Capital Markets School

Capital Markets School

August 5-9, 2024 Albuquerque, NM

@ www.csbs.org ♦ @csbsnews

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

August 5-9, 2024 Capital Markets School Albuquerque, NM

ATTENDEES Georgia Department of Banking and Finance Davis, Matt

mdavis@dbf.state.ga.us bhouston@dbf.state.ga.us

Houston, Billy

Idaho Department of Finance Carpenter, Scot

scot.carpenter@finance.idaho.gov

Nebraska Department of Banking and Finance Mestl, Tyler

tyler.mestl@nebraska.gov

New York State Department of Financial Services Huffman, Abigail

abigail.huffman@dfs.ny.gov dawn.murray@dfs.ny.gov andrew.oh@dfs.ny.gov lance.ware@dfs.ny.gov

Murray, Dawn Oh, Andrew Ware, Lance

Ohio Division of Financial Institutions Clark, Debra

debra.clark@com.ohio.gov marie.currier@com.ohio.gov

Currier, Marie

Oklahoma State Banking Department McDaniel, Kendall INSTRUCTORS Alabama State Banking Department Coker, Brad

kendall.mcdaniel@banking.ok.gov

brad.coker@banking.alabama.gov jeremy.lindsey@banking.alabama.gov

Lindsey, Jeremy

North Carolina Office of the Commissioner of Banks Parker, Joshua

jparker@nccob.gov

CSBS STAFF Hoyle, Katie

khoyle@csbs.org

Richardson, Amy Romano, Chris

arichardson@csbs.org cromano@csbs.org

Capital Markets School Albuquerque, New Mexico August 5 - 9, 2024

DoubleTree by Hilton Albuquerque Downtown Meeting Room: Crystal II

Monday, August 5, 2024 7:30 am – 8:30 am

Registration & Breakfast Lounge 201 (Main Lobby) Welcome & Introductions Instructors

8:30 am – 10:15 am

10:15 am – 10:30 am 10:30 am – 11:30 am

Break

CSBS Data Analytics Josh Parker, Brennan Zubrick, Carlos Cordova

11:30 am – 1:00 pm 1:00 pm – 2:00 pm

Lunch on your own

Size and Complexity Defined Josh Parker Case Study Access to Tools Amy Richardson, Katie Hoyle

2:00 pm – 2:30 pm

2:30 pm – 2:45 pm 2:45 pm – 4:30 pm

Break

Yield Curves, Economic Data, and Forecasting Brad Coker

Adjourn

4:30 pm

Networking Reception Coral III Ballroom

5:30 pm – 7:30 pm

Tuesday, August 6, 2024 7:30 am – 8:30 am

Breakfast Lounge 201 (Main Lobby) Case Study Introduction Brad Coker

8:30 am – 9:00 am

Liquidity Josh Parker

9:00 am – 10:00 am

10:00 am – 10:15 am 10:15 am – 11:30 am

Break

Liquidity Josh Parker

11:30 am – 1:00 pm 1:00 pm – 2:30 pm

Lunch on your own

Sensitivity to Market Risk Brad Coker

2:30 pm – 2:45 pm

Break

Sensitivity to Market Risk Brad Coker Questions and Review Instructors

2:45 pm – 3:45 pm

3:45 pm – 4:30 pm

Adjourn

4:30 pm

Wednesday, August 7, 2024 7:30 am - 8:30 am

Breakfast Lounge 201 (Main Lobby) Balance Sheet Structure Brad Coker

8:30 am – 10:00 am

10:00 am – 10:15 am 10:15 am – 11:30 am

Break

Balance Sheet Structure Brad Coker

11:30 am – 1:00 pm 1:00 pm – 2:30 pm

Lunch on your own

Derivatives Brad Coker

2:30 pm – 2:45 pm 2:45 pm – 4:00 pm

Break

Independent Review and Lines of Defense Instructors

Model Risk Management Josh Parker

4:00 pm – 4:30 pm

Adjourn

4:30 pm

Thursday, August 8, 2024 7:30 am – 8:30 am

Breakfast Lounge 201 (Main Lobby) Model Risk Management Josh Parker

8:30 am – 9:00 am

Case Study

9:00 am – 11:30 am 11:30 am – 1:00 pm 1:00 pm – 4:00 pm 4:00 pm – 4:30 pm

Lunch on your own

Case Study

Submit Case Study Presentation

Adjourn

4:30 pm

Friday, August 9, 2024 7:30 am – 8:30 am

Breakfast Lounge 201 (Main Lobby)

Case Study Presentations

8:30 am – 10:00 am 10:00 am – 10:15 am 10:15 am – 12:00 pm

Break

Current Events and Emerging Issues Instructors

Adjourn

12:00 pm

Internal Use Only

Capital Markets School Introduction

Internal Use Only

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

Internal Use Only

Bank Examinations Coordinator Alabama State Banking Department Jeremy Lindsey

Internal Use Only

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

Internal Use Only

Introductions

NAME

STATE

FUN FACT ABOUT YOURSELF

EXPERIENCE

WHAT DO YOU HOPE TO LEARN DURING THIS CLASS?

Internal Use Only

What is a “Capital Markets”?

Internal Use Only

What is a “Capital Markets”?

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

Internal Use Only

Defining Capital Markets

Internal Use Only

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”.

Internal Use Only

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.

Internal Use Only

Course Objectives: • Go beyond

traditional guidance presentations

Internal Use Only

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

Internal Use Only

Course Objectives: • Broad insights into safety & soundness

Internal Use Only

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

Internal Use Only

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

Internal Use Only

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

Internal Use Only

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

Internal Use Only

Internal Use Only

Capital Markets School Data Analytics

Internal Use Only

CSBS Data Analytics Tools

Internal Use Only

Single Sign-On

sso.csbs.org

Internal Use Only

Single Sign-On

Internal Use Only

Single Sign-On

Internal Use Only

Single Sign-On

Internal Use Only

Analytics

Internal Use Only

Internal Use Only

Internal Use Only

Internal Use Only

Internal Use Only

Internal Use Only

Internal Use Only

Internal Use Only

Self-Service Analytics

Internal Use Only

Risk Scoping Workbook

Internal Use Only

Questions

Internal Use Only

Capital Markets School Size & Complexity

Internal Use Only

Bank Size & Complexity

Internal Use Only

Bank Size & Complexity

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

Leverage Ratio (CBLR)

Internal Use Only

Bank Size & Complexity

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

Internal Use Only

Internal Use Only

Size

• 4 size classes • Tailoring rules further define

Internal Use Only

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

Internal Use Only

BY THE NUMBERS: NATIONAL BANKING INDUSTRY

Total Assets by Asset Category ($)

8

Confidential (For State Bank Supervisors Only) / Not For Redistribution / Pre-Decisional – Data as of June 30, 2022

Internal Use Only

BY THE NUMBERS: NATIONAL BANKING INDUSTRY

Total Assets by Charter Type ($)

Total Assets

Number of Banks

9

Confidential (For State Bank Supervisors Only) / Not For Redistribution / Pre-Decisional – Data as of June 30, 2022

Internal Use Only

BY THE NUMBERS: NATIONAL BANKING INDUSTRY

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

10

Internal Use Only

Size - What Do Our Class Participants Cover?

Source: CSBS State Interactive Dashboard, 2Q22

Internal Use Only

Size - What Do Our Class Participants Cover?

Source: CSBS State Interactive Dashboard, 2Q22

Internal Use Only

Community Banks

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

Internal Use Only

Mid-Sized Banks

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

• Governance structures • Need for consultants

Internal Use Only

Mid-Sized Banks

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

Internal Use Only

Large Banks

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

Internal Use Only

Large Banks

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

Internal Use Only

Large Banks

• Regulatory requirements drive classifications • More flexibility

Internal Use Only

Large Banks

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

Internal Use Only

Large Banks

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

Internal Use Only

Community Bank Leverage Ratio (CBLR)

Internal Use Only

Community Bank Leverage Ratio (CBLR)

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

Internal Use Only

Community Bank Leverage Ratio (CBLR)

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

Internal Use Only

The Tailoring Rule & Stress Tests

Internal Use Only

The Tailoring Rule

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

Internal Use Only

The Tailoring Rule - Simplified

Category

Size Levels

Capital Requirements 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.

LCR Requirements Same as Category II

I

U.S. GSIBs

II

=>$700 billion in total asset

100% LCR with 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)

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

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.

Internal Use Only

Large Bank Categories

Internal Use Only

Large Bank Categories

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

Internal Use Only

Large Bank Categories

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

Internal Use Only

Large Bank Categories

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

Internal Use Only

Large Bank Categories

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

• EGRRCPA shift • “Too big to fail”

Internal Use Only

Large Banks - Liquidity Categories

Liquidity Coverage Ratio (LCR)

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

Internal Use Only

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

Internal Use Only

Large Banks - Liquidity Categories

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

Internal Use Only

Complexity

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

• Optionality? • Derivatives?

Internal Use Only

Complexity

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

• Risk identification • Risk management • Governance

Internal Use Only

Bank Size & Risk

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

Internal Use Only

Internal Use Only

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

Internal Use Only

Yield Curves

Interest Rates

Term Structure

Yield Curve

Internal Use Only

US Treasury Yields

US Treasury Yields (9/1/2022)

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

*GuruFocus.com 9/1/22

Internal Use Only

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

Internal Use Only

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

Internal Use Only

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

Internal Use Only

Menti

Internal Use Only

Federal Funds Target Rate (Upper Limit)

Internal Use Only

Federal Reserve Balance Sheet

Internal Use Only

Federal Reserve Balance Sheet Asset Composition

Internal Use Only

QE1, QE2, Operation Twist, and QE3

Internal Use Only

Federal Reserve Balance Sheet (Tapering)

Internal Use Only

Impact of the Yield Curve on Decision Making

Internal Use Only

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

Federal Funds

FNMA Bullet

Muni REV Bond

Internal Use Only

FNMA Bullet

Internal Use Only

Municipal Revenue Bond

Internal Use Only

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

Federal Funds

FNMA Bullet

Muni REV Bond

Internal Use Only

Cumulative Interest Income on $10,000,000 Investment

$933,333

$68,667 $204,167

Internal Use Only

Duration

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

Internal Use Only

FNMA Bullet

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

Internal Use Only

MUNI Rev Bond

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

Internal Use Only

Cumulative Interest Income on $10,000,000 Investment

$933,333

$68,667 $204,167

Internal Use Only

Expected Value of $10,000,000 Investment

$10,000,000

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

Internal Use Only

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?

Internal Use Only

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

25

Internal Use Only

Economic Data and Forecasting

Internal Use Only

Economic Data

Internal Use Only

Federal Reserve Economic Data

https://fred.stlouisfed.org/

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

Internal Use Only

Federal Reserve Economic Data

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

Internal Use Only

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

Internal Use Only

Private Sources of Economic Data

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

Internal Use Only

Forecasting: Applying Economic Data to Decisions

Internal Use Only

Data Sources for Scenario Generation

Internal Use Only

Data Sources for Scenario Generation

Internal Use Only

Applying Economic Data

Internal Use Only

Capital Markets School Liquidity & Funds Management

Internal Use Only

Liquidity Measurement & Management Process

Internal Use Only

Liquidity Measurement & Assessment

Internal Use Only

Complex

Moderate Complexity

Non Complex

Community Banks

$10B TA

Large Financial Institutions

Mid-Sized Banks

$1B TA

Internal Use Only

Liquidity

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

Internal Use Only

Liquidity

Found on both sides of the Balance Sheet

Internal Use Only

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

Internal Use Only

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

Internal Use Only

Liquidity versus Funding

Liquidity is the end result of Funding activities

Internal Use Only

On Balance Sheet Liquidity Measurement

Internal Use Only

What is On Balance Sheet Liquidity?

Internal Use Only

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

Internal Use Only

Question

Are all “Highly Liquid Assets” always included in On Balance Sheet Liquidity?

Internal Use Only

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

Internal Use Only

OBS Example At your table, calculate on-balance sheet liquidity for Cloyd Bank & Trust as of December 31, 2021. • Calculate the total dollar amount, • As a percent of assets, • As a percent of total deposits. • Compare numbers to 4.6 Cloyd Bank and Trust On Balance Sheet Liquidity.

Internal Use Only

Cash Flow Analysis

Internal Use Only

Cash Flow Analysis

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

Internal Use Only

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

Internal Use Only

Cash Flow Analysis

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

Internal Use Only

Cash Flow Analysis

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

Internal Use Only

Cash Flow Example At your table review item 4.1 Cloyd Bank and Trust Basic Short Term Liquidity. • Assess the process and assumptions. • Is there any additional information you would like to see included? • Is this adequate for the size and complexity of the bank? • Would it be appropriate if the bank was much larger? • Or much smaller?

Internal Use Only

Developing Stress Scenarios

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

Internal Use Only

Liquidity Measurement & Management Process

Internal Use Only

Liquidity Events

Probability

Low Probability, High Impact Events

High Probability, Low Impact Events

Liquidity Impact

Internal Use Only

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

Internal Use Only

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)

Internal Use Only

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

Internal Use Only

Complex

Moderate Complexity

Non Complex

Community Banks

$10B TA

Large Financial Institutions

Mid-Sized Banks

$1B TA

Internal Use Only

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

Internal Use Only

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

Internal Use Only

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?

Internal Use Only

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?

Internal Use Only

Stress Scenario Development - Assumptions

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

Internal Use Only

Stress Scenario Development - Assumptions

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

Internal Use Only

Liquidity Stress Testing (LST)

Quantitative Analysis of the Stress Scenarios

Internal Use Only

Liquidity Stress Testing

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

Internal Use Only

Liquidity Stress Testing - Scenarios

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

Internal Use Only

LST Expectations Given Size & Complexity

Complex

Moderate Complexity

Non Complex

Internal Use Only

The Contingency Funding Plan (CFP)

The managerial response to the Stress Scenarios & LST results

Internal Use Only

The Contingency Funding Plan • Qualitative analysis of stress scenarios

• Policies & procedures • Provides documented

framework for managing unexpected liquidity situations

Internal Use Only

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

Internal Use Only

The Contingency Funding Plan

• Liquidity event

management process • Management reporting • Monitoring framework

Internal Use Only

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

Internal Use Only

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

Internal Use Only

Liquidity Stress Testing - Assumptions

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

Internal Use Only

LST - Assumptions & Scenarios

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

Internal Use Only

LST - Assumptions & Scenarios

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

Internal Use Only

LST - Assumptions & Scenarios

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

Internal Use Only

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?

Internal Use Only

Liquidity Stress Testing - Output

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

Internal Use Only

LST and CFP Example Review Cloyd Bank & Trust’s Liquidity Stress Test and Contingency Funding Plan. • Are the scenarios appropriate? • Are the assumptions supported? • Is the CFP appropriate relative to the Stress test?

Internal Use Only

Questions

Internal Use Only

Capital Markets School Sensitivity to Market Risk

Internal Use Only

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

Internal Use Only

Types of Interest Rate Risk

• Repricing Risk

• Basis Risk

• Yield Curve Risk

• Option Risk

• Price Risk

Internal Use Only

Sources of Interest Rate Risk

• Funding Sources

• Product Pricing Strategies

• Mortgage Banking Operations

• Fee Income Business Lines

• Embedded Options

Internal Use Only

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

Internal Use Only

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

Internal Use Only

Model Inputs

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

Internal Use Only

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

Internal Use Only

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

Internal Use Only

Evaluating the Model Inputs

Determine the approach used.

How is the General Ledger and other information loaded?

Data Quality Assurance?

Internal Use Only

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?

Internal Use Only

Scenarios

Internal Use Only

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

13

Internal Use Only

Shock Scenarios

• Most Impactful, Least Likely

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

• Reveals Exposures in the greatest stress situations

14

Internal Use Only

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

15

Internal Use Only

Non-Parallel Scenarios

• Most likely scenario

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

16

Internal Use Only

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)

Internal Use Only

Assumptions

What happens when you assume?

Internal Use Only

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

Internal Use Only

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

20

Internal Use Only

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

22

Internal Use Only

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.

23

Internal Use Only

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

Internal Use Only

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

25

Internal Use Only

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

Internal Use Only

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

Internal Use Only

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

Internal Use Only

Deposit Decay

Federal Deposit Insurance Corporation

Internal Use Only

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?

31

Internal Use Only

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

Internal Use Only

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.

Internal Use Only

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…

Internal Use Only

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

Internal Use Only

IRR Measurement Models and Model Risk

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.

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.

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?

Internal Use Only

Model Outputs

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

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.

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?

Internal Use Only

Non-Linear Simulation Results

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.

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?

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.

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?

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).

Internal Use Only

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.

Internal Use Only

Non-Maturity Deposit (NMD) Behavior

Internal Use Only

Non-Maturity Deposit (NMD) Behavior

Internal Use Only

Non-Maturity Deposit (NMD) Behavior

Internal Use Only

Non-Maturity Deposit (NMD) Behavior

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)?

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 .

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.

Internal Use Only

RATING SENSITIVITY TO MARKET RISK

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

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.

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.

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.

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.

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.

Internal Use Only

Capital Markets School Balance Sheet Components & Structure

Internal Use Only

The Balance Sheet

Liabilities

Assets

Capital

Internal Use Only

The Balance Sheet Assets • Cash • Investment Securities • Loans

Liabilities

• Deposits • Borrowings

• Fixed Assets • Other Assets

Capital

• Common Stock • Retained Earnings • AOCI

Internal Use Only

Balance Sheet Structure and the Yield Curve

A bank’s balance sheet structure and strategic direction is influenced by:

• Level of interest rates (Yield Curves) • Economic Data and Expectations • Competitive landscape • Profitability • Risk Tolerance

4

Internal Use Only

Balance Sheet Structure and the Yield Curve

Each component on the balance sheet has specific traits and concerns related to liquidity, interest rate risk, and earnings and capital.

5

Internal Use Only

Assets

This Photo by Unknown Author is licensed under CC BY-SA

Internal Use Only

The Balance Sheet Assets • Cash • Investment Securities • Loans

Liabilities

• Deposits • Borrowings

• Fixed Assets • Other Assets

Capital

• Common Stock • Retained Earnings • AOCI

Internal Use Only

Cash and Due Froms

Internal Use Only

Assets: Cash

Includes: • Cash (coin and currency, vault cash, etc.)

• Due From Accounts

• Interest Bearing Bank Balances

Internal Use Only

Investment Securities

Internal Use Only

Assets: Investment Securities

• 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

Internal Use Only

Internal Use Only

Risks in the Investment Portfolio Credit

Market

Focus on Interest Rate Risk

Liquidity

Internal Use Only

Credit Risk

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

Overall, the credit risk in an investment portfolio is low

• Municipal Securities • Corporate Securities • Private Label Mortgage Securities Credit Risk is concentrated in Credit-Related securities

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