Capital Markets School - October 2023
Capital Markets School
October 16-20, 2023 Minneapolis, MN
@ www.csbs.org ♦ @csbsnews
CONFERENCE OF STATE BANK SUPERVISORS 1300 I Street NW / Suite 700 / Washington, DC 20005 / (202) 296-2840
Capital Markets School Minneapolis, MN October 16-20, 2023
Embassy Suites by Hilton - Minneapolis Downtown Meeting Room: Plymouth Ballroom B
Monday, October 16, 2023 7:30 am – 8:30 am
Registration Outside Plymouth Ballroom Welcome & Introductions
8:30 am – 10:00 am 10:00 am – 10:15 am 10:15 am – 11:30 am 11:30 am – 1:00 pm 1:00 pm – 2:30 pm 2:30 pm – 2:45 pm 2:45 pm – 4:30 pm
Break
Size and Complexity Defined
Lunch on your own
Yield Curves, Economic Data, and Forecasting
Break
Liquidity Adjourn
4:30 pm
Networking Reception Outside Plymouth Ballroom
5:30 pm – 7:30 pm
Tuesday, October 17, 2023 8:30 am – 10:00 am
Sensitivity to Market Risk
10:00 am – 10:15 am 10:15 am – 11:30 am 11:30 am – 1:00 pm 1:00 pm – 2:00 pm 2:00 pm – 2:15 pm 2:15 pm – 3:15 pm 3:15 pm – 3:30 pm 3:30 pm – 4:30 pm
Break
Independent Review and Lines of Defense
Lunch on your own CSBS Data Analytics
Break
Model Risk Management
Break
Questions and Review
4:30 pm
Adjourn
Wednesday, October 18, 2023 8:30 am – 10:00 am
Balance Sheet Structure
10:00 am – 10:15 am 10:15 am – 11:30 am 11:30 am – 1:00 pm
Break
Balance Sheet Structure
Lunch on your own
Derivatives
1:00 pm – 2:30 pm 2:30 pm – 2:45 pm 2:45 pm – 3:45 pm 3:45 pm – 4:30 pm
Break CECL CBLR
4:30 pm
Adjourn
Thursday, October 19, 2023 8:30 am – 9:00 am
Case Study Introduction
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 Decision
4:30 pm
Adjourn
Friday, October 20, 2023 8:30 am – 10:00 am 10:00 am – 10:15 am 10:15 am – 12:00 pm
Case Study Presentations
Break
Current Events and Emerging Issues
12:00 pm
Adjourn
Internal Use Only
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 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: < $1 Billion
Mid ‐ Sized Banks
Community Banks
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BY THE NUMBERS: NATIONAL BANKING INDUSTRY
Total Assets by Asset Category ($)
Confidential (For State Bank Supervisors Only) / Not For Redistribution / Pre ‐ Decisional – Data as of June 30, 2023
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BY THE NUMBERS: NATIONAL BANKING INDUSTRY
Total Assets by Charter Type ($)
Confidential (For State Bank Supervisors Only) / Not For Redistribution / Pre ‐ Decisional – Data as of June 30, 2023
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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, 2023.
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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-$100 billion • Until tailoring, this group was very challenged at meeting size & complexity regulatory issues • DFAST starts at $250 billion
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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 • 33 banks over $100 billion in 2022
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The Tailoring Rule - Simplified
Category
Size Levels U.S. GSIBs
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
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.
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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 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
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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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IRR Measurement Models and Model Risk
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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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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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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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Model Outputs
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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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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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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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Non-Linear Simulation Results
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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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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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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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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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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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Non-Maturity Deposit (NMD) Behavior
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Non-Maturity Deposit (NMD) Behavior
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Non-Maturity Deposit (NMD) Behavior
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Non-Maturity Deposit (NMD) Behavior
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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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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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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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Rating Sensitivity to Market risk
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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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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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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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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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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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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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Capital Markets School The Lines of Defense & Independent Review
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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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The Lines of Defense
Another View:
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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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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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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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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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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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