ASSET/LIABILITY MANAGEMENT - YEAR 2

Transcription

1 ASSET/LIABILITY MANAGEMENT - YEAR 2 Tying It All Together: Implementation of a Risk/Return Framework David W. Koch President & CEO FARIN Financial Risk Management Fitchburg, WI dkoch@farin.com August 2, 2018

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

3 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

4 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

5 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

6 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

7 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

8 EVOLUTION OF ALCO

9 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

10 Static vs. Dynamic IRR Measurement Static Systems Measure IRR in Existing Balance Sheet Fail To Consider Institution Strategy Can t Be Used to Evaluate Risk/Return Tradeoffs Regulatory Systems Are Static EAR Examples - Static Balance Sheet Income at Risk VAR Examples - Duration, Current VAR, Dynamic Systems Measure IRR in Future Balance Sheet Consider Institution Strategy Evaluate Risk/Return Tradeoffs EAR Example Dynamic BS Income at risk, VAR Example Running VAR on projected balance sheets under projected interest rate scenarios

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12 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

13 Defining Capital & Risk Appetite Available Capital 13.0% Risk Appetite 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 11.0% 8.5 % 6.0% Your definition of acceptable minimum lev Proper stress testing helps us ID the necessary levels of capital for risk in today s exposures and tomorrow s plans

14 Stress Testing 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 see previous rate graphs Income at risk measures impact of changes on capital formation

15 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

16 Interest Rate Risk Stress Tests Sensitivity Tests Test the impact of key variables on results Immediate & Parallel Rate Shocks on 1 & 2 Yr Net Interest Income What are we really measuring when we check out +400 bp instantaneous change? How do we interpret the results +4% change in rates results in -10% change in NII Economic Value of Equity (EVE) on last quarter end balance sheet Impact of long-term changes in rates on the performance of

17 Measuring Earnings At Risk (EAR) Typical measurement 12 & 24 month simulation of balance sheet Test effect of rate changes on net interest income Common Approach Hold balance sheet constant static model Avoids influence of growth on earnings Move rates up equally across all terms (parallel movement) What is the goal? Identify if there is significant change to earnings as the current balance sheet reprices?

18 Major Assumption in IRR Measurement Repricing of assets & liabilities Most assets assumed to rise\fall by 100% of market rate change (beta = 1.0) with no lag in change Most non-maturity deposits projected to move by less than 100% of market rate change when rates rise and closer to 100% of change when rates fall, both sides lagging the change in market rates CD and borrowing rates assumed to rise\fall by 100% of market rate change (beta = 1.0) with little\no lag in change

19 Earnings at Risk: Common Issues How do you compare new assets with different maturities? Loan example: 1 Yr. maturity, 20 Yr. amort 3.0% 3 Yr. maturity, 20 Yr. amort 3.5% 5 Yr. maturity, 20 Yr. amort 4.0% 7 Yr. maturity, 20 Yr. amort 4.25% 10 Yr. maturity, 20 Yr. amort 4.50%

20 Comparing Unlike Cash Flows 1 Yr Loan 3 Yr Loan 5 Yr Loan 7 Yr Loan 10 Yr Loan Comparing Unlike Cash Flows 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Yr 7 Yr 8 Yr 9 Yr 10 Yr Assume all loans made today ALM model projects principle and interest from origination to maturity What problems does this pose when measuring earnings at risk? Time Cash flow consistency

21 Comparing Unlike Cash Flows 1 Yr Loan Comparing Unlike Cash Flows Analysis Horizon 3 Yr Loan 5 Yr Loan 7 Yr Loan 10 Yr Loan 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Yr 7 Yr 8 Yr 9 Yr 10 Yr Time EVE captures the remaining value of cash flows not considered in 1 & 2 year earnings at risk!

22 Major Assumption in EAR Total P&I Cash Flow Yr 1 Ttl 1 YR Loan 5, , , , , , , , , , , , ,031, YR Loan 5, , , , , , , , , , , , , YR Loan 6, , , , , , , , , , , , , YR Loan 6, , , , , , , , , , , , , YR Loan 6, , , , , , , , , , , , , Total P&I cash flow comparison 1 Yr loan shows significantly higher repricing cash flows due to 12 month balloon

23 Major Assumption in EAR Interest Yr 1 Ttl 1 YR Loan 2, , , , , , , , , , , , , YR Loan 2, , , , , , , , , , , , , YR Loan 3, , , , , , , , , , , , , YR Loan 3, , , , , , , , , , , , , YR Loan 3, , , , , , , , , , , , , Yr 2 Ttl Ttl 2 Yrs 2, , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , Interest cash flow comparison flat rates 1 Yr balloon loan produces approx. $30k less interest income if rates stay flat So what s your bet on interest rate movements? Rates rise we will make more $ by reinvesting at higher rate Over what horizon?

24 Major Assumption in EAR Interest Yr 1 Ttl 1 YR Loan 2, , , , , , , , , , , , , YR Loan 2, , , , , , , , , , , , , YR Loan 3, , , , , , , , , , , , , YR Loan 3, , , , , , , , , , , , , YR Loan 3, , , , , , , , , , , , , Yr 2 Ttl Ttl 2 Yrs 4, , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , Interest cash flow comparison +200 bp Even after a 2% increase in rates, 1 Yr balloon loan produces less interest income than the 10 Yr loan. But is has positive volatility What is our goal, more repricing capacity or more total income?

25 Loan Rate Betas Asset\Liability Model Assumptions As interest rates move, asset rates move 1:1 Reality is very different and impacts IRR Comparison of loan rates YTD Feb 2017 vs Feb 2018 filtered by origination year Using straight average No control for risk rating Type Code Beta Loan Type Description 1A % FR B % FR 15 1C % FR 10 1M % Construction 2A % RE HE 2C % RE 2nd Mtg FR 2N % RE HE 3C 3.99 FR RE Purchased 3I 2.71 Blue Wave Solar HE 4A % Share loans 4D % Pers & HE 4G OD Protection 6A % Comm RE LOC 6E % CRE 10 Yr ARM 6I % CRE 5Yr ARM 6L % CRE FR 20 Yr 7A % C&I LOC IO 7I C&I OD Prot 7J % C&I Term Fixed

26 Loan Comparison 2017 to 2018 Type Code Balance Sum Balance Sum Beta Loan Type Description 1A 3.91 $18,778, $48,893, % FR B 3.01 $14,088, $25,820, % FR 15 1C 2.75 $1,155, $3,730, % FR 10 1M 3.88 $397, $756, % Construction 2A 3.92 $359, $138, % RE HE 2C 4.75 $79, $47, % RE 2nd Mtg FR 2N 2.62 $1,509, $1,325, % RE HE 3C 3.99 $7,440,477 FR RE Purchased 3I 2.71 $5,108,363 Blue Wave Solar HE 4A 4.28 $239, $66, % Share loans 4D $2, $3, % Pers & HE 4G $ $0 OD Protection 6A 5.50 $493, $ % Comm RE LOC 6E 4.50 $4,485, $11,729, % CRE 10 Yr ARM 6I 4.38 $1,398, $3,665, % CRE 5Yr ARM 6L 5.25 $1,148, $379, % CRE FR 20 Yr 7A 5.50 $361, $ % C&I LOC IO 7I $3, $959 C&I OD Prot 7J 5.80 $882, $18, % C&I Term Fixed Total $57,932,051 $96,576,870 Change 59.99%

27 Conclusion from Example Market rates moved significantly, but bank rates did not Lag in rates? Is beta really 1.0? What happened to many banks deposit rates on NMDs? Lags came out of market Modeling a 12 month lag, reality was a 3 month or less lag Beta higher than projected Past Fed actions caught up to demand for higher rates. What s the right way to measure real earnings risk for your bank?

28 What if Market rates move and we move deposit rates faster and higher than expected? Market rates move and our loan rates are sticky? Market rates move and our variable and short assets demand longer refinance options? Cash flows on loans begin to slow as higher interest costs consume cash flow of borrower? Future loan growth accelerates\declines in desired or less desirable structures? Market rates don t all move by the same amount and\or don t stay at the new level forever?

29 Defining Risk Three Inherent Risks to all Financial Intermediaries Credit risk The obligation to pay back depositors regardless of whether loans are repaid 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 Liquidity Risk Not enough cash will be generated from assets to meet deposit withdrawals or contractual loan funding

30 Sensitivity Testing 2 applications for sensitivity testing 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 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

31 Sensitivity Testing Goal The goal is NOT to predict actual earnings & capital levels but rather: Identify key assumptions that could impact your PLAN What are the major decisions and controls we must monitor?

32 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? 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!

33 More Realistic Stress Tests Scenario Analysis Involves coherent, logical story on why events could occur and potential impact Not a one-size fits all approach Types of Stress Tests Functional Catastrophic Developing Functional Stress Tests Build base business plan & develop realistic alternative events (stresses) including impact on institution Assign probability to events Model impact of stress tests and compare results to base plan Interest Rate Liquidity Credit Capital Earnings Growth Developing Catastrophic Stress Tests Big Bank Stress Test DFAST

34 Scenario Testing Goal The goal IS to predict path of probable earnings & capital levels: Under various sets of key assumptions Calculating driving costs is 1 component of overall trip cost What happens to total cost if: Weather delays Road\bridge closures Car trouble

35 Market rate changes What happened between Dec 15 Mar 16 (Dark Blue to Orange)? LT rates fell What happened by Q (Dark Blue to Grey) ST rates up more than LT rates What happened by Q (Dark Blue to Green) ST rates up significantly more than LT rates Remember duration formula Chg MV = - Duration * Chg MR

36 Market rate changes Dec 15 Mar 16 (Orange) 10 Yr rate down approx. 40 bp 5 Yr duration * -50 by change = 2.5% chg in MV Dec 15 Mar 18 (Green) 10 Yr rates up approx. 30 bp 5 Yr duration *.30 bp change = -1.5% chg in MV

37 Market rate changes What about short term rates? Dec 15 Mar 16 (Orange) 1 Yr rate down approx. 10 bp.5 Yr dur * 10 bp change = 0.05% chg in MV Dec 15 Mar 18 (Green) 1 Yr rate up approx. 120 bp.5 Yr dur * 120 bp change = -0.6% chg in MV

38 Capital\ALCO Planning Sensitivity Tests Key Questions: What if our key assumptions aren t quite right? Credit Quality Market Rates Liquidity sources Funding sources & costs Asset Growth & Mix Goal: ID key planning assumptions that must go RIGHT!

39 Capital\ALCO Planning Scenario Tests Key Question: Are we OK in the event of a real set of possible events? Rates Funding sources & costs Credit Quality Projected Growth Goal: Determine if we meet capital plan goals under stress

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

41 IRR Example Looking Back 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?

42 IRR Example Looking Back

43 IRR Example Looking Back 2015 results show Improvement in ROE\ROA Decline in capital ratio (increase in eq. multiplier below) What did they do?

44 IRR Example Looking Back 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

45 IRR Example Looking Back Earnings components Net Int Margin\EA up from 2.71% to 2.94% (up 23 bp or 8.5%) What might be the cause?

46 IRR Example Looking Back 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

47 IRR Example Looking Back 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?

48 IRR Example Looking Back 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

49 IRR Example Looking Back 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?

50 IRR Example Looking Back 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

51 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 will change 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

52 IRR Example Looking Back 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?

53 IRR Example Looking Back 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

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

55 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

56 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

57 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

58 Taking This to Year 3 Community bank competition Model allocates resources based on pricing and growth actions that your team in relation to other institutions Performance measured against overall performance measures AND your performance to overall bank strategic plan\capital plan Remember: ROE = ROA * Leverage Remember: What are the drivers of ROA? Remember: What are potential risks to different ALCO risk areas that you need to protect or insure against How much capital is enough or too much