Bank Analysis School eBook

Bank Analysis School

November 4-8, 2024 Kansas City, MO

@ www.csbs.org ♦ @csbsnews

CONFERENCE OF STATE BANK SUPERVISORS 1300 I Street NW / Suite 700 / Washington, DC 20005 / (202) 296-2840

November 4-8, 2024 Bank Analysis School Kansas City, MO

ATTENDEES Iowa Division of Banking Kelly, Skyler

skyler.kelly@idob.state.ia.us hope.schroeder@idob.state.ia.us chris.wardell@idob.state.ia.us

Schroeder, Hope

Wardell, Christopher

Kansas Office of the State Bank Commissioner Butler, Dylan

dylan.butler@osbckansas.org eddie.deltoro@osbckansas.org hanna.ediger@osbckansas.org matthew.hanke@osbckansas.org carly.walter@osbckansas.org

Del Toro, Eddie Ediger, Hanna Hanke, Matthew

Walter, Carly

Massachusetts Division of Banks Allen, Devin

devin.allen@mass.gov vivian.a.dzimey@mass.gov mark.missett@mass.gov lindsey.slater@mass.gov

Dzimey, Vivian Missett, Mark Slater, Lindsey

Minnesota Department of Commerce Aussem, Timothy

timothy.aussem@state.mn.us

Mississippi Department of Banking & Consumer Finance March, Logan

logan.march@dbcf.ms.gov faith.marshall@dbcf.ms.gov justin.wright@dbcf.ms.gov

Marshall, Faith Wright, Justin

New York State Department of Financial Services Mumin, Ryan

ryan.mumin@dfs.ny.gov

Onunaku, Augustine

augustine.onunaku@dfs.ny.gov noorul.sabaah@dfs.ny.gov

Sabaah, Noorul

Oklahoma State Banking Department Nelson, Jake

jake.nelson@banking.ok.gov

Utah Department of Financial Institutions Lounsbury, Melissa

mlounsbury@utah.gov

INSTRUCTORS Iowa Division of Banking Digmann, Adam

adam.digmann@idob.state.ia.us

Massachusetts Division of Banks Reyes, Denisse

cenisse.reyes@mass.gov

Oregon Division of Financial Regulation Gordon, Stephen

stephen.gordon@dcbs.oregon.gov

CSBS STAFF Hoyle, Katie

khoyle@csbs.org

Richardson, Amy Romano, Chris

arichardson@csbs.org cromano@csbs.org

Bank Analysis School Kansas City, Missouri November 4-8, 2024

Kansas City Marriott Country Club Plaza Meeting Room: Sevill e 1

Monday, November 4, 2024 7:30 am – 8:15 am

Registration & Breakfast Grand Ballroom D – 2 nd Floor

Introductions

8:15 am – 8:45 am

Communication

8:45 am – 9:45 am

Regulatory Overview

9:45 am – 10:15 am

10:15 am – 10:30 am

Break

Asset Quality & Investments

10:30 am – 12:00 pm

12:00 pm – 1:15 pm

Lunch on your own

Earnings

1:15 pm – 2:45 pm

2:45 pm – 3:00 pm

Break

Earnings Case Study

3:00 pm – 4:30 pm

Networking Reception Plaza Terrace – 3 rd Floor

5:30 pm – 7:30 pm

Tuesday, November 5, 2024 7:30 am – 8:15 am

Breakfast Grand Ballroom D

Prior Day Review (Reg Overview, AQ, Investments & Earnings)

8:15 am – 9:00 am

Liquidity

9:00 am – 10:15 am

10:15 am – 10:30 am

Break

Liquidity Case Study

10:30 am – 12:00 pm

12:00 pm – 1:15 pm

Lunch on your own

Capital

1:15 pm – 2:30 pm

2:30 pm – 2:45 pm

Break

Capital Case Study & Comment Writing

2:45 pm – 4:30 pm

Adjourn

4:30 pm

Wednesday, November 6, 2024 7:30 am – 8:15 am

Breakfast Grand Ballroom D

Prior Day Review (Liquidity & Capital)

8:15 am – 9:15 am

9:15 am – 10:15 am

Interest Rate Risk

Break

10:15 am – 10:30 am

Interest Rate Risk Case Study

10:30 am – 11:30 am

11:30 am – 12:45 pm

Lunch on your own

Management

12:45 pm – 1:45 pm

Assign & Support Ratings

1:45 pm – 2:00 pm

2:00 pm – 2:15 pm

Break

Prepare Presentations

2:15 pm – 4:30 pm

Adjourn

4:30 pm

Thursday, November 7, 2024 7:30 am – 8:15 am

Breakfast Grand Ballroom D

Student Presentations

8:15 am – 9:15 am

9:15 pm – 9:30 am

Break

Interactive Market Simulation

9:30 am – 12:00 pm

12:00 pm – 1:15 pm

Lunch on your own

Interactive Market Simulation

1:15 pm – 2:30 pm

2:30 pm – 2:45 pm

Break

Interactive Market Simulation

2:45 pm – 4:30 pm

Adjourn

4:30 pm

Friday, November 8, 2024 7:30 am – 8:00 am

Breakfast Grand Ballroom D

Interactive Market Simulation

8:00 am – 10:00 am

10:00 am – 10:15 am

Break

Review of the week

10:15 am – 10:45 am

Final Assessment & Closing

10:45 am – 11:00 am

Adjourn

11:00 am

Internal Use Only

Bank Analysis School November 4-8, 2024

Internal Use Only

Schedule • Breakfast will be available at 7:30 AM each day in Grand Ballroom D. • Begin at 8:15 AM each day expect for Friday starts at 8 AM. • Lunch on your own • Reception tonight at 5:30-7:30 PM in the Plaza Terrace. Guests are welcome!

Internal Use Only

Attendance Policy In order to receive a certificate of completion for a CSBS in-person training, an attendee may not miss more than 1 hour throughout the duration of the training. Attendees must also participate in all training activities to receive the credit hours (CEHs) and certificate including: 1. Case Study Assignments 2. Case Study Group Presentation

3. Capital Comment 4. Final Assessment 5. OJT Progress Updates

Internal Use Only

Senior Examiner Iowa Division of Banking Adam Digmann

Internal Use Only

Chief of Regulation and Supervision Oregon Division of Financial Regulation Stephen Gordon

Internal Use Only

Regional Field Manager Massachusetts Division of Banks Denisse Reyes

Internal Use Only

Introductions

EXPERIENCE

NAME

STATE

FUN FACT

SOMETHING YOU HOPE TO LEARN

Internal Use Only

Write down your favorite: C - Cuisine A –Animal

M – Movie/film genre E – Exercise/activity L – Location/travel destination S – Song/music genre

Do not write your name!

Internal Use Only

Bank Analysis School Resource Guide

Topic

Title/Description

Location / Link

Emailed

CSBS UBPR Ratio Flow Chart for Earnings Analysis Intended to aid in navigating the UBPR, analyzing key ratios, and calculating “core” earnings.

EARNINGS

Emailed

CSBS Investments Analysis Guide Guide for understanding investments.

Municipal Bond Job Aid (csbs.org) Supervisory Insights Summer 2013 (fdic.gov)

CSBS Municipal Bond Job Aid Resource to help understand and analyze municipal bonds. FDIC Supervisory Insights – Summer 2013 Contains an article covering securities pre-purchase analysis and ongoing monitoring expectations. CSBS Capital Guide Resource to understand components of capital, key ratios, etc.

INVESTMENTS

Emailed

CAPITAL

Emailed

CSBS Liquidity Analysis Guide Guide for analyzing this component.

FIL-13-2010

FIL-13-2010: Funding and Liquidity Risk Management States that all banks need a Contingency Funding Plan and outlines expectations surrounding cash flow projections and stress-testing.

LIQUIDITY

FIL-39-2023

FIL-39-2023: Importance of Contingency Funding Plans

Emailed

CSBS Sensitivity to Market Risk Analysis Guide Guide for analyzing this component.

FIL-2-2010

FIL-2-2010: Joint Interagency Advisory on Interest Rate Risk Management Outlines risk management best practices for interest rate risk.

SENSITIVITY TO MARKET RISK

FIL-2-2012

FIL-2-2012: Interest Rate Risk Management FAQs

Technical Assistance Videos (fdic.gov) Supervisory Insights Winter 2014 (fdic.gov) Basics for Bank Directors (kansascityfed.org) Bank Accounting Advisory Series (occ.gov)

FDIC Interest Rate Risk Technical Assistance Videos Includes six short videos (6-12 minutes each) covering interest rate risk.

Winter 2014 Supervisory Insights Entire issue is dedicated to interest rate risk.

Basics for Bank Directors Resource which explains basic banking and regulatory concepts.

GENERAL

OCC Bank Accounting Advisory Series Addresses key accounting concepts in a Q&A format.

Internal Use Only

Communication …it’s better than a root canal

Internal Use Only

Objectives

Identify Techniques for Conducting Effective Management Meetings Identify Conflict Management Techniques Tips for Conducting Effective Meetings Common Mistakes

Internal Use Only

Types of Management Meetings

Entrance or First Day Meetings

Loan Discussion Meetings

Operational Discussion Meetings

Exit or Wrap Up Meetings

Board of Directors Meetings

Internal Use Only

Purpose of First Day Meeting

Introductions

Scope of Examination

Organization Structure

New Activities and Initiatives

Status of Previous Exam Findings

Internal Use Only

Purpose of Loan Discussion

Credit Underwriting and Loan Administration

Loan Loss Reserve Provisions

Problem Loan Recognition

Conformity to Loan Policy

Credit Quality

Internal Use Only

Purpose of Exit Meeting Discuss Examination Findings •Report Worthy •Worthy of Management’s Attention

Verify Examination Findings

Document Management Responses

Disclose Tentative CAMELS’ Component and Composite Ratings

Provide Guidance and Recommendations

Discuss Next Steps

Internal Use Only

Purpose of Board Meeting

Convey Examination Findings

Provide Guidance and Recommendations

Document Board Response

Disclose Tentative CAMELS’ Component and Composite Ratings

Advise on Any Potential Regulatory Actions

Discuss Next Steps

Internal Use Only

Skills to Hone

Verbal Communication Skills

Grammar, Vocabulary, & Pronunciation Articulation – clarity of spoken sounds Volume – the loudness of your voice Inflection – emphasis on words Variety – rate and pace

Internal Use Only

More skills Image and Personal Appearance

Always Look Neat and Professional For High Level Meetings Wear Your Best

Be Courteous and Friendly Maintain a Positive Attitude

Internal Use Only

Even More skills Nonverbal Forms of Communication

Eye Contact Gestures and Facial Expressions Posture/Body Language

Internal Use Only

Conflict Management

Be Prepared Keep Non-Verbal Communication in Check Be Assertive, Not Combative Focus on the Issues, Not the Person Understand the Other Person’s Viewpoint / Perspective Try to be Flexible- when appropriate

Internal Use Only

Tips for Successful Meetings

Plan for the Worst But Hope for the Best.

Make sure communication goes both ways

Stick to factual comments

Avoid personal pronouns

Internal Use Only

Tips for Successful Meetings (cont.)

If you want the audience’s attention to be on you, your attention should be on them.

Develop a system or routine.

Pace yourself

Internal Use Only

More Tips … ad nauseum Use an Agenda and Outline Use Your Own Style and Words Try to Meet as Many People in Advance as Possible Understand Disagreements are Inevitable

Internal Use Only

Common Mistakes

Unprepared

Making Comments That Are Unsupported or Inconsistent With Exam Findings

Conducting Meetings Alone

Avoid “We” When Referencing Management

Not Keeping Management Informed

Internal Use Only

Report Writing

4 Dominant Communication Styles

Although there are many different personalities, communication styles can be broken into four major profiles. If you take into consideration the needs of each style when communicating with others, you have the greatest chance of establishing rapport and trust. Ignore the styles and you risk rubbing people the wrong way, possibly shutting down the possibility of gaining the results you want. In addition, when you acknowledge your own dominant style, you can build on your strengths and set goals to adapt or ask for help in areas you avoid.

The styles are based the most important needs when communicating, whether it be on achievement or on relationship, on idea creation or on action.

The two styles most focused on task:

DOERS Doers like to be in control. They like quick action and they like to see results. They like to get to the point with little formalities. They don’t care for details and love finding shortcuts. Otherwise, they get bored easily. They like autonomy, freedom and taking risks. They are self-starters, innovators and love to expend physical energy. They like public recognition, especially for putting what they most value into action and for creating results that make a difference in the world (or at least in world they see and act in every day). THINKERS Thinkers love to gather information. They enjoy reading and presenting their findings in detail. However, they need to mentally rehearse before they present, and take time to evaluate and wind down after the show. They take their time making decisions, but stand by what they decide once they do. They don’t care to talk about personal issues, but enjoy discussing hobbies and issues. They desire clear expectations, specific goals, deadlines and structure. They live by a sense of order, methodologies and personal responsibility. Thinkers love to win, and will compete with themselves if no one is available. They will jump into the game with no coaxing if they perceive they have a fighting chance. They are proud of their good work. They like acknowledgment but won’t ask for it.

The two styles most focused on relationship:

INFLUENCERS Influencers like to verbally process their thoughts so they welcome situations where they can “think out loud” with others. They like to interrupt others, especially when they are excited about the topic. They view this as conversation, not a disruption. They enjoy people, desire approval and tend to be friendly, creative and persuasive. However, they may need some help staying on track and following through on tasks. They desire social interaction, acknowledgment and chances to be creative and have fun. They often see the bright side and can be very amusing, dramatic and passionate about work. They help others get through difficult times and can build rapport and support. They genuinely like people. However, they might find themselves caught up in a lot of drama since they are quick to want to help fix things and people. Teasing is one of their favorite pastimes. CONNECTORS Connectors count on others to set the tone and determine direction. They are consistent and reliable once given their responsibilities. They like to work with others instead of alone but take their time trusting and allowing new people to join their established groups. They do not readily give opinions, but this does not mean they don’t have any. Because they are diligent and dependable, they often know the most about how work is getting done. They like to be asked what they know and they appreciate personal recognition (done privately, not in front of others). They desire consistency, social bonds and acknowledgment for effort as well as results. Although they may appear stubborn, they can be very flexible and adaptable if they understand why the changes are being made and how they will benefit themselves and others. They seek to reduce stress and promote harmony.

Rate Your Dominant Communication Style

When under pressure, do you tend to be (circle the adjective that most fits you):

Write the item number here:

Humorous 3

Regimental 2

Concise 1 Excited 3

Concerned 4

______ ______ ______ ______ ______ ______ ______ ______ ______ ______ ______ ______ ______ ______ ______ ______ ______ ______ ______ ______ ______ ______

Focused on outcome 1

Focused on steps 2

Apprehensive 4

Aggressive 1

Talkative 3

Disciplined 2 Resistant 2 Creative 3 Absorbed 2 Multi-tasking 1

Nurturing 4 Assertive 1 Productive 4

Non-confrontational 4

Schmoozer 3

Innovative 1

Talented 2

Driven 1

Enthusiastic 3

Seeking the peace 4

Scattered 3

Structured 2

Helpful 4

Analytical 2 Prophetic 1 Consistent 4 Competitive 2 Charismatic 3 Encouraging 4

Clear 1

Tolerant 4

Imaginative 2

Logical 2

Resourceful 3

Practical 4 Empathic 3

Heroic 1

Critical 2

Directing 1 Forceful 1

Enrolling 3 Friendly 4 Intellectual 2

Reliable 4

Technical 2

Independent 1

Light-hearted 3

Likes short-term goals 2

Socializer 3

Likes long-term goals 4

Risk-taker 1

Rule-breaker 1

Tests Rules 3

Abides by Rules 4

Upholds Rules 2

Explaining 2

Expecting 1

Supporting 4

Mediating 3

Leading teams 1

Avoiding teams 2

Motivating teams 3

Seeking teams 4

Leading by example 1 Overlooking others 1

Sharing leadership 3 Criticizing others 2

Avoiding leadership 4 Understanding Others 3

Leading by necessity 2

Promoting others 4

Shy from drama 4

Ignore drama 1

Hate drama 2 Questioning 2

Manage drama 3

Tough 1

Contained 4

Curious 3

Likes physical challenge 1 Avoids conflict 3

Likes mental challenge 2

Avoids stress 4

Avoids confrontation 4

Diffuses confrontation 3 Angered by confrontation 1 Energized by confrontation 2 ______

SCORING:

Count up how many 1s, 2s, 3s and 4s you had and put the total below:

Total 1s __________

Total 2s __________ Total 3s __________ Total 4s __________

SCORING INTERPRETATION

1 = Doer

2 = Thinker

3 = Influencer

4 = Connector

Your score:

_____ Doer

_____ Thinker

_____ Influencer

_____ Connector

Your high score demonstrates your strongest communication style, especially under pressure. Your secondary score indicates your fall-back or adaptive style or styles. There are strengths associated with each style as well as limitations.

Doers tend to be high achievers and leaders and drive necessary results. They also tend to be impatient and insensitive to others.

Thinkers tend to excel when they like their work and can think through all angles and contingencies. They can appear to be combative, critical and sarcastic.

Influencers can lighten up even the darkest of moments. They can be inspirational, understanding and encouraging. They can also be wishy-washy in their decision-making and seem impractical. They are often late on assignments they do not like. Connectors are reliable team players who look after everyone in their “tribe.” They are consistent and caring. They can also be stubborn and non-supportive of pushy people and what they judge to be impulsive ideas. If you scored below a five on any style, be aware of how you treat others who demonstrate this style. You may have little patience or tolerance for people who tend toward these styles. Yet these are people you need around you to support your efforts. Do not alienate them. Instead, find ways to collaborate with them. In the end, all the styles need to develop more tolerance for the other styles, and develop an appreciative point of view for what each style brings to the table. Diversity is the key to innovation and success.

COMMUNICATION TIPS When communicating with a DOER style:

~ Be clear, specific, brief and to the point. ~ Stick to business. ~ Be prepared to support your ideas and work.

Factors that will create tension or dissatisfaction: ~ Talking about things that are not relevant to the task or issue. ~ Being unprepared or incomplete. Avoiding or beating around the bush. ~ Appearing unsure or disorganized, but not asking for help.

When communicating with a THINKER style:

~ Prepare your “case” in advance. Be prepared for a debate. ~ Stick to business. ~ Be accurate and realistic.

Factors that will create tension or dissatisfaction: ~ Being giddy, casual, informal, emotional or loud. ~ Pushing too hard for results or being unrealistic with deadlines. ~ Being disorganized or messy.

When communicating with an INFLUENCER style:

~ Provide a warm and friendly environment. Do little things to show your care. ~ Don’t deal with a lot of details (put them in writing). ~ Ask “feeling” questions to draw their opinions or comments. Factors that will create tension or dissatisfaction: ~ Being curt or cold. Cutting them off if they have something to say. ~ Controlling the conversation. Not allowing them to talk and express. ~ Focusing on facts and figures.

When communicating with a CONNECTOR style:

~ Begin with a personal comment--break the ice. ~ Present your case smoothly, non-threateningly. ~ Ask “how?” questions to draw their opinions.

Factors that will create tension or dissatisfaction: ~ Rushing headlong into business. Creating tension. ~ Being domineering or demanding. ~ Forcing them to respond quickly to your ideas. Demanding change.

LIST YOUR COMMUNICATION STRENGTHS:

WRITE TWO COMMUNICATION GOALS FOR YOURSELF TO BETTER RELATE WITH OTHER STYLES:

Public Speaking Tips:

1) Visualize the space you will be speaking in. Walk through the room beforehand if possible and see how you will have to project your voice. 2) Be aware of the rate and depth of your breath, the volume of your voice, and the speed of your speech. 3) Know your audience and how to connect to them. 4) Be yourself. Trust yourself. 5) Think about how you’re going to say your message. 6) Deliver your message from a place of power. 7) Understand the different forms of body

language (over-gesturing, body movement). 8) Understand the impact of costume (how you dress). 9) Accept your nervousness. It’s normal. 10) Practice, practice, and practice.

EFFECTIVE WRITING TECHNIQUES

The Report of Examination (ROE) is intended to communicate the findings of an examination and support the assigned component ratings. The following suggestions may be helpful in increasing the effectiveness of written communication: • Understand the audience (primarily Board of Directors). • Comments supporting component ratings should relate to the UFIRS ratings definitions and evaluation factors. • The tone of component comments should match the assigned rating (for a 1 rated component the comments should be mostly positive; components rated 3 or worse should include very little or no favorable comments). • Consider developing an outline before you start. Coherent paragraphs include a topic sentence and supporting information. • Report of Examination comments should be fact-based, professional, and objective. • Use clear, concise, language appropriate to the subject and the intended audience. Simple language and short sentences and paragraphs are generally the most effective. • Examiners should not rely upon ratios alone to convey the ideas they wish to express. When ratios are cited, they should be in support of a conclusion, and their import should be made understandable to the reader. While ratios are meaningful to examiners, their significance is not always apparent to bankers and particularly bank directors. • Peer group comparisons are not a part of the UFIRS ratings definitions, so examiners should avoid over reliance on peer group comparisons in written commentary.

Bank Analysis School Bank Supervision: Overview & Key Concepts

“

Banking is a very good business unless you do dumb things.

” Warren Buffett

Bank Failures Kahoot

2

Bank Failures are not Uncommon

157

140

Failed Banks

92

51

25

24 18

7 4 11

8 5 8

3 4 0 0 3

0 4 4 0 0 5

Commonalities of Failed Banks Summary Analysis of Failed Bank Reviews report from the Office of the Inspector General Aggressive growth Concentration in construction and land development loans Reliance on noncore funding Poor risk management Compensation incentives encouraging risk-taking 1 2 3 4 5

How do Banks Fail?

Interest rate risk materializes

Asset quality issues

Fraud

or

or

Weak earnings

RISK MANAGEMENT PRACTICES!

Capital

Liquidity

Today’s Risks

• Credit risk (CRE) • Interest Rate Risk / Low Net Interest Margins • Liquidity / Deposits • Cyber Threats • Nonbank Growth

How Do We Assess a Bank’s Health? (Examination Process) • CAMELS Framework / UFIRS Ratings

• Risk-Focused Approach • Continuous Monitoring • Types of Examinations

Examination Key Roles

Examiner-in charge (EIC)

Asset Manager (AM)

Operations manager (OM)

Course Objectives

Analyze and assess risk

• Presentations and real-world stories/examples • Locate and analyze key ratios in the Uniform Bank Performance Report (UBPR) and Depository Deep Dive (3D)

Assign and support ratings

• Uniform Financial Institution Rating System Definitions (UFIRs) • Case Study

Case Study: Sunny State Bank

Each group will present one component (random draw) on Thursday

Work in groups to analyze CAMELS components

Objective is to assign and support ratings

Bank Analysis School ASSET QUALITY

1

Why is asset quality important?

3 Asset quality is one of the most critical areas in determining the overall condition of a bank…Examiners should be diligent and focused when reviewing a bank’s assets, as they can significantly impact most other facets of operations. ” - FDIC Risk Management Manual

Learning Objectives

1 – Importance and Impact on Other Components

2 – Asset and Loan Categories

3 – Asset Classification / Problem Assets

4 – Allowance for Credit Losses

How could weak asset quality impact earnings?

Earnings

Asset Quality Problems

• Provisions • Collection Expenses (legal fees, extra staff) • Nonearning Assets (nonaccrual loans, OREO)

How could weak asset quality impact capital?

Net income

Earnings Feed Capital Earnings flow into capital

- Dividends = Retained earnings (part of capital)

Capital

How do Banks Fail?

Interest rate risk materializes

Asset quality issues

Fraud

or

or

Weak earnings

Capital

Liquidity

How could weak asset quality impact liquidity?

How could weak asset quality impact our assessment of management?

“

To a great extent, the quality of an institution's loan portfolio determines the risk to depositors and to the FDIC's insurance fund. Conclusions regarding the institution’s condition and the quality of its management are weighted heavily by the examiner's findings with regard to lending practices.

” - FDIC Risk Management Manual

12

Learning Objectives

1 – Importance and Impact on Other Components

2 – Asset and Loan Categories

3 – Asset Classification / Problem Assets

4 – Allowance for Credit Losses

What are the largest asset categories for banks (top 2)?

Most Bank Assets are Loans and Securities

Average Community Bank Asset Mix (12/31/2023)

All Other, 15%

Cash/FFS/IBBB, 9%

Loans, 59%

Securities, 17%

15

What is the riskiest asset category?

Lending Concentrations can Increase Risk

“

Concentrations are not inherently bad but do add a dimension of risk which management should consider when formulating plans and policies. ” - FDIC Risk Management Manual

17

Learning Objectives

1 – Importance and Impact on Other Components

2 – Asset and Loan Categories

3 – Asset Classification / Problem Assets

4 – Allowance for Credit Losses

Asset Classification

Pass

No or limited concerns

Special Mention

Criticized but not classified

Substandard

Doubtful

Adversely classified

Loss S E V E R I T Y

19

Basic Facts: • XYZ Corp. has an equipment loan that is severely past due. • Review of the company’s financials reveals that sales have dropped significantly, and the business is reporting losses. • The equipment securing the loan was independently valued at $110,000 one month ago. • The loan balance is $120,000. How would you classify this loan? Loan Classification Decision #1 (XYZ Corp)

Loan Classification Decision #2 (Smith Farming)

Basic Facts: • Smith Farming, LLC has an equipment loan that is severely past due. • The operation has been unsuccessful, and a farm sale is being held next month. • The last financial statement indicates the equipment securing the loan is worth $300,000; however, it is unknown how much the auction will bring. • The loan balance is $300,000.

How would you classify this loan?

Basic Facts: • Babe Ruth has an unsecured $5,000 loan for personal expenses. • He is unable and unwilling to make any more payments on the debt. • The loan is currently 240 days past due. Loan Classification Decision #3 (Babe Ruth)

How would you classify this loan?

Classification Amounts Feed into the Adversely Classified Items Coverage Ratio

Sunny State Bank

Adverse classification / Tier 1 Capital and ALLL

Sunny State Bank Nonaccrual/Total Loans

• Charts from Depository Deep Dive • Source data UBPR page 8A

Sunny State Bank Past Due & NA / Total Loans

• Charts from Depository Deep Dive • Source data UBPR page 8A

Sunny State Bank OREO/Avg. Assets

• Chart from Depository Deep Dive • Source data UBPR page 6

Based on the preceding UBPR ratios, how would you describe the level of problem assets at Sunny State Bank?

Sunny State Bank Net Loan Losses

• Chart is from Depository Deep Dive • Source data UBPR page 7

How would you describe the level of loan losses at Sunny State Bank over the last few years?

Learning Objectives

1 – Importance of AQ / Impact on Other Components

2 – Asset and Loan Categories

3 – Asset Classification / Problem Assets

4 – Allowance for Credit Losses

Does a loan charge-off directly affect net income?

The Allowance for Credit Losses (ACL) is a Rainy-Day Fund to Cover Potential Losses

Provision Expenses Recoveries

Charge-Offs

The UBPR Includes a Year-Over-Year ACL Reconcilement

Ties to balance sheet [prior year] (pg. 4)

Ties to income statement (pg. 2) Ties to balance sheet [current year] (pg. 4)

Why is the ACL ending balance higher than the beginning balance?

The ACL is an evaluation factor for which three component ratings?

Please write down one take away from this session.

Asset Quality Recap Asset quality problems are the primary cause of most bank failures.

Loans are the largest and riskiest asset category.

The five regulatory classification grades are: Pass, Special Mention, Substandard, Doubtful, and Loss. The Adversely Classified Items Coverage Ratio is the primary ratio used by regulators to measure risk. Underwriting standards and loan administration are critical.

The ALLL is a rainy-day fund to cover potential losses.

36

How Would You Rate Sunny State Bank?

• Strong asset quality and credit administration practices. Asset quality is of minimal concern. 1 • Satisfactory asset quality and credit administration practices. The level and severity of classifications and other weaknesses warrant a limited level of supervisory attention. 2 • Asset quality or credit administration practices are less than satisfactory. The level and severity of classified assets and risks require an elevated level of supervisory concern. 3 • Deficient asset quality or credit administration practices. The levels of risk and problem assets are significant, inadequately controlled, and subject the bank to potential losses that may threaten its viability. 4 • Critically deficient asset quality or credit administration practices that present an imminent threat to the institution's viability.. 5

Bank Analysis School Investments

Which are the biggest potential risks in the investment portfolio?

The Securities Portfolio Impacts Every Component!

Capital

• Wide range of risk-weightings can impact capital ratios

Asset Quality Management

• Credit risk and potential for adverse classification

• Risk management: pre-purchase analysis, ongoing monitoring, etc.

Earnings Liquidity Sensitivity

• Interest Income; realized gains/losses

• Cash flow, marketability, pledging

• Term structure may contribute to or mitigate interest rate risk • Price volatility with rate changes

Learning Objectives

1 – Impact on Other Components

2 – Investment Types and Terminology

3 – Yield Curve and Credit Risk Premium

4 – Interest Rate Risk

Community Banks Invest in Bonds

Other - 0% Average Securities Mix (9/30/2024)

Corporates - 2%

U.S. Treasuries/ Agencies - 28%

MBS/CMOs/ ABS - 34%

Municipals - 36%

Investment Terminology

Premium & Discount

Available-for-Sale

Held-to-Maturity

Par Value

Amortized Cost (a.k.a. book value)

Coupon Rate

Market Value

Yield to Maturity

Maturity Date

Pre-Payment

CSBS Investments Guide includes definitions

Learning Objectives

1 – Impact on Other Components

2 – Investment Types and Terminology

3 – Yield Curve and Credit Risk Premium

4 – Interest Rate Risk

The Yield Curve is a Picture of Bond Yields

U.S. Treasury Yield Curve (Risk Free Rate)

1% 2% 3% 4% 5% 6%

10/21/2024

1 Mo 3 Mo 6 Mo 1 Yr

2 Yr

3 Yr

5 Yr

10 Yr

20 Yr

30 Yr

Do higher-risk bonds yield more or less than lower-risk bonds?

Credit Risk Premium

4.5%

High risk (e.g. Corporates) Low risk (e.g. U.S. Treasuries)

4.0%

3.5%

3.0%

Yield

2.5%

2.0%

1.5%

1.0%

0.5%

0.0%

1m

3m

6m

1y

2y

3y

5y

7y

10y

20y

30y

Maturity

Credit Risk U.S. Treasuries (RW 0%) U.S. Agencies (RW 20%) Municipals – General Obligations (RW 20%) Municipals – Revenue (RW 50%) Corporates (RW 100%)

Minimal

CREDIT RISK

Moderate

Securities Review – May 2022 Exam

Five-fold increase in Corporate bonds since the last exam (Q1 2019)

• Corporate bonds rated either subinvestment or lowest investment grade represented nearly 200% of capital. • Weak investment practices (policy, pre-purchase analysis, ongoing monitoring). • Asset Quality, Capital, and Management components were downgraded.

Management was Reaching for Yield since Risk Free Rates were Extremely Low

6.0%

5.0%

4.0%

3.0%

4/30/2021

Yield

1.65%

2.0%

4/30/2020

0.64%

1.0%

1m 2m 3m 6m 1y

2y

3y

5y

7y

10y

20y

30y

Maturity

Credit Risk Premium

4.5%

High risk (e.g. Corporates) Low risk (e.g. U.S. Treasuries)

4.0%

3.5%

3.0%

Yield

2.5%

2.0%

1.5%

1.0%

0.5%

0.0%

1m

3m

6m

1y

2y

3y

5y

7y

10y

20y

30y

Maturity

Learning Objectives

1 – Impact on Other Components

2 – Investment Types and Terminology

3 – Yield Curve and Credit Risk Premium

4 – Interest Rate Risk

Bond Prices (Values) Move Opposite Interest Rates

5%

0% 3%

10-Year Treasury Yield

4%

3%

-9% -6% -3%

Appreciation/Depreciation % of Bond Portfolio

2%

-14.01%

1%

-15% -12%

Securities Review – August 2022 Exam

Management invested heavily in long-term Municipal bonds in 2020 and 2021…

Which led to enormous depreciation in 2022…

Sensitivity to Market Risk and Management components were downgraded.

Management was Reaching for Yield since Risk Free Rates were Extremely Low

6.0%

5.0%

4.0%

3.0%

4/30/2021

Yield

1.65%

2.0%

4/30/2020

0.64%

1.0%

1m 2m 3m 6m 1y

2y

3y

5y

7y

10y

20y

30y

Maturity

The Federal Reserve Influences Interest Rates to Keep the Economy Healthy

Federal Reserve dual mandate

Promote maximum employment

Promote price stability

Low Interest Rates Reduce Unemployment

Lower Interest Rates

More Spending

More Jobs

More Borrowing

High Interest Rates Reduce Inflation

Higher Interest Rates

Less Spending

Lower Inflation

Less Borrowing

Investment Decisions (Refer to Investment Options sheet)

Scenario 1: The economy is showing signs of a slowdown, and inflation is low. Considering potential interest rate changes, which investment do you choose?

Initial yield curve

Yield curve after the Fed lowered rates to stimulate the economy

Investment Decisions

Scenario 2: GDP growth has been strong and the stock market is at a record high. However, inflation is also up sharply. Considering potential interest rate changes, which investment do you choose?

Yield curve after the Fed raised rates to combat inflation

Initial yield curve

Investment Decisions Scenario 3: A large depositor just placed a significant deposit at your bank and intends to withdraw the full amount in 1-2 years for an upcoming project. Senior management has directed the Investment Committee (your table) to purchase a safe and highly liquid investment to ensure the funds are available when needed. Which investment option do you choose?

Investment Decisions

Scenario 4: Your bank has strong liquidity, but the Net Interest Margin is low. Senior management has directed you to purchase a high-yielding investment to improve earnings. Which investment option due you choose?

Please write down one take away from this session.

Securities Portfolio Impacts Every Component

Capital

• Wide range of risk-weightings can impact capital ratios

Asset Quality Management

• Credit risk and potential for adverse classification

• Risk management: pre-purchase analysis, ongoing monitoring, etc.

Earnings Liquidity Sensitivity

• Interest Income; realized gains/losses

• Cash flow, marketability, pledging

• Term structure may contribute to or mitigate interest rate risk • Price volatility with rate changes

INVESTMENTS GUIDE

ALLOWABLE INVESTMENTS • Bank investments consist of debt securities (bonds). Debt securities are essentially loans from the bondholder to the issuer of the bond. In exchange for the investment, the issuer pays interest and repays the bond by a set date. Bond issuers include corporations, municipalities, the federal government, and federal agencies. • Banks are generally not allowed to invest in equity securities (stocks). However, there are exceptions for certain membership stocks required or allowed by regulation (e.g., Federal Home Loan Bank stock, Federal Reserve Bank stock, and stock in Bankers' Banks). INVESTMENT TYPES U.S. Treasuries • Direct obligations of the U.S. government; considered “risk-free.” U.S. Agencies • Issued by U.S. government agencies (e.g., FHLB, Freddie Mac, Fannie Mae). • Not a direct obligation of the U.S. government but considered to have minimal credit risk. Mortgage-backed securities (MBS) Minimal

• Most are backed by residential home mortgages, although some are backed by commercial mortgages (CMBS). • Mostly issued by government agencies (e.g., Fannie Mae or Freddie Mac); some are issued by private companies (private-label MBS). • Two main structures: ° Pass-through MBS: Investors receive portions of principal and interest as the underlying mortgage loans are paid. ° Collateralized Mortgage Obligation (CMO): Payments are split into “tranches” and distributed based on priority. Municipal bonds • General Obligation (GO) bonds are backed by the full taxing authority of the municipality. • Revenue bonds are supported by revenue from specific projects or services (e.g., sewer, water.) • Industrial development bonds (relatively uncommon) are used to support private companies’ projects within a municipality, with repayment tied to company revenues. Considered riskier than GO and revenue bonds. Corporate bonds • Issued by U.S. corporations.

CREDIT RISK

Moderate

PRIMARY INVESTMENT PORTFOLIO RISKS • Market risk (interest rate risk): The risk that rising interest rates will cause the market value of existing bonds to fall. • Credit risk: The risk that a bond issuer may default on its obligation. Bonds from lower-rated issuers or those facing financial difficulties pose a higher credit risk. Typically, there is less credit risk in a bank’s investment portfolio compared to the loan portfolio. • Liquidity risk: The risk that an investment cannot be easily sold and converted to cash. Certain municipal bonds (e.g., small non-rated issues) or complex mortgage-backed securities may be difficult to sell. • Operational risk: Risk resulting from inadequate internal processes and systems. This can include accounting errors, fraud, or system failures.

APPENDIX A: INVESTMENT TERMINOLOGY It is important to understand key investment terms to analyze a bank’s securities inventory and other investment reports. Below are some common terms related to debt securities.

• Bonds that could be sold before they mature. AFS bonds are reported at their market value, but changes in value don't affect earnings unless the bond is sold.

Available-for-Sale (AFS)

• Bonds that an investor intends to hold until they mature. HTM bonds are reported at their amortized cost and aren’t affected by market price changes.

Held-to-Maturity (HTM)

• Dollar value of a security as stated by the issuer on the “face” of the instrument. For bonds that mature at a single point in time, this is the principal amount due at maturity.

Par Value (Face Value)

• Reflects the original price paid for a bond and any discount accretion or premium amortization over time. Held-to-maturity bonds are reported at amortized cost.

Amortized Cost (Book Value)

• Current price at which a bond could be bought or sold. Quoted market prices are the best indication of fair value. Available-for-sale bonds are reported at market value.

Market Value (Fair Value)

• Amount by which the price paid for a bond is lower than the par value. This amount is gradually recognized as income (accreted) over the life of the bond.

Discount

• Amount by which the price paid for a bond is higher than the par value. This amount is amortized as an expense over the life of the bond.

Premium

Coupon Rate

• The annual interest rate paid to the investor, experessed as a percentage of the par value.

Yield-to-Maturity

• Overall return to the investor, factoring in any premium or discount.

• Weighted average time until a bond's cash flows are received. Duration is used to measure a bond's price sensitivity to interest rate changes.

Duration

APPENDIX B: BOND RATINGS Bond ratings help investors understand the creditworthiness of a bond issuer. Standard & Poor's (S&P) and Moody's Investors Service (Moody's) are prominent independent credit rating agencies which assign bond ratings based on their analysis of an issuer's financial h ealth, economic environment, and other relevant factors. Bond ratings are described in the table below. Subinvestment quality bonds are typically adversely classified during examinations.

S & P’s Rating

Moody’s Rating

Description

AAA

Aaa

Highest Grade

QUALITY INVESTMENTS Includes the four highest rating categories and unrated debt securities of equivalent quality

AA

Aa

High Grade

A

A

Upper Medium Grade

BBB

Baa

Lower Medium Grade

Non-Investment Grade Speculative

SUBINVESTMENT QUALITY Includes grades below the four highest rating categories, unrated debt securities of equivalent quality, and defaulted debt securities

BB

Ba

B

B

Highly Speculative

CCC

Caa

Substantial Risks

Extremely Speculative/ Default Imminent

CC/C

Ca

D

C

In Default

APPENDIX C: PRE-PURCHASE ANALYSIS AND ONGOING MONITORING OF SECURITIES

Pre-Purchase Analysis The Dodd-Frank Act 1 required banks to move away from relying solely on external credit ratings (e.g., Moody’s, Standard & Poor’s) when assessing the creditworthiness of investments. Instead, banks must perform their own assessment to determine if a bond is “Investment Grade” prior to purchasing the bond. "Investment Grade" means that the bond has a low risk of default and is expected to make full and timely payments of both principal and interest. Certain securities, including common types of investments held by community banks such as U.S. Treasuries, U.S. Agencies, general obligation municipal bonds, and municipal revenue bonds (for well-capitalized banks), are exempt from this "Investment Grade" determination. However, municipal bonds still require an initial credit assessment and ongoing monitoring to ensure they meet safety and soundness standards. Banks and examiners can use resources like the Electronic Municipal Market Access (EMMA) website to research municipal bonds. The depth of due diligence should match the size and complexity of the institution and the risk characteristics of the investments. Ongoing Monitoring After purchasing a bond, banks must regularly assess the issuer’s ability to meet financial commitments. This means ensuring a low risk of default, with full and timely payments of principal and interest expected. Regulators expect banks to understand all risks in their investment portfolio, including credit risk, interest rate risk, liquidity risk, and operational risk.

1 The Dodd-Frank Act was passed in 2010 in response to the financial crisis, wh en some banks suffered significant losses on bonds that had been highly rated by external credit rating agencies.

Internal Use Only

Bank Analysis School Earnings

Internal Use Only

What role do earnings play in a bank's overall financial health and sustainability?

Internal Use Only

From a bank regulator’s standpoint, the essential purpose of bank earnings is to absorb losses and augment capital .

3 ”

- FDIC Risk Management Manual

Internal Use Only

Learning Objectives 1 – How Banks Generate Income

2 – Income Statement 3 – UBPR Ratio Analysis 4 – Budget 5 – Impact on Capital 6 – Risk vs. Return

Internal Use Only

Banks are the “Middleman” Connecting Depositors and Loan Customers

BANK

Funding (savers)

Assets (borrowers)

Internal Use Only

Net Interest Income is the “Bread and Butter” for Most Community Banks

Interest income (assets) - Interest expense (liabilities) = Net interest income

Internal Use Only

What percentage of Sunny State Bank’s total income (Adjusted Operating Income) is from Net Interest Income?

Internal Use Only

Net Interest Margin is the “Profit Margin”

Net Interest Income Average Earning Assets

NET INTEREST MARGIN

=

Internal Use Only

Internal Use Only

Learning Objectives

1 – How Banks Generate Income 2 – Income Statement 3 – UBPR Ratio Analysis 4 – Budget 5 – Impact on Capital 6 – Risk vs. Return

Internal Use Only

Internal Use Only

Some Banks Focus More on Noninterest Income than Others

Sunny State Bank

Another Bank

Internal Use Only

Noninterest Income Can Be Volatile

Internal Use Only

Advice for Evaluating Noninterest Income

1. Determine the sources of noninterest income (UBPR Page 3 and/or general ledger)

2. Consider volatility and future prospects

3. Consider the relationship to overhead costs (Overhead Less Noninterest Income Ratio on UBPR Page 3)