GRADUATE SCHOOL OF BANKING AT COLORADO CLASS OF Intersession Research Project RISK MANAGEMENT. Timothy Koch & Jerry Crigger

Transcription

1 GRADUATE SCHOOL OF BANKING AT COLORADO CLASS OF 2014 Intersession Research Project RISK MANAGEMENT Timothy Koch & Jerry Crigger

2 2 Introduction GRADUATE SCHOOL OF BANKING AT COLORADO INTERSESSION RESEARCH PROJECT - RISK MANAGEMENT CLASS OF 2014 During your enterprise risk management (ERM) and loan portfolio management classes at GSBC, you were exposed to different methodologies to identify and manage interest rate risk and credit risk in a bank and plan for contingency funding. This intersession assignment provides you with an opportunity to apply these concepts to your organization. After you complete the assignment, you will have a better understanding of the general value of a risk profile, the specific profile of your bank, and what your bank does to manage overall balance sheet risk and the credit risk in the bank's loan portfolio. The intent is for you to combine the ERM activities with specific Credit Risk Management activities within your bank to better help you make strategic decision. Importantly, the final part of the assignment is to make recommendations along these lines. Project Resources and Information Needed To complete this project, you are expected to generate portions of an internal risk assessment of your institution. In particular, you are asked to assess risk associated with capital adequacy (C), asset quality (A), liquidity (L) and sensitivity to interest rate risk (S). A. To assess your institution s capital and liquidity risk profile, you may use your UBPR or UTPR information for the most recent quarter (plus trends) or other information generated by your ALCO or Risk Committee. In order to complete the interest rate risk analysis, you will need to obtain copies of your bank s reports that analyze GAP, Net Income Sensitivity Analysis / Simulation, and/or Economic Value of Equity Sensitivity Analysis. You should be able to obtain this information from your bank s ALCO or Risk Management Reports. Supporting information is also available in the UBPR/UTPR or Canary Report. B. Several templates are available at the GSBC website to facilitate completing the credit risk (asset quality) assessment. To access the template, go to An instruction sheet is provided on the site to facilitate entering data into the template. Within your bank, you should obtain Loan Quality information with supporting information available from the UBPR/UTPR. ( If you are a regulator or do not work for a financial institution, attempt to gather the information from a bank you have examined or from regulatory reports, e.g. examination reports, and the Uniform Bank Performance Report (UBPR). Alternatively, you might ask one of your fellow students to share information on his/her bank. To protect the confidentiality of the information, it is not necessary that regulators disclose the name of the bank.

3 I. Executive Summary [5%] 3 Briefly, describe the current situation in your institution regarding ALCO and Credit Risk. Using GSBC experience, comment on the quality and completeness of these activities. Briefly summarize your current job responsibilities. For additional project context, summarize your financial institution s asset size; age of the institution; ownership structure (e.g. family owned, closely held, subchapter S, publicly traded); markets served; and principal loan products offered. II. ERM: Construct a Profile for the institution s Capital adequacy, Liquidity and Interest Rate Risk [40%] Obtain a recent copy of your bank's ALCO report or Risk Management report. Supplement this information with UPBR / UTPR data as appropriate. For Parts A, B and C, refer to the most comprehensive method of measuring interest rate risk (static GAP, earning/income sensitivity and/or simulation, economic value of equity (EVE) or net present value sensitivity, model simulations, etc.) that your bank uses to analyze the bank's current exposure to interest rate changes. A. What are the bank s interest rate risk policy targets? Cite specific policies related to the allowable size of GAP, the sensitivity of earnings, and/or the sensitivity of EVE. Interpret what the figures mean. A. Describe your bank s current interest rate risk profile. Attach a copy of all relevant data. This information will be shared only with the grader. a) Explain what the figures indicate regarding the bank s interest rate risk exposure. Specifically, is the bank asset or liability sensitive and is the bank positioned to profit if rates increase or decrease? If your bank does earnings sensitivity analysis or EVE sensitivity analysis, what is the estimated impact on earnings and/or the economic value of equity across different rising and falling rate environments? Cite specific figures for the earnings impact by comparing the change in earnings compared to some base case or most likely case. b) Is the bank s aggregate interest rate risk exposure large or small? Describe how you arrive at this conclusion. C. Discuss the impact of embedded options. In its sensitivity analysis, explain how your bank explicitly attempts to measure the impact of loan prepayments, bonds being called, and asset yields changing differently than liability costs when rates change. Also, discuss also the impact of early withdrawals of deposits on interest expense. Describe any specific approach, or modeling, that is used by your institution to address embedded options potential earnings impact.

4 4 For Parts D, E, F and G, identify the financial ratios and related metrics - including your contingency funding plan - that your institution uses to identify, measure and manage capital and liquidity. Use the information to address the issues referenced in each part. D. Examine and report the following ratios at your bank versus peers in the most recent period. Indicate what the figures mean in terms of trying to assess whether the bank has adequate liquidity. Interpret what the values for your bank suggest regarding the bank s liquidity position. Where relevant, compare your bank s ratios with those for peer banks. 1. Loans-to-deposits 2. Core deposits to total assets 3. [Cash plus unencumbered (liquid) assets] divided by [deposits plus short-term borrowings] 4. Pledged securities to total securities. E. To what extent does your bank rely on purchased, non-core liabilities? Cite specific data for federal funds purchased and repurchase agreements (RPs), Federal Home Loan Bank advances, jumbo CDs, internet and rate board deposits, etc. and compare key ratios to peers. F. Discuss what contingency funding sources the bank has available. Assume that your bank needs to borrow a significant amount of funds in the next 5 days. Explain where and how it would get the funds. Explain where and how you would get a significant amount of funds that you need over the next 30 days. Discuss, in general, whether and why your institution s liquidity risk is low, moderate or high. G. Examine and report the three regulatory capital ratios for your bank versus peers. What are the key trends from 2007 present? Did your institution raise external capital over this period? If so, discuss in what form it raised the capital and its strategic purpose. Discuss, in general, whether and why the risk profile of your institution s capital position is low, moderate or high. III. Construct and Assess an Aggregate Credit Risk Profile [40%] A: Construct a Quantity of Risk Profile for your bank The Quantity of Risk Profile utilizes summary loan portfolio information which should be available from the senior credit officer or senior lender in your bank as well as from the UBPR or UTPR. (NOTE: If the information requested is not readily available, do the best you can. However, be sure to describe any shortcomings to the complete analysis, whether you believe it might be beneficial for your bank to develop more comprehensive portfolio information, and what information additions you believe will be helpful). 1. Use the Transaction Risk Profile (Directional Assessment) template to array the loan portfolio by Risk Rating in a format that displays:

5 a) The % of total loan portfolio by Risk Rating in each Rating Category. Ideally, Risk Ratings will be assigned to Commercial & Industrial (C&I); Commercial Real Estate (CRE); Agriculture; Consumer; and Residential Permanent Mortgage Loans. b) NOTE: If certain categories of loans are not assigned a Risk Rating in your bank, use your best judgment to assign Ratings. Be sure to describe the methodology used for your assessment. c) Also NOTE: The Transaction Risk Profile template provides a choice among four Risk Rating scales. If your bank uses a different methodology, use the closest scale provided and state in the paper how you assigned the categories. 2. Include a table in the paper of your bank s major lines of business expressed in as a percentage (%) of total portfolio outstandings and of bank capital. a) NOTE: This may be found in the UBPR: a. % of Average Gross Loans (page 7A of the UBPR-- Analysis of Credit Allowance and Loan Mix-- has % of Avg. Gross Loans for major loan categories) b. Major loan categories as a % of Total Capital may be found on page 7B of the UBPR (Analysis of Concentrations of Credit). b) REMEMBER: If an industry within a Line of Business is => 20% of Capital, that industry should be identified separately to be used with the Intrinsic Risk Scoring Worksheet. a. NOTE: Owner Occupied Commercial Real Estate should be included in C&I and broken down by respective industries if possible. b. Examples of Industries within Lines of Business (See 3c below for sample Lines of Business): i. Within Agriculture: 1. Dairy 2. Row Crop ii. Within CRE (Permanent): 1. Multi-family 2. Strip Retail Centers 3. Office 4. Warehouse c. As with Transaction Risk, if all data are not available, do the best you can. Comment on what is available, how you used that information, and whether you believe additional bank-wide tracking might or might not be beneficial. Provide reasons for your assessment. 3. Use the information contained in the Line of Business/Industry table to determine how many Intrinsic Risk Scoring Worksheets should be completed, and complete the Worksheets. 5

6 NOTE: a) One Intrinsic Risk Scoring Worksheet will be completed for each Line of Business (after subtracting Industries within that Line of Business that =>20% of Capital i.e. Tier1 + ALLL or Total Capital from the UBPR). b) One Intrinsic Risk Scoring Worksheet will be completed for each Industry that =>20% of Capital. c) If a line of business has nominal outstandings (i.e. <5% of the loan portfolio) combine the outstandings for all similar lines of business and intuitively assign an Intrinsic Risk Score. Examples of lines of business include: :Consumer Direct Indirect Home Equity Credit Card :Commercial and Industrial (C&I) :Real Estate Commercial Construction Commercial Permanent Residential Construction Residential Permanent :International :Municipalities :Agriculture :Factoring/Commercial Finance/Asset Based Lending :Not for Profit 6 4. Include a table in the paper highlighting major Concentrations expressed as follows: a) Borrower: 10 largest borrowers as % of Capital (do not use actual names. A total or list by Borrower 1, Borrower 2, etc. is sufficient) b) Industry, Property Type, or Type of Ag as % of Capital c) Lines of Business as % of Capital (Do not include C&I, Ag, or CRE portfolio: Concentrations in the C&I, Ag and CRE portfolios will be picked up in borrower and industry concentrations. If the Ag and CRE portfolios are considered to be homogeneous, then they may be used as the largest line of business if outstandings warrant). d) Use the information contained in the table to aid in completing the Concentration Risk Assessment template in four categories: 1-Borrower; 2-Geography (Note that Geography has its own template on the GSBC website-- for use in determining geographic concentration risk);3- Lines of Business; and 4-Industry.

7 Finalize a Quantity of Risk Assessment: 7 Use the Quantity of Risk information and templates prepared as instructed above to construct a Quantity of Risk Assessment for your bank. STEP 1: Once you have completed the templates for Transaction Risk, Intrinsic Risk, and Concentration Risk and assessed the level of risk for each of the three, provide a summary graphic (such as below) to indicate the relative risk in each category and the combination risk you observe when all three are displayed together: Low Medium High T C I T = Transaction Risk I = Intrinsic Risk C = Concentration Risk STEP 2: Summarize your conclusions regarding the Quantity of Risk for your bank. a) What does the Quantity of Risk profile suggest about the potential for volatility in portfolio credit quality, earnings, and risk to capital? b) If you believe that any of the components of Quantity of Risk should be addressed in your bank, provide potential solutions that you would deploy if you were in charge of the risk profile for the institution. B. Construct a Quality of Risk Management Assessment: STEP 1: Using the Strategic Loan Portfolio Management Visual provided, plot points on the Visual or describe the position on the respective continuum for Stated Priorities/Culture, Observed Risk Strategy, and Implemented Risk Controls where you see your bank. STEP 2: Discuss the relationship between the Stated Priorities/Culture in your bank and the Observed Risk Strategy. a) Describe the Stated Priorities/Culture for your bank. b) Describe the Observed Risk Strategy (based on your assessment of the Quantity of Risk) c) Are the two consistent? d) If not, what do you believe may be the reasons? STEP 3: Discuss the Implemented Risk Controls in your bank focusing on the Visual continuum of Behavior Influencing through Behavior Controlling a) Describe your assessment (and reasons for that assessment) of the appropriateness of the Implemented Risk Controls given the Observed Risk Strategy STEP 4: Discuss the Loan Portfolio Management Tools utilized in your bank as outlined in the Quality of Risk Management hierarchy a) Provide an assessment (and reasons for that assessment) of the appropriateness of the Loan Portfolio Management Tools utilized given your bank s Observed Risk Strategy and Implemented Risk Controls

8 8 b) What steps would you recommend to better monitor, manage, or reduce the portfolio risk revealed in the profile? C. Aggregate Risk Determination and Loan Portfolio Management Conclusions: a) Combine the determined Quantity of Risk assessment with the determined Quality of Risk Management assessment (similar to the quadrant combination used in class. (You do not have to create a visual just state the conclusions for each category. For example: Quantity of Risk-- Moderately High: Quality of Risk Management Moderately Weak) b) Based on this combination, provide a conclusion (and your reasons for that conclusion) of the efficiency and effectiveness of the Loan Portfolio Management system in your bank i. If the LPM system is appropriate, what makes it so? ii. If your LPM system has identified weaknesses, what are they and what solutions would you recommend? IV. Economic Scenario and Recommendations [15%] Suppose that the U.S. and global economy face a stagflation environment in which economic growth is slow, inflation is rising and unemployment remains higher than anticipated. Because of asset quality problems, your bank is experiencing a decline in core funding. Recommend at least two activities or strategies (for each) that could be implemented to improve the risk management practices of the institution in the area of credit risk, liquidity risk, and interest rate risk. Identify specifically how the institution would benefit from each.