Integrating Risk Appetite, tress Testing and Capital Planning

Transcription

1 Risk Management for Community Banks Integrating Risk Appetite, tress Testing and Capital Planning Boston August 15, 2013

2 Discussion Topics Questions for the Audience Some Basics Definitions Where Do We Start? How Does Risk Appetite Lead to Capital Planning? How Do You Layer in Stress Testing? Why Is It Essential to Integrate These Three Components? 2

3 Questions for the Audience Whose bank is over $10 billion? Whose bank is a mutual? Does any bank not make commercial loans? Does any bank not make CRE loans? Is anyone stress testing today? Does anyone think they are under-capitalized? 3

4 Some Basic Definitions What Do We Mean by Risk Appetite? - Risk appetite is the level of risk that an organization is prepared to accept. What do we mean by risk? Risk is the volatility of the investment and the potential loss (expected and unexpected) if conditions change. - A Risk Appetite Document provides a consistent framework for understanding risk through the organization and a means to ensure that risk considerations are ingrained in the day-to-day operation of the firm. 4

5 Some Basic Definitions What Do We Mean by Stress Testing? - Stress testing is a way to gauge a bank s potential vulnerability to exceptional but plausible adverse events. This testing should identify the amount of additional capital an institution may need in a variety of stressed situations. Stress testing should assess and quantify an institution s vulnerabilities under multiple unfavorable scenarios. - Once the potential downside is understood, the institution can take steps to reduce or mitigate those risks, or it can ensure it had sufficient capital to manage those risks. 5

6 Some Basic Definitions What Do We Mean by Capital Planning? - Capital Planning defines the amount of capital a bank should hold to absorb both expected and unexpected losses in both normal and stressed conditions, anticipating both the bank s current and future business lines. 6

7 Some Basic Definitions Expected loss is identified through the Allowance for Loan and Lease Losses methodology and calculation. Unexpected loss is covered by the capital reserves a bank holds on its balance sheet. - This is directed by bank regulators and by a bank s board which must determine how much excess capital is necessary for an institution based on the type of lending risk it is willing to take. 7

8 WHERE DO WE START? 8

9 Risk Appetite Risk appetite defines the starting spot. Each organization should be able to define the types of risks it is willing to take. Based on that starting risk profile, management should be able to determine the amount of capital the bank should hold to cover the expected and unexpected losses for the normal condition of the current business lines. 9

10 HOW DOES RISK APPETITE LEAD TO CAPITAL PLANNING? 10

11 Capital Planning The bridge to Capital Planning is defined the by the range of exceptional but plausible adverse events that a bank believes could occur due to changes in macroeconomic (or local) conditions. The bank s appetite for loss and volatility. And the expected future condition of the bank s balance sheet. 11

12 Capital Planning To simplify our discussion, let s look at some examples of risk appetite related to loan portfolios, and to simplify the presentation, we ll talk specifically about CRE lending. We should all agree, however, that this approach can apply to all credit risk the institution underwrites and it can apply to other types of risk that affect your organization (interest rate, liquidity, etc.) 12

13 Capital Planning We re willing to lose up to $1.5 million on a $90 million loan portfolio in order to earn an above average return. or We re willing to lose up to $1.0 million on a $90 million loan portfolio in order to earn an average return. or We re only willing to lose up to $500,000 on a $90 million loan portfolio but we understand we will earn a below average return. 13

14 Capital Planning AND We never want our capital ratio to drop below 9% under a once in a lifetime set of events. AND We never want any loan portfolio segment to lose more than $xxx,xxx. AND We never want to lose more than $yyy,yyy to a single individual. 14

15 Risk Appetite and Capital Planning We re willing to lose up to $1.0 million on a $90 million loan portfolio in order to earn an average return AND we never want our capital ratio to drop below 9% under a once in a lifetime set of events AND we never want any loan portfolio segment to lose more than $xxx,xxx AND we never want to lose more than $yyy,yyy to a single individual. These conditions now define the amount, type, size and diversity of loans an institution is willing to write. We can now calculate how much capital a bank should hold for baseline present and future conditions. 15

16 HOW DO YOU LAYER IN STRESS TESTING? 16

17 Stress Testing Stress Testing to Determine Risk Appetite - For example, let s model the three different portfolios the above average return, the average return and the below average return. Stress Testing to Determine Growth Plans - Take current portfolio, devise multiple growth strategies to look at income and ROA. Then overlay stress conditions to see which growth trajectories will meet the bank s defined risk appetite. 17

18 WHY IS IT ESSENTIAL TO INTEGRATE THESE THREE COMPONENTS? 18

19 Risk Appetite + Capital Planning + Stress Testing Integrating these three concepts helps a financial institution manage and deploy capital more efficiently. Information does not flow in just one direction. Once you stress a portfolio or look at a future growth model under stressed conditions, you should go back to your risk appetite framework to validate that the institution is willing to handle (and capable of handling) the projected potential loss and volatility. 19

20 Risk Appetite + Capital Planning + Stress Testing If you re good enough to balance these three elements, your institution is probably at the top of its game among peers for ROA, margin and efficiency ratio. And we all want to work for a topflight organization, because they pay the most for talent. 20

21 Thank You