Enterprise Risk Management and the ALCO Process

Transcription

1 Enterprise Risk Management and the ALCO Process Session 1: Gathering the Parts David Koch Chief Operating Officer ext 4217

2 Agenda Session 1 Overview of ERM Evolution of ERM Regulatory Emphasis Role of Capital Planning Stress vs. Scenario Testing Review of Current Risk Measures: Stress Testing Session 2 Defining Scenario Testing Building Scenarios Probability vs. Stress Cross Risk Considerations Running Scenario Testing vs. Business Plan Genesis of Dynamic Modeling Sensitivity Testing Scenarios 2

3 Enterprise Risk Management (ERM) Definition: An integrated approach to identifying, assessing, managing, and monitoring risk in a way that maximizes business success. Requires Risk Management Systems to Assess What Could Go Wrong, as well as, Understanding of what must go right to be successful 3

4 Enterprise Risk Management ERM Generally includes: aligning the entity's risk appetite and strategies, enhancing the rigor of the entity's risk-response decisions, reducing the frequency and severity of operational surprises and losses, identifying and managing multiple and crossenterprise risks, proactively seizing on the opportunities presented to the entity, and improving the effectiveness of the entity's capital deployment. ERM & ALCO Begin and End with the Capital Planning Process 4

5 Reading Materials OCC Guidance for Evaluating Capital Planning and Adequacy FFIEC Advisory on Interest Rate Risk Management Interagency Guidance on Funding and Liquidity Risk Management Remarks by Carolyn G. DuChene Deputy Comptroller Operational Risk at the Bank Safety and Soundness Advisor Community Bank Enterprise Risk Management Seminar October 22, 2012 OCC Guidance on Community Bank Stress Testing OCC : Managing Risk in Outsource Relationships 5

6 ERM & THE ALCO PROCESS Credit Risks Market Risk Liquidity Risk Regulatory Risk Capital Planning Interest Rate Risk Reputation Risk Operational Risk 6

7 Enterprise Risk Management in FIs Financial & Business Risk Management Financial Risks Business Risks Operational Risks Liquidity Risk Credit Risk Interest Rate Risk Management Risks People Risks Maturity Mismatch Default Commodity Prices Strategic Risk Legal Risks Asset/Liability Imbalance Downgrade Equity Prices System Risks Cash Flow Counterparty Interest Rate Changes External Risks 7

8 ERM Reality: Institutions are already engaged in ERM Risk management function has focused on assessing risks within each area CRE Stress Tests Liquidity Stress Tests Earnings and Value at Risk tests Missing: Relational risks Link to plans/goals Consistent Assumptions between analysis ERM is about determining appetite for risks 8

9 ERM: Integration of Existing Risk Measures Credit Risk Earnings at Risk Value at Risk Liquidity Risk What s Your Appetite? How do differences in regional upbringing and cuisine impact an individual s selection of a restaurant and meal Did you recently experience higher levels of Credit Risk? Did you knowingly put that on your plate at the buffet? 9

10 Defining Risk Appetite Risk Appetite: The amount and type of risk your institution is prepared to take on, accept, or tolerate in pursuit of capital planning goals Note this is a recognition of risk/reward You pursue a result at some peril Risk Tolerance: How much risk can we bear as a part of the plan? Good Board Question: Do you understand that in pursuing the goals we manage these risks and that they can come back to bear on us if we miss? 10

11 Risk Appetite Risk Appetite is only relevant if you can manage the risk to the levels set. Risk is a given to achieve returns/goals Most institutions don t have an appetite but know they must eat to survive Little guidance exists on risk appetite A buzz word used to sell software solutions, consulting assistance or other services Truth is, only the management and board can answer how hungry they are for the results in a plan or projection Appetite MUST change as markets change 11

12 Board & Management Questions Are you clear on the types and amounts of risk we must take to meet strategic objectives? Compare fast growth to no growth scenarios What does it take to increase capital ratio 50% vs. today s levels? Are the objectives we are attempting to achieve clearly defined? What is the top dog in the list of wants? What actions or strategies are implicit or explicit in the stated objectives? Are controls and systems in place to assess, manage and report risks? 12

13 Comparison of Objectives Rural Community Bank Slow growth rates in community/area Low turnover Concentration in employment base Concentration risks in asset types Limited funding options Urban/Metro Bank CRE Focus High levels of market presence and marketing by other players Opportunity to diversify if that is the objective Higher market turnover More diversified employment? What are the drivers of return for each of the above? How do risks vary and what risks pose greater risk to the success of the institution? Are the goals of each bank likely to be the same? If not, how do you defend plan vs. the perceptions of a template approach to balance sheet management? 13

14 ERM and the ALCO ERM is a fancy name for an integrated or dynamic ALCO process Requires a straddle of old approaches and new ideas to be meaningful This is a growing process there are no right answers See the comments from the OCC Deputy Director. Capital Plan drives it all 14

15 CAPITAL PLANNING 15

16 Capital Planning Process Capital planning is a dynamic and ongoing process that, in order to be effective, is forward-looking in incorporating changes in a bank s strategic focus, risk tolerance levels, business plans, operating environment, or other factors that materially affect capital adequacy. OCC Guidance on Capital Planning 16

17 Capital Planning Process Capital planning assists the board of directors and senior management to identify risks, improve their understanding of the bank s overall risks, set risk tolerance levels, and assess strategic choices in longer-term planning. identify vulnerabilities such as concentrations and assess their impact on capital. integrate business strategy, risk management, capital and liquidity planning decisions, including due diligence for a merger or acquisition. have a forward-looking assessment of the bank s capital needs, including capital needs that may arise from rapid changes in the economic and financial environment. 17

18 Capital Planning Process The most effective capital planning considers both short- and longer-term capital needs and is coordinated with a bank s overall strategy and planning cycles, usually with a forecast horizon of at least two years. From OCC

19 Why is a Capital Plan Important Business strategies need to be developed and applied in the context of a business plan or strategy. We are dealing with Asset quality issues affecting earnings and capital accumulation in many shops. The probability of increased capital standards. High liquidity levels that are decreasing spreads Maturing loans and investments going back out at lower rates. Deposit costs at near 0% levels Your capital plan feeds: Core funding growth goals Non-Regulatory core funding goals Goals for overall level of investments Goals for business plan or strategy we will be evaluating and stress testing 19

20 Capital Is King Since the economic crisis of 2009, financial institutions have been urged to increase capital levels Examination Reports Regulatory Guidance New Proposed Capital regulations Increasing Capital results in less leverage Deleveraging is saying more capital! Remember Financial Institutions Manage ROE ROE = ROA * LEVERAGE Leverage = Assets / Capital More capital = Less Leverage = Less Equity Growth or Shareholder return! In order to grow assets (capital) more, must increase earnings in a commodity based industry! What does that spell for your strategic plan? 20

21 Interrelated Risk An Example Today many institutions are faced with the following situation: High liquidity levels earning little to no income in the investment portfolio Low loan demand, at least in products that the institution favors Continued Low interest rates Recovering from past credit risk Regulatory environment that promotes risk adverse Low ROEs, thus low capital growth Increasing interest rate risk from longer term, lower rate assets What is ALCO s goal in the next few years? 21

22 Interrelated Risks An Example Potential solutions and impacts: Decrease liquidity by buying investments with longer maturities and higher yield Increase earnings now and for the next few years Lose liquidity (and possibly capital) in coming years when rates rise and value of security falls Decrease liquidity by shrinking the institution Lower deposit rate even more (if you can) and drive off funding from low relationship accounts. Problem with fixed costs against a smaller denominator. May not fix ROA. Increase loans by holding longer term, fixed rate loans Increase the earnings at risk volatility as rates rise, these loans won t reprice Perception of high risks with this activity in eyes of management, board and regulators Remember the song by the 80 s rock band, The FIXX One thing leads to another yeah yeah. 22

23 Effective Capital Planning Process Horizon 3 to 5 Year Horizon Step 1 Long-Range Financial Goals Reconcile earnings, capitalization, & growth Equalize LT growth - core, loans, & assets. Should Include Setting Balance sheet mix Loans, investments, NE assets Core deposits, Borrowing Levels, other Liabilities, capital Step 2 Set Annual Goals Lead to achieving financial goals Provide framework for drilling down in greater detail Step 3 Build the Business Plan Using you re A/L & Planning model Attempt to hit annual goals set in Step 2 Step 4 Build Core Funding Strategy Board involved in setting Steps 1 & 2. Management and ALCO have to determine how Step 3 works and if goals are achievable. What comes out of 1 & 2 are prioritized goals that determine HOW ALCO should set the course for achievement 23

24 Step 1: Long Range Goal Setting ROA Required to Maintain Capital Ratio Step 1: Set Strategic Financial Goals That Work! Growth Scenario Beginning Assets Total Capital Capital Ratio Annual Asset Growth Assets After Growth New Total Capital to Maintain Ratio Additional Capital Needed Average Assets ROA 1 $ 100,000 $ 8, % 0.00% $ 100,000 $ 8,500 $ - $ 100, % 2 $ 100,000 $ 8, % 5.00% $ 105,000 $ 8,925 $ 425 $ 102, % 3 $ 100,000 $ 8, % 10.00% $ 110,000 $ 9,350 $ 850 $ 105, % 4 $ 100,000 $ 8, % 15.00% $ 115,000 $ 9,775 $ 1,275 $ 107, % 5 $ 100,000 $ 8, % 20.00% $ 120,000 $ 10,200 $ 1,700 $ 110, % 6 $ 100,000 $ 8, % 25.00% $ 125,000 $ 10,625 $ 2,125 $ 112, % Growth Scenario Beginning Assets Total Capital Long Term Capital Ratio Annual Asset Growth Assets After Growth New Total Capital to Maintain Ratio Additional Capital Needed Average Assets ROA 1 $ 100,000 $ 8, % 0.00% $ 100,000 $ 9,500 $ 1,000 $ 100, % 2 $ 100,000 $ 8, % 5.00% $ 105,000 $ 9,975 $ 1,475 $ 102, % 3 $ 100,000 $ 8, % 10.00% $ 110,000 $ 10,450 $ 1,950 $ 105, % 4 $ 100,000 $ 8, % 15.00% $ 115,000 $ 10,925 $ 2,425 $ 107, % 5 $ 100,000 $ 8, % 20.00% $ 120,000 $ 11,400 $ 2,900 $ 110, % 6 $ 100,000 $ 8, % 25.00% $ 125,000 $ 11,875 $ 3,375 $ 112, % 24

25 ROA Targets 12% ROE Will raising industry capital targets bring capital into the industry or drive it out? Remember the basic leverage equation: ROE = ROA * Leverage Leverage = Assets/Capital Higher Capital = Lower ROE or the need for higher ROA to support growth 25

26 Capital Goal Setting Step 2: Move from Macro View (Step 1) to Annual Goals Set Year by Year goals for Capital/Asset Growth Earnings Dividend Payout Establish a Priority for goals Does Capital win over earnings or growth? Is it time now to grow and let capital drop for a while? Board establishes priority and risk limits Step 3: ALCO and Management takes the results and determines viability and required actions necessary to hit annual goals Using ALM modeling what are the required changes to meet the overall plans May involve more risks but can be measured against established limits 26

27 Step 2: Setting Annual Goals Scenario 1: Increase Capital & Grow at 10% Year Beginning Assets Total Capital Beginning Capital Ratio Targeted Capital Ratio Annual Asset Growth Assets After Growth New Total Capital to Achieve Ratio Additional Capital Needed Average Assets Net Income Current $ 100,000 $ 8, % 8.50% 10.00% $ 110,000 $ 9,350 $ 850 $ 105, % Year 2 $ 110,000 $ 9, % 8.75% 10.00% $ 121,000 $ 10,588 $ 1,238 $ 115, % Year 3 $ 121,000 $ 10, % 9.00% 10.00% $ 133,100 $ 11,979 $ 1,392 $ 127, % Year 4 $ 133,100 $ 11, % 9.25% 10.00% $ 146,410 $ 13,543 $ 1,564 $ 139, % Year 5 $ 146,410 $ 13, % 9.50% 10.00% $ 161,051 $ 15,300 $ 1,757 $ 153, % Scenario 2: Increase Capital and slow asset growth Year Beginning Assets Total Capital Beginning Capital Ratio Targeted Capital Ratio Annual Asset Growth Assets After Growth New Total Capital to Achieve Ratio Additional Capital Needed Average Assets Net Income Current $ 100,000 $ 8, % 8.50% 0.00% $ 100,000 $ 8,500 $ - $ 100, % Year 2 $ 100,000 $ 8, % 8.75% 2.50% $ 102,500 $ 8,969 $ 469 $ 101, % Year 3 $ 102,500 $ 8, % 9.00% 5.00% $ 107,625 $ 9,686 $ 718 $ 105, % Year 4 $ 107,625 $ 9, % 9.25% 7.50% $ 115,697 $ 10,702 $ 1,016 $ 111, % Year 5 $ 115,697 $ 10, % 9.50% 10.00% $ 127,267 $ 12,090 $ 1,388 $ 121, % 27

28 Basel III Proposed Requirements Definition changes Risk Weight changes Increased or new Basel III - p

29 These are Minimums How will you do this? 29

30 Setting Capital Goals 1. Start with Regulatory Minimums 2. Assess your combined risk Credit Risk Interest rate risk Liquidity risk How? 1. Stress Test 2. Short Form 3. Add risk buffer from Step 2 to well capitalized requirement. 30

31 Capital Goal Setting Issues Stress Tests What are reasonable and appropriate stress tests for Community FI s We are dealing with that here Remember these are custom fit to your situation Issues Capital & Buffer Where are capital requirements headed? How should the buffer be determined Qualitatively? Quantitatively? Our Take on the Buffer Concept Based on Credit, Liquidity and Interest Rate Risk in your shop, how much MORE capital is required to maintain Core Minimums AFTER the adverse event. This is an ALCO measurement process. 31

32 ALCO Goal Develop measurement systems that: Project the future earnings of the institution over a short horizon (2-3 years) Test the performance of earnings in a variety of interest rate scenarios Develop strategies to minimize undesirable risks or manage risks taken Develop Processes that Maximize financial performance under all foreseeable economic conditions 32

33 Goal Example Tier 1 Leverage Example Capital Goal + 2% Established Through Stress Testing Capital Goal Answers the Question, How Much Capital Cushion Do I Need to Remain Well Capitalized After a Stress Test? 33

34 Capital Planning Objectives (OCC) Capital Plan to Assess Capital Adequacy in Relation to Overall Risks Plan for Maintaining Adequate Capital Levels If Analysis Shows Institution Falling Below Regulatory Minimums, Board and Management Should Take Some Combination of the Following Actions: Increase Monitoring of Market Information Adjusting Strategic and Capital Plans Changing Risk Appetite and Tolerance Levels Limiting or Stopping Loan Growth and Adjust Mix Adjusting Underwriting Standards Raising More Capital Selling or Hedging Loans 34

35 STRESS TESTING VS. ERM 35

36 OCC Community Bank Stress Testing Issued 10/18/2012 Lays Out Supervisory Expectations Primarily focused on Credit Stress Testing Generally Stress Tests Should Lay Out Plausible What If Questions Assess Impact of What-If Incorporate Results into Institution Risk Management Process If Major Problems are Uncovered at the Basic Level, Additional Detailed Analysis May be Necessary 36

37 FDIC Stress Testing - Defined Stress testing is a forward-looking quantitative evaluation of stress scenarios that could impact a banking institution s financial condition and capital adequacy. These risk assessments are based on assumptions about potential adverse external events, such as changes in real estate or capital markets prices, or unanticipated deterioration in a borrower s repayment capacity. Stress tests are most useful when customized to reflect the characteristics particular to the institution and its market area, and can be used to evaluate credit risk in the overall loan portfolio, segments of portfolios, or individual loans. Stress tests also can be used to evaluate whether existing financial (such as capital and liquidity) and operational (such as staffing and internal systems) resources are sufficient to withstand an economic downturn or unexpected event. Focus of all Regulatory Documents is on CRE Lending though can be applied universally in Top Down Testing 37

38 5 Key Stress Testing Principles: 1. The framework should include activities and exercises that are tailored to and sufficiently capture the organization's material exposures, activities and risks. 2. An effective stress testing framework employs multiple conceptually sound stress testing activities and approaches 3. An effective stress testing framework is forward-looking and flexible 4. Stress test results should be clear, actionable, well supported, and inform decision-making. 5. Strong governance and effective internal controls help ensure that the framework contains core elements, from clearly defined stress testing objectives to recommended ones. 38

39 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. The guidance state: "It can help to assess a combined impact on several variables, parameters, factors, or drivers. For example, an organization could better understand the impact on its credit losses from a combined increase in default rates and a decrease in collateral values...an organization can also explore the impact of highly adverse capitalization rates, declines in net operating income, and reductions in collateral when evaluating risk from CRE exposure." 39

40 Two Approaches to Stress Testing Scenario Analysis: a technique where you 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. This is what we tie into other ALCO risks we monitor 40

41 Consider this Stress Testing is to be done both within a risk area AND across areas. So, where do we use sensitivity testing vs. scenario testing in ERM? Sensitivity Testing: What key variables have significant impact on results. Run first in the silo How confident are the assumptions? What are the outer boundaries? Scenario Testing: Run across Silos to see combined effect on performance Stress scenarios with sensitivity tests for planning 41

42 CREDIT RISK STRESS TESTING 42

43 Credit Risk and the ALCO Credit Risk is defined as the risk of loss of principal and/or loss of interest due to a borrower's failure to repay a loan or otherwise meet a contractual obligation. Financial Institutions are compensated for assuming credit risk by way of interest payments from the borrower or issuer of a debt obligation. So how does Credit Risk fit into the ALCO Process? Changes in risk impacts earnings and capital growth Changes in risk effects liquidity of the bank 43

44 Mitigating Credit Risk How do institutions control credit risk? Rates/term on loans Risk based pricing Credit tightening Decreasing concentrations in product/risk classes Requiring credit insurance products for marginal borrowers PMI Credit Life/Disability 44

45 FDIC Credit Risk Supervisory Guidance Summer 2012 Financial institutions can create a variety of stress tests to evaluate credit portfolio risk and the potential impact on capital. These types of generalized stress tests can be used by community banks to meet supervisory expectations (e.g., expectations contained in the 2006 CRE Guidance) or by institutions seeking to complement and enhance their other risk management activities. As suggested by this list, there is no one right way to conduct stress tests. Existing supervisory guidance states that banks with significant concentrations in commercial real estate (CRE) or subprime lending should conduct portfolio stress tests of these exposures as part of their ongoing risk management activities 45

46 OCC Community Bank Stress Testing Issued 10/18/2012 Lays Out Supervisory Expectations Primarily focused on Credit Stress Testing Generally Stress Tests Should Lay Out Plausible What If Questions Assess Impact of What-If Incorporate Results into Institution Risk Management Process If Major Problems are Uncovered at the Basic Level, Additional Detailed Analysis May be Necessary 46

47 Portfolio Level Stress Test Loan Portfolio Categories Call Report or SIC? Begin with Quarter End Portfolio Balances Apply Stress Period Loss Rates At Portfolio Category Level Bank s Historical Experience a Starting Point Severity Should Consider Economic Scenario Impact Rolls Up to Economic Effect Minimum 2 Year Forecast Horizon Economic Effect Components Income Pre-Provision Net Income Provision to Cover Stress Losses Provision to Maintain Adequate ALLL Income Tax Effect Net Income Capital Focus on Effect on Tier 1 Capital and Tier 1 Leverage Likely to Change with Basel III to all 4 Ratios This is a sensitivity test. No bearing to the future performance, only past factors that can be stress tested 47

48 OCC Example Sum of Losses Carries to Calculation for Stress Loss Rate This example groups by call report category. We believe this is too aggregated and should be set at SIC or NAICS code levels 48

49 OCC Example 2 Yr. Loss Provision from prior Stress Calculation PLL required for Maintaining Adequate ALLL based on loan growth and mix and should be a part of your ALM modeling assumptions already! 49

50 OCC Example Stress Test costs the bank 3.7% of tier 1 Capital Pre-stress tier 1 ratio: 88 / 738 = 11.9% Post-stress tier 1 ratio: 60.8 / 738 = 8.2% Credit buffer Requirement 3.7% above minimum capital levels But what about the impact of the loss of cash flow on liquidity needs? What about the reinvestment return expected, not just interest lost? These are scenario issues 50

51 Impact of 2010 Liquidity Guidance Liquidity Requirements More asset based liquidity (cash & securities) No guidance on how much is enough! Why: It is the only form of liquidity you can absolutely count on being there during a liquidity stress event Less reliance on wholesale funding for core growth What is your core funding plan? Where will you raise the funding needed to: Increase investments? Reduce non-core funding? 51

52 Impact of 2010 Liquidity Guidance Liquidity Requirements Cash Flow Based Liquidity Measurement How do we to integrate with IRR measurements Stress Tests Like Rate Shocks in IRR? What kinds of stress tests do we have to run? How frequently do we run them? 52

53 Liquidity Definitions Asset Based or Core Liquidity: Cash and other financial assets that can be easily converted to cash for operational needs Withdrawals Originations Total (Cash Flow Based) Liquidity : Does your projection maintain sufficient sources to meet financial obligations: withdrawals, loan demands and other commitments. To what extent is liquidity changing level and/or form Should include measures of debt or borrowing capacity. 53

54 Asset Based Liquidity Considered most reliable source of liquidity Many failed institutions had high levels of borrowings and low levels of asset based liquidity, therefore more is better. But, How Much is Enough? Answering the question How long can you survive a crisis without having access to wholesale funding? Requires: An understanding of the sources of asset based liquidity An estimation of the sensitivity of liabilities at risk A method for calculation 54

55 Calculating Asset Based Liquidity Sources of Asset Based Liquidity Cash & Cash Equivalents (FF, MMA, etc.) Unpledged Securities (at market value or deeper discounts) Scheduled Investment cash flows and maturities Scheduled Loan cash flows and maturities Uses that you have to cover Firm Loan commitments Maturing Borrowings/Non-Core funding Maturing CDs Some amount of Non-maturity balances considered at risk Potential draw down on lines of credit 55

56 Asset Based Liquidity: LCR Ratio Basel Liquidity Coverage Ratio (LCR) Test Can you survive a 30 day stress event with assets only? Numerator Cash & Due From Highly Liquid Unencumbered Marketable Securities Denominator Projected Deposit Runoff Loss of all Non-Core Funding renewing in time horizon Projected Increased Line Draw Downs Less Cash Inflows from loans (& securities?) - Limited amounts included Note that this is the first Liquidity rate to consider loan cash flows as a source! Note this is a sensitivity test can change factors or horizon to assess needed asset based liquidity. 56

57 Deposit Definitions Stable/Less Stable Basel Says Stable is Fully insured Meaningful business relationship Applies to retail, small business, large business Penalties adequate on CDs just count 30 day maturities Penalties inadequate count all the balances Less Stable Deposits not meeting the above definition Bank Regulators (Likely) Fully Insured Call Reports Internal systems? Not sure how bank regulators will deal with penalty issue What does my core study say about the volatility of these funds? Do I know the sensitivity? How does this impact earnings projections? Capital Growth? 57

58 Liquidity Coverage Ratio Numerator (Basel Approach) We are hopeful that they change and add stressed cash flows coming off loans and non-highly liquid securities here instead of denominator. Available liquid assets in 30 days 58

59 Liquidity Coverage Ratio Funding Outflows Denominator Sum of Outflows = Potential 30 day liquidity needs 59

60 Liquidity Coverage Ratio Net Loan Outflows 60

61 Liquidity Coverage Ratio Available Needs Indicates the Stress Results for Short Term Liquidity Needs. Can easily sensitivity test with new factors and recalculate. FARIN Suggested LCR Changes: Move Loan Cash Flows to the Numerator to track all Sources together Establish consistency on deposit outflow assumptions with core deposit study info used in IRR Calculations Remove limit on amount of total loan flows counted (Move to numerator eliminates negative denominator Remove prepayment limitation assumptions on loan flows Consider calculating how much runoff would be necessary to fail assuming sources are solid. 61

62 Asset Based Liquidity Stress Test Conclusion: If LCR Ratio shows insufficient funds, institution must Increase cash or investments Decrease exposure to volatile liabilities Lower off balance sheet exposures Increase speed of cash flow repayment on loans (shorter amortization terms) Question: How do we translate that to capital? If your business plan is to run tight on liquidity, then your buffer for shortfall must be on top of the regulatory minimum capital ratio Think of personal cash in the bank vs. credit availability 62

63 Liquidity Gap Report Pro forma cash flow analysis: Projected sources and uses of funds over various scenarios Like rate movements or what-if plans Show exposures to variables and report to board and establish contingencies What sources change and why (optionality, credit risk, performance risk) What uses change and why (loan demand, potential deposit outflow, etc.) Assumptions should be reasonable and appropriate. Institutions with reliance on securitization and sale for cash should consider impact of conditions that may effect availability of funds. 63

64 Liquidity Gap Report Liquidity Gap Report Summary of Cash Flow sources and uses impact on liquidity Use a forecast (Plan) for growth assumptions Use starting cash flows to project inflows and outflows Allows for Assessment of Contingency Funding Plan Stress Tests to Determine Liquidity needs Impact of missing deposit growth by 10% What if loan repayments accelerate or slow? What happens to total ratio if access to key funding sources is gone? Brokered CDs FHLB This is a silo approach to scenario planning 64

65 Sources/Uses Summary Test passed because of wholesale and investments available for liquidity, NOT CASH FLOW. Determining Adequacy of limits by applying realistic stress tests and deciding how low you can go. 65

66 Liquidity Silo Stress Testing LCR is a Stress Test by Design Basel III proposes a second ratio (NSFR) to measure longer term cash flow needs Less reliable and based on call report data Cash Flow Liquidity Gap Better internal measure Apply stress tests to cash flow gap and determine impact on availability of funds Cover shortfalls with capital or change in business plan Consider this: What is the minimum amount of remaining borrowing capacity you want to keep available for emergency needs? 66

67 INTEREST RATE RISK STRESS TESTS 67

68 Types of Testing Short Term: Income at Risk Static testing: Test ability to meet planned capital growth (earnings) with current earnings over 1-2 year horizon No Planned growth or mix changes Captures repricing and option risks Does not capture: Basis, Yield Curve or Value at Risk Long Term: Value at Risk (NEV,EVE) Current Balance Sheet: Assess long-term structure of balance sheet ability to produce earnings under different interest rate scenarios. Impact measured on value of capital. Captures Repricing, value and option risk Does not capture: Basis or yield curve risks 68

69 Static Income Simulation Definition Projecting financial statements assumes a constant balance sheet. No change in level or mix. Measure effect of rate changes on income by running multiple rate environments. Income at risk = Projected changes in income in the different rate environments Policy limits set to minimize rate change effect one key metric used in measuring return Example Drop in Net Interest Income should not be more than 15% of base level if rates move against institution. 69

70 Static Income Simulation Today Typically 1-3 Years Horizon Usually run against Gradual and/or Immediate & Permanent Rate movements Current Balance Sheet and Forecast Balance Sheet are the Same Income is a flow that occurs over time. To test income at risk you must run a forecast. In static income at risk the balance sheet composition is held constant throughout the forecast. 70

71 Dynamic Income Simulation Definition Projection of institution s financial statements based on a set of assumptions. Total Assets may change Loan/Investment & deposits/borrowings levels change Consistent with Budgeting and Liquidity management Measure effect of rate changes on income by measuring multiple rate forecasts. Income at risk is measured by fluctuations in income measurement under the different rate environments 71

72 Measuring Earnings at Risk 72

73 Measuring Earnings at Risk 73

74 Interest Rate Risk Market Value Portion of Definition Market value risk is the risk that a change in market interest rates will raise or lower the market value of instruments in an institution s portfolio. Value at Risk measures the relative worth of instruments total cash flows versus alternatives. Measure is a long-term income comparison at that point in time 74

75 Interest Rate Risk Market Value of Capital (Equity) Present value of expected cash flows from assets Less: present value of expected cash flows from liabilities Plus: present value of expected cash flows from offbalance sheet activities Sum divided by the present value of assets = Present Value of Equity Ratio (capital/assets or EVE/NEV Ratio) 75

76 Reading a Market Value Report NPV Ratio after 200 bp shock Interest Sensitivity Measure bp bp bp Over 400 bp Over 12% Minimal (1) Minimal (1) Minimal (1) Moderate (2) 8% to 12% Minimal (1) Minimal (1) Moderate (2) Significant (3) 4% to 8% Minimal (1) Moderate (2) Significant (3) High (4) Below 4% Moderate (2) Significant (3) High (4) High (4) 76

77 Interest Rate Risk Buffer Concepts: Silo Analysis: Earnings at Risk: Must add to capital ratio if earnings are not sufficient to cover planned growth, or Must restructure plan to stay within capital goals Value at Risk: If Long term earnings structure (EVE/NEV) shows risks to the ratio, plan should Increase base levels of capital Change the future Asset/Liability Mix Restructure current balance sheet Issues: All options impact other risks and overall earnings growth 77

78 Next Session A look at sensitivity testing for some key variables Defining Scenarios across Silos Assessing the impact of scenarios on overall risk levels 78