William C. Handorf, Ph. D.

Transcription

1 Risk Management and Value Creation

2 William C. Handorf, Ph. D. Current Professor of Finance The George Washington University Consultant Banks Central Banks Expert Witness Director and Vice Chair Federal Home Loan Bank of Atlanta Experience Director Federal Reserve Bank of Richmond; Chair Baltimore Branch Federal Home Loan Bank System Regulator Federal Deposit Insurance Corporation Federal Home Loan Bank Board Lender National Bank of Detroit 2 Officer, United States Army

3 Brasil s Banking Sector between 2011 and Biggest Opportunities for Banks: Biggest Threats for Banks:

4 Past Problem Sectors in US Emerging Market Debt - Countries Do Not Go Bankrupt Agricultural Sector - We All Need Food Oil Sector - We Must Have Oil Commercial Real Estate - You Have Collateral 4

5 US Home Prices: Case Shiller Composite 10 Cities Annual Price Change 2001: 8.2% 2002: 15.3% 2003: 14.0% 2004: 18.7% 2005: 15.1% 2006: -0.4% 2007: -11.5% 2008: -19.4% 2009: -0.1% % 2011 Decreasing 5

6 Housing Problem History Home prices rise quickly after dot.com bust and low interest rate engineered by the central bank encouraged ARM loans Investors earn 50+% returns with 10% annual appreciation and encourage speculators to purchase more property Mortgagors need innovative loans and piggy-back loans to afford a home prior to even higher prices Wall Street encourages brokers to originate more high-yield loans for MBS MBS losses trigger dominoes to fall 6

7 Ignoring the Five C s of Credit Loan Purpose Analysis Amount, Use and Term of Request? Character of Debtor is Key Loan Repayment Analysis Sources of Repayment? Capacity and Capital Important Loan Structure Analysis Pricing, Collateral and Conditions? Structure is Function of Risk Loan Monitoring Analysis Timely Payment and Conditions Satisfied? Systems and Review Critical 7

8 Bank Failure Liquidation Economic Financial Managerial 8

9 Recent US Failures due to AIG Bank United Bear Stearns Citibank Downey Fannie & Freddie GMAC Indy Mac Lehman Brothers Wachovia WAMU Smaller Banks Who will fail next Friday? Housing Loan Losses 9

10 Bank Failure and Management High number and percentage of loans to insiders Passive Board of Directors Lack of coherent business plan Quick growth funded by high cost funds offset by high yield assets High dividend payouts and stock repurchase programs Shrinkage to maintain capital ratios leading to larger losses given fixed non-interest costs Ineffective risk management Fraud 10

11 Red Flags Late Financial Reports Rapid Growth Unexplained New Activity Profit or Production Based Bonuses Weak Controls High Management Turnover Ineffective Audit Weak Board 11

12 Focus on Board Responsibilities Assess Performance Internal Controls Management Operations Credit Rating Regulatory Rating Share Value Approve ALM Policies Develop and Implement Business Plan Adopt Rigorous Risk Management Program 12

13 Bank Failure and the Economy Economic Recession High and/or Increasing Unemployment High Real Interest Rates Regional Boom to Bust Low Confidence in Banks or the Central Bank 13

14 Bank Failure and Asset/Liability Management Low Capital Losses Loan Problems Concentrated Portfolio Loss of Cost Control Quick Growth Liquidity Non Core Fund Reliance Lack of Good Collateral Bad Press & Run High-yield Assets High Sensitivity 14

15 Empirical Analysis of Recent US Bank Failure Leading Causes High problem loans to capital and ALLL Large losses High provision Losses on securities High non current loans Portfolio concentration in high risk ADC loans Risk Index < 3 Low capital High non-core funding Other Factors Prior quick growth High yield assets 15

16 The Risk Index Risk Index (RI) is number of standard deviations bank is from their capital ratio declining below a stated threshold RI = (Capital Ratio + Mean ROA Stated Threshold) ROA Sigma As Risk Index declines, probability of capital problems increase due to: Low Capital Ratio Low (or negative) mean ROA High Volatility of Earnings from Bad Loans, Shifting Strategy, Sensitivity, Illiquidity, etc. 16

17 The Risk Index Applied Implied Probability Tier 1 Equity < 5% in One Year RI = (Equity + ROA 5.0%) Sigma ROA Tier 1 Equity Average ROA ROA Sigma Risk Index Probability < 5% Comerica BB&T Bank America SunTrust

18 Risk Index Inferences Normal Distribution Use Normal Table Little Regulatory Concern > 10 Sigma Non-normal (but symmetrical) Probability =.5 [(1 (RI) 2 ] Risk Index Probability 10.5% 5 2.0% 3 5.5% % % 18

19 Value Creation Coordinated Approach Of Implementing Strategy Create Value ROE>COE Achieve Good Regulatory Rating Maintain Debt AAA/BBB Grade 19

20 Share Value: Return on Equity v. Cost of Equity Value Creation ROE > COE Price/Book Premium Asset Growth Value Destruction ROE < COE Price/Book Discount Asset Shrinkage ROE = LM x ROA NI E = A E x NI A COE =8% to 20% 20

21 Market Pricing 21

22 Price-earnings v. Price/Book Price/Book = Price/EPS x EPS/Book Value Price/Book = Price-earnings Ratio x ROE The PE Ratio conveys information about future growth in earnings Return on Equity (ROE) conveys information about current earnings Market Value Added equals the market value of the bank s stock minus the book value of equity provided by shareholders 22

23 Implications of Selling at a Price/book Premium or Discount A Discount Increases ROE on a Market Value Perspective while a Premium Decreases ROE Assume a Bank is Earning ROE 5.0%, then ROE Market is: 150% P/B: 3.3% 100% P/B: 5.0% 75% P/B: 6.7% 50% P/B: 10.0% 25% P/B: 20.0% 23

24 Cost of Equity or Required Return on Equity Arbitrary 8% 12% 20% Bond Premium Model Long-term Debt Yield + Equity Premium Capital Asset Pricing Model Treasury Bond Yield + Beta (Market Premium) 24

25 Bond Rating Agencies Moody s (1, 2, 3) Aaa: Best Quality Aa: High Quality A: Upper Medium Baa: Medium Grade Ba: Speculative Elements B: Lack Desirable Investment Quality C: Extremely Poor Prospects; May be in Default S & P (+, -) AAA: Extremely Strong Capacity AA: Very Strong Capacity A: Strong Capacity BBB: Adequate Capacity BB: Uncertainties Could Lead to Default B: Vulnerable D: In Default 25

26 Studies of Bank Bond Ratings: Probability of Default and Loss Given Default? Higher Grade High Capital High ROA Low Earnings Variability Large Companies Low Risk Portfolio Effective Management 26

27 Moody s Financial Strength Ratings A: Exceptional B: Strong C: Good D: Adequate to Vulnerable E: Very Weak Likelihood bank will require assistance? B+ TD B Bank Hawaii B- BB&T C+ Bank China C Capital One C- Citibank D+ Bank India D Bank Ireland D- California B&T E+ Bank Moscow 27

28 Bank Credit Ratings and Financial Strength Bank Credit Rating Strength Morgan Chase Aa1 B Bank America Aa3 C- Citibank A1 C- BB&T A1 B- E-Trade Ba3 D- Bradesco Baa2 B- Banco Paulista B1 E+ 28

29 Beta Beta represents the Systematic risk of a Bank Holding Company (HC) HC Sigma/Index Sigma Correlation of HC to Index Implications of Beta Average 1.0 < The Regression Slope is Beta HPR= [P(1) + D - P(0)] /P(0) Holding Period Return: Holding Company Holding Period Return: Index >

30 Applying CAPM in US and Brasil Cost of Equity = Long-term Risk-free Yield + Beta (Market Risk Premium) Average Risk US Bank Cost of equity = 3.20% (5.50%) = 8.70% Average Risk Brasilian Bank Cost of equity = 6.20% (7.70%) = 13.90% The required return to create value is higher in Brasil due to higher long-term interest rates and a higher market risk premium. 30

31 Valuation Example US Bank (Citi) with 6.4% and 2.55 Cost of equity = 3.20% (5.50%) = 17.23% Bank is destroying value and sells at P/B discount Brasilian Bank (Bradesco) with 24.2% and 1.60 Cost of equity = 6.20% (7.70%) = 18.52% Bank is creating value and sells at P/B premium 31

32 Price/book Ratios and Financial Metrics P/B = (Beta); R 2 = 17% Higher Beta (risk) leads to lower valuation P/B = (ROE); R 2 = 54% Higher Return on Equity leads to higher valuation P/B = (ROE COE); R 2 = 68% Higher spread between ROE and COE leads to higher valuation 32

33 Basel III Banks will require more capital, more equity capital, buffer capital, systemic capital and countercyclical capital Banks will require more long-term funding and shortterm, marketable investment securities. 33

34 Liquidity Concerns Reputation and credit rating of the bank Proportion of assets invested in securities, especially shortterm, high-grade and marketable instruments Proportion of securities pledged Proportion of securities within the available-for-sale portfolio or trading portfolio v. held-to-maturity Proportion of funds provided by core deposits and longterm borrowed money Unused lines of credit available from central bank or correspondent bank Cash budget or liquidity gap report with stress test for sources of funds Focus on contingent funding plan or CFP 34

35 Liquidity Issues Unexpected withdrawal of deposits and an inability to borrow funds Collateral deterioration and inability to pledge assets or suffer lower advance rate Market panic leads to absence of bid price to sell investment securities Unexpected takedown of credit lines by borrowers 35

36 Basel III Liquidity Ratios Liquidity Coverage Ratio: A bank must have high quality, unencumbered liquid assets to withstand a 30-day period of market stress. Net Stable Funding Ratio: A bank must have long-term stable sources of funding relative to potential calls on its resources. 36

37 Implications of Higher Liquidity Need invest in more short-term, high-grade marketable securities Need fund more assets with long-term debt The implications are relatively similar given a steeply upward sloping yield curve; ROA should decline Rules 37

38 Determine ROA Impact of Liquidity 100 million bank needs to move 1% of assets short-term and lose interest 4.0% to enhance liquidity Bank 1: 1.00% with 20% marginal income tax rate Bank 2: 2.00% with 40% marginal income tax rate 38

39 Financial Impact of Higher Bank 1 (ROA = 1.00%) Net 1,000,000 Interest -40,000 Income 8,000 Net 968,000 The 1% higher liquidity rule decreases ROA by 3.2% Clearly, higher liquidity coverage ratio adversely affects valuation Liquidity Bank 2 (ROA = 2.00%) Net 2,000,000 Interest -40,000 Income 16,000 Net 1,976,000 The 1% higher liquidity coverage ratio decreases ROA by 1.2% The impact is not as severe for the high-profit bank able to offset lost interest income with lesser tax obligations 39

40 Stable Long-term Bank Funding Letras Financeiras Banco do Brasil S. A. (Incorporated in the Federative Republic of Brazil with limited liability) US$200,000, % Notes due Five Years US$200,000, % Notes due Ten Years issued under the US$1,000,000,000 GLOBAL-MEDIUM TERM NOTE PROGRAM Interest Cost Currency Term and Yield Curve Expectations Liquidity Premium Credit Premium Credit Rating Issuance Cost & Fees Control Covenants Collateral 40

41 Purpose of Capital o Provide Cushion for Loss o Inspire Confidence o Limits Growth Potential o Limits Risk Exposure o Affects Loan-to-one Borrower o Impacts Return on and Cost of Equity 41

42 Cost of Capital Cost of Capital K(o) = K(e) x W(e) + K(d) x W(d)(1-t) Where: K(o): is cost of capital K(e): is cost of equity K(d): is cost of debt W: is weight of funds by equity and debt t : is tax rate Bank Application Cost of Capital : 10% (.10) + 6%(.90)(1-.35) = 4.51% Any bank with a lower cost of capital retains a strategic advantage over competitors 42 42

43 Leverage and Cost of Capital Leverage Cost of debt < cost of equity Interest on debt creates tax shield Affects leverage multiplier and ROA; hence affects ROE Increasing Capital Use less low-cost debt and more high-cost equity; lose tax shield on debt Improve credit rating; lower cost of debt Decrease beta; lower cost of equity Β L = Β U (1+(1-Tax)(D/E)) 43

44 Capital Issues What is capital? How much capital is needed? Basel II Issues Probability of Default (PD) Loss Given Default (LGD) Exposure at Default (EAD) Correlation (R) Basel II Guidance ALLL = Expected Losses Capital > Unexpected Losses 44

45 Basel II Model 45

46 Implied Residential Mortgage Loan Risk Weights 10% LGD 30% LGD.25% PD % PD % PD % PD % PD % PD

47 Bank Lending and Capital Rules BANK FOR INTERNATIONAL SETTLEMENTS Pre-Basel Capital Banks need capital equal to 5% of Loans 1988 Basel Accord Banks need risk-based capital equal to 4% of Mortgage Loans: 50% Risk Weight Basel II (Standardized) Banks need risk-based capital equal to 2.8% of Mortgage Loans; 35% Risk Weight 47

48 Credit Modeling Problems Data May Not Reflect: Severe economic contraction Sharp change in interest rates or value of currency New tax or bankruptcy laws Shift in GAAP Fraud New Loan Structure 48

49 Capital Impact on ROA and ROE 100 million bank needs 1% more equity capital; replace 8.0% with new stock Bank 1: 1.00% (20% tax rate); increase capital from 9% to 10%; 11.11% Bank 2: 2.00% (40% marginal tax rate); increase capital from 10% to 11%; 20.00% 49

50 Financial Impact of Higher Capital Bank 1 (ROE = 11.11%) Net 1,000,000 Interest 80,000 Lost Tax -16,000 Net 1,064,000 Projected ROE 1,064,000/10,000,000 ROE Decreases to 10.64% ROA increases from 1.00% to 1.064% LM declines from to 10.0 The 1% higher capital decreases ROE by 4.23% Bank 2 (ROE = 20.00%) Net 2,000,000 Interest 80,000 Lost Tax -32,000 Net 2,048,000 Projected ROE 2,048,000/11,000,000 ROE Declines to 18.62% ROA increases from 2.00% to 2.048% LM declines from 10.0 to 9.09 The 1% higher capital lowers ROE by 6.90% 50

51 Risk Management Ensure Every Key Risk to Bank is Identified Measured and Controlled Focus on Factors that have High Impact and/or Probability Assess Potential Impact of Remote Black Swan Events Approve Risk Appetite Statement Prioritize Risks Identify Acceptable Risk 51

52 The Business Plan Mission Statement Vision Statement Goals Objectives Measures Milestones 52