Unraveling the Myths & Mysteries of ERM and Global Credit Risk Management

Transcription

1 Unraveling the Myths & Mysteries of ERM and Global Credit Risk Management June 20, 2012 Presented by: Robin D. Hoag, CPA, CGMA, CMC Director, Financial Institutions Group

2 Overview Enterprise Risk Management (ERM) Background Regulatory Environment Components of ERM Suggestions for ERM Implementation Benefits of ERM Barriers to ERM Upcoming Changes to COSO s Framework Myths/Mysteries Answered DM

3 ERM BACKGROUND DM

4 Committee of Sponsoring Organizations (COSO) Major objective: identify factors causing fraudulent financial reporting and make recommendations to reduce incidences Issued Internal Control Integrated Framework report in 1994 DM

5 Committee of Sponsoring Organizations (COSO) Joint initiative Institute of Internal Auditors (IIA) American Accounting Association (AAA) American Institute of Certified Public Accountants (AICPA) Financial Executives International (FEI) Institute of Management Accountants (IMA) Provides guidance on ERM, internal control and fraud deterrence DM

6 Committee of Sponsoring 1992 Organizations (COSO) Establishes common definition of internal control Creates framework for evaluating the effectiveness of internal control 2004: framework expands to create ERM; sometimes referred as COSO II February 2009: releases Guidance on Monitoring Internal Control Systems Provides assistance in setting up real-time intelligence for consistency and change management (more proactive vs. reactive) DM

7 Committee of Sponsoring Organizations (COSO) October 2009: Recommends improved board risk oversight Issues new thought paper Indicates challenge during this economic crisis January 2011 Issues two additional thought papers on ERM implementation DM

8 Committee of Sponsoring Organizations (COSO) December 2011: draft update on Internal Control Framework published Due to business and operating environments dramatic change in 20 years Should enable more effective application in practice Release postponed to 1Q 2013 (see appendix for detail of expected changes) DM

9 Committee of Sponsoring Organizations (COSO) January/March 2012: Additional thought papers Enhancing board oversight Understanding and communicating risk appetite DM

10 Definition of ERM As defined by COSO: A process, effected by an entity s board of directors, management and other personnel, applied in strategy setting and across the enterprise, designed to identify potential events that may affect the entity, and manage risk to be within its risk appetite, and to provide reasonable assurance regarding the achievement of the entity s objectives. DM

11 Elements of ERM Aligning risk appetite with organizational strategies Enhancing rigor of riskresponse decision Reducing frequency and severity of operational surprises and losses DM

12 Elements of ERM Identifying and managing multiple and crossenterprise risks (across silos) Proactively seizing on opportunities presented along with threats Improving effectiveness of capital deployment DM

13 Key Players Board has overall responsibility for ensuring risks are managed Management is responsible for ERM execution Identifying risks and managing them ERM requires everyone in an organization to participate to ensure success DM

14 Regulatory Environment Currently no specific regulation exists requiring ERM; however: FFIEC Information Security Booklet indicates IS risk assessments consider potential risk in all business lines and risk categories GLBA [Section 501(b)] establishes requirement for financial institutions to safeguard privacy of customer financial information Many references by Federal Reserve, FDIC, NCUA and state examiners in recent exams Focus on board s fiduciary responsibilities for general direction and control of the financial institution DM

15 Regulatory Environment 2009: Securities and Exchange Commission Requirements for proxy disclosure on board s overall risk oversight 2010: Federal Financial Reform legislation Mandates risk committees for boards of institutions and other entities overseen by the Federal Reserve 2010: Recent rule for corporate credit unions Requires establishment of risk management committee DM

16 Regulatory Environment January 2012: Supervisory focus Credit risk/responsible lending Interest rate risk and liquidity Concentration risk May 2012: Interest rate risk and policy requirements issued Focus on compliance Consumer Financial Protection Bureau (CFPB) Unfair and Deception Practices (UDAP) for overdraft and lending DM

17 ERM COMPONENTS DM

18 COSO Cube Objectives focus on: Strategy Operations Reporting Compliance Distinct but overlapping categories DM

19 As outlined in COSO s 2004 Enterprise Risk Management Integrated Framework DM

20 Internal Environment Encompasses entity s tone or risk culture Sets basis for how risk is viewed: top level support Strong ERM leader/team Knowledge: risks / industry / regulation Credibility / acceptance across organization Understands core strategies Good relationship with board / senior management DM

21 Internal Environment Establish Risk Committee (suggestion) Representation from key departments Board liaison Assistance in acceptance and understanding Not always necessary DM

22 Objective Setting Must exist before management can identify potential events affecting its achievement ERM ensures management has a process in place to set objectives ERM ensures objectives are in line with entity s mission and consistent with its risk appetite DM

23 Objective Setting Definitions: Risk Appetite: amount of risk on a broad level an entity is willing to accept in pursuit of value Use of quantitative or qualitative terms Risk Tolerance: range of acceptable variation DM

24 Event Identification Internal and external events can affect achievement of objectives Events must be identified and distinguished between risk and opportunities Understanding of the difference between key performance indicators (KPI) and key risk indicators (KRI) DM

25 Event Identification KPI Performance metrics in place Department Overall entity Almost exclusively on historical performance Untimely warning indicators KRI Metrics that early on identify increasing risk exposure Can be simple (key ratio) or elaborate model DM

26 Event Identification Objective: Manage loan portfolio losses to a minimum KPI examples Charge-off ratio for June 30, 2012 Delinquency ratio for June 30, 2012 KRI examples Unemployment data Property value trends Financial concentration trends of commercial borrowers Financial trends of community employer Loan Officer experience levels concentration Combinations of items DM

27 Event Identification Opportunities/risks are channeled back to management's strategy or objective setting Linkage to core strategy Assists in identification of type of information necessary to timely alert of emerging risk DM

28 Risk Assessment Risks should be analyzed considering likelihood and impact Analysis should be basis for determining how risk should be managed Risks should be analyzed on an inherent and residual basis Linkage of top risks to core strategies DM

29 Risk Assessment Regulators have recommended utilization of a stress testing framework within ERM Forward looking Ultimate steps of cause and effect Traditional risk management usually focuses on one step in the process DM

30 Risk Assessment Stress test example Step 1: Asset shrinkage will improve net worth ratio Step 2: Decline likely will impact earnings Step 3: Asset decline could effect liquidity Step 4: Negative earnings and reduced liquidity could impact net worth and CAMEL rating DM

31 Risk Response Management should determine how to respond to risk Develop action plans to align risks with risk tolerances and appetite DM

32 Control Activities Establish and implement policies and procedures Should help ensure risk responses are effectively carried out Effective controls for managing critical risks DM

33 Information & Communication Relevant information should be identified, captured, measured and communicated Risks within acceptable limits, right level of information reported? Appropriate individuals informed? Should be in a form and timeframe enabling people to carry out their responsibilities DM

34 Monitoring Entirety of ERM should be monitored and modified as necessary Accomplished through ongoing management activities and separate evaluations Use of dashboard reporting Visual displays with trigger points Consistency linkage to overall objectives Risks that should be stress tested frequency determined DM

35 Effectiveness Risk is within the entity s risk appetite Directors and management have reasonable assurance they understand: Strategic objectives are being achieved Opportunities are being identified Reporting is reliable Applicable laws and regulations are complied with DM

36 Effectiveness No material weaknesses in control Components don t function the same for all entities Potentially less formal in smaller organizations Limitations Cannot have absolute assurance due to human judgment (can be faulty) and controls (could be circumvented) DM

37 CPI GDP MACROECONOMIC HOUSING AFFORDABILITY CONSUMER CONFIDENCE RETAIL SALES TREASURY YIELD CURVE LOAN INTEREST RATES IN MARKET CUNA CU FORECAST DM

38 Labor Conditions UNEMPLOYMENT EMPLOYMENT LABOR FORCE POPULATION REAL DISPOSABLE INCOME # DM

39 EMPLOYMENT VS. UNEMPLOYMENT TRENDS/FORECAST 12.00% 10.00% 8.00% 6.00% 4.00% 2.00% 0.00% -2.00% -4.00% -6.00% -8.00% Q1, 2009 Q2, 2009 Q3, 2009 Q4, 2009 Q1, 2010 Q2, 2010 Q3, 2010 Q4, 2010 Q1, 2011 Q2, 2011 Nonfarm Payroll Employment Unemployment Source: Realtor.org: U.S. Economic Outlook DM #

40 Unemployment Rate by County - Example Source: U.S. Bureau of Labor Statistics; Google Public Data Last updated June 7, 2010M DM

41 LABOR FORCE FORECAST 168, , , , , , , , , DM #

42 POPULATION Source: US BLS via Google Public Data DM #

43 REAL DISPOSABLE INCOME 8.00% 6.00% 4.00% 2.00% 0.00% -2.00% -4.00% -6.00% Q1, 2009 Q2, 2009 Q3, 2009 Q4, 2009 Q1, 2010 Q2, 2010 Q3, 2010 Q4, 2010 Q1, 2011 Q2, 2011 DM #

44 Supply & Demand EXISTING & NEW HOME SALES & PRICES INVENTORY SUPPLY PENDING HOME SALES INDEX HOUSING STARTS AUTO SALES TRENDS COMMERCIAL TRENDS # DM

45 HOME SALES & PRICES FORECAST 60.0% 50.0% 40.0% 30.0% 20.0% 10.0% 0.0% -10.0% -20.0% -30.0% -40.0% -50.0% Q1, 2009 Q2, 2009 Q3, 2009 Q4, 2009 Q1, 2010 Q2, 2010 Q3, 2010 Q4, 2010 Q1, 2011 Q2, 2011 Existing Home Sales New Single-Family Sales 10.00% 5.00% 0.00% -5.00% % % % Q1, 2009 Q2, 2009 Q3, 2009 Q4, 2009 Q1, 2010 Q2, 2010 Q3, 2010 Q4, 2010 Q1, 2011 Q2, 2011 Existing Home Prices New Home Prices DM #

46 EXISTING HOME SALES & MONTHS INVENTORY FORECAST 4,500, ,000,000 3,500, ,000, ,500,000 2,000, ,500, ,000, , Apr '09 May '09 Jun '09 Jul '09 Aug '09 Sept '09 Oct '09 Nov '09 Dec '09 Jan '10 Feb '10 Mar Apr r '10 p '10 Inventory Mos. Supply DM #

47 PENDING HOME SALES Pending Home Sales Year States Northeast Midwest South West States Northeast Midwest South West Seasonally Adjusted Annual Rate Not Seasonally Adjusted 2009 Aug Sept Oct Nov Dec Jan Feb Mar Apr May Jun Jul r Aug p vs. last month: 4.3% -2.9% 2.1% 6.7% 6.4% 6.4% 0.8% 4.2% -1.5% 23.9% vs. last year: -20.1% -28.8% -26.5% -13.1% -19.6% -18.4% -25.5% -24.2% -12.2% -18.5% Source: Realtor.org DM #

48 US NEW AUTOS SALES FORECAST $20 $ Millions $ $5 $ Source: U.S. Dept. of Transportation and CUDL Forecast DM #

49 COMMERCIAL CLI AL ASSOCIATION OF REALTORS COMMERCIAL LEADING % change Time CLI from a quarter ago % change from a year ago % 2.7% % 2.8% % 2.4% % 2.1% % 3.1% % 2.3% % 2.1% % 1.4% % 0.5% % 0.7% % 0.1% % -0.3% % -1.2% % -2.2% % -3.6% % -9.4% % -13.3% % -13.7% p % -11.1% r = revision; p = preliminary CLI is a commercial leading indicator index designed to provide early signals of turning points peaks and troughs between expansions and slowdowns of commercial real estate activity. Industrial production REIT Price Index NCREIF Total Return Personal Income minus Transfer Payments Jobs in Financial Activities Jobs in Professional Business Service Indicator Components Jobs in Temporary Help Jobs in Retail Trade Jobs in Wholesale Trade Initial Claims for Unemployment Insurance Manufacturers Durable Goods Shipment Wholesale Merchant Sales Retail Sales and Food Service DM #

50 COMMERCIAL SALES VOLUME # DM

51 COMMERCIAL SALES PRICE # DM

52 COMMERCIAL RENT GROWTH 0.0% 2009 III 2009 IV 2010 I 2010 II 2010 III 2010 IV 2011 I -0.5% -1.0% -1.5% -2.0% -2.5% Office Industrial Retail Multi-Family DM #

53 COMMERCIAL VACANCY 20.0% 18.0% 16.0% 14.0% 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% 2009 III 2009 IV 2010 I 2010 II 2010 III 2010 IV 2011 I Office Industrial Retail Multi-Family DM #

54 COMMERCIAL INVENTORY 14, S q u a r e F e e t 12,000 10,000 8,000 6,000 4, U n i t s i n m i l l i o n s 2, III 2009 IV 2010 I 2010 II 2010 III 2010 IV 2011 I Office Industrial Retail Multi-Family 14 DM #

55 Member Credit RESCORING YOUR LOAN PORTFOLIO # DM

56 RESCORED PORTFOLIO: THE SOFT SCORE Total Loans Weighted Averages Delinquency Valuation Average Current Category Count Contractual FICO Category Balance Balance <30 30 and <60 60 and <90 90 and < Rate Term Remaining Age Score 10-Year Balloon 129,235 48,075, % ,885, , ,046 89, Year Fixed 50,176 11,088, % ,031,117 57, Year Fixed 68,692 48,359, % ,934, ,501 86, Year Fixed 84,391 11,308, % ,941, ,575 69,015 3/1 ARM (FR) 131,507 2,235, % ,106, ,878 3/1 ARM (VR) 126,494 2,529, % ,114, , , Year Fixed 107, ,853, % ,822,455 4,208, , ,848 5/1 ARM 106, , % ,999 7-Year Balloon 157,524 6,931, % ,622, ,869 TOTALS 94, ,343,108 2, % ,419,774 6,169, ,693-1,133, ,589,196 1,753,912 Rescoring your portfolio allows a current picture of the enhancement or degradation of member credit quality. A combination of a drop 90 points or more in credit score (essentially two credit grades) and delinquency of more than 20 days provides an area of immediate focus for prioritizing which loans to address first. DM #

57 ERM IMPLEMENTATION DM

58 Five Steps For Implementing A Successful ERM Strategy 1. Select the appropriate team 2. Understand your institution 3. Documentation and analysis of processes and control techniques 4. Identify and monitor key risk indicators(kri) 5. Test controls and report test results DM

59 1. Select the Appropriate Team Leader - specific skill sets Possible representation of significant business units include Lending Operations (branch/deposits) Finance Marketing IT Compliance/Audit Start in increments and build on each accomplishment DM

60 2. Understand Your Institution Perform risk assessment to identify key processes, risks, and controls for Operations Compliance Financial reporting Identify key process owners DM

61 2. Understand Your Institution Inventory/build on existing systems in place Quantify severity/frequency/probability Measure consistently DM

62 3. Documentation & analysis of processes & control techniques Interview process owners Consistent documentation of the process Identify risks and related controls Analyze risk management techniques and take inventory Measurement of risks Benchmarks Metrics Consistency/defined DM

63 3. Documentation & analysis of processes & control techniques Perform process and control reviews Identify control deficiencies Fill in gaps Remediate deficiencies Risk control strategies DM

64 4. Identify & Monitor Key Controls Identify key controls to be monitored Identify KRI to be monitored Assign monitoring resources Train resources assigned to monitor key controls DM

65 Identification of Events Process Root Cause Event Intermediate Event Risk Event DM 2012 Source: 65

66 Example Documentation Format Risk Category Description of Risk Likelihood Impact to Institution Velocity Institution Readiness Priority Financial Risk Significant losses due to exposure on lending and collection Medium High (Direction: increasing, decreasing, stagnant) (Put measurement) High or rank DM 2012 Source: 66

67 Example Documentation Format Risk Category Risk Owners(s) Risk Appetite Metrics Monitoring Action Plans Company Oversight Board Oversight Financial VP of Lending Loan and Collection Policy Quarterly results communication of environment and actual statistics Modification of lending policy / collection techniques President/ CEO Internal Audit Full Board DM 2012 Source: 67

68 5. Test Controls & Report Results Determine test procedures Develop test plans Link to internal audit Document tests and report results Ongoing communication with senior management is essential Dashboard reports Challenge current strategy and tactics: achieving objectives? DM

69 FINANCIAL SENSITIVITY ANALYSIS

70 APPROACH SCENARIO PLANNING Routinely perform portfolio-level scenario and sensitivity tests (with your ALM/IRR management) to quantify the impact of changing economic conditions on asset quality, earnings and net worth. An example could be for concentration in Real Estate loans would be the risk to earnings if unemployment in the area doubled while housing market values declined by 20%. DM #

71 SCENARIO EXAMPLE: CONSIDERING THE DATA Macro Labor Supply & Demand Systematic Risks Category Risk Assessment Scale Output Category Risk Assessment Scale Output CPI Low Risk 1 Delinquency Trends High Risk 3 GDP Low Risk 1 Charge-Offs High Risk 3 Housing Affordability Moderate Risk 2 Provision For Loan Loss High Risk 3 Consumer Confidence Low Risk 1 Loan Growth Moderate Risk 2 Retail Sales Moderate Risk 2 Loan Mix Low Risk 1 Treasury Yield Curve Low Risk 1 Savings Growth Moderate Risk 2 Loan Interest Rates Moderate Risk 2 CUNA CU Forecast Moderate Risk 2 Credit Idiosyncratic Risks Rescoring Member Loans Moderate Risk 2 Unemployment High Risk 3 Employment Moderate Risk 2 Labor Force Low Risk 1 Concentrated member relationships Low Risk 1 Population Low Risk 1 Type Low Risk 1 Real Disposable Income Moderate Risk 2 Geographic Area Low Risk 1 Fixed vs. variable Low Risk 1 Lien position Low Risk 1 Existing & New Home Sales Moderate Risk 2 Employer Low Risk 1 Home Prices Moderate Risk 2 Seasoning of portfolio Low Risk 1 Inventory Moderate Risk 2 Supply In Months Moderate Risk 2 Pending Home Sales Index Moderate Risk 2 Underlying Collateral Value Moderate Risk 2 Housing Starts Moderate Risk 2 Current Loan-to-Value Moderate Risk 2 Auto Sales Trends Moderate Risk 2 Commercial CLI Moderate Risk 2 Commercial Prices Moderate Risk 2 Commerical Vacancy Moderate Risk 2 Risk Summary Total Average Macro Labor Risk Categorization Legend Risk Value Supply & Demand High Risk 3 Benchmarking Moderate Risk 2 Credit Low Risk 1 Concentration No Risk 0 Value Benchmarking Concentration Value DM #

72 SCENARIO EXAMPLE: MODEL SCENARIO VARIABLE INPUT Troubled Portfolio Portion Based on Real Estate Loand 1.00% 1,690 a Troubled Portfolio Portion Based on Auto Loans 0.00% - b Troubled Portfolio Portion Based on Commerical Loans 5.00% 903 c Troubled Portfolio Portion Based on Other Consumer Loans 0.00% - d Sales Price 80.00% 2,075 e Gain/(Loss) on Sale (519) f Maintenance Fees on Loan Amount Based on Loan Amount 5.00% (130) g Legal Fees Fixed Dollar Amount (4,500) (4,500) h Broker Fees Based on Sales Price 6.00% (124) i Total Gain/(Loss) $ (5,273) j Current Adjustment Adjusted BALANCE SHEET ASSETS Cash e+g+h+i 6,398 (2,680) 3,719 Investments 90,310 90,310 Real Estate a 169,038 (1,690) 167,348 Auto Loans b 89,658-89,658 Commerical c 18,056 (903) 17,153 Other Consumer d 83,896-83,896 Gross Loans 360,647 (2,593) 358,054 Allowance -1.93% (6,973) 50 (6,923) Net Loans 353,674 (2,543) 351,131 Other Assets 20,067 20,067 Total Assets 470,448 (5,223) 465,226 LIABILITIES & CAPITAL Notes Payable 33,550 33,550 Other Liabilities 3,251 3,251 Deposits 395, ,292 Capital 38,356 (5,223) 33,133 Liabilities & Capital 470,448 (5,223) 465,226 Current Adjustment Adjusted INCOME STATEMENT Loan Income 24,297 24,297 Investment Income 1,459 1,459 Total Interest Income 25,755 25,755 Deposit Interest Expense 6,845 6,845 Borrowing Interst Expense 1,582 1,582 Total Interest Expense 8,427 8,427 Total Non-Interest Income 7,339 7,339 Total Non Interest Operating Expense 18,463 18,463 Provision for Loans Losses 2.03% 7, ,237 Non-Operating Gains/(Losses) j 2,295 (5,273) (2,977) Net Income 1,313 (5,324) (4,012) Capital/Asset Ratio 8.15% 7.12% DM #

73 ERM BENEFITS DM

74 Benefits of ERM Helps entity manage risks to protect and enhance value by: Focusing on establishing sustainable competitive advantage Optimizes cost of managing risk Helps management improve business performance Helps management to effectively deal with uncertainty and associated risk and opportunity DM

75 Benefits of ERM As a result, institutions are more likely to: Identify and correct internal control problems on a more timely basis Produce more accurate and reliable information for use in decision-making Prepare accurate and timely financial statements Be in position to provide periodic certifications or assertions on the effectiveness of internal control DM

76 BARRIERS TO ERM DM

77 Barriers Industry observations: Lack of Board/Senior management support Lack of appropriate resources to champion the project Not taking it slow Lack of a consistent definition of risk measurement/approach DM

78 MYTHS AND MYSTERIES ANSWERED DM

79 I need to implement ERM in its entirety at the start of the project. No; it is more beneficial to start slow and focused (one or two business functions/units) in order to finetune the process and not get overwhelmed. I need a department or Chief Risk Officer on staff to implement ERM. No; organizations have been able to utilize current staff and committees, as long as they possess the appropriate skill sets as noted previously. DM

80 I need to have a system model to implement ERM. No; Models could be useful; however, as long as risk measurement and documentation format is consistent and defined, it is not mandatory. My current risk monitoring is appropriate and constitutes ERM. These monitoring functions are essential and a good base; however, traditionally they haven t been focused on the whole organization s objectives and are not woven into the company s culture/process/capital/objectives. DM

81 Once a credit union implements ERM, it does not have to change. No; ERM is constantly evolving and modifying to the current environment and strategies of the organization. DM

82 Source for Additional Information Committee for Sponsoring Organizations ( Guidance papers, surveys and articles on ERM, internal control and fraud deterrence DM

83 QUESTIONS? DM

84 OFFICES: FLORIDA, TEXAS AND MICHIGAN Robin D. Hoag, CPA, CGMA, CMC Director, Financial Institutions Group direct DM

85 Financial Institutions Group Services ERM consulting Audit Internal audits Information technology assurance Vulnerability assessments Penetration testing Lending reviews Loan loss and delinquency control systems Regulatory compliance consulting Mergers & acquisition consulting Business valuation analysis DM