Lecture Materials ASSET/LIABILITY MANAGEMENT YEAR 2

Transcription

1 Lecture Materials ASSET/LIABILITY MANAGEMENT YEAR 2 David Koch President & CEO FARIN Financial Risk Management Madison, Wisconsin dkoch@farin.com August 3, 2017

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3 TYING IT ALL TOGETHER: IMPLEMENTATION OF A RISK/RETURN FRAMEWORK David Koch President\CEO FARIN & Associates, Inc. dkoch@farin.com

4 Combining Yr. 1 & 2 BPA Taught financial drivers that ALCO manages Capital Planning Teaching inter-relationship of financial goals Core Funding Importance of Pricing in Liquidity and profitability (IRR) risk Investments Understand Risk/Reward in various investments ALM Positioning-Profitability-Process: Understanding the key drivers of net interest income and their relationship with liquidity, interest rate risk, and capital Interest Rate Risk: Measuring and Managing Margin Risks Liquidity Managing sources and uses of funds in good and bad times 2

5 Course Objectives BPA & Funding Yr 1 BPA Assess management philosophy and goals by evaluating the financial performance of a bank Identify is a bank is performing well or poorly and explain major contributors these causes Be able to use the financial relationships to determine how changes in performance ratios from events like changes in interest rates will effect bank performance Make recommendations to senior management on what financial concerns are contributors to the problem and possible remedies Funding Develop a deposit pricing strategy for their institution Choose between alternative deposit strategies using marginal cost and benchmark rates in making decisions Understand the tradeoffs in use of wholesale funding Use a PC-based system to gather, interpret and analyze data that is a crucial input to deposit pricing decisions 3

6 Course Objectives ALM Yr 1 the purpose and responsibilities of an effective asset/liability committee (ALCO) the primary purposes of the bank s investment portfolio the types of securities commonly found in the bank s investment portfolio and their respective risk/reward characteristics the basics of liquidity management, including the need to plan for future liquidity needs (or determine excesses), using projected sources and uses of funding reports understanding funding alternatives to a bank s normal deposit base the basics of interest rate risk management, and some of the tools banks use to monitor/manage these risks (i.e., GAP, duration analysis, income simulation, EVE, etc.) the impact of changes in market interest rates on the value of loans and investments, and generally understand terms such as duration why an adequate capital plan is so important in running a successful bank 4

7 Course Objectives ALM Yr 2 Understand the drivers of net interest income and the components of net interest margin Understand what causes net interest income and EVE to change Understand the various measures of financial risks Describe the strengths and weaknesses of earnings sensitivity analysis earnings at risk and EVE Evaluate the impact of embedded options, such as loan prepayments and callable bonds, on financial institution profitability and risk Describe a procedure for estimating the rate sensitivity of deposits Develop a basic understanding of strategies to manage IRR Evaluate a financial institution s liquidity risk profile and identify available sources of liquidity 5

8 What Is Asset/Liability Management? Asset/Liability management (ALM): the process of planning, controlling & monitoring financial performance to achieve financial goals of the capital plan while managing risks. Financial risks are measured to determine if plan can be met in reasonable risk situations When changes in credit quality occur When market interest rates move When liquidity needs or availability change When regulators modify expectations ALM should recognize we manage risk to make money! We are NOT risk minimizers. 6

9 EVOLUTION OF ALCO 7

10 Evolution of ALCO ALCO s job moving from monitoring each individual risk area to measuring and managing integration between risks, and running reasonable stress tests on each risk area to build capital component parts, and Running stress tests within each model to determine hidden risks embedded in models used to calculate risk FFIEC Model Validation Guidance of

11 ALCO Evolution Primarily Interest Rate Risk Focused Gap Reporting Static Balance Sheet Projections Immediate & Parallel Rate Shocks Spread Reporting Moving Towards Dynamic Balance Sheet Dynamic EVE Reporting Non-Parallel Rate Projections What If Comparisons Integrated With Other Risk Tests 9

12 OCC Definition from April 2010 presentation titled Capital Planning: The New Normal 10

13 Managing Risk Managing risk is not just about identifying, assessing, and monitoring all the things that could go wrong. It also is about understanding all the things that need to go right for a bank to achieve its mission and objective of safely and profitably serving its customers and community. Carolyn G. DuChene Deputy Comptroller Operational Risk 11

14 Defining Capital & Risk Appetite Risk Appetite Available Capital Excess capital Strategic risk buffer Based on a change to assuming full risk Current risk needs Based on a current levels of risk Regulatory requirement Your definition of acceptable minimum levels 13.0% 11.0% 8.5% 6.0% Proper stress testing helps us ID the necessary levels of capital for risk in today s exposures and tomorrow s plans. 12

15 Stress Testing a Short or Long Term Horizon Income at risk (IAR) measures are short term looks at risks to capital formation Value at risk (EVE) measures look at structural concerns on capital needs from balance sheet mix EVE levels can be changed over time IAR risks are stress events on capital CREATE SYNERGY. DRIVE PROFITABILITY 13

16 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. Scenario Analysis: 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. CREATE SYNERGY. DRIVE PROFITABILITY 14

17 Base Plan & Stress Tests Run baseline stress tests on all major risk areas separately (silo) Credit risk Liquidity risk Interest rate risk Change key assumptions in each analysis Which assumptions have greatest impact for small changes? CREATE SYNERGY. DRIVE PROFITABILITY What is the overall confidence level and documentation for those assumptions Where confidence or documentation is low, allocate resources to upgrade Not a test of institution s capital or earnings! Goal of Sensitivity Tests: determine most critical assumptions in your plan! 15

18 Defining Risk Three Inherent Risks to all Financial Intermediaries 1. Credit risk The obligation to pay back depositors regardless of whether loans are repaid 2. Interest rate risk The timing and size of changes in the rates that they receive from their assets rarely match the timing and size of rate changes for their liabilities 3. Liquidity Risk Not enough cash will be generated from assets to meet deposit withdrawals or contractual loan funding 16

19 Sensitivity Testing 2 applications for sensitivity testing 1. Within its own risk silo (credit, liquidity, IR) adjusting key factors to determine that factor s impact on overall results Rank order in level of impact 2. Applied to a scenario test (like a base forecast result) Modify most critical assumptions slightly to check performance if we are wrong Used as a reality check to planning assumptions Key?: If we miss on key assumptions, can we still meet goals? Using sensitivities in the base forecast helps identify key things that must go RIGHT in the plan Not the usual focus of what can go wrong Note sensitivity testing is not the same as scenario testing. CREATE SYNERGY. DRIVE PROFITABILITY 17

20 What Is Your Efficient Earnings Frontier Risk\Return concept is well defined and accepted by most as true in banking But, what s missing from the trade-off talk is the concept of an optimal return. Efficient earnings frontier sets out a target for the highest potential return given a defined level of risk Or the expected level of risk for expected return It is the target for evaluating risk\return trade offs Returns are not infinite unless risk can be expanded! 18

21 What is Asset\Liability All About? 19

22 What is Asset\Liability All About? 20

23 Market rate changes Remember duration formula Chg MV = - Duration * Chg MR Long term discount rate down bp 5 Yr duration * -50 by change = 2.5% Chg in mv 21

24 Market rate changes 10Yr FHLB December 2015: 2.98 March 2016: 2.59 Change

25 Market rate changes 10Yr FHLB December 2015: 2.98 December 2016: 3.22 Change

26 Market rate changes 10Yr FHLB December 2015: 2.98 March 2017: 3.13 Change

27 Optimal Earning Asset Matrix EA Mix Example Cash Govt' s Munis 1-4 Family Const. CRE C&I Ag Cons Other Loans Option1 25% 25% 5% 15% 5% 15% 5% 0% 5% 0% Option2 15% 15% 5% 15% 10% 30% 5% 0% 5% 0% Option3 15% 10% 0% 25% 0% 0% 2% 45% 3% 0% Option4 10% 10% 0% 40% 15% 20% 2% 0% 3% 0% Option5 10% 10% 0% 35% 15% 25% 2% 0% 3% 0% Comparison of 5 different model balance sheet types Risk averse Option 1 CRE Option 2 Ag Option 3 Thrift Option 4 Balanced Option 5 Is it right to expect the same level of earnings or growth for all 5 types in the coming years? Is the natural level of earnings and volatility in earnings the same for all 5? Is your model balance sheet established and managed? 25

28 Optimal Earning Asset Matrix Mapping each mix with earnings volatility to show realistic returns. Note that higher returns show higher levels of variance in returns. What strategy has higher earnings potential and less risk Measure of Return ROE/ROA Volatility of earnings Where is your current and projected performance vs. actual? Given your risk appetite what is your domain of optimal return? 26

29 CURRENT ISSUES IN CAPITAL PLANNING AND ALM 27

30 Key Risk Questions in Today s World Interest Rate Risk If Market Rates Move, How much will Bank Earnings Change? Credit Risk If Market Rates Move, what will happen to loan performance, charge-offs and potential volumes? Liquidity Risk If market conditions change, what will happen to depositors that have been sitting waiting for higher returns or business deposits that have been idle in slow times? 28

31 Common Concerns Long term assets on the rise 29

32 Common Concerns Long term assets on the rise 30

33 Common Concerns Long term assets on the rise 31

34 Common Concerns 32

35 Common Concerns Deposit risks elevated 33

36 Common Concerns Deposit risks elevated 34

37 Common Concerns Deposit risks elevated 35

38 What Does This Graph Imply? Why did this happen? 36

39 Historical Rate Comparison In the past has there ever been an immediate and parallel rate shock? What worries you more, all rates going up 3% or short term rates moving, more than long term rates? Current concern is that rates may move as they did in

40 How Many Banks Are We Talking About? 2004 Data 201 Banks $1 billion and long term assets 50% 478 Banks $1 billion and long term assets 40% 977 Banks $1 billion and long term assets 30% A small sample size of banks with 50% of LT Assets is not that telling What does history teach us? It is not about what happened to some banks in the past, but why it happened and how are YOU prepared to deal with changes in market conditions! Note that those with 30 40% exposure saw a much smaller decline in margin, and what s missing is the discussion on the overall LEVEL of margin 38

41 Performance of FI s from 2004 w > 30% LT Assets Average Performance of Banks < $1 billion and LT Assets (04) > 30% Changes from Change in Int Exp +91 bp Change in Int Inc +79 bp Y 2014Y 2013Y 2012Y 2011Y 2010Y 2009Y 2008Y 2007Y 2006Y 2005Y 2004Y NII\AA Int Inc\AA Int Exp\AA

42 Measuring ALCO Risks RISK VS. RISK AND RISK VS. RETURN 40

43 Home Community Bank Example Historically low financial performance breakeven or loss since 2007 Strong capital levels sustained through recession Little or no asset growth Predominate loans VR CRE with rates floors High levels of investments to total assets Interest rate risk reports say they will make more $$$ if rates rise But it doesn t say if they will make ENOUGH $$$ if they don t! Would you like no or low earnings with little volatility or higher earnings with managed volatility? 41

44 Home Community Bank 42

45 Home Community Bank 2015 results show improvement in ROE\ROA Decline in capital ratio (increase in eq. multiplier below) What did they do? 43

46 Home Community Bank Growth Rates Loans\EA up from 53% to 64% past 4 years 2013 year loans grew faster than assets 2014 Assets grew faster than loans Relate this to the bank s capital ratio performance 44

47 Home Community Bank Earnings components Net Int Margin\EA up from 2.71% to 2.94% (up 23 bp or 8.5%) What might be the cause? 45

48 Home Community Bank Earnings components Non-Int Margin\EA up unchanged or slightly worse -2.26% to -2.37% Increase is not due to more fees or expense cuts 46

49 Home Community Results Trends show increased performance identified as main cause the increase in loan\earning asset levels What questions does this raise about the future of the bank s earnings if rates change? What happened to liquidity in this case Are we at all concerned about potential for credit losses in the new loans? 47

50 Traditional Risk Using Immediate Rate Shocks, Sample Bank appears fine All rates move together, immediately Effect of floors is lost Traditional Rate Shock Analysis says no earnings at risk When subjected to a different rate projection, that moves gradually and non-parallel 48

51 Traditional Risk Under planned growth (Dynamic) little risk in high rates -0.69%, but slightly more in +2% immediate -1.37% Under static plan (no growth or change in mix), risks don t change in the gradual rate moves (GI) but more severe in the I&P moves. How does the BPA trend information help us here? Does this bank look to have an interest rate risk problem? 49

52 Traditional Risk Yr. 2 shows that in the GI High rate increase, margin IMPROVES +2.28%, but in immediate shock of +2% it declines -3.76% Which one do we use to manage our bank? Note again the impact of the planned growth vs. the static values. Static results less positive and more negative The impact of the growth and mix changes planned by management 50

53 Short or Long Term Horizon Unanswered question: Is the bank making enough money for capital and risk needs Income at risk (IAR) measures are short term looks at risks to capital formation Value at risk (EVE) measures look at structural concerns on capital needs from balance sheet mix EVE levels can be changed over time IAR risks are stress events on capital Base capital component on IAR analysis Use EVE to select strategy when either IRR measure is OUT of compliance 51

54 Home Community Current EVE Current EVE levels show strong levels of EVE in all shocked scenarios However, the % change in the EVE ratio is significant. Most ALM policies limit the % change in EVE. Max change averages -35% Home outside their limit for % change What does this imply? 52

55 EVE Clues Strong book capital provides the cushion for volatility As bank grows, how far will the cushion erode Capital growth vs asset growth Longer term assets in loan or investment portfolio As rates increase, values decrease on long-term, fixed rate assets Strategy options include Shorter term and variable rate loans Sell LT investments and reinvest short What is the trade-off for each? Short term, more volatile funding costs As rates risk, the cost of funds rises so no value from having fixed rate funding to match to the assets What assumptions are made for non-maturity deposits? Strategy options include Lengthen liability maturities Incent consumers to longer term products Initiate new Non-maturity Account to lag market rates Use longer term borrowings Reduce overall size by running off maturing balances 53

56 Finding the right path for Risk vs. Return SOLVE THE EVE ISSUE BY LENGTHEN BORROWING 54

57 Lengthen Borrowings Bank Liability Maturities: Large amount of maturing borrowings in next 5 months. In the fast shock scenarios, replacement costs rise quickly while asset values decline causing a negative impact on EVE Income will be OK as long as new loans continue at higher rates Option being considered: Purchase longer term advances now, and allowing the others to roll off at maturity Inflate Assets, lower Capital/Assets and ROA temporarily Save Interest Expense 55

58 Lengthen Borrowing Results EVE Results Purchase of 5 & 7 year borrowings increases Pre-shock EVE by nearly 2% Post shock EVE less sensitive with longer liabilities in shorter assets Sensitivity improves to within policy range Income results Baseline margin declines by 3% of original value to buy protection Base margin was 2.98% in Base rate forecast, dropped 11 bp or 3% to 2.89% Allows the bank to make some additional long term loans with better asset yields while managing additional EVE risk. 56

59 Concept of Risk vs. Return The Right ALCO Question? Which performance line would you choose? Who answers this question at your bank? How do they decide the answer Gut or intuition Scenario analysis What other issues should we think about? Associated credit risk Bank expertise? Competition Etc. 57

60 Taking This to Year 3 Banksim Community bank competition Allocates resources based on real-world pricing and growth actions that your team is willing to take Remember: ROE = ROA * Leverage Remember: What are the drivers of ROA? Remember: What are potential market risks to different ALCO risk areas that you need to protect or insure against How much capital is enough or too much 58