Capital Markets Examiner School, Providence, RI

Capital Markets Examiner School Providence, Rhode Island May 20 - 24, 2019

ATTENDEES Arkansas State Bank Department Nathan Elliott

nelliott@banking.state.ar.us jhoman@banking.state.ar.us dsims@banking.state.ar.us jwelch@banking.state.ar.us

501-324-9019 501-324-9019 501-324-9019 501-324-9019

Jim Homan Daniel Sims

Johnathon Welch

Kansas Office of the State Bank Commissioner Jill Druse

jill.druse@osbckansas.org

785-296-1379

Massachusetts Division of Banks Domenick Lasorsa

domenick.lasorsa@mass.gov

617-956-1500

New Jersey Department of Banking and Insurance Elizabeth Baroh New York State Department of Financial Services Albert Eng

elizabeth.baroh@dobi.nj.gov

609-292-7272

albert.eng@dfs.ny.gov

212-709-7759

Rhode Island Division of Banking Tadeusz Klas

tadeusz.klas@dbr.ri.gov

401-462-9663

INSTRUCTORS Alabama State Banking Department Brad Coker

brad.coker@banking.alabama.gov

Marshall McDowell

marshall.mcdowell@banking.alabama.gov

CSBS EDUCATION FOUNDATION STAFF Kim Chancy

kchancy@csbs.org

202-802-9554

Capital Markets Examiner School Providence, Rhode Island May 20 – 24, 2019

Monday, May 20, 2019 8:30 AM

Welcome and Introductions Brad Coker Marshall McDowell

9:30 AM 10:00 AM 10:15 AM 10:45 AM 12:00 PM 1:30 PM 3:00 PM 3:15 PM 4:15 PM 5:00 PM 9:00 AM 10:15 AM 10:30 AM 11:00 AM 12:00 PM 1:30 PM 3:00 PM 3:15 PM 5:00 PM

Size and Complexity

Break

Size and Complexity (cont’d)

Yield Curves

Lunch

Balance Sheet Structure

Break

CSBS Data Analytics

Policies and Risk Management

Adjourn

Tuesday, May 21, 2019 8:30 AM

Morning Refresher Investment Portfolio

Break

Liquidity Introduction

Liquidity Assessment and Measurement

Lunch

Liquidity Assessment and Measurement (cont’d)

Break

Liquidity Assessment and Measurement Activity

Adjourn

Wednesday, May 22, 2019 8:30 AM

Morning Refresher

9:00 AM 10:00 AM 10:15 AM 11:00 AM

Liquidity Risk Management

Break

Liquidity Risk Management (cont’d) Liquidity Risk Management Activity

12:00 PM 1:00 PM 1:30 PM 3:00 PM 3:15 PM 5:00 PM 9:00 AM 10:00 AM 10:15 AM 12:00 PM 1:30 PM 2:00 PM 2:30 PM 3:00 PM 3:15 PM 4:00 PM 5:00 PM 9:00 AM 10:00 AM 10:15 AM 11:00 AM 12:00 PM

Lunch

Interest Rate Risk Introduction

Interest Rate Risk Inputs and Scenarios

Break

Interest Rate Risk Assumptions

Adjourn

Thursday, May 23, 2019 8:30 AM

Morning Refresher

Interest Rate Risk Model Risk and Outputs

Break

Interest Rate Risk Activity

Lunch

Independent Review

Model Risk Management

Derivatives

Break

Derivatives (cont’d)

Mortgage Banking and Asset Securitization

Adjourn

Friday, May 24, 2019 8:30 AM

Morning Refresher

Group Recap

Break

Current Events

Regulatory Emerging Issues

Adjourn

Capital Markets Course

May 20-24 Providence, RI

Instructors

 Brad Coker, Alabama

 Certified Examiner-in-Charge and Examinations Coordinator for the Alabama State Banking Department Market and Liquidity Risk team.  16 years experience with community, mid-sized, and large financial institutions, with dedicated coverage of Regions Bank.  Instructor for the CSBS Examiner-in-Charge course. Prior experience in Corporate Accounting at Colonial Bank, NA, responsible for regulatory reporting.

Instructors

 Marshall McDowell, Alabama

 Certified Examiner-in-Charge with 8 years examination experience with Alabama State Banking Department. Began as a community bank examiner for first 2 years. Currently with the Market and Liquidity Risk team.  Focus on market and liquidity risk issues within both our community banks and large institutions, and currently provides dedicated coverage for all BBVA Compass Treasury/ALCO activity.  Provides OJT and classroom training to field examiners .

Now it’s your turn….

 Name

 State

 Experience

 What do you hope to gain or learn from this class?

What is a “Capital Markets”

 Sensitivity to Market Risk?

 Liquidity?

 Investment Portfolio?

 Capital?

 Stress Testing?

The Capital Markets Examiner

 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”.  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.

Course Objectives

 This course is not focused on traditional guidance presentations as they are adequately covered in other training venues available to examiners.  Guidance and regulations will be discussed where relevant. A working knowledge commensurate with the FDIC ALM School is assumed.  This course is aimed at intermediate to advanced level examiners and assumes familiarity with those topics.  Examples and exercises will be interspersed throughout the week in order to generate review and discussion of the covered topics.  The focus will also be on open discussions and questions and not on a guidance/analysis lecture approach.

Course Objectives

Focus is on liquidity, sensitivity and investments and related bank strategies in the formation of the balance sheet structure and approaches to managing exogenous shifts in a safe and sound manner.

 What do we mean by balance sheet structure?  Every bank’s balance sheet is largely a result of conscious decisions made my bank management

regarding the types and amounts of various assets, liabilities and equity.  i.e. The bank evolves as a result of bank strategies and customer demands & needs.  How does the bank monitor the evolution of its balance sheet relative to its goals?  Is risk control a properly represented part of this process.

 Exogenous changes occur in the economy and financial markets.  How well structured is the balance sheet to absorb these inevitable and unpredictable changes.  How well attuned and able is management to react to these changes from a structural and capability perspective.

Size and Complexity Defined

Bank Size and Complexity

 Regulatory guidance occasionally states requirements in terms of the “size and complexity” of the bank

 Size and complexity are not broadly defined in regulatory guidance but are instead covered in specific regulatory applications  Capital  Liquidity

 Unless specifically stated pursuant to a size metric, regulations apply to all banks

Bank Size and Complexity

 While this course focuses on community bank applications in the case studies, it’s helpful to understand some of the key terms and provisions which differentiate them from “large banks”

 This is a core concept which sets both regulatory framework and examiner mindset/judgement.

Complex

Moderate  Complexity

Non‐ Complex

$1B TA

$10B TA

Community  Banks

Mid‐Sized Banks

Large Financial  Institutions

Size

In general, there are three size classes

 Community Banks (< $1 Billion in Total Assets)

 Mid-Sized Banks (Between $1 Billion and $10 Billion in Total Assets)

 Large Financial Institutions (> $10 Billion in Total Assets)

States Represented

www.amcharts.com

Size – What Do Our Class Participants Cover?

Size – What Do Our Class Participants Cover?

Community Banks

• As the smallest group, this segment must work with expected limited resources of a sub-$1 billion institution. • Relative to these resources, questions of complexity become even more important in many ways as heightened risks can pose an even greater threat to a bank with limited management, technical and financial resources. • Examiners must be more attuned to looking for complexity issues which can outstrip those resources. – Local and business sector concentrations can also heighten risks if they exist.

Mid-Sized Banks

Community banks (sub-$10 billion) are similarly more stabilized as most are far from any shifts in regulatory requirements.

 Traditionally work with much more limited staffs, reporting and governance structures.

 Higher need for consultants.  The board and senior management must maintain responsibility and need to retain capability to scrutinize 3 rd party work.

Mid-Sized Banks

 Most will not dabble in large bank provisions voluntarily with the exception of the LCR

 Many of the risks are still the same as large banks with less expertise and governance  They just don’t rise to the same level of systemic risk as their size limits their impact on other banks

Large Banks

 Large regionals/nationals between $10 and $250 billion  Also a break at $50 billion

 National and international banks above $250 billion

Large Banks

 Regional and national banks with greater than $10 billion in total assets

 Large Banks have many names  SIFIs, G-SIBs, FBO, CCAR banks etc.

 Regulations, largely in the capital and liquidity environments, trigger new sets of regulatory requirements and acronyms and drive these classifications

Large Banks

 Strategic decisions and balance sheet structures at larger banks have a much higher degree of flexibility due to shear size.  Banks above $50 billion are fairly well-established and attuned to the regulatory structures and have accommodated for them in their regulatory approach.  The mid-sized regionals ($10-50 billion) can be the most interesting and evolving entities as they work through the potential of crossing into higher reporting requirements and enhanced prudential standards.

Large Banks

 Large Banking Organizations (LBOs)

 Large Foreign Banking Organizations (Large FBOs)

 Systemically Important Financial Institutions (SIFIs) are a creation of Dodd- Frank, and any bank with assets above $50 billion is deemed systemically important.  Shifting in stages to $250 billion per the 2018 Economic Growth, Regulatory Relief, and Consumer Protection Act (EGRRCPA) with an immediate shift to $100 billion.

Large Banks-Capital Categories

 Dodd Frank Act Stress Tests (DFAST)

 Horizontal Capital Review (HCR)/Comprehensive Capital Analysis and Review (CCAR)

 Large Institution Supervision Coordinating Committee (LISCC)

Large Banks-Liquidity Categories

 Liquidity Coverage Ratio – for banks greater than $50 billion  a ratio to cover 30 days of liquidity with internal bank assets

 Net Stable Funding Ratio (NSFR) – for banks greater than $50 billion  available amount of stable funding required to exceed the required amount of stable funding for a one-year period of extended stress

 Both LCR and NSFR are modified for banks below $250 billion

Complexity

 Beyond the regulatory approaches, what is “Complexity”

 Non-traditional asset classes?

 Optionality?

 Derivatives?

 The shift from complex to non-complex is a function of experience, risk identification, risk management, and governance  Is complexity a function of management skill and depth

Bank Size and Risk

Conclusions regarding size and complexity

 The obvious: banks of all sizes have risks  There are numerous rules aimed primarily at the $50 billion plus segment to define large and complex  Examiners cannot make an assumption on the “riskiness” because of asset size  “Small” banks can be more risky than “Big” banks particularly if management builds a structure which is beyond their capabilities

SIZE AND COMPLEXITY EXERCISE

Size and Complexity-Discussion Exercise

• Consider and prepare to discuss a bank from your state and how you would classify them along the size and complexity scale. – Size is simple to classify – consider if it inherently drives complexity in any way – Gauge your institution’s complexity on the below factors used for BB&T • Should other factors be considered for gauging complexity? – Consider if/how you adjust for exams depending upon size and complexity issues. – Discuss factors that guide your classification such as: • Lending portfolio • Investment portfolio • Funding structure • Non-banking activities • Management skillset relative to complexity • Applicable regulations – Discuss with other participants in order to present an array of sizes and complexity levels.

Size and Complexity-Discussion Exercise

BB&T

Size

Large, $220 billion

Regulatory Environment

SIFI, HCR/CCAR/DFAST, LCR, NSFR, Resolution Planning (not one of the approved living wills)

Lending

Full spectrum of standard products in C&I, CRE, auto(prime/nonprime), mortgage, specialized  (government, equipment leasing, insurance premiums etc.) Predominantly Agencies and Treasuries with lower levels of municipals and private label MBS. Standard diverse pool of deposits, checking, MMA, time deposit.  Active note issuance  program and minimal foreign office deposits.  Active MSR and derivatives hedging.  Non‐interest activity dominated by insurance business.   Holding company has small but active broker‐dealer.

Investment Portfolio

Funding

Revenue/Expenses

Footprint

Predominantly Southeast and mid‐Atlantic US.

Complexity Level

Moderately complex.

The Yield Curve & The Balance Sheet

How market forces impact balance sheet structure and strategies

Balance Sheet Structure and the Yield Curve

 Bank balance sheet structure and strategic direction is influenced by:  Level of interest rates  Competitive landscape  Profitability  Risk Tolerance  The shape of the yield curve is influenced by a number of factors, including:  Monetary policy as controlled by the Federal Reserve Open Market Committee (FOMC)  How fiscal policy influences the taxing and spending activity of the government  General health and stability of financial markets  Global financial market activity

Primary Dealers

 Primary dealers are trading counterparties of the New York Fed trading desk in its implementation of monetary policy.

What Affects the Yield Curve?

 Primary dealers affect the yield curve primarily through the implementation of monetary policy, including all activity within the trading desk at the New York Fed.

 The Federal Reserve makes decisions based on its assessment of economic and market conditions; however, fiscal policy will influence these conditions.

 Current yield curve is not a true representation of market conditions. There is much work to do to normalize the Federal Reserve’s balance sheet which will cause some volatility.

April 22, 2018

April 29, 2019

Aug 17, 2017

Cost of Liquidity

The True Cost of Excess Liquidity Cumulative 24 Month Earnings on $10mm Invested

Duration Examples

Why does it matter?

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?

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

Yield Curve Shifts

 Shifts are all hypotheticals used to demonstrate the bank’s ability to absorb a range of market conditions.  Interest rate scenarios Parallel versus non-parallel +/- 100 to 400 basis points  The main point is whether the bank is accommodating for changes in the shape of the curve when appropriate.  Dynamic modeling, and “What-if” scenarios depending upon the level of balance sheet complexity  Can be valuable and necessary considering recent M&A activity Shocks Ramps

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Policies and Risk Management

Governance

Board of Directors

Policies

Bank Management

Risk Management

Complex

Moderate  Complexity

Non‐ Complex

$1B TA

$10B TA

Community  Banks

Mid‐Sized Banks

Large Financial  Institutions

Policies & Risk Management

 What is the “tone at the top”?

 Is a risk appetite clearly established by the board that can be readily followed by staff?

 Does the board and senior management link balance sheet structure and earnings capacity to risks?

 Is there clear capital markets reporting?

Policies & Risk Management-Staffing and Resources

 Do they provide reasonable staffing and IT sources to risk management efforts?

 This is where size can draw distinct differences and complexity can drive needs

 However, complexity can drive needs

Policies & Risk Management

 Is there a clear and consistent documentation structure?  Policies – standards – procedures?

 Policies – board approved, high level documents that set risk appetite and delegate authority  Standards-senior management implementation of policies for key staff guidance  Procedures – the “how to” documents which describe operational processes

 Larger institutions frequently rely on the 3 layers

 At smaller institutions, the 3 layers can merge into 2 (and sometimes 1) document

Policy Limits

• How do banks set policy limits?

– Randomly

– Recommended

– Purchased

– Calculated

Assessing Policy Limits (Real Life Example)

12/31/2018 Actual • NII

+/- 100 bp shock NII Limit: -25% • NII 2,233 • Non Int Inc 751 • Non Int Exp 3,120

2,978

• Non Int Inc • Non Int Exp

751

3,120

• Pre-Tax Op Income 609

• Pre-Tax Op Income (136)

Assessing Policy Limits

12/31/2018 Actual • NII

+/- 400 bp shock NII Limit: -60% • NII 1,191 • Non Int Inc 751 • Non Int Exp 3,120

2,978

• Non Int Inc • Non Int Exp

751

3,120

• Pre-Tax Op Income 609

• Pre-Tax Op Income (1,178)

Liquidity and Funds Management

“Liquidity, you either have it or you don’t.” -Retired Examiner

Liquidity Measurement and Management Process

Liquidity Policy

Contingency  Funding Plan

Measurement and Assessment

Stress  Scenario  Development

Board  Reporting

On Balance  Sheet Liquidity

Base Case Cash  Flow Analysis

Liquidity  Stress Testing

Risk Management

Independent Review

LIQUIDITY MEASUREMENT AND ASSESSMENT

Complex

Moderate  Complexity

Non‐ Complex

$1B TA

$10B TA

Community  Banks

Mid‐Sized Banks

Large Financial  Institutions

Liquidity

 A financial institution’s ability to fund assets and meet obligations

 Meet customer withdrawals

 Compensate for balance sheet fluctuations

 Provide funds for growth

 Liquidity is found on both sides of the Balance Sheet

Liquidity Sources

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Liquidity Sources

Assets

Liabilities

 Deposits

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

 Public Funds  Deposit Listing Services

 Wholesale Funding  Borrowings  Federal Funds

Purchased/Correspondent Lines  FHLB  Federal Reserve Discount Window

 Brokered Deposits  True Brokered

 CDARS/Reciprocal CDARS/ICS

Liquidity versus Funding

Liquidity

Funding  Unencumbered Investment Securities  Loans  Wholesale Funding  Borrowings  Federal Funds Purchased/Correspondent Lines  FHLB  Federal Reserve Discount Window  Brokered Deposits  True Brokered  CDARS/Reciprocal CDARS/ICS

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

Liquidity versus Funding

Liquidity is the end result of Funding activities

ON BALANCE SHEET LIQUIDITY MEASUREMENT

What is On Balance Sheet Liquidity?

 A static measure of current liquidity

 A starting point for stress testing and contingency planning

O n

B alance

S heet Liquidity

Highly Liquid Assets:

Measured Against:  Total Deposits  Measures the coverage of potential deposit outflows  Total Funding  If the bank has high levels of wholesale funding  Total Assets  Ability to fund growth

 Cash and Due From Accounts

 Interest Bearing Bank Balances

 Federal Funds Sold

 Unencumbered Investments

On Balance Sheet Liquidity

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Mitigating Factors

Assets with liquidity that may be slower to convert to cash or risk large haircuts but could be considered for liquidity in certain circumstances

 Excess Pledged Collateral

 Unencumbered Held-To-Maturity securities

 Loans Held-for-Sale

 Sub-Investment Grade, Exotic Structures, or Thinly Traded Securities

OBS EXAMPLE

CASH FLOW ANALYSIS

Cash Flow Analysis

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

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

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

Cash Flow Analysis

Sources of Liquidity

Uses of Liquidity

• Securities Portfolio

• Loan commitments

– Principal and Interest Payments – MBS cashflows – Maturities and Calls

• CD maturities

• Public funds obligations

• Loan Portfolio

– Principal and Interest Paymens – Maturities

• Repos

• Borrowing repayments such as FHLB and FRB Discount Window

Cash Flow Analysis

 Behavioral assumptions – the usual key factors

 Deposit flows (Marketing and Incentive programs)

 Loan and securities prepayments

 New loan activity

 Investment transactions

Cash Flow Analysis

 Supporting Information and Documentation

 Budget

 Investment cash flow reports

 Loan pipeline reports

 Maturity reports for CDs

 NMD maturity estimates from IRR model

CASH FLOW EXAMPLE

DEVELOPING STRESS SCENARIOS “If anything can go wrong, it will.” – Murphy’s law

Liquidity Events

Probability

Low Probability,  High Impact  Events

Liquidity  Impact

High Probability,  Low Impact  Events

Liquidity Events

High Probability, Low impact  Daily liquidity position movements  Routine deposit fluctuations  Seasonality of Public Funds  Tax Deposits  Typical funding of off-balance sheet items  Measured through base case Cash Flow analysis

Low Probability, High Impact  Significant impact on the liquidity position  Idiosyncratic and Systemic  Measured through Liquidity Stress Testing (LST)  Managed through the Contingency Funding Plan (CFP)

Liquidity Measurement and Management Process

Liquidity Policy

Contingency  Funding Plan

Stress  Scenario  Development

Board  Reporting

On Balance  Sheet Liquidity

Base Case Cash  Flow Analysis

Liquidity  Stress Testing

Independent Review

Examples of Liquidity Stress Events

Idiosyncratic  Deterioration in Asset Quality  Consistent Operating Losses  Rising Reputational Risk  Inability to Access Funding Lines  Downgrade to External Credit Ratings  Prompt Corrective Action Classification Downgrade  Deposit Run/Rapid Redemption of Time Deposits  Changes in Collateral Requirements

Systemic  Funding Markets Cease to Function  Bond Market Fluctuations  Inability to Sell Assets/Securitize Assets  Negative News  Downgrade to External Credit Ratings  Changes in Cost of Significant Funding Vehicles

Complex

Moderate  Complexity

Non‐ Complex

$1B TA

$10B TA

Community  Banks

Mid‐Sized Banks

Large Financial  Institutions

Stress Scenario Development

A robust set of scenarios includes idiosyncratic, systemic, and regulatory events, and interactions between the types of events , across a range of possible outcomes (mild, moderate, severe)

 “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

Stress Scenario Development

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

 Does the bank know its limits via some form of reverse stress testing?  What “breaks the bank”

Stress Scenario Development - Assumptions

 Scenarios are the high-level picture of a potential negative event.  Do the assumptions generated for that scenario accurately reflect the event?  Do they assume an integrated stress event – i.e. beyond a pure idiosyncratic event, most exogenously driven stress events may be the result of numerous economic and financial market issues.  Are stresses kept relevant to the bank’s balance sheet and cash flows?  Are both short- and long-term stresses considered?  Is there any analysis of yield curve shift impacts on products in relation to their place along the yield curve?

Stress Scenario Development - Assumptions

• Scenarios are the high-level picture of a potential negative event – Once the “event” has been determined, it must be defined through assumptions

• Do the assumptions generated for that scenario accurately reflect the event?

• Are assumptions kept relevant to the bank’s balance sheet and cash flows?

• Are short-term and long-term, integrated impacts considered? – Yield Curve Shifts – Regulatory Actions

LIQUIDITY STRESS TESTING (LST) Quantitative Analysis of the Stress scenarios

Liquidity Stress Testing

 A quantitative analysis of the stress scenarios

 Stresses are applied to the base case cash flow analysis

 Determines gaps in funding over future time horizons

Liquidity Stress Testing –Scenarios

 Are there an adequate number of events and are they severe enough?  The bank should test across the spectrum from mild to severe events.  Do the risks presented in the scenarios accurately reflect risks which are relevant to the bank?

 Once again, do the scenarios present a reasonable story or are they just an random amalgam of stresses forced onto the baseline?

 Most importantly, is there a broad, overall logical approach to developing AND maintaining assumptions and scenarios?  How often are they routinely reviewed for potential updates?

LST Expectations given Size and Complexity

Complex

Moderate  Complexity

Non‐ Complex

LST EXAMPLE

THE CONTINGENCY FUNDING PLAN (CFP) The managerial response to the Stress Scenarios and LST results

The Contingency Funding Plan

 Qualitative analysis of the stress scenarios

 Delineates policies and procedures

 Provides a documented framework for managing unexpected liquidity situations

The Contingency Funding Plan

 Identify the Stress Events with Trigger Events  Shifts Between Stress Scenarios

 Assess Levels of Severity and Timing

 Assess Funding Sources and Needs  Liquidity Stress Testing

 Identify Potential Funding Sources

The Contingency Funding Plan

 Establish a Liquidity Event Management Process

 Identify Management Reporting, Including Frequency

 Establish a Monitoring Framework for Contingent Events

Operational Testing of the Contingency Funding Plan

 Affirmative Testing, when applicable  Testing Liquidity Lines

 Updating Roles and Responsibilities

 Ensuring Legal and Operational Documents are up-to-date and appropriate

 Ensuring Cash and Collateral Movement Procedures are Correct

CFP EXAMPLE

LIQUIDITY EXERCISE

Liquidity Stress Testing – Process

 Does the bank have a structured approach to building assumptions and scenarios?  As an example:

1) Identify baseline cashflows 2) Determine useful events 3) Derive cashflows for each scenario 1) Clearly differentiate drivers 1) Non-discretionary/contractual

2) Customer behavior 3) Management driven 4) Blend into CFP – what do they cover the gaps with 1) Be aware of facilities that can disappear.  Is adequate detail available for reviewers and regulators to understand how the scenarios and assumptions translate into outcomes?  Who reviews and approves scenarios and how much information do these individuals have in this process?

Liquidity Stress Testing – Assumptions

 Does the bank clearly differentiate and calculate LSTs as long-term events (e.g. 12 months) and not a daily or shorter-term (e.g. overnight) liquidity exercise?  How well do they assume they can manage depositor and investor/public confidence issues in a stress event?  Beware of overly optimistic banks in the CFP.

Liquidity Stress Testing – Assumptions

 How well do they delineate their major balance sheet components?  Cash flows – review uncertainty of CFs and maintaining awareness of ongoing business variations/risks such as regulatory rulings, judgements etc.  Balance sheet  Assets – valuation risks – (see stress modifier #5 above)  Funding – CP or MTNs not common at community banks  Off-balance sheet – fees, cash payments from credit facilities can slow – (see stress modifier # 7 above)  At what point do the bank’s borrowing sources become curtailed or closed?

Liquidity Stress Testing – Assumptions

 Does their assumption building have time dimensions as a consideration:  More assets can be sold over longer time periods.  Are there significant levels of those assets that will need time?  Liquidity facilities allow the bank to buy time to sell less liquid assets.  When does the clock run out?

 Community banks lack the funding diversity and “too big to fail” access that larger competitors may have.

Liquidity Stress Testing – Assumptions & Scenarios

 What level of assumption and scenario development is focused on deposit decay and disintermediation risks?  Are stress events solely deterministic or does the bank have the insight and ability for a stochastic approach?  This could be a stretch for most community banks.  Do loan repayment cash flows and the marketability of the investment portfolio reasonably reflect the assumed economic environment in a systemic stress?  As yield curves shift, is funding disintermediation understood and accounted for as deposits move from short to long (or vice-versa)?

Liquidity Stress Testing – Assumptions & Scenarios

 Are unfunded lending commitments accurately reflected?  How is public confidence in the bank reflected in bank liabilities?  Are there differing perspectives depending upon liability type from deposits to CDs to marketable debt issuances?  Does the bank display any unrealistic assumptions about funding available under these scenarios?  Is there any relation between liquidity stress modeling and sensitivity modeling particularly for high-impact segments such as NMDs, loan repayments and unfunded commitments?  Is the bank realistic for borrowing facilities?  Will potentially needed collateral be available?  Does the bank display any high level of reliance on borrowing facilities that must be accounted for?

Liquidity Stress Testing - Output

 Are qualitative adjustments clearly shown vs. quantitative approaches?  How are management adjustments reviewed and scrutinized?  It should be systematic for consistency in approach.  Are results clearly and routinely reported?  Are the results taken seriously by senior management and the board?  Have any actions ever been taken in reaction to LST results?  Is there any indication of challenge to the process?  Does the bank regard this as a regulatory check-box exercise or is it clearly embedded as a useful risk management tool?  Is there any independent validation of the process and results?  How do policy limits compare to stress scenarios? Is there any linkage?  Do the results make sense relative to how the balance sheet is structured?

Investment Securities

So much risk. So little attention.

What Investment Portfolio Factors are Most Important?

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The Investment Portfolio

 Second Largest Earning Asset on the Balance Sheet  Sometimes the largest

 Other than derivatives, fastest and easiest method to alter the Balance Sheet Structure

 Despite its overall importance, the portfolio structure and risks are often overlooked

Investment Securities to Total Assets (4Q2018)

Complex

Moderate  Complexity

Non‐ Complex

$1B TA

$10B TA

Community  Banks

Mid‐Sized Banks

Large Financial  Institutions

What Drives Complexity in the Investment Portfolio?

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Risks in the Investment Portfolio

 Credit

 Market

 Focus on Interest Rate Risk

 Liquidity

Credit Risk

 Do they have the ability (and intent) to repay

 Overall, the credit risk in an investment portfolio is low

 Credit Risk is concentrated in Credit-Related securities  Municipal Securities  Corporate Securities  Structured Securities

 Banks should consider doing a media check on every credit they review  The rating agencies can be slow to react and even the markets may lag particularly for thinly-traded securities.

Credit Risk

 Municipal Securities  Where do broad predictions go wrong (see picture), why contagion doesn’t really exist and how many other Puerto Rico’s and Detroit’s are out there?  Fundamental Investment Guidance on credit evaluation is key just like with other credits.

 Corporate securities

 Simply large loan so analysis is the same as Loan Credit Underwriting.  Most banks stay within the financial sector for investments.  Does the bank have adequate credit administration for the loan portfolio?  Worldcom

Credit Risk

 US Agency Debt

 GNMA, FNMA, FHLMC

 Explicit Guarantee versus Implicit Guarantee  Explicit – GNMA (a unit of HUD),  Implicit – FNMA/FHLMC (via FHFA), FHLB, Tennessee Valley Authority

Credit Risk

 A bank’s due diligence process is a key safeguard to mitigating credit risk.

 Banks should be able to demonstrate a professional level of credit analysis for all credit-related (i.e. non-US Treasury or explicitly supported) securities.

 Per the Uniform Agreement on the Classification and Appraisal of Securities Held by Depository Institutions:  “The depth of analysis should be a function of the security’s risk characteristics, including its size, nature, and complexity. Individual security analysis should form the basis of any classification determination.”

Credit Risk

• Most banks set the minimum bar at the OCC grid:

Credit Risk-Example of Due Diligence

 How does the grid apply and what should examiners see for the following issuers:  Consider credit review “tear sheets” for:  A large community bank – small regional bank ($5 – 15 billion)  High Profile/Actively Traded Name General Obligation Bonds (preferably mid-level IG – AA-A)  Low-rated, relatively unknown, thinly traded municipal revenue bond  Private-label MBS  How well do the analyses present the credit profile of the various securities?  Are there any specific strengths or weakness of this approach?  Is this sufficient support for due diligence?  If not, what should be added?

Credit Risk-Example of Due Diligence

 Please refer to slides in Appendix A for credit analyses.

 Points for consideration:  Does the document adequately describe the borrower?

 Can you understand the terms and structure of the investment?  Is the operating environment of the borrower clearly presented?  Is there sufficient information to assess the borrower’s financial wherewithal?  Does it at a minimum address the OCC grid?

 Go to www.menti.com to rank how well the tear sheets reflect due diligence concerns.

Market Risk

Market risk , sometimes referred to as systematic risk , involves factors that affect the overall economy or financial markets. It is the risk that an overall market will decline, bringing down the value of an individual investment in an entity regardless of that entity's growth, revenues, earnings, management, and capital structure.

Market Risk

There are four types of market risk – rates, equity, foreign exchange and commodities  Rate  Equity  Foreign Exchange  Commodities

Typically manifested in the investment portfolio through rate (i.e.price) risk

Market Risk

 Inverse Relationship Between Market Interest Rates and Bond Prices

 Does Management (and the Examiner) understand the extent of price risk in the portfolio?  The portfolio must also be examined on an overall basis

The Yield Curve

• The major factor to watch for its impact on the portfolio

• Management and Board focus on the curve

• Remember the cost of liquidity graph – Is the bank maintaining liquidity or reaching for yield/earnings in their portfolio?

• Is the investment portfolio used to offset positions/risks in the loan side of the balance sheet in order to get some balance along the curve?

Market Risk

 Chasing yield by going out on the yield curve increases the market risk to the individual investment and overall portfolio

 Proper risk management of the portfolio involves understanding this relationship, understanding the current position of the portfolio, understanding the earnings needs of the bank, and balancing the risk with the overall structure of the portfolio

Interest Rate Risk in the Investment Portfolio

 2 Key Factors:  Fixed vs variable rate investments  Callability and rollover.

 How well does the bank assess this at both purchase and on an ongoing basis?

Liquidity Risk

 Two types of Liquidity Risk

 Liquidity in the market

 Risk to the Bank’s liquidity position

Liquidity from the Investment Portfolio

 Source of Cash Flow

 Pledgeability

 Convertible to Cash

Can Also Be the Source of Risks to Liquidity from the Investment Portfolio

 Source of Cash Flow

 Pledgeability

 Convertible to Cash

Policies and Risk Management

 Board Approved Investment Policy

 Clear Strategy for the Portfolio

 Identified Investment Officer  Has trading authority been properly delegated?

Policies and Risk Management

 Regular Reporting to the Board

 Independent Review/Audit

 Separate investment operations?

Policies and Risk Management

• Sets the stage for bank oversight of key investment risks. – Remember setting the tone from the top.

• How do policies provide a framework to oversee and control these risks within the bank’s appetite?

• Is there a good feedback loop from treasury to the Board and senior management to ensure compliance?

Investment Security Classes

 US Government Securities

 US Government Agency Debt

 Mortgage Debt

 Municipals

 Corporate Debt

US Government Securities

 Bonds, Notes, Bills issued by the US Treasury

 Full Faith and Credit of the US Treasury

 Credit Risk

 Market Risk

 Liquidity Risk

US Government Agency Securities

 Debt issued by Agencies of the US Government  Either Explicit or Implicit Guarantee by the US Treasury

Bullets • Stated Maturity • Fixed or Floating Rate Credit Risk Market Risk Liquidity Risk

Callables • Callable at Issuer’s Option • Fixed or Floating Rate Credit Risk Market Risk Liquidity Risk

Structured Notes • Typically Step‐Up Bonds • Usually Callable Credit Risk Market Risk Liquidity Risk

Agency Debt Spread to Treasury

US Government and Government Agency – Greatest Risk

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Agency Mortgage-Backed Securities (MBS) Pools

 GNMA, FNMA, FHLMC

 Individual mortgage loans grouped by underwriting characteristics

 Sold on a pro-rata share basis

 Ownership percentage determines amount of the interest and principal you receive monthly

Agency Mortgage Spread to Treasury

Agency MBS Pools

 Credit Risk

 Market Risk

 Liquidity Risk

Agency MBS– Greatest Risk

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Agency Mortgage Derivative Products

 Pools take principal and interest and pass it along to investors based on their ownership

 Mortgage Derivative Products create a structure that distributes the principal and interest payments based on the characteristics of each tranche in the structure

Agency Mortgage Derivative Products

 Understanding the overall structure and the characteristics of your tranche are vital to understanding your investment and how/when/if you will get paid

 While these products are not considered credit-related, diligence is required to understand the IRR and liquidity risks from potentially volatile payment streams  Does the bank have the capability to manage this complexity?

Agency Mortgage Derivative Products

 Collateralized Mortgage Obligation (CMO)

 Collateralized Debt Obligation (CDO)

 Real Estate Mortgage Investment Conduit (REMIC)

Agency Mortgage Derivative Products

 Credit Risk

 Market Risk

 Liquidity Risk

Agency Mortgage Derivatives– Greatest Risk

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AGENCY VS PRIVATE MORTGAGE STRUCTURES The Big Short . Dir. Adam McKay. Perf. Ryan Gosling, Christian Bale, and Steve Carell. Paramount Pictures, 2015.

Private Label Mortgage Products

 Issued by private companies, usually banks, mortgage companies, brokerage companies, and even homebuilders

 Same types of products that the Agencies issue  Pass-Thru Pools, CMO, CDO, REMIC

 However, the issuer does not assume the credit risk

PLMBS Historical Spreads to Treasury

Aug 17, 2017

Private Label Mortgage Products

 Credit Risk

 Market Risk

 Liquidity Risk

PLMBS – Greatest Risk

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Municipal Securities

 Muni Securities – The bread and butter of the community bank investment portfolio

 Tax Benefits

 Attractive Yields

 Community Investment  Many banks have good local/regional knowledge of issuers

 Call Protection

Municipal Securities

 General Obligation Bonds (GO)  Generally stronger than most revenue bonds but not perfect

 Revenue Bonds (REV)  Quality can range widely from essential services such as water & sewer to risky continuing care retirement communities and apartment complexes with very narrow revenue bases

Municipal Securities

 Common Terms Associated with Municipal Securities

 Pre-Refunded

 Sinking Fund

 Credit Ratings, or the lack thereof

Municipal Security Spread to Treasury

Municipal Securities

General Obligation bonds

Revenue Bonds

 Credit Risk

 Credit Risk

 Market Risk

 Market Risk

 Liquidity Risk

 Liquidity Risk

Municipal Securities – Greatest Risk

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Corporate Bonds

 Issued by private corporations

 Long term financing option instead of a loan

 Terms, covenants, and structures vary

 Investment sector matters – most banks tend to stay with other financials  Is it a sign of possible M&A activity?

Corporate Bonds Spread to Treasury

Corporate Bonds

 Credit Risk

 Market Risk

 Liquidity Risk

Corporates – Greatest Risk

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Spreads to Treasury - Current

Spreads to Treasury - Current

INVESTMENTS EXERCISE

Interest Rate Risk

SMR: The S-end of the camel.

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

MODEL INPUTS

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

Model Input Approaches

 Call Report  Easy Approach, usually found on “economical” models  Highly Aggregated  Chart of Account  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)  Hybrid  Call Report based inputs with additional information from subsidiary reports

Evaluating the Model Inputs

 Determine the approach used  Is this appropriate given the risk profile you’ve assessed from the balance sheet structure and any significant risk drivers such as deposits and funding, loan repayment, or unfunded commitments?

 How is the General Ledger and other information loaded?  Integrated into the core processing system?  Updated to a secure portal?

 Data Quality Assurance?  Management controls, Internal Audit, and Independent Review

Static versus 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?

SCENARIOS

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 Movement Expectations

Shock Scenarios

 Most Impactful, Least Likely

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

 Reveals Exposures in the greatest stress situations

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

Non-Parallel Scenarios

• Most likely scenario

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

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)

ASSUMPTIONS What happens when you assume?

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

Prepayment Assumptions

 Prepayment of loans and mortgage securities based on interest rate expectations

 As rates mover higher, prepayments slow

 SMM, CPR and PSA

 Peer assumptions versus bank specific assumptions

 Implications of Prepayment Assumptions?