DIY Credit Stress Test: Steps to Create & What the Numbers Tell You

Transcription

1 DIY Credit Stress Test: Steps to Create & What the Numbers Tell You Independent Bankers Association of New York State 2018 Credit Conference June 5th, 2018

2 Today s Speaker Shawn O Brien President QwickRate Shawn O Brien President QwickRate Leads the Strategy for QwickRate Leads the Strategy for QwickRate Leads the Strategy for QwickRate Partner, Monroe Financial Partners Partner, Monroe Financial Partners Partner, Monroe Financial Partners Co-founder of QwickAnalytics Co-founder of QwickAnalytics Co-founder of QwickAnalytics Director, National Bank of St. Anne Director, National Bank of St. Anne Director, National Bank of St. Anne shawn.obrien@qwickrate.com

3 QwickAnalytics Created by Bankers to Assist Community Banks

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14 Community Bank Stress Testing

15 Why are you being asked to Stress Test? Because Capital is Important! Capital Absorbs Losses Capital designates the percentage of assets that a financial institution can stand to lose without becoming solvent. Promotes public confidence Restricts excessive asset growth Overall intention to reduce systemic risk protect depositors and the Deposit Insurance Fund Lessons Learned from the Crisis: Failed Bank autopsies Boards & Management not on same page Bankers should better understand the largest component of risk on their Balance Sheet! Next step in the Risk Management Process!

16 Why am I being asked to Stress Test? Let s not forget the 2008 Financial Crisis Cost of Crisis - $12.8 trillion (estimated) Over 8 million jobs lost, household wealth declined over $19 trillion Losses on U.S. residential mortgages topped $2 trillion Home equity declined by $7 trillion 1 out of every 5 banks (21%) traded today have Tangible Book Value (TBV) less than their TBV pre-crisis

17 Why am I being asked to Stress Test? With the good comes the bad! Regulator/Government response to the Financial Crisis Deposit Insurance saved our industry; no panic Troubled Asset Relief Program (TARP) Temporary Liquidity Guarantee Program (TLGP) Housing Economic Recovery Act of 2008 (HERA) Basel III Dodd-Frank Act Stress Test (DFAST) Designed to increase financial stability and prevent future devastation from financial crises Comprehensive Capital Analysis & Review (CCAR) Requires large bank holding companies with consolidated assets greater than $50 billion to submit a proposed capital plan on an annual basis to the Fed

18 Community Bank Stress Testing Post Crisis: What should have been the regulator s response to what happened during the crisis? Was nothing an acceptable answer?

19 Why am I being asked to Stress Test? Regulatory Imperative Self-regulation failed Stress Tests were created after the 2008 financial crisis when banks were found to overleveraged and overexposed to a overheated real estate market Stress testing is a forward looking quantitative evaluation of adverse environments that could impact a financial institution s condition and capital adequacy.

20 Why are you being asked to Stress Test? Because Trees do not grow to the sky! Regulators want you to know what would happen to your borrowers if? Rates increased 100 or 200bps? Commodity prices dropped significantly? Capitalization rates changed? NOI dropped by 10-20%? How would any of these changes impact your borrowers? Idiosyncratic Risk is there a large outstanding risk that is unique to your Bank? What if what makes you successful turned on you?

21 What do I hope to learn from my Stress Test? Stress Test Objectives Ensure capital is sufficient to withstand an economic downturn Ensure integrity in the capital planning process Understand and evaluate overall credit risk and exposure

22 Oversight Risk Management What are regulators looking to learn about you and your Bank? How do you educate/inform your Board? How do you identify, discuss and document risks? Are you sensitive to or aware of concentration/correlation risks? How do you compare to your peers? Can you effectively manage what you do not measure? What is your Strategic/Capital planning process?

23 Oversight Risk Management Does the Bank Understand their Risk Profile?

24 Oversight Risk Management Does the Bank Document their Understanding?.., if not? It is as if it never happened!

25 Why are you being asked to Stress Test? Next up? A Capital Plan Every Bank needs one - Capital is King! Stress Testing Informs the Capital Plan More robust Capital Planning is a must! Lessons Learned from the Crisis: Capital Plans at failing banks did not either work or did not exist Lack of Capital Plans will not happen again

26 Building Your Credit Stress Test 1. Understand why you are being asked you are not being punished 2. Understand what is being asked of you by Regulators 3. Start Relatively Simply match your bank s complexity 4. Get Good Data 5. Don t Forget about Capital Implications Basel/CECL 6. Make It Useful to Your Board 26

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

28 Divining Regulatory Expectations Statement to Clarify Supervisory Expectations for Stress Testing by Community Banks Community banks are not required or expected to conduct the types of stress testing specifically articulated in the initiatives directed at larger organizations. Issued Jointly By the Federal Reserve, OCC and FDIC May 14, 2012 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. 28

29 Divining Regulatory Expectations Let it be written, let it be done. Statement to Clarify Supervisory Expectations for Stress Testing by Community Banks The agencies continue to emphasize that Issued Jointly By the Federal Reserve, OCC and FDIC May 14, 2012 all banking organizations, regardless of size, should have the capacity to analyze the potential impact of adverse outcomes on their financial condition. 29

30 Risk Management The best way to demonstrate risk management is to practice risk management!

31 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. 31

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

33 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 1. 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 E.g. in the 80th percentile of your peer group If you are growing loans quickly If you are a larger, more sophisticated bank E.g. trending closer to the $10 billion Dodd-Frank limit 33

34 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); OCC Supervisory Guidance October 18, 2012 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 overall risk management, asset/liability, and strategic and capital planning processes. 34

35 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. 35

36 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 36

37 Sorry! I know the following slides will be hard to see/read. I will send you a copy of your Bank s Credit Stress Test. I will also send a copy of the revised presentation. If I don t have your address, please give me a card and I will send when I am back in the office.

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41 3 Loss Scenario for Historical & Peer Tests Baseline Scenario Your Historical Experience Your loss rates for the 4 most recent quarters Peer Loss Test Average losses for the most 4 recent quarters Adverse Scenario Your Historical Experience Average of 2 worst years of losses Peer Loss Test 75 th percentile of peer losses Severely Adverse Scenario Your Historical Test Your Worst year of losses Peer Loss Test 90 th percentile of peer losses

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45 Determining Your Loss Rates Utilize Call Report Categories Identify Historical Loss Rates Multiply Call Report Loan Balances by Loss Rates for each category in each scenario don t overthink this! Keep it very straightforward! The objective is to give you goal posts.

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47 2 Year Cumulative Pro Forma Earnings Impact (Losses +Projected Core Earnings)

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50 Review of Methodology 2 Years of Earnings 2 Year Estimate of Credit Losses for each scenario Add/(Subtract) After Tax Earnings/(Losses) from Existing Capital Calculate Pro Forma Capital Ratios 50

51 What level of losses will it take to break the bank? Reverse Stress Test When all other tests don t provide needed data point

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55 Regulatory Expectations Use your Results to Inform your Capital Plan 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

56 Tie Results to Capital Planning Action Plan: incorporate stress testing results into capital planning Up-To-Date: ensure future capital rations include all levels of Basel III phase-ins Document: provide evidence of proactive planning in file

57 Display Digestible Data Make it Useful to your Board Comprehensible: summarize the results in graph form Actionable: make implications of results easy to understand Credible: provide detailed assumptions behind summaries if needed Consistent: be able to replicate annually at least

58 Final Thoughts Basel III tells you how much capital you need to operate your bank; the Credit Stress Test tells you how much capital you need to survive another crisis!

59 Return of Capital Bank Shareholders today are worried equally about the Return of their Capital as they are about the Return on their Capital!

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63 Thank You For Attending! Sign up for a 30-day free trial of QwickAnalytics! Go to Call us at to get started. Melissa Wallace melissa.wallace@qwickrate.com Shawn O Brien shawn.obrien@qwickrate.com Ricki Dagosta ricki.dagosta@qwickrate.com