $800 million bank with $615 million in loans and $75 million in Tier 1 Capital Step 1. Estimated Loan Portfolio Stress Losses 90th PCT Loss Range Loan Portfolios from Call Report Schedule RC-C Quarter End $Balances Two-Year Stress Loss Rate % Two-Year Stress $ Losses Loans secured by type of real estate a. Construction and development $ % $ 14.1 b. Farmland % 0.4 c. 1-4 family housing % 6.9 d. Multifamily housing % 3.9 e. Nonfarm nonresidential property % 4.3 Agricultural production % 0.3 Commercial and industrial % 8.9 Consumer loans % 1.0 All other loans % 0.4 Total $ % $

27 Peer Credit Stress Test Example Key Assumptions: Core Operating Earnings Pre-Tax Pre-Provision Net Interest Income Core Non-Int Income Core Non-Int Expense OREO write-downs / costs 27

28 Peer Credit Stress Test Example Step 2. Estimated Impact of Stress on Earnings Previous Two Years Actual Pro Forma 2 Year Stress Period Core Operating Earnings (PTPC) Less provision to cover two-year losses Less provision to maintain adequate ALLL - (1.0) Less OREO losses Pretax Income 12.0 (15.3) Income tax expense (benefit) 4.5 (5.7) Net Income 7.5 (9.5) 28

29 Peer Credit Stress Test Example Key Questions What Do These Results Suggest? What Actions May Be Required? 29

30 Peer Credit Stress Test Example Step 3. Estimated Impact of Stress on Capital Quarter End $ Balances Pro Forma Stress Tier 1 Capital $ Net change in Tier 1 Capital from stress period (net income from Step 2) N/A (9.5) Pro Forma Tier 1 Capital $ Quarterly Average Assets $ Tier 1 Leverage Ratio % 9.5% 8.4% Total Capital Total Risk Based Assets Total RBC Ratio 12.7% 11.5% 30

31 Reverse Credit Stress Test What Level of Losses Will It Take to Break the Bank? 31

32 Don t Forget Basel III 1. Higher Overall Levels of Common Equity Required Leverage & Tier 1 capital creativity is frowned upon 2. New enforcement powers: restrictive rules around shareholder distributions, buybacks and bonuses, all limited by capital levels Capital Conservation Buffer Common Equity = KING 3. More detailed and conservative approach to weighting the risk of assets (administratively burdensome) Larger denominator = MORE CAPITAL RESULT More Capital & More Administration 32

33 Benefits of Stress Testing Identification and mitigation of risks Changes to underwriting policies Portfolio concentrations and limits Credit oversight and proactive management of loans Capital planning Understanding / assessing future capital needs Especially with BASEL III Impact on ALLL provisions Prepare contingency plans Best practices: Demonstrate risk management Relatively easy to comply (but for data) 33

34 Polling Question: Is your board aware of the new stress test requirements? Poll 34

35 Getting Started 3 Tips 1. Start Simple Fit to organization: simplicity as a base, with increasing sophistication if/as warranted Pick the few critical variables that matter Loss rates by category Core Operating Earnings Go deeper if results suggest red flags 35

36 Getting Started 3 Tips 2. Conclusions Are Only As Good As The Assumptions Assumptions based on observable data carry much greater credibility Actual bank experience Peer data Design results with usable output in mind 36

37 Getting Started 3 Tips 3. Just Do It Don t wait until you have designed the perfect process Let the process evolve and inform your model 37

38 Questions? Monroe Financial Partners Greg Dingens EVP & Head of Investment Banking (312) QwickRate Shawn O Brien President shawn.obrien@qwickrate.com (815) Serving Community Banks Since 1968 Experienced Investment Banking National Market Making Affiliated Asset Management Premier Non-Brokered CD Marketplace Over 3,300 institutions in 50 states Unbiased, nationwide CD rates No transaction fees 38