CMS Sept 2022

Capital Markets School

September 19-23 , 202 2

@ www.csbs.org � @csbsnews

CONFERENCE OF STATE BANK SUPERVISORS 1129 20th Street NW / 9th Floor / Washington, DC 20036 / (202) 296-2840

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Capital Markets School Introduction

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Examinations Coordinator, Market and Liquidity Risk Alabama State Banking Department Brad Coker

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Financial Examiner North Carolina Office of the Commissioner of Banks Joshua Parker

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Financial Examiner North Carolina Office of the Commissioner of Banks Michael Culnan

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Introductions

NAME

STATE

FUN FACT ABOUT YOURSELF

EXPERIENCE

WHAT DO YOU HOPE TO LEARN DURING THIS CLASS?

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What is a “Capital Markets”?

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What is a “Capital Markets”?

• Sensitivity to Market Risk? • Liquidity? • Investment Portfolio? • Capital? • Stress Testing?

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Defining Capital Markets

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Defining Capital Markets

“The examination of bank financial risk at the intersection of balance sheet structure and its interaction with exogenous and endogenous market risk sensitivity”.

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Defining Capital Markets

In this definition, “sensitivity” is considered beyond the “S” sensitivity rating and instead encompasses a broad sensitivity to economic and financial market events and their impact on the balance sheet structure.

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Course Objectives: • Go beyond

traditional guidance presentations

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Course Objectives: • Focus on mid- to large community banks

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Course Objectives: • Broad insights into safety & soundness

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Course Objectives: • What do we mean by balance sheet structure?

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Course Objectives: • How does the bank monitor the evolution of its balance sheet relative to its goals?

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Course Objectives: • How well structured is the balance sheet to absorb inevitable & unpredictable changes?

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Course Objectives: • How well attuned and able is management to react to these changes from a structural & capability perspective?

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Capital Markets School Data Analytics

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CSBS Data Analytics Tools

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Single Sign-On

sso.csbs.org

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Single Sign-On

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Single Sign-On

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Single Sign-On

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Analytics

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Self-Service Analytics

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Risk Scoping Workbook

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Questions

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Capital Markets School Size & Complexity

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Bank Size & Complexity

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Bank Size & Complexity

• Used by examiners and guidance • Tailoring Rule & Community Bank

Leverage Ratio (CBLR)

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Bank Size & Complexity

• Regulation applicability • Community bank vs. “large banks” • Core concept

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Size

• 4 size classes • Tailoring rules further define

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Size

Large Financial Institutions (LFI)  ‐ Tailoring Large Financial Institutions (LFI) – No Tailoring

• LFI – Tailoring: > $100 Billion • LFI – No Tailoring: > $10 Billion • Mid ‐ Sized: $1 ‐ 10 Billion • Community: < $1 Billion

Mid ‐ Sized Banks

Community Banks

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BY THE NUMBERS: NATIONAL BANKING INDUSTRY

Total Assets by Asset Category ($)

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Confidential (For StateBank Supervisors Only) / Not For Redistribution/ Pre ‐ Decisional – Data as of June 30, 2022

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BY THE NUMBERS: NATIONAL BANKING INDUSTRY

Total Assets by Charter Type ($)

Total Assets

Number of Banks

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Confidential (For StateBank Supervisors Only) / Not For Redistribution/ Pre ‐ Decisional – Data as of June 30, 2022

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BY THE NUMBERS: NATIONAL BANKING INDUSTRY

Banks over $10 Billion represent 95% of all National Bank assets Confidential (For StateBank Supervisors Only) / Not For Redistribution/ Pre ‐ Decisional – Data as of June 30, 2022.

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Size - What Do Our Class Participants Cover?

Source: CSBS State Interactive Dashboard, 2Q22

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Size - What Do Our Class Participants Cover?

Source: CSBS State Interactive Dashboard, 2Q22

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Community Banks

• Sub-$1 billion • Limited resources • Role of complexity • Examiner focus

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Mid-Sized Banks

• Sub-$10 billion • Limited • Staffs • Reporting

• Governance structures • Need for consultants

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Mid-Sized Banks

• Large bank provisions • CBLR election • Risks similar • Less expertise • Less governance

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Large Banks

• Regionals & nationals $10- $250 billion • Cutoff for key regulatory requirements now generally $250 billion per tailoring • Nationals & internationals above $250 billion

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Large Banks

• Many names: • SIFIs • G-SIBs • FBO • CCAR banks

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Large Banks

• Regulatory requirements drive classifications • More flexibility

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Large Banks

• Regionals $10-$50 billion • Until tailoring, this group was very challenged at meeting size & complexity regulatory issues

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Large Banks

• Above $250 billion • Generally well-established • Regulatory approach

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Community Bank Leverage Ratio (CBLR)

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Community Bank Leverage Ratio (CBLR)

Economic Growth Regulatory Relief & Consumer Protection Act of 2018 (EGRRCPA)

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Community Bank Leverage Ratio (CBLR)

A “qualifying community bank” permitted to comply with CBLR in lieu of minimum leverage & risk-based capital requirements.

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The Tailoring Rule & Stress Tests

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The Tailoring Rule

• Defined size standards • Aligned requirements • CCAR • 35 banks over $100 billion

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The Tailoring Rule - Simplified Category Size Levels Capital Requirements

LCR Requirements Same as Category II

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U.S. GSIBs

Category I plus GSIB Buffer Category III plus AOCI flow through, SA ‐ CCR and Advanced Approach RWA all required Category IV plus countercyclical buffer and supplementary leverage ratio.

II

=>$700 billion in total asset

100% LCR with daily calculation.

100% LCR if $75 billion average SWTF; 70% LCR if < $75 billion. Daily calculation.

III

=> 250 billion in total assets or => $100 billion in total assets with > $75 billion in average weighted short ‐ term wholesale funding (SWTF)

IV

=> $100 billion in total assets

Standardized Approach for Counterparty Credit Risk (SA ‐ CCR) and AOCI flow through optional.

70% LCR if SWTF > $50 billion with monthly calculation. No LCR for others.

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Large Bank Categories

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Large Bank Categories

Lage Banking Organizations (LBOs) • Domestic bank and S&L holding company • $100 billion or more not included in LISCC

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Large Bank Categories

Lage Foreign Banking Organizations (Large FBOs) • Combined assets • U.S. operations • $100 billion or more not included in LISCC

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Large Bank Categories

Lage Institution Supervision Coordinating Committee (LISCC) • 8 largest, most complex banks • Consolidated supervision

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Large Bank Categories

Systemically Important Financial Institutions (SIFIs) • Dodd-Frank • Assets above $250 billion

• EGRRCPA shift • “Too big to fail”

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Large Banks - Liquidity Categories

Liquidity Coverage Ratio (LCR)

• Generally, banks > than $250 billion • Cover 30 days of liquidity with internal bank assets

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Net Stable Funding Ratio (NSFR) • Generally, banks > than $250 billion • Available stable funding to exceed required amount for 1-year period of extended stress Large Banks - Liquidity Categories

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Large Banks - Liquidity Categories

Note - both LCR & NSFR may be modified for banks below $700 billion

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Complexity

What is “Complexity”? • Non-traditional asset classes?

• Optionality? • Derivatives?

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Complexity

Shift from complex to non-complex is a function of: • Experience

• Risk identification • Risk management • Governance

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Bank Size & Risk

Conclusions: • Banks of all sizes have risks • Numerous rules to define ‘large & complex’ • Don’t assume! • Management capabilities?

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Capital Markets School The Yield Curve, Economic Data, & Forecasting

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Yield Curves

Interest Rates

Term Structure

Yield Curve

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US Treasury Yields

US Treasury Yields (9/1/2022)

Term Yield 1Month 2.313% 1 Year 3.541% 2 Year 3.526% 10 Year 3.263% 30 Year 3.383%

*GuruFocus.com 9/1/22

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US Treasury Yield Curve (Bloomberg, Sept. 1, 2022)

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US Treasury, Corporates, and Munis Yield Curve (Bloomberg, Sept. 1, 2022)

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The Shape of the Yield Curve The shape of the yield curve is influenced by several factors, including:

• Monetary policy • Fiscal policy • Economic activity • Financial Market activity

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Menti

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Federal Funds Target Rate (Upper Limit)

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Federal Reserve Balance Sheet

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Federal Reserve Balance Sheet Asset Composition

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QE1, QE2, Operation Twist, and QE3

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Federal Reserve Balance Sheet (Tapering)

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Impact of the Yield Curve on Decision Making

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3 Options for a $10,000,000 Investment (24-month horizon)

Federal Funds

FNMA Bullet

Muni REV Bond

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FNMA Bullet

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Municipal Revenue Bond

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3 Options for a $10,000,000 Investment (24-month horizon)

Federal Funds

FNMA Bullet

Muni REV Bond

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Cumulative Interest Income on $10,000,000 Investment

$933,333

$68,667 $204,167

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Duration

• What if the yield curve shifts during the 24- month time horizon?

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FNMA Bullet

+300 bp shift Price decreases by 16.95 ULE  ‐ $1,999,292

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MUNI Rev Bond

+300 bp shift Price decreases by 27.72 ULE  ‐ $2,935,819

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Cumulative Interest Income on $10,000,000 Investment

$933,333

$68,667 $204,167

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Expected Value of $10,000,000 Investment

$10,000,000

$7,064,181 $8,000,708

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Balance Sheet Alignment with the Yield Curve

• Different points along the balance sheet yield curve all pose different risks to the bank. • What strategies will banks employ along the different segments of the yield curve depending upon the recent, current and expected yield curve shape? • How does this approach address the banks risk vs. rewards strategy? • Are Management/ALCO strategies appropriately framed in policy limits and risk management practices?

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Examining Yield Curve Issues • Examiners and bankers alike will have a view of current fiscal and monetary policy and its impact on the level of interest rates.  As well as current local markets • Most importantly, examiners should be aware of how the balance sheet structure may impact the risk management process across the investment portfolio, liquidity and IRR.  How does strategic discussion within the ALCO and Board meetings address structural imbalances and are they well documented?  Re-pricing assets and liabilities  Product offerings  Competition

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Economic Data and Forecasting

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Economic Data

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Federal Reserve Economic Data

https://fred.stlouisfed.org/

https://www.clevelandfed.org/en/our ‐ research/indicators ‐ and ‐ data.aspx

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Federal Reserve Economic Data

https://www.atlantafed.org/research/data ‐ and ‐ tools.aspx

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U.S. Bureau of Labor Statistics (https://www.bls.gov/)

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Private Sources of Economic Data

https://www.regions.com/about ‐ regions/economic ‐ update

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Forecasting: Applying Economic Data to Decisions

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Data Sources for Scenario Generation

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Data Sources for Scenario Generation

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Applying Economic Data

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Capital Markets School Liquidity & Funds Management

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Liquidity Measurement & Management Process

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Liquidity Measurement & Assessment

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Complex

Moderate Complexity

Non ‐ Complex

Community Banks

$10B TA

Large Financial Institutions

Mid ‐ Sized Banks

$1B TA

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Liquidity

Ability to fund assets and meet obligations: • Withdrawals • Balance sheet fluctuations • Growth

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Liquidity

Found on both sides of the Balance Sheet

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Liquidity Sources

Assets

Liabilities

• Cash • Due From Accounts • Interest Bearing Bank Balances • Federal Funds Sold/Repos • Unencumbered Investment Securities • Loans

• Deposits

• Public Funds • Deposit Listing Services • Wholesale Funding • Borrowings • Brokered Deposits

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Liquidity versus Funding Liquidity

Funding • Unencumbered Investment Securities • Loans • Wholesale Funding • Borrowings • Brokered Deposits

• Cash • Due From Accounts • Interest Bearing Bank Balances • Federal Funds Sold/Repos • Deposits • Public Funds • Deposit Listing Services

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Liquidity versus Funding

Liquidity is the end result of Funding activities

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On Balance Sheet Liquidity Measurement

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What is On Balance Sheet Liquidity?

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O n B alance S heet Liquidity

Highly Liquid Assets: • Cash & Due From Accounts • Interest Bearing Bank Balances • Federal Funds Sold/Repos • Unencumbered Investments

Measured Against: • Total Deposits • Measures coverage of potential deposit outflows

• Total Funding

• If high levels of

wholesale funding

• Total Assets • Ability to fund growth

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Mitigating Factors Assets that may be slower to convert to cash or risk large haircuts could be considered for liquidity in certain circumstances • Excess Pledged Collateral • Unencumbered HTM Securities • Loans Held-for-Sale • Sub-Investment Grade, Exotic Structures, or Thinly Traded Securities

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OBS Example

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Cash Flow Analysis

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Cash Flow Analysis

After establishing the current liquidity position, does the bank have realistic baseline cash flow analysis & assumptions based on a current, expected outlook?

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Cash Flow Analysis

OBS indicates the bank’s ability to meet liquidity needs today.

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Cash Flow Analysis

Cash Flow Analysis indicates management’s ability to manage expected inflows & outflows in the near future.

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Cash Flow Analysis

Sources of Liquidity

Uses of Liquidity

• Securities Portfolio • P&I payments • MBS cashflows • Maturities & calls • Loan Portfolio • P&I payments • Maturities

• Loan commitments • CD maturities • Public funds obligations • Repos • Borrowing repayments

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Cash Flow Analysis

Behavioral assumptions: • Deposit flows • Prepayments • Loan activity • Investments

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Cash Flow Analysis

Supporting information & documentation: • Budget • Investment reports • Pipeline reports • CD maturity reports • NMD maturity estimates

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Cash Flow Example

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Developing Stress Scenarios

“If anything can go wrong, it will.” – Murphy’s Law

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Liquidity Events

Probability

Low Probability, High Impact Events

High Probability, Low Impact Events

Liquidity Impact

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Liquidity Events

High Probability, Low Impact

Low Probability, High Impact

• Daily liquidity position movements

• Significant impact on liquidity • Idiosyncratic & Systematic

• Deposit fluctuations • Public funds seasonality • Tax deposits • Typical off-balance sheet funding

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Liquidity Events

High Probability, Low Impact

Low Probability, High Impact

• Measured through base case Cash Flow analysis

• Measured through: • Liquidity Stress Testing (LST) • Contingency Funding Plan (CFP)

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Liquidity Measurement & Management Process

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Examples of Liquidity Stress Events Idiosyncratic • AQ deterioration • Consistent operating losses • Rising reputational risk • Inability to access funding lines • Credit rating downgrade • PCA downgrade • Deposit run/rapid redemption of time deposits • Collateral requirement changes Systemic • Funding markets cease to function • Bond market fluctuations • Inability to sell/securitize assets • Negative news • Credit rating downgrade • Significant funding vehicles cost changes

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Complex

Moderate Complexity

Non ‐ Complex

Community Banks

$10B TA

Large Financial Institutions

Mid ‐ Sized Banks

$1B TA

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Stress Scenario Development

A robust set of scenarios includes: • Idiosyncratic • Systemic • Regulatory • Interactions between types of events • A range of possible outcomes: • Mild • Moderate • Severe

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Stress Scenario Development

“If there is a possibility of several things going wrong, the one that will cause the most damage will be the FIRST to go wrong.” – Murphy’s Law, Extreme Version

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Stress Scenario Development - Assumptions

The process to develop, and maintain, scenarios and assumptions should be broad and logical

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Stress Scenario Development - Assumptions

What “breaks the bank”?

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Stress Scenario Development - Assumptions

• Scenarios are a high-level picture of a potential negative event. • Do assumptions generated for that scenario accurately reflect event? • Do they assume an integrated stress event?

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Stress Scenario Development - Assumptions • Are stresses kept relevant to the bank’s balance sheet & cash flows? • Are both short- & long-term stresses considered? • Is there any analysis of yield curve shift impacts on products?

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Stress Scenario Development - Assumptions

• The “event” must be defined through assumptions • Are assumptions an accurate reflection?

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Stress Scenario Development - Assumptions

• Are assumptions relevant to bank’s balance sheet & cash flows? • Are short- & long-term, integrated impacts considered?

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Liquidity Stress Testing (LST)

Quantitative Analysis of the Stress Scenarios

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Liquidity Stress Testing

• Quantitative analysis of stress scenarios • Stresses applied to base case cash flow • Determines funding gaps over time

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Liquidity Stress Testing - Scenarios

• Adequate number of events? • Severe enough? • Reasonable or random? • Broad, logical approach to developing AND maintaining?

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LST Expectations Given Size & Complexity

Complex

Moderate Complexity

Non ‐ Complex

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The Contingency Funding Plan (CFP)

The managerial response to the Stress Scenarios & LST results

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The Contingency Funding Plan • Qualitative analysis of stress scenarios

• Policies & procedures • Provides documented

framework for managing unexpected liquidity situations

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The Contingency Funding Plan • Identify stress events with trigger events • Assess severity & timing • Assess funding sources & needs • Identify potential funding sources

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The Contingency Funding Plan

• Liquidity event

management process • Management reporting • Monitoring framework

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Operational Testing of the CFP • Affirmative testing • Roles & responsibilities • Documentation • Legal & operational • Up-to-date & appropriate • Accuracy of procedures

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Liquidity Stress Testing - Process

Does the bank have a structured approach to building assumptions and scenarios?

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Liquidity Stress Testing - Process

• Adequate detail available? • Who reviews & approves scenarios?

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Liquidity Stress Testing - Assumptions

• LSTs clearly differentiated and calculated as long-term events? • Assumptions about managing confidence in a stress event?

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Major balance sheet components delineated? • Cash flows • Balance sheet • Assets – valuation risks • Funding • Off-balance sheet Liquidity Stress Testing - Assumptions

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Liquidity Stress Testing - Assumptions

• Time considerations • Asset sales • Liquidity facilities • When does the clock run out? • Funding diversity

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LST - Assumptions & Scenarios

• Deposit decay • Disintermediation risks • Stochastic approach • Economic environment • Yield curve shifts

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LST - Assumptions & Scenarios

• Unfunded commitments • Public confidence • Differing perspectives • Unrealistic assumptions

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LST - Assumptions & Scenarios

• Relation between liquidity stress modeling & sensitivity modeling? • Borrowing facilities • Collateral availability • Reliance?

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Liquidity Stress Testing - Output

• Qualitative adjustments • Reporting of results • Results taken seriously? • Actions taken • Challenge to the process • Regulatory exercise or useful risk management tool?

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Liquidity Stress Testing - Output

• Independent validation • Policy limits • Results make sense relative to balance sheet structure?

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LST and CFP Example

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Questions

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Capital Markets School Sensitivity to Market Risk

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Sensitivity to Market Risk (SMR)

• Degree to which changes in interest rates, foreign exchange rates, commodity prices, and equity prices can have an adverse affect on a bank’s earnings and capital

• Most risk in community banks is interest rate risk

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Types of Interest Rate Risk

• Repricing Risk

• Basis Risk

• Yield Curve Risk

• Option Risk

• Price Risk

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Sources of Interest Rate Risk

• Funding Sources

• Product Pricing Strategies

• Mortgage Banking Operations

• Fee Income Business Lines

• Embedded Options

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Interest Rate Risk Management

• Board should establish an appropriate framework to identify, measure, monitor, and control interest rate risk

– Board Oversight – Senior Management Oversight – Policies and Procedures – Strategies – Risk Limits – Risk Monitoring and Reporting

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IRR – Process Overview

Policy

Inputs (GL, Loans, Investments, Deposits)

Model Outputs (Net Interest Income and Economic Value of Equity)

Scenarios (Shocks, Ramps, Non ‐ Parallel)

Interest Rate Risk Measurement Model/System

Board Reporting

Assumptions (Prepayments, Betas, Average Life)

Independent Review

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Model Inputs

Dr. Jones. Source code copyright © 2013 ‐ 2017 Dave Jones,

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Model Inputs

First Step of the Modeling Process – Getting the Bank into the Box • Complete Profile of the Bank • Capture the Structure, Optionality, and Points of Risk Granularity versus Aggregation Accuracy is critical

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Model Input Approaches

• Easy Approach, usually found on “economical” models • Highly Aggregated Call Report

• General Ledger is mapped over to model inputs by line item • Aggregation occurs at bank/model discretion • Also utilizes subsidiary reports and inputs (loans, investments, deposits) Chart of Account • Call Report based inputs with additional information from subsidiary reports Hybrid

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Evaluating the Model Inputs

Determine the approach used.

How is the General Ledger and other information loaded?

Data Quality Assurance?

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Static vs Dynamic Balance Sheets

• Regulatory Guidance requires that models be run with a Static Balance Sheet  Assuming no growth  Maturities, Paydowns, and Run-off is simply replaced with same product • Produces simulation results without interference from Management/Strategic Growth Assumptions

• Which is best? • Should Management run both?

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Scenarios

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Scenarios • Typically Driven by Guidance

 Shocks  Ramps  Non-Parallel  +/- 100 through 400 basis points

• Time horizons • Forecasting expected movements in the Yield Curve • Advanced Modeling Incorporates Forward Rate Expectations

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Shock Scenarios

• Most Impactful, Least Likely

• All tenor points along the Yield Curve move simultaneously  Parallel

• Reveals Exposures in the greatest stress situations

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Ramp (Prolonged) Scenarios

• More likely scenario

• All tenor points on the Yield Curve move in parallel, except the increase is spread over the time horizon

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Non-Parallel Scenarios

• Most likely scenario

• Yield Curve is steepened and flattened by moving short-term or long-term rates

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Forecasted Yield Curve Expectations

Market Forward Curves

Can be developed internally or sourced externally

Projections based on perceived risks and stresses

Multiple yield curves (Treasuries, LIBOR, etc)

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Assumptions

What happens when you assume?

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Assumptions

Most important point of the modeling process

Inputs are standard and Scenarios are defined.

Assumptions determine the accuracy of the outputs

Assumptions impact Assets and Liabilities

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Prepayment Assumptions • Prepayment of loans and mortgage securities based on interest rate expectations

Answer in the chat: What are the implications of Prepayment Assumptions?

• As rates mover higher, prepayments slow

• SMM, CPR and PSA

• Peer assumptions vs bank specific assumptions

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Non-Maturity Deposit Assumptions

Most emphasized assumptions in the process

‐ Deposit Repricing Betas and Lags ‐ Decay Rates ‐ Average Life

Involved in earnings at risk and economic value of equity simulations

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Increase in NMD

• Depositors moved away from long term products as rates remained at historically low rates. • Significant changes in technology, demographics, and competition since these deposits came into the banks.

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Repricing Betas

Deposit Repricing Betas have many names • Betas

• Repricing Betas • Pass Thru Rate • Price Sensitivity Percentage of a market rate increase that is applied to a deposit account type Beta = Account Rate Change/Market Rate Change

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Repricing Betas

• Peer versus Bank Specific

Answer in the chat: What are the implications of Repricing Beta Assumptions?

• Do they generally make sense? Do they account for anticipated changes in the market? • Betas can differ depending on the current level of interest rates, as well as the direction and magnitude of rate changes modeled

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Repricing Lag

Pricing of deposits is a managerial decision

‐ Management decides the amount ‐ Management decides the timing

By lagging an increase in deposit rates, management can create a temporary increase in Net Interest Income

Banks in competitive markets are running a balancing game of rate increases and timing, but can realize a benefit

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Increase in Surge Deposits

• Bank Deposits increased resulting in Surge Deposits and Parked Funds

• Since the Financial Crisis, there has been a flight to quality

• Management should be preparing for the loss of these “parked” funds as consumer confidence grows and the economy recovers

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Deposit Mix

• Increases in NMD and increases in Surge Deposits resulted in large amounts of low cost or no cost deposit products  Great for bank’s Interest Expense

• The departure of Surge Deposits is a definite funding risk for the bank

• However, if the Surge Deposits stay but migrate to a different product, the bank realizes an immediate increase in Interest Expense without gaining additional funding

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Deposit Decay

Federal Deposit Insurance Corporation

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Decay Rates

• Deposit Decay Rate = Balance Run Off/Total Deposits  Calculated by product or account type

Answer in the chat:

What are the implications of Decay Rate Assumptions?

• Should be measured at the product or account level (by sample)

• Bank Specific or Peer Assumptions?

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Average Life of NMD

By Definition, NMD do not have a stated maturity

However, an IRR model needs a maturity date in order to calculate EVE

The Average Life assumption is THE critical assumption for EVE

The determined Average Life determines the point on the Yield Curve used to calculate EVE

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Implications of Average Life Assumptions  EVE = NPV Assets – NPV Liabilities

The longer the time period, the lower the NPV. For Liabilities in a positive yield curve (holding assets constant), a lower NPV equates to a higher EVE or more Asset Sensitive.

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Sensitivity Testing of Assumptions

• Assumptions drive simulation results

• Assumptions are (hopefully) based on historical analysis and expected behavior

• But what if the assumptions are wrong….  What if loans prepay faster than expected…

 What if depositors require higher interest rate increases…  What if surge deposits leave…  What if our deposits are not as long-lived as we think…

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Sensitivity Testing of Assumptions

•Betas are doubled •Decay Rates increased •Change the deposit mix •Average Life cut in half Management should be running alternative (Stressed) assumptions at least annually •Accelerated prepayments could reduce Interest Income •A shift in Betas could greatly reduce Net Interest Income •Loss of Surge Deposits or change in deposit mix could greatly increase Interest Expense Running stressed scenarios can reveal risks in the balance sheet structure

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Internal Use Only

IRR Measurement Models and Model Risk

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Internal Use Only

IRR Simulation Models

• In general terms, Regulatory Guidance states that there is no reason why a bank shouldn’t be using simulation models for measuring Interest Rate Risk.  Models can be developed in-house.

 Models can be purchased and run in-house.  Modeling can be outsourced to a third-party.

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Internal Use Only

Evaluating IRR Simulation Models

• We are not PhD’s in mathematics, statistics, and economics.

 We do not have the expertise to determine if a model is accurate  Model Validation will be discussed tomorrow

But we can evaluate if the model is appropriate given the risk profile and balance sheet structure, and if the model meets Regulatory requirements.

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Internal Use Only

Evaluating IRR Simulation Models

One ‐ off Simulation Runs • Can management run what ‐ if simulations on strategic ideas?

Model Inputs

Scenarios • Magnitude,

Assumptions

Outputs • NII, EVE, NI

• Call Report, Chart of Accounts, or Hybrid

• Is

Pace (Shock vs. Ramps), Time Horizon, Yield Curve Shifts (Parallel vs. Non ‐ parallel)

management able to input and change assumptions?

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Internal Use Only

Model Outputs

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Internal Use Only

Short-term vs. Long-term IRR

• Earnings ‐ at ‐ risk simulations • NII and NI • GAP

Short ‐ term IRR Measurements

• Equity ‐ at ‐ risk • Economic Value of Equity (EVE) • Duration

Long ‐ term IRR Measurements

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Internal Use Only

Earnings-At-Risk: Short-Term IRR • Earnings-at-risk is a measurement of how much the bank’s margin could change given a change in interest rates.

• Short-term = 1 year or less.

• Short-term interest rate risk is measured by initially establishing a one year earnings forecast (which may include a dynamic market rate forecast, earnings growth, and balance mix & volume changes). • The earnings at risk is the negative change between the base forecast and one of the "shock" scenarios. The measure is usually stated as a percentage change from the base income.

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Internal Use Only

Earnings-at-Risk: short-term IRR • There are two significant characteristics of the earnings at risk measurement that should be reviewed:

1. What rate shock, up or down, produces the worst case change? Is the bank exposed to rising or falling rates? 2. What is the amount of projected change or magnitude of risk? How much exposure is there?

• Do results expose any anomalies or points of risk on the balance sheet?

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Internal Use Only

Non-Linear Simulation Results

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Internal Use Only

GAP Measurements

• A gap report is a single scenario, point in time measurement, and only shows behavior in a base case rate environment.

Answer in the chat: How many people see GAP used as a measurement tool at their banks?

• The gap report is an inadequate tool to measure optionality.

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Internal Use Only

GAP Measurements – Question?

I'm looking at our gap report and it shows our cumulative gap to be 116% which is asset sensitive, yet when I look at the rates up simulation on the income shock report it shows my net interest margin declining when rates rise. Is there something wrong with the model?

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Internal Use Only

GAP Measurements – Question?

• No , you've just observed the biggest weakness of the gap report. It doesn't capture option risk .

• There are several accounts where option risk is likely to show up on a bank's balance sheet today.

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Internal Use Only

Why are Earnings-At-Risk and GAP not enough? • Earnings-at-risk and GAP are tools that only measure short-term interest rate risk . • Earnings-at-risk simulations usually only project the change in interest income one-year into the future. And the typical gap measurement is the “one-year cumulative gap”.

• But what about potential risk beyond one-year?

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Internal Use Only

Economic Value of Equity (EVE) at risk

• To evaluate long-term IRR, an economic perspective is necessary.

• Focus on the value of the bank in today's interest rate environment and that value's sensitivity to changes in interest rates. This concept is known as Economic Value of Equity (or EVE) at Risk . • Requires a complete present value balance sheet to be constructed. This is done by scheduling the cash flows of all assets and liabilities and applying a set of discount rates to develop the present values. The economic value of equity (EVE) is the difference between the present value of assets and liabilities. (Equity = Assets - Liabilities).

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Internal Use Only

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Internal Use Only

Critical Assumptions • With heightened levels of NMDs in community banks today, it is important that banks apply appropriate decay rates, average lives, and price sensitivity assumptions (i.e., betas) in IRR modeling. • Traditional assumptions associated with NMDs (long average lives and lower price sensitivities). • Newer segments of NMDs acquired during the financial crisis may not behave like typical core deposits. • Institutions should update their model assumptions to capture changes in funding mix to ensure any adverse impact is appropriately considered and planned for so that management can make well-informed decisions.

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Internal Use Only

Non-Maturity Deposit (NMD) Behavior

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Internal Use Only

Non-Maturity Deposit (NMD) Behavior

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Internal Use Only

Non-Maturity Deposit (NMD) Behavior

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Internal Use Only

Non-Maturity Deposit (NMD) Behavior

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Internal Use Only

Relationship Between EAR and EVE

• Why do they often seem to contradict one another?

• How can the bank have earnings exposure to rates down, but EVE exposure to rising rates (or vice versa)?

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Internal Use Only

Relationship Between EAR and EVE • The biggest reason why is that we don't measure earnings-at- risk by adding up the present values of all future earnings flows. Typically only look at a one-year time frame (you have the same problem even if you look at a two or three year time frame). • EVE reflects the sensitivity of all periods , while EAR is measured for just a single defined period .

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Internal Use Only

Relationship Between EAR and EVE • How can the bank have earnings exposure to rates down, but EVE exposure to rising rates (or vice versa)? • The bottom line answer is that earnings-at-risk measures short-term risk exposure, and EVE-at-risk measures long-term risk exposure. • It comes down to a short-term/long-term trade-off. • For example, buying longer-term 7-10 year bonds will probably have a positive impact on your overall margin today and in the immediate future (because it creates more spread). But continue that strategy long enough in a rising rate environment and your gains from investing longer-term will be eaten up by rising funding costs over time.

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Internal Use Only

RATING SENSITIVITY TO MARKET RISK

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Internal Use Only

SMR Component Rating

• The sensitivity of the institution’s earnings or the economic value of its capital to adverse changes in interest rates

• Ability of management to identify, measure, monitor, and control given the institution’s size, complexity, and risk profile

• Nature and complexity of interest rate risk from nontrading positions

• Nature and complexity of market risk from trading and foreign operations

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Internal Use Only

SMR Component Rating

A rating of 1 indicates that market risk is _____ controlled and that there is minimal potential that the earnings performance or capital position will be adversely affected. Risk management practices are ______ for the size, sophistication, and market risk accepted by the institution. The level of earnings and capital support provide substantial support for the degree of market risk taken by the institution.

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Internal Use Only

SMR Component Rating

A rating of 2 indicates that market risk sensitivity is _________ controlled and that there is only moderate potential that the earnings performance or capital position will be adversely affected. Risk management practices are _______ for the size, sophistication, and market risk accepted by the institution. The level of earnings and capital provide adequate support the degree of market risk taken by the institution.

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Internal Use Only

SMR Component Rating

A rating of 3 indicates that control of market risk sensitivity _________ or that there is _______ potential that the earnings performance or capital position will be adversely affected. Risk management practices _______ given the size, sophistication, and level of market risk accepted by the institution. The level of earnings and capital provide may not adequately support the degree of market risk taken by the institution.

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Internal Use Only

SMR Component Rating

A rating of 4 indicates that control of market risk sensitivity is _____ or that there is ______ potential that the earnings performance or capital position will be adversely affected. Risk management practices are ______ for the size, sophistication, and level of market risk accepted by the institution. The level of earnings and capital support provide _______ support for the degree of market risk taken by the institution.

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Internal Use Only

SMR Component Rating

A rating of 5 indicates that control of market risk sensitivity is _____ or that the level of market risk taken by the institution is an imminent threat to its viability. Risk management practices are ______ for the size, sophistication, and level of market risk accepted by the institution.

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Internal Use Only

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Internal Use Only

Capital Markets School The Lines of Defense & Independent Review

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Internal Use Only

The Lines of Defense Banks should prepare a risk management framework (RMF) in order to establish clear lines of responsibility in overseeing the multitude of risks. The Board of Directors (Board) is usually the ultimate owner and overseer of risk management. The RMF includes three mutually supportive lines of defense:

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Internal Use Only

The Lines of Defense Another View:

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Internal Use Only

The Lines of Defense - First The ongoing roles and responsibilities of the 1LOD include the following: • Engage in risk-taking activities, which include developing and implementing strategies to drive revenue opportunities. • Ownership and Accountability for business risks and control design/effectiveness to operate within the policies, standards, and limits set by the 2LOD. • Escalate changes in the business or the risk environment that could affect the Company’s risk profile and control environment. • Effectively manage activities to meet strategic objectives within Risk Appetite.

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Internal Use Only

The Lines of Defense - First • Identify measure, monitor, assess, control, and report on risks associated within its activities. • Provide input to and accept articulation of Risk Appetite in policies, standards, and limits set by risk committees. • Ensure business activities operate within policies, standards, and limits. • Facilitate ongoing risk and control self-assessments to identify key risks and document, monitor, and evaluate control design & effectiveness.

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Internal Use Only

The Lines of Defense - Second The key responsibilities of the 2LOD include the following:

• Establish policies, procedures, processes, and standards to guide risk management execution. • Oversee the 1LOD’s identification and assessment of current and emerging risks, as well as the effectiveness of processes and controls to manage risks. • Facilitate the integration of Risk Appetite within strategic planning processes. • Independently monitor, challenge, and report on aggregate exposures in alignment with the Risk Appetite Framework. • Independently escalate risk management gaps and issues.

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Internal Use Only

The Lines of Defense - Second As part of the 2LOD, an independent credit risk review unit may evaluate credit risk and the potential exposure to loss associated with managing credit products and processes.

• CRR may be an independent assurance provider organizationally housed within the Company’s RMO and reporting functionally to the Board or a Board Risk Committee (BRC).

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Internal Use Only

The Lines of Defense - Third Internal Audit is the third line of defense (3LOD).

• IA provides independent and objective internal audit assurance for the bank. • It evaluates the design and effectiveness of risk management, governance and oversight as well as internal control systems and processes.

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Internal Use Only

Independent Review Standalone market risk and model risk functions are relatively uncommon in the community bank space, consequently independent review falls to staff which is often enhanced with consultants.

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Internal Use Only

Independent Review Regulatory Guidance details 5 requirements for an independent review: 1. The adequacy of, and personnel’s compliance with, the bank’s internal control system 2. The appropriateness of the bank’s risk measurement system given the nature, scope and complexity of its activities 3. The accuracy and completeness of the data inputs into the bank’s risk measurement system 4. The reasonableness and validity of scenarios used in the risk measurement system 5. The validity of the risk measurement calculations. (actual vs forecasted results)

10