What Is Asset/Liability Management?

A BEGINNERS GUIDE TO ASSET\LIABILITY MANAGEMENT, RISK APPETITE AND CAPITAL PLANNING David Koch President\CEO dkoch@farin.com 800-236-3724 ext. 4217 What Is Asset/Liability Management? Asset/liability management (ALM) is the process of planning, controlling and monitoring risks to reach financial goals while remaining safe & sound. Primary risks measured to determine if plan can be met reasonably: 1

Asset/Liability Defined More Practically Asset-liability management Constraints: 6 Components of the ALM Process 1. Setting achievable financial goals 2. Identifying levels of financial risk 3. Developing appropriate risk measurement systems 4. Integrating measurements into management process (the ALCO process) 5. Evaluating new ideas before implementation to determine risk 6. Implementing & tracking new strategies\ideas to maximize performance 2

Financial Goals Earnings (ROE, ROA, Net Interest Margin) Capital (Real and Regulatory) Managing goals requires the ability to project cash flows and future plans for assets and liabilities. What is it and how much do I need? CAPITAL 3

Capital Is King Since the economic crisis of 2009, financial institutions have been urged to increase capital levels Increasing capital results in less leverage Remember financial institutions manage roe New Capital Requirements How much capital is enough? New capital regulations 4

Capital Definitions Common Equity Tier 1 Capital Common stockholder s equity, Qualifying noncumulative perpetual preferred stock (including related surplus), and Minority interest in the equity accounts of consolidated subsidiaries; Plus outstanding cumulative preferred perpetual stock; Minus all intangible assets except mortgage servicing rights that are included in tier 1 capital. Tangible Equity Subset of equity that is not preferred and not intangible. Critically undercapitalized shops are those with this ratio below 2% - Capital Definitions Banks (continued) Additional Tier 1 Capital Tier 2 Capital 5

Bank & CU Capital Ratio Definitions Common Equity Tier 1 Capital Common equity tier 1 risk-based capital ratio (CET1) - NEW Tier 1 risk-based capital ratio (Tier 1 RBC) - Increased Total risk-based capital ratio (Ttl RBC) Credit Unions Net Worth Ratio Risk Based Net Worth Ratio Leverage ratio (Leverage) Tangible equity ratio (TE) PCA Basel I & Basel III Requirements Prior 6

CU vs. Bank Capital Standards Bank Standards These are Minimums How will you do this? Basel III 50, 94-95, 505 7

Defining Capital & Risk Appetite New Capital Standards Phase 2 - Build supervisory approach to new standards Requires a capital plan 8

Why is a Capital Plan Important Business strategies need to be developed and applied in the context of a business plan or strategy. We are dealing with Your capital plan feeds: 9

Capital Planning Defined Capital planning is a dynamic and ongoing process that, in order to be effective, is forward-looking in incorporating changes in a bank s strategic focus, risk tolerance levels, business plans, operating environment, or other factors that materially affect capital adequacy. The most effective capital planning considers both shortand longer-term capital needs and is coordinated with a bank s overall strategy and planning cycles, usually with a forecast horizon of at least two years. Effective Capital Planning Process Set the planning horizon 2 year minimum (regulatory) Ideally 3 to 5 year Step 1 Set long-range goals Balance equation of earnings, capitalization, & growth Define desired balance sheet mix Step 2 Set annual goals Determine annual progress goals Step 3 Model the base plan Step 4 Stress test the plan 10

Setting Achievable Financial Goals Step 1: Assess Long-Range Goals ROA Required to Reach a Desired Capital Ratio Beginning Assets Total Capital Target Capital Ratio Annual Asset Growth Additional Capital Needed % of NI Divided Payout $ Dividend Required ROA $ 200,000 $ 16,000 9.00% 0.00% $ 2,000 30.00% $ 857 1.43% $ 200,000 $ 16,000 9.00% 5.00% $ 2,900 30.00% $ 1,243 2.02% $ 200,000 $ 16,000 9.00% 10.00% $ 3,800 30.00% $ 1,629 2.59% $ 200,000 $ 16,000 9.00% 15.00% $ 4,700 30.00% $ 2,014 3.12% Is this a realistic set of goals? What can we give up to meet everyone s wishes? ROA Needed to Reach 12% ROE Banking s basic leverage equation: ROE = ROA * Leverage Where: Leverage = Assets/Capital Higher Capital = Lower ROE or the need for higher ROA to support growth 11

ALM Financial Goals Balancing Earnings, Growth & Capital ROE = ROA * (Assets/Capital) NI/AC = NI/AA * AA/AC What happens in this game if 3 teams pull together? Think about growth, earnings, capital & risk Capital Goal Setting Step 2: Move from Macro View (Step 1) to Annual Goals Step 3: ALCO and Management takes the results and determines viability and required actions necessary to hit annual goals 12

Setting Achievable Financial Goals 5 Year Capital Planning Model Year Beginning Assets Total Capital Start Capital Ratio Targeted Capital Ratio Annual Asset Growth Assets After Growth Additional Capital Needed % of NI Divided Payout Required Net Income ROA Current $ 200,000 $ 16,000 8.00% 8.25% 0.00% $ 200,000 $ 500 30.00% $ 714 0.36% Year 2 $ 200,000 $ 16,500 8.25% 8.35% 3.00% $ 206,000 $ 701 30.00% $ 1,001 0.49% Year 3 $ 206,000 $ 17,201 8.35% 8.45% 4.00% $ 214,240 $ 902 30.00% $ 1,289 0.61% Year 4 $ 214,240 $ 18,103 8.45% 8.50% 5.00% $ 224,952 $ 1,018 30.00% $ 1,454 0.66% Year 5 $ 224,952 $ 19,121 8.50% 8.50% 5.00% $ 236,200 $ 956 30.00% $ 1,366 0.59% Stepping into Goals Sample of Prioritized Goals 2016-2018 Goals in Priority Order: 13

Risk Appetite HOW DO I MAKE MORE $? Understanding Financial Risks What financial risks impact core earnings? Factors in measuring risks 14

How Much ROA Should You Make? Many institutions underperform potential earnings Most agree with concept of risk\return Would you be happy earning 3% if you knew that 5% was possible with your situation? What Can You Really Expect to Earn? Efficient earnings frontier Concept of risk vs return concept is well accepted What s missing in the trade-off talk is concept of maximum return. Efficient earnings frontier defines highest potential return for a defined amount of risk 15

Optimal Earning Asset Combinations Mapping each mix vs. earnings volatility helps show risk\return options Most often higher returns mean higher volatility What s The Difference? Given an appetite for a particular risk sector, how much exposure are we willing to extend? 16

Risk Appetite INTEREST RATE RISK What Is Interest Rate Risk? Interest Rate Risk is the risk that an institution s earnings AND market value will change as market interest rate change. 17

Interest Rate Risk Redefined Income Portion of Definition Institutional ALCO Approaches Regulatory Approach Run For Regulatory Compliance Often outsourced May Use Same Tool for Budget & Board Reports Management Approach Used to assess risk/return trade offs Run dynamic models of budgets/business plans Usually in-house or high-end outsource 18

Key Interest Rate Risk Question If Market Rates Move, How much will Bank Earnings Change? How do we traditionally measure this risk? Historical Rate Comparison In the past decade has there ever been an immediate and parallel rate shock? This graphs explains both yield curve and basis risk management! Current concern is that rates may move as they did in 04-07 19

Sample Bank Margin Performance 04-07 performance Margin declines 0.1% Understanding Interest Rate Risk Assume our Bank has a 25% reduction in NIM ROAA Declines to 0.60% ROEE Drops to 4.21% 25% Chg. in Margin = 65% decline in ROA/ROE 20

IRR Measurement Techniques Picking the Right Tool to match the job Gap Analysis Income Simulation Economic Value of Equity (EVE) Static vs. Dynamic IRR Measurement Static Systems Dynamic Systems 21

Advanced Issues in Dynamic IAR When running dynamic IAR institution s must consider Often assumptions held constant Static vs. Dynamic IAR Measuring the change in NII over 1 year from base case to alternative interest rate. Bars show $ levels and lines show % change from Base 44 22

Value at Risk MEASURING INTEREST RATE RISK Interest Rate Risk Market Value Portion of Definition 23

Measuring Value at Risk Value at Risk is defined by: Market value of capital is a derived value and does not necessarily correlate to book value of capital Present value is the current worth of a future sum of money or stream of cash flows given a specified rate of return. In essence, market value represents a long-term income statement view. Reading a Market Value Report NPV Ratio after 200 bp shock Interest Sensitivity Measure 0-100 bp 100-200 bp 200-400 bp Over 400 bp Over 12% Minimal (1) Minimal (1) Minimal (1) Moderate (2) 8% to 12% Minimal (1) Minimal (1) Moderate (2) Significant (3) 4% to 8% Minimal (1) Moderate (2) Significant (3) High (4) Below 4% Moderate (2) Significant (3) High (4) High (4) 24

Market Value (EVE/NEV) Choices Current/historical EVE/NEV Forecast EVE/NEV EVE Summary EVE/NEV is a critical measurement for ALCO to incorporate Use EVE/NEV as a decision making tool on potential strategies 25

What does this mean? How do we do this? STRESS TESTING FDIC Stress Testing - Defined Stress testing is a forward-looking quantitative evaluation of stress scenarios that could impact a banking institution s financial condition and capital adequacy. These risk assessments are based on assumptions about potential adverse external events, such as changes in real estate or capital markets prices, or unanticipated deterioration in a borrower s repayment capacity. Stress tests are most useful when customized to reflect the characteristics particular to the institution and its market area, and can be used to evaluate credit risk in the overall loan portfolio, segments of portfolios, or individual loans. Stress tests also can be used to evaluate whether existing financial (such as capital and liquidity) and operational (such as staffing and internal systems) resources are sufficient to withstand an economic downturn or unexpected event. Focus of all regulatory documents is on CRE lending though can be applied universally in top down testing 26

Stress Testing Options Sensitivity Testing Scenario Testing One is a choice, the other is to help determine what variables are most critical to success 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. 27

Two Approaches to Stress Testing Scenario Analysis: a technique where you 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. Applying Stress Tests 2 Approaches Sensitivity Test Process: Major change to key variables Assess impact on financial results Scenario Test Process: Assumptions for future performance given a set of expected conditions All forecasts are fundamentally wrong 28

STEP 4: RUN THE SCENARIOS WITH SENSITIVITY TESTS Building the Base Plan Develop written narrative of budget\forecast of planned growth and mix Define credit risk expectations Define liquidity assumptions 29

Building the Base Plan Run sensitivity tests on base plan Review key performance metrics Base Plan Sensitivity Tests Sensitivity Assumptions #1 30

Base Plan Sensitivity Tests Sensitivity Assumptions #2 Base Plan with Sensitivity Tests Tier 1 Capital Current Q1 Q2 Q3 Q4 Q5 Q6 Q7 Q8 Baseline 9.81% 9.59% 9.65% 9.72% 9.79% 9.86% 9.94% 10.03% 10.12% Basline Sensitivity 1 9.81% 9.59% 9.65% 9.72% 9.79% 9.86% 9.94% 10.02% 10.11% Basline Sensitivity 2 9.81% 9.59% 9.66% 9.73% 9.79% 9.87% 9.95% 10.04% 10.13% Total Risk Based Capital Current Q1 Q2 Q3 Q4 Q5 Q6 Q7 Q8 Baseline 11.55% 9.59% 9.65% 9.72% 9.79% 9.86% 9.94% 10.03% 10.12% Basline Sensitivity 1 11.55% 15.37% 15.48% 15.60% 15.71% 15.85% 15.98% 16.13% 16.29% Basline Sensitivity 2 11.55% 15.37% 15.48% 15.61% 15.73% 15.86% 16.00% 16.16% 16.31% Net Interest Margin Current Q1 Q2 Q3 Q4 Q5 Q6 Q7 Q8 Baseline 3.19% 3.28% 3.21% 3.22% 3.20% 3.22% 3.22% 3.24% 3.23% Basline Sensitivity 1 3.19% 3.28% 3.21% 3.22% 3.19% 3.21% 3.21% 3.23% 3.21% Basline Sensitivity 2 3.19% 3.29% 3.21% 3.21% 3.17% 3.18% 3.17% 3.17% 3.14% ROA Current Q1 Q2 Q3 Q4 Q5 Q6 Q7 Q8 Baseline 1.16% 1.22% 1.12% 1.15% 1.15% 1.17% 1.19% 1.23% 1.24% Basline Sensitivity 1 1.16% 1.23% 1.12% 1.15% 1.14% 1.16% 1.18% 1.22% 1.22% Basline Sensitivity 2 1.16% 1.23% 1.12% 1.14% 1.12% 1.13% 1.13% 1.16% 1.15% 31

Testing the Adverse Plan Scenario Assumptions Adverse Scenario Applied same types of sensitivity tests Base Plan vs. Adverse Stress Test Tier 1 Capital Current Q1 Q2 Q3 Q4 Q5 Q6 Q7 Q8 Baseline 9.81% 9.59% 9.65% 9.72% 9.79% 9.86% 9.94% 10.03% 10.12% Basline Sensitivity 1 9.81% 9.59% 9.65% 9.72% 9.79% 9.86% 9.94% 10.02% 10.11% Basline Sensitivity 2 9.81% 9.59% 9.66% 9.73% 9.79% 9.87% 9.95% 10.04% 10.13% Scenario 1 9.81% 9.56% 9.53% 9.38% 9.14% 8.97% 8.86% 8.72% 8.61% Scenario 1 Sensitivity 1 9.81% 9.58% 9.45% 9.27% 9.00% 8.81% 8.67% 8.50% 8.37% Scenario 1 Sensitivity 2 9.81% 9.60% 9.38% 9.16% 8.85% 8.62% 8.43% 8.21% 8.03% Total Risk Based Capital Current Q1 Q2 Q3 Q4 Q5 Q6 Q7 Q8 Baseline 11.55% 9.59% 9.65% 9.72% 9.79% 9.86% 9.94% 10.03% 10.12% Basline Sensitivity 1 11.55% 15.37% 15.48% 15.60% 15.71% 15.85% 15.98% 16.13% 16.29% Basline Sensitivity 2 11.55% 15.37% 15.48% 15.61% 15.73% 15.86% 16.00% 16.16% 16.31% Scenario 1 11.55% 15.17% 14.97% 14.78% 14.39% 14.14% 14.03% 13.86% 13.73% Scenario 1 Sensitivity 1 11.55% 15.10% 14.85% 14.61% 14.19% 13.91% 13.77% 13.56% 13.39% Scenario 1 Sensitivity 2 11.55% 15.05% 14.76% 14.47% 13.98% 13.63% 13.41% 13.12% 12.88% 32

Base Plan vs. Adverse & Sensitivity Tests Net Interest Margin Current Q1 Q2 Q3 Q4 Q5 Q6 Q7 Q8 Baseline 3.19% 3.28% 3.21% 3.22% 3.20% 3.22% 3.22% 3.24% 3.23% Basline Sensitivity 1 3.19% 3.28% 3.21% 3.22% 3.19% 3.21% 3.21% 3.23% 3.21% Basline Sensitivity 2 3.19% 3.29% 3.21% 3.21% 3.17% 3.18% 3.17% 3.17% 3.14% Scenario 1 3.19% 3.33% 3.34% 3.27% 3.09% 3.00% 2.93% 2.84% 2.82% Scenario 1 Sensitivity 1 3.19% 3.34% 3.32% 3.22% 3.02% 2.93% 2.84% 2.74% 2.73% Scenario 1 Sensitivity 2 3.19% 3.35% 3.27% 3.11% 2.88% 2.76% 2.64% 2.51% 2.50% ROA Current Q1 Q2 Q3 Q4 Q5 Q6 Q7 Q8 Baseline 1.16% 1.22% 1.12% 1.15% 1.15% 1.17% 1.19% 1.23% 1.24% Basline Sensitivity 1 1.16% 1.23% 1.12% 1.15% 1.14% 1.16% 1.18% 1.22% 1.22% Basline Sensitivity 2 1.16% 1.23% 1.12% 1.14% 1.12% 1.13% 1.13% 1.16% 1.15% Scenario 1 1.16% 1.26% 1.25% 1.26% 1.15% 1.14% 1.12% 1.09% 1.13% Scenario 1 Sensitivity 1 1.16% 1.27% 1.24% 1.23% 1.11% 1.10% 1.07% 1.03% 1.07% Scenario 1 Sensitivity 2 1.16% 1.28% 1.20% 1.13% 0.98% 0.94% 0.89% 0.82% 0.87% ALCO COMPOSITION AND PROCESS 66 33

ALCO s Primary Responsibilities Manage the level of net interest income/net income Management of balance sheet structure Risk measurement and management So with a set of prioritized goals established, ALCO can now determine how best to meet these goals and what risks are inherent in hitting the targets. Elements of an Effective ALCO Meeting Select strategies that: Provide earnings to meet objectives Manage Risks to acceptable levels Better the risk/return profile 68 34

ALCO Composition Head lending officer(s) by area Head of retail operations (deposit gathering) Chief financial officer President/CEO Marketing manager Board representation Any other team member with direct responsibility for managing business plan objectives. 69 ALCO Agenda Review prior minutes Review actual performance to projected Monitor status of prior actions Measure performance relative to Review trends and costs for recent funding Review economic outlook and interest rate forecasts Review income simulation results & assumptions 70 35

ALCO Agenda (continued) Review market value results Review simulation results of any major actions or plans being considered Review current and projected liquidity positions Review non-earning asset and non-performing loans Review investment\borrowing activities Set loan & deposit targets for upcoming quarter. 71 Imagine ALCO With Pertinent Information Many ALCO meetings considered boring or less valuable Time is spent But we met! 36

Imagine ALCO With Pertinent Information Make ALCO more meaningful with a simple 20 minute walk 37