GEORGIA BANKERS ASSOCIATION Georgia Banking School Asset/Liability Management II 2017 Georgia Banking School May 10, 2017 Joel Updegraff Managing Director, ALM SunTrust Robinson Humphrey
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Class Agenda Asset/Liability Management (ALM) Overview Definitions, goals & constraints, duties & responsibilities, outputs/reports Interest Rate Risk Management Definitions, risk contributors, measurement methods, interpreting results 3
Asset/Liability Management is not 4
Asset/Liability Management Process of managing assets, liabilities, and derivatives to obtain a risk/return trade-off that is optimal for your institution. What is optimal? Which side (risk vs. return) and to what degree, drives the decisions? 5
Goals of the ALM Process Earnings growth and stability Equity growth and stability Risk management Interest rate risk Credit risk Liquidity risk Leverage No surprises in performance 6
Competing Goals ALCO goals can conflict with each other Desire higher earnings Need to control risk Trade-off between risk and return ALCO decisions involve balancing competing objectives Continuous process of optimization 7
Example: Optimization Challenges Management tries to achieve higher capital ratios by Lower risk based asset weightings Deleverage or contraction Increasing book equity ($) Result Typically lowers yields Typically lowers NII/NIM Higher earnings only if institution is well run in other aspects 8
Constraints on ALM Process/Decisions Economic, financial market conditions Local market conditions Institution s characteristics Regulatory environment 9
Constraints on ALM Process/Decisions: Q1 2017 STRH Bank Survey 10
ALM Decision Making 11
ALM Decisions Balance sheet optimization Composition of assets Composition of liabilities Intensity of capital utilization Capital allocation to asset classes Pricing strategies Risk management strategies Should be taken in context of overall balance sheet. These decisions and corresponding actions should be interconnected at all levels of operations. 12
Effective Risk Management Process Must be able to evaluate risk-return tradeoffs on a regular basis Must adjust asset, liability balances, pricing, and hedging for appropriate tradeoff Must be an on-going process with board and senior management 13
ALCO Reports Georgia Banking School Market Overview Balance Sheet Composition Change from prior, current, projected Earnings Performance Current, trends, projected Risk Reports IRR Liquidity Credit Other Peer Comparison 14
Rates/Market Overview Georgia Banking School 15
Rates/Market Overview Georgia Banking School 16
Balance Sheet Composition Loan composition and growth Securities portfolio, composition and role Deposit composition and growth Wholesale funding Yields on assets, rates on liabilities Capital ratios Trend, current level, and projections 17
Earnings Performance Reports Current earnings Earnings ratios ROE, ROA, NIM Earnings, expenses as pct of assets Trends, peer comparison Yields on assets, rates on liabilities Competitor s rates 18
System of Internal Controls 19
System of Internal Controls Maintain strong control environment Internal controls should promote effective operations, reliable reporting, and compliance with laws, regulations, and policies Internal audit should evaluate: Effectiveness of controls Compliance with limits Reliability, timeliness of management reports Independence of risk management process 20
Interest Rate Risk What is interest rate risk? What causes it? Why should we be concerned about it? How do we evaluate our exposure to it? How do we reduce exposure if it s too high? 21
What is Interest Rate Risk? Interest Rate Risk (IRR) is the risk that changes in interest rates can adversely effect the bank s earnings or economic value of equity. Economic value of equity (EVE) is the economic value of assets less the economic value of liabilities. EVE provides a long-term look at our interest rate risk exposure. 22
What causes IRR for banks? Loans & investments = earning assets Core deposits & other funding = funding liabilities The degree to which earning assets and funding liabilities create cash flow mismatch over time and as rates change primarily drive a bank s interest rate risk exposure. 23
Interest Rate Risk Primary Types: Repricing risk Options risk Basis risk Yield curve risk Risk types were focus of the ALM 1 course. Risk models quantify the degree of exposure to future earnings and/or capital from these risks. ALM 2 will focus on developing a basic understanding of modeled IRR exposures. 24
Why should we be concerned about it? Risk management is about preparing for what might happen in the future. The bank must be willing to live with changes in interest rates. Once rates move, the impact can not be avoided. The bank must make adjustments before interest rates change to avoid adverse impact to earnings and/or capital. 25
Interest Rate Risk Models 26
Risk Measurement Models Income Simulation Economic Value Analysis GAP Analysis 27
What is income simulation? A short-term (e.g.12 months) forward assessment (projection) of how changes in interest rates may impact a bank s net interest income and net income. The projection incorporates all earning assets and funding liabilities. Must incorporate: Mathematical relationships Behavioral reactions 28
Measuring Risk with Income Simulation Step 1: project next 12 months net interest income (NII) under base case scenario NII = interest income on earning assets less interest expense on funding liabilities Base case scenario = market rates as of the scenario date Step 2: project next 12 months NII for shocked scenarios Shocked scenario: base case market rates are shocked up/down +- 300 basis points Step 3: Change in projected income from base case is measure of risk 29
Measuring Risk with Income Simulation Step 1 Step 2 Step 3 What does this information tell us? 30
How does it compare to the average risk profile of 150 banks? 31
What would an unfavorable income simulation result look like? 32
What would an unfavorable income simulation result look like? 33
Disadvantages of Income Simulations Short-term focus misses impact of longer term cash flow mismatches Does not fully capture option-related risk *May not provide a sufficiently robust picture of the bank s interest rate risk exposure if used in isolation 34
Risk Measurement Systems Income Simulation Economic Value Analysis GAP Analysis 35
What is Economic Value analysis? A long-term assessment (projection) of how changes in interest rates may impact a bank s economic value of equity. Long term means the longest dated cash flow of any earning asset or funding liability on the balance sheet Must incorporate: Mathematical relationships Behavioral reactions 36
Economic Value of Equity (Defined) EVE = present value of the bank s assets less the present value of its liabilities Present value = the current worth of a future stream of cash flows given a specified rate of return EVE analysis includes present value estimates on the entire balance sheet and represents theoretical present value of the bank s capital position EVE changes as rates change 37
Net Present Value C NPV t (1 r) Changing interest rates affect economic value: By changing the discount rate t For items with variable rates, by changing the interest payments With embedded options, by changing the cash flows t 38
Measuring Risk with EVE Step 1: Project EVE under base case scenario Calculate present value of earning assets, deduct present value of funding liabilities Base case scenario = market rates as of the scenario date Step 2: Project EVE for shocked scenarios Shocked scenario: base case market rates are shocked up/down +- 300 basis points Step 3: Change in projected EVE from base case is measure of risk 39
Measuring Risk with EVE Step 1 Step 2 Step 3 What does this information tell us? 40
How does it compare to 150 banks? 41
What would unfavorable EVE results look like? Ouch 42
Advantages of Economic Value Analysis Most complete measure of interest rate risk (captures all cash flows) Captures repricing, basis, and options risk Regulators increasingly rely on economic value analysis 43
How do banks reduce their IRR exposure? On balance sheet actions: Investment portfolio decisions Loan products, terms, and conditions Funding products, terms and conditions Off balance sheet management: Interest rate swaps Other derivative products and strategies Risk reduction is most effectively performed before interest rates change 44
Risk Measurement Systems Income Simulation Economic Value Analysis GAP Analysis 45
What is a GAP analysis? Short term earnings exposure tool based on cumulative repricing differences between earning assets and funding liabilities The difference between the volume of earning assets and funding liabilities that reprice within one year (12 months gap) is the common evaluation benchmark. General application: if interest rates rise by 100 basis points, change in income should approximate 1% times the 12 month gap. 46
Advantages of GAP Analysis Quick, simple to construct Comparatively easy to understand and interpret Gives a big picture assessment of risk May be adequate in very small institutions with very simple balance sheets 47
Disadvantages of GAP Analysis Lack of precision in risk estimate Static model, does not capture behavior Options, prepayments, deposits Limited in output s application Usually not comprehensive or accurate enough for most institutions 48
Summary Asset/liability management requires an ongoing process of risk/return optimization Process should strive to minimize surprises in operating performance while effectively communicating goals/objectives throughout the bank. Interest rate risk can adversely impact a bank s earnings and/or capital. Risk measures must incorporate both short term (earnings) and long term (EVE) assessments 49
Summary (continued) Earnings simulation is the common tool for measuring short-term interest rate risk while EVE is the common long-term risk measure. Gap analysis is a limited scope risk metric and should be used only in a support capacity. IRR management should entail a proactive, ongoing process. Mitigating risk after rates change can be costly and prohibitive. 50
Questions? Joel Updegraff Managing Director, ALM SunTrust Robinson Humphrey joel.updegraff@suntrust.com 51
Sample GAP report Up to 3 >3 Mos. >1 Year >3 Years >5 Years >10 Years Description Mos. <1 Year <3 Years <5 Years <10 Years <20 Years >20 Years Total Total Investments 17,899,416 44,021,501 118,953,109 71,860,086 38,379,788 7,726,566 1,222,933 300,063,399 Total Loans 212,625,789 61,051,556 82,748,649 43,588,583 30,069,772 16,086,043 569,003 446,739,395 Total Earning Assets 230,525,205 105,073,057 201,701,758 115,448,669 68,449,560 23,812,609 1,791,936 746,802,794 Total Cost of Funds 93,093,290 128,041,480 165,422,340 78,434,794 77,299,220 - - 542,291,124 Interest Sensitive Assets 230,525,205 105,073,057 201,701,758 115,448,669 68,449,560 23,812,609 1,791,936 746,802,794 Interest Sensitive Liabilities 93,093,290 128,041,480 165,422,340 78,434,794 77,299,220 - - 542,291,124 GAP 137,431,915 (22,968,423) 36,279,418 37,013,875 (8,849,660) 23,812,609 1,791,936 204,511,670 Cumulative GAP 137,431,915 114,463,492 150,742,910 187,756,785 178,907,125 202,719,734 204,511,670 204,511,670 GAP Ratio 2.48 0.82 1.22 1.47 0.89 1.38 Cumulative GAP Ratio 2.48 1.52 1.39 1.40 1.33 1.37 1.37 1.38 Gap as % of Total Assets 16.38 (2.74) 4.32 4.41 (1.05) 2.84 0.21 24.37 Cumulative GAP as % of TA 16.38 13.64 17.97 22.38 21.32 24.16 24.37 24.37 Gap as % of Earning Assets 18.40 (3.08) 4.86 4.96 (1.18) 3.19 0.24 27.38 Cumulative GAP as % of EA 18.40 15.33 20.19 25.14 23.96 27.15 27.38 27.38 Demand Deposits 5,617,689 16,853,067 112,353,744 44,941,512 44,941,500 224,707,512 52