Your State Association Presents. Interest Rate Risk: What Does th Future Hold? Program Materials

Transcription

1 Your State Association Presents Interest Rate Risk: What Does th Future Hold? Program Materials Use this document to follow along with the live webinar presentation. Please test your system before the broadcast. Be sure to print enough copies for all listeners. Monday, July 27, 2015 Presenter: Technical Support (for faster service please submit inquiries via or online): (Registration & Tech Support): - Phone- (877) FOR ADDITIONAL ASSISTANCE PLEASE REFER TO OUR FAQs

2 Interest Rate Risk What does the future hold Integrating Financial Risk Enterprise Risk Management History of Interest Rate Risk Management How to Effectively Manage Risk Six Questions The Difference between Planning and Risk Management The Importance of Stress Testing Unpacking your Risk Profile Liquidity Risk Applying the Same Methodology Enterprise Risk Management Integrating the Big Three: Interest Rate Risk Credit Risk Liquidity Risk Outline 1

3 The History of IRR January was Pivotal FFIEC Issues an Advisory on Interest Rate Risk Interest Rate Risk Prior to the Advisory IRR, so what, who cares? After the advisory, You better care, OR ELSE! What did the FFIEC Advisory Say Material weakness in risk management processes or high levels of IRR exposure relative to capital will require corrective action. Such actions could include recommendations or directives to: Raise additional capital Reduce levels of IRR exposure Strengthen IRR management expertise Improve IRR management information and measurement systems 2

4 What did the FFIEC Say Before 2010 Joint Agency Policy Statement: Interest Rate Risk (1996) Banks that are found to have high levels of exposure and/or weak management practices will be directed by the agencies to take corrective action. Such actions will include directives to: Raise additional capital, Strengthen management expertise, Improve management information systems, Reduce levels of exposure, or a combination thereof. What Changed in 2010 In Principle Nothing Practically Speaking Everything Now the Board and Management have to: Understand IRR The Concern of the Regulators is: Capital - EVE 3

5 Understanding & Managing Risk Six Key Questions 1. What is my risk? 2. What is causing my risk? 3. What material assumptions I am making? 4. Where did I get those assumptions? 5. What happens if I am wrong about those assumptions? 6. What is my plan if I am wrong? A Key Distinction Risk vs. Planning What is Planning? What I think is going to happen. What I want to happen. What I hope will happen. What better happen if I want to keep my job! 4

6 A Key Distinction Risk vs. Planning What is Risk? What happens if I am wrong? What causes me to blow up? When does my institution collapse? You have to do both. Plan Manage Risk A Key Distinction Risk vs. Planning Planning is Educated Guessing Risk Management is Stress Testing your Guessing 5

7 Stress vs. Guess What does the Advisory say about Stress Testing? Stress Testing should include a sensitivity analysis to help determine which assumptions have the most influence on model output can be used to determine the conditions under which key business assumptions and model parameters break down Stress vs. Guess Stress Testing is the Heart of Risk Management Stress Testing Answers the Three Questions What happens if I am wrong? What causes me to blow up? When does my institution collapse? 6

8 How Do You Stress Test? There are Two Ingredients in every Risk Model Facts Assumptions How Do You Stress Test? What are the Facts? Balance Sheet and Market Facts Contractual Facts Balance Rate Repricing characteristics Payment characteristics, etc. 7

9 How Do You Stress Test? What are the Assumptions? Things that are made up Rate scenarios Non maturity deposit behavior Prepayments How Do You Stress Test? Assumptions: Are elements of the Planning Process because they are made up This means your Risk Profile is NOT a Scientific Fact Your Risk Profile is a Belief System 8

10 How Do You Stress Test? Determine which Assumptions are Most Critical Stress Test Critical Assumptions What do Regulators Want? Management and the Board should be able to: Understand and Explain your Risk 9

11 What do You Want? The Regulators to go away If you want them to go away, see previous slide. What Should You Do? Demonstrate you Understand Cooperate and Graduate 10

12 Unpacking Your Risk EVE Volatility With No Options Unpacking Your Risk EVE Volatility Adding Back Options 11

13 Unpacking Your Risk EVE Volatility Adding Back Prepayments Unpacking Your Risk EVE Volatility Adding Back NMD Assumptions 12

14 Non Maturity Deposit Stress Test Unpacking Your Risk On the Balance Sheet What is Causing Risk 13

15 Unpacking Your Risk On the Balance Sheet What is Causing Risk Unpacking Your Risk On the Balance Sheet What is Causing Risk 14

16 Unpacking Your Risk On the Balance Sheet What is Causing Risk Earnings at Risk vs EVE Risk Management is primarily interested in making more money. That is best accomplished by leveraging the balance sheet (i.e. lower capital ratios). Regulators want more capital and less EVE risk which will typically cost you earnings. EVE at Risk and Earnings at Risk Mixed signals, you may have one but not the other 15

17 A Tale of Two Banks $100 million in Assets Bullet 30-Year UST $100 million in Equity Does this bank have interest rate risk? A Tale of Two Banks Earnings at Risk No! A Locked in Margin EVE at Risk? A LOT! 16

18 A Tale of Two Banks $100 million in Assets Fed Funds Sold $100 million in Equity Does this bank have interest rate risk? A Tale of Two Banks EVE at Risk No! No Gains or Losses due to Changes in Rates Earnings at Risk? A LOT! 17

19 What are the Regulators Worried About? Asset Durations - Lengthening Liability Durations Shortening How the combination hurts earnings and capital in Rising Rates They are most concerned about EVE at Risk What are the Regulators Worried About? 18

20 What are the Regulators Worried About? What are the Regulators Worried About? 19

21 What are the Regulators Worried About? Liquidity Risk Definition and Overview Liquidity Risk The risk that an institution s financial condition or overall safety and soundness is adversely affected by an inability (or perceived inability) to meet its obligations. In Other Words The risk of your bank running out of money 20

22 Liquidity Risk Definition and Overview Your bank is mainly composed of assets that have contractually defined cash flows extending over time loans and investments. Credit Risk Will I get those cash flows back? Liquidity Risk The balance sheet is funded primarily by Core Deposits a series of puts funding sources that can go away instantly. These Core Deposits are the primary source of your: Value Liquidity Risk Interest Rate Risk Sources of Liquidity Asset-Based Liquidity o Liquid Assets Dollars in your Wallet Cash Deposits at Other Institutions Unpledged Securities Loans and Other Assets that can be Sold 21

23 Sources of Liquidity Liability-Based Liquidity o Borrowing Capacity Credit Cards in your Wallet FHLB Brokered Deposits Internet CDs Funds Purchased Sources of Liquidity Risk What are my sources of liquidity risk? Funding mismatches Inability to convert assets into cash Inability to access sources of funding Contingent liquidity events 22

24 Regulatory Concerns - Past Most guidance dates back to 1979 the origin of CAMELS Examiners focused on balance sheet position Ratios Liquidity sources were mostly Asset Based Securities Core Deposits were considered the only stable source of funding Regulatory Concerns - Current Core Deposits are still critical Diversified funding sources are a positive Liability Based Liquidity High Quality Liquid Assets are important Both Liquidity Position and Managing Liquidity Risk are important Ratios are still important, but What If simulation and cash flow projections are a necessity 23

25 Regulatory Concerns Current Questions What is your reliance on non core funding? What are your liquid assets? What is your borrowing capacity? How stable are your large deposits? Do you have a written Contingency Funding Plan (CFP) Have you tested your CFP and access to funding sources? Are you performing dynamic cash flow analysis? What worked during the Crisis? FDIC Guarantees Federal Home Loan Bank Internet CDs 24

26 Answering the Six Questions What is my risk? Ratio Analysis Answering the Six Questions What is my risk? Cash Flow Mismatches 25

27 Answering the Six Questions What is my risk? Surge Balances Change in Balance Sheet Mix Answering the Six Questions What is my risk? Surge Balances Change in Average Balance per Account 26

28 Answering the Six Questions What is causing my risk? Answering the Six Questions What are my critical assumptions? 27

29 Answering the Six Questions What are my critical assumptions? Answering the Six Questions What are my critical assumptions? 28

30 Answering the Six Questions Where did I get my assumptions? Historical Observation? Balance Sheet Growth Prepayments Early Withdrawals Non maturity deposit decay Borrowing lines from Correspondents Answering the Six Questions What happens if I am wrong? 29

31 Answering the Six Questions What is my plan? Wholesale funding? No Go to the Discount Window? - No Shrink the Balance Sheet Yes Internet CD s - Yes Enterprise Risk Management (ERM) An Effective ERM Process: Regulators aren t sure what this looks like Neither are we. Theoretically Encompasses all Types of Risk Must Incorporate the Big Three Credit Risk Liquidity Risk Interest Rate Risk Shows How they Combine to Affect Capital 30

32 ERM Stress Test Rotate Neg Dn 400 Dn 300 Dn 200 Dn 100 Forward Up 100 Up 200 Up 300 Up 400 Rotate Pos Tier 1 Capital 10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000 Stress Level 100% Interest Rate Risk (EV Gain/Loss) 1,600 2,000 1,750 1,500 1,250 1, (500) (1,000) 350 4% Credit Risk (3,000) (3,000) (3,000) (3,000) (3,000) (3,000) (3,000) (3,000) (3,000) (3,000) (3,000) 50% Liquidity Risk (1,000) (100) (250) (500) (1,000) (1,500) (2,000) (2,500) (25) Forecasted Retained Earnings 1, ,000 1,100 1,200 1,300 1, Total Equity 8,700 9,600 9,450 9,200 8,900 8,500 7,600 6,700 5,800 4,900 8,075 Total Assets 98,700 99,600 99,450 99,200 98,900 98,500 97,600 96,700 95,800 94,900 98,075 Target 8% Capital to Assets 8.81% 9.64% 9.50% 9.27% 9.00% 8.63% 7.79% 6.93% 6.05% 5.16% 8.23% 1% ROA 1.11% 0.60% 0.70% 0.81% 0.91% 1.02% 1.13% 1.24% 1.36% 1.48% 0.76% 10% ROE 12.64% 6.25% 7.41% 8.70% 10.11% 11.76% 14.47% 17.91% 22.41% 28.57% 9.29% Conclusion The most important question: Why? 31

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