LOAN PORTFOLIO MANAGEMENT - YEAR 2 · 3. Maintaining a strategy to ensure capital adequacy and contingency planning Should have contingency plans for capital preservation, i.e. raise

LOAN PORTFOLIO MANAGEMENT - YEAR 2

“Stress Testing for the DIYers”

Kelly J. Gaeth Vice President, Credit Administration

First National of Nebraska, Inc. Credit Risk Administration

Omaha, NE [email protected]

402-602-5229

August 1, 2018

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Stress TestingFor the DIYers

Kelly GaethVice President of Portfolio Risk Management

First National Nebraska, Inc.

GRADUATE SCHOOL OF BANKING MADISON - KELLY GAETH COPY RIGHT

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GSB Demographics


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How We Got Here

“Summary Analysis of Failed Banks Review” Office of the Inspector General – 9-30-2011

Background:

• 35 failed SMB (state member bank) reviewed Represent 4.2% of 824 SMB supervised by Federal Reserve Board

Total loss to DIF (deposit insurance fund) was $4.8B Average loss size per bank to DIF was 21% of total assets

Size of banks analyzed (31 of the 35) 11 = $100M-$300M in assets 16 = $300M - $1B in assets 4 = $1B - $3B in assets


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How We Got Here

Findings:

In addition to economic decline that triggered asset quality deterioration:1. Aggressive growth objectives that led to poor decisions2. Loan growth exceeding risk management's capabilities and/or internal controls3. Concentrations in CRE, construction, land, or LD, which increase vulnerabilities to

changes in marketplace4. Management failure to raise sufficient capital to cover losses5. Reliance on specific/non-core funding 6. Incentives encourage inappropriate risk taking

FYI, regulators got beat up a little too! (quicker action, one size fits all approach to portfolios risk, limitation of PCA’s, etc.)


Community Bank Stress Testing?

GRADUATE SCHOOL OF BANKING MADISON - KELLY GAETH COPY RIGHT 5

A. Overview of Section 165(i) of the Dodd-Frank Act

The Dodd-Frank Act was enacted on July 21, 2010.1 Section 165(i)(2) of the Dodd-Frank Act (‘‘section 165(i)(2)’’) requires the Corporation, as a Federal primary financial regulatory agency, to issue regulations that require FDIC insured state nonmember banks and FDIC-insured state-chartered savings associations with total consolidated assets of more than $10 billion to conduct annual stress tests… establish methodologies for the conduct of the stress tests that provide for at least three different sets of conditions, including baseline, adverse, and severely adverse conditions…

FEDERAL DEPOSIT INSURANCE CORPORATION12 CFR Part 325 RIN 3064–AD91 Annual Stress Test

Original Law passed in 2010


Congress Enacts Bipartisan, ABA-Advocated Regulatory Reform Bill

May 22, 2018

In a landmark moment for post-crisis banking policy, the House by a bipartisan 258 to 159 vote today passed S. 2155, the Senate’s regulatory reform bill. The bill’s passage marks an important step toward bringing much-needed regulatory relief to help banks better serve their customers and communities, and President Trump is expected to sign it into law in the coming days.

Bill Highlights and Testimonials

“Ends company-run stress tests for banks with under $250 billion in assets and allow federal regulators to design tailored supervisory stress tests for banks between $100 billion and $250 billion.”


Update


Agencies (Federal Reserve, FDIC, OCC) 5-14-12 statement to clarify stress testing for community banks

“Community banks are not required or expected to conduct the types of stress testing specifically articulated in the initiatives noted above, which are directed at larger organizations. In particular, community banks are not required or expected to conduct the enterprise-wide stress tests required of larger organizations under the capital plan rule, the proposed rules implementing Dodd-Frank Act stress testing requirements, or as described in the stress testing guidance for organizations with more than $10 billion in total consolidated assets.

The agencies continue to emphasize that all banking organizations, regardless of size, should have the capacity to analyze the potential impact of adverse outcomes on their financial condition. Certain portions of existing interagency guidance applicable to all banking organizations discuss addressing potential adverse outcomes as part of sound risk management practices. The agencies note that such existing guidance, including that covering interest rate risk management, commercial real estate concentrations, and funding and liquidity management (among others), continues to apply.”


Community Bank Stress Testing?OCC Bulletin 2012-33 – October 18, 2012

• Community Banks regardless of size, should analyze the potential impact of adverse outcomes on to their bank

• Encourages community banks to adopt stress test methods that fit their business size and risk

• Community banks not required to use such holistic stress testing as banks that are $10B and above (comments made when law still required for banks $10B and above to complete DFAST stress testing)


Community Bank Stress Testing?OCC Bulletin 2012-33 – October 18, 2012

Common elements for community banks should consider:

1. Ask “what if” on key vulnerabilities2. Reasonable impact of stress event on earnings and capital3. Results incorporated into bank’s risk management, asset/liabilities

strategies and capital planning4. Loss stress rates used from historical loss experience during stress

periods.5. 2 year time frame (9 quarters)

Banks that exceed CRE concentration thresholds are expected to use more robust stress testing practices to manage concentrations and capital (OCC Bulletin 2006-46)


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Guidance for Evaluating Capital Planning and Adequacy OCC Bulletin 2012-16

OCC expects every bank regardless of size or charter type, to have an effective, internal process to 1) assess its capital adequacy to risk and 2) plan for maintaining appropriate capital levels.

Consider both short and long term capital needs (use a forecast horizon of two years)

1. Identify and evaluate Risk Risk include: Credit, operational, interest rate, liquidity, price and compliance. Banks may use a variety of methodologies to translate risk into capital: need to ask yourself

“what if”

2. Setting and assessing capital adequacy goals that relate to risk Based on material risk and strategic direction of bank Consider; operational risk, fiduciary, off balance sheet, 3rd party relationships, contingent

exposure, business cycles and economic environment. - Need to ask “what if” question.


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3. Maintaining a strategy to ensure capital adequacy and contingency planning Should have contingency plans for capital preservation, i.e. raise capital, asset sales, etc.

4. Ensure integrity in the capital planning assessment and process -accomplished through good governance and oversight by BOD

Supervisory Review: Examiners consider:1. Banks’ overall corporate governance of risk taking activities2. Quality of risk management, internal controls, model validation, audit process and

management’s expertise

Guidance for Evaluating Capital Planning and Adequacy OCC Bulletin 2012-16


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Stress Testing – Model ConsiderationsStress testing guidance: OCC Docket No. OCC-2012-0004 dated May 2012

The guidance does not give you specifics or details of how to build or execute a stress test model.

The guidance allows (and expects) you to develop a model that is tailored to the asset and loan product mix of your institution.

The guidance will give you what the regulators are expecting to see in a summary (i.e. 9 quarter forward looking on losses, capital, revenue, economic scenarios, etc.)


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Stress Testing – Model Considerations

3rd Party Vendor vs. In-house Development (challenges: MIS & regulatory scenario translation)

1. For Vendors, you will still do 80-90% of the work in collecting and organizing data to export in an specified extract

Top Down vs. Bottoms Up (transaction level)1. Top Down typically for consumer type portfolios (homogeneous) or looking at

the bank balance sheet holistically2. Bottoms-up for non-consumer portfolios (i.e. CRE, Ag, C&I)

Bottom-up model can overlaps several of the Stress Test Approaches (Scenario, Sensitivity Analysis, Enterprise Wide, Reverse Stress Testing)


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Top Down Model

Projection


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Top Down Model

Correlation Strength Positive NegativeStrong 0.70 -0.70Moderate 0.50 -0.50Weak 0.30 -0.30No relationship 0.00 0.00

Correlation Direction


Correlation and Forecast Functions in Excel

16GRADUATE SCHOOL OF BANKING MADISON - KELLY GAETH COPY RIGHT

Top Down Model: C&I Example

CorrelationC/O vs Domestic Sales -0.621

Future Projected Numbers

Numbers forecasted by the

“Forecast” Function in Excel


Individual Borrower Current Financial State

Bottoms Up ModelIndividual Borrower

Current Financial StateIndividual Borrower



Current Financial State

Individual Borrower Projected Financial State





Apply Stress Factors to Credits

New snap shot of stressed loan portfolio by credit

quality / risk rating

Aggregate

Apply projected / recession high historical loss rates

Projections: Losses, reserve requirements, capital, NPPR

non-accruals, etc.

Pass findings on to Capital Planning Committee

i.e. Interest Rates, Sales, Commodity Prices, etc.

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Bottoms Up Model: CRE Example

Stress FactorsAppraisal Value Change -20.0%NOI Value Change -10.0%

Borrower Loan $ Interest Rate Amort. Annual P&I NOI Property Value DSCR LTV DSCR LTVBorrower 1 500,000 6.50% 240 44,734 65,000 750,000 1.45 66.7% 1.31 83.3%Borrower 2 2,500,000 5.95% 240 214,065 281,000 2,980,000 1.31 83.9% 1.18 104.9%Borrower 3 375,000 6.25% 180 38,584 45,000 425,000 1.17 88.2% 1.05 110.3%Borrower 4 315,000 6.25% 180 32,411 40,513 400,000 1.25 78.8% 1.13 98.4%Borrower 5 1,250,000 6.00% 240 107,465 165,000 1,875,000 1.54 66.7% 1.38 83.3%Borrower 6 750,000 5.95% 225 66,467 77,525 1,000,000 1.17 75.0% 1.05 93.8%Borrower 7 365,000 7.00% 120 50,856 55,000 425,000 1.08 85.9% 0.97 107.4%Borrower 8 265,000 7.00% 120 36,922 38,500 335,000 1.04 79.1% 0.94 98.9%Borrower 9 1,375,000 5.75% 180 137,018 165,000 1,680,000 1.20 81.8% 1.08 102.3%Borrower 10 175,000 7.25% 240 16,598 18,650 225,000 1.12 77.8% 1.01 97.2%Totals 7,870,000 745,119 951,188 10,095,000 1.28 78.0% 1.15 97.4%

Actual

CRE Stress Scenario Summary

Stressed


Stress Adjusted$600,000$58,500

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Bottoms Up Model: CRE Example


Risk Rating DSCR minumum Loss RateStrong 1.40 0.00%Pass 1.20 0.05%

Watch 1.00 0.25%Classified below 1.0x 26.00%

Stress FactorsAppraisal Value Chang -20.0%NOI Value Change -10.0%

Original Stressed Original StressedBorrower Loan $ Int. Rate Amort. P&I NOI Property Value DSCR LTV DSCR LTV Risk Rating Risk Rating Est. Loss Est. LossBorrower 1 500,000 6.50% 240 44,734 65,000 750,000 1.45 66.7% 1.31 83.3% Strong Pass - 250 Borrower 2 2,500,000 5.95% 240 214,065 281,000 2,980,000 1.31 83.9% 1.18 104.9% Pass Watch 1,250 6,250 Borrower 3 375,000 6.25% 180 38,584 45,000 425,000 1.17 88.2% 1.05 110.3% Watch Watch 938 938 Borrower 4 315,000 6.25% 180 32,411 40,513 400,000 1.25 78.8% 1.13 98.4% Pass Watch 158 788 Borrower 5 1,250,000 6.00% 240 107,465 165,000 1,875,000 1.54 66.7% 1.38 83.3% Strong Pass - 625 Borrower 6 750,000 5.95% 225 66,467 77,525 1,000,000 1.17 75.0% 1.05 93.8% Watch Watch 1,875 1,875 Borrower 7 365,000 7.00% 120 50,856 55,000 425,000 1.08 85.9% 0.97 107.4% Watch Classified 913 94,900 Borrower 8 265,000 7.00% 120 36,922 38,500 335,000 1.04 79.1% 0.94 98.9% Watch Classified 663 68,900 Borrower 9 1,375,000 5.75% 180 137,018 165,000 1,680,000 1.20 81.8% 1.08 102.3% Pass Watch 688 3,438 Borrower 10 175,000 7.25% 240 16,598 18,650 225,000 1.12 77.8% 1.01 97.2% Watch Watch 438 438 Totals 7,870,000 745,119 951,188 10,095,000 1.28 78.0% 1.15 97.4% 6,920 178,400

Overall Loss Rate 0.09% 2.27%

Estimated increase in Net C/Os (Provision Expense) 171,480

Actual Stressed

CRE Stress Scenario Summary

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Pros and Cons of Model Types

Pros of Bottoms Up Model

1. Micro level results: breakout by market, lender, risk factor, etc.2. Able to show specific “at risk” credits – allows for mitigation

analysis/steps3. Lender level feed back4. Doesn’t use “average” industry data5. Scalable (used on $300M to $10B portfolios): Most times you will

only use a sample size to represent the entire portfolio.

6. Form of validation of current risk rating process7. Good for non-homogeneous loan pools


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Cons of Bottoms Up Model

1. More time consuming than Top Down2. Modeling is easy; data collection can be hard

Data collection can be 90% of work Have to integrate data into usable format (core data, financials,

LLR, non-accruals, appraisal data, etc.)3. Different model types depending on portfolio (i.e. Ag,

CRE, C&I)4. Harder to correlate annual financials to quarterly output

(9 Qtrs) for DFAST requirements


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Pros of Top Down Model

1. Generally less data collection; shorter time frame to run stress test

2. Can develop same stress correlation process through multiple portfolios

3. Easier to correlate and report on a 9 quarter basis (as required by DFAST)

4. Good for homogeneous loan pools


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Cons of Top Down Model

1. Requires enough data to establish an adequate sample size – which might force you to use industry data.

2. Industry data can skew your true bank results.3. Less granular, can’t use results to set up specific

remediation steps. 4. Can be run by stats/quant people rather than lenders

which can impede realistic assumptions and outcomes.


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Principals To Work By

Principal #1: Your stress test should capture your organization’s risk and exposure in activities that you perform at various levels, and all key considerations, both internally and externally, that drive those risks.

Example: Stressfactors for non-owner occupied CRE (Bottoms up model)


Aggregate CRE Model

Income Producing CRE

Collateral Dependent

CRE

Interest Rates

NOI

CPPI Collateral Value

Global Cash Flow

Interest Rates

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Principal #2: Document the assumptions used in the model and why you choose to use them. Note any “degree of uncertainty” that pertains to your model. Example of “degree of uncertainty” = Ag commodities and hedging/forward contracting.



Example: Correlation Matrix of stress factors used in our portfoliosPositive Correlation minimum goal 0.70Negative Correlation minimum goal -0.70

DomesticReal GDP growth

DomesticNominal GDP growth

DomesticReal disposable income growth

DomesticNominal disposable income growth

DomesticUnemployment rate

DomesticCPI inflation rate

Domestic3-month Treasury yield

Domestic10-year Treasury yield

DomesticBBB corporate yield

DomesticMortgage rate

DomesticDow Jones Total Stock Market Index

DomesticHouse Price Index

DCo Es In

Corn $/bu -0.27 -0.32 -0.24 -0.23 0.64 -0.02 -0.56 -0.82 -0.27 -0.74 0.37 -0.14Cattle Avg Price Recvd Per Hundred Weight 0.05 0.05 -0.06 -0.03 0.39 0.07 -0.24 -0.72 -0.62 -0.69 0.66 0.23Hogs $ 0.03 0.03 -0.14 -0.14 0.42 0.02 -0.26 -0.60 -0.52 -0.60 0.47 0.04Corn % change -0.11 0.01 -0.03 0.08 -0.10 0.29 0.09 -0.02 -0.10 0.05 0.37 0.09Cattel % Change 0.31 0.33 0.09 0.11 0.23 0.08 -0.28 -0.37 -0.58 -0.39 0.16 -0.12Hogs % change 0.03 0.05 -0.12 -0.18 0.18 -0.17 -0.23 -0.22 -0.27 -0.23 0.00 -0.02Real Retail and Food Services Sales 0.73 0.72 0.33 0.42 0.13 0.25 -0.04 -0.09 -0.79 -0.25 0.25 -0.04Value of Manufacturers' Shipments for All Manufacturing Industries 0.68 0.75 0.33 0.52 0.03 0.47 0.06 -0.11 -0.83 -0.22 0.52 0.32Consumer Price Index for All Urban Consumers: All Items 0.39 0.54 0.29 0.51 -0.43 0.58 0.41 0.17 -0.47 0.19 0.50 0.40Producer Price Index: Finished Goods 0.39 0.50 0.21 0.43 -0.06 0.52 0.10 -0.13 -0.62 -0.14 0.53 0.363-Month Treasury Constant Maturity Rate 0.19 0.36 0.22 0.30 -0.80 0.23 0.96 0.68 0.04 0.66 0.33 0.681-Year Treasury Constant Maturity Rate 0.18 0.36 0.22 0.30 -0.83 0.23 0.95 0.71 0.07 0.69 0.31 0.685-Year Treasury Constant Maturity Rate 0.19 0.32 0.25 0.31 -0.83 0.19 0.85 0.88 0.26 0.85 0.02 0.42Bank Prime Loan Rate 0.16 0.32 0.19 0.29 -0.81 0.27 0.99 0.67 0.06 0.67 0.39 0.691-Month London Interbank Offered Rate (LIBOR), based on U.S. Dollar 0.12 0.30 0.17 0.28 -0.83 0.29 0.98 0.67 0.08 0.69 0.40 0.713-Month London Interbank Offered Rate (LIBOR), based on U.S. Dollar 0.07 0.25 0.15 0.24 -0.82 0.26 0.97 0.65 0.11 0.67 0.40 0.741-Month London Interbank Offered Rate (LIBOR), based on U.S. Dollar 0.12 0.30 0.17 0.28 -0.83 0.29 0.98 0.67 0.08 0.69 0.40 0.7112-Month London Interbank Offered Rate (LIBOR), based on U.S. Dollar 0.04 0.23 0.14 0.22 -0.80 0.22 0.94 0.63 0.13 0.65 0.38 0.75

Ag Portfolio

C&I

All Portfolios

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Principal #3: Your model should be forward looking (at least 9 quarters).

Principal #4: Communicate your results to the appropriate personnel within the organization that can use the information; especially for capital planning and strategies.

Principal #5: Strong governance and internal controls.



Stress Test Execution

Top Down Model or Bottoms

Up Model

Capital Planning Committee

CRE Stress Test

Ag Stress Test

C&I Stress Test

Cons. Stress Test

Liquidity Risk

Other Risk

Operation Risk

Projections:Capital Ratios, PPNR, LLR, etc.

Frame work for Governance

Board of Directors

Input / Feedback

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Reality Check & Hurdles


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Models are just that, models.

William White (former economist at the Bank of England, the Bank of Canada, and Bank of International Settlements) made a frank admission:

“The analytical underpinnings of what we [mainstream economists] do are actually pretty shaky. A reflection of that fact, is that virtually every aspect you can think of with respect to monetary policy, about best practice, has changed and changedrepetitively over the course of the last 50 years. So, this stuff ain’t science…Think about what’s happened recently. One, its completely unprecedented. People are making it up as they go along. This is hardly science – building on the pillars of the past…Secondly, what they’ve been making up as they go along actually differs across central banks [The Bundesbank, for example, is fighting the threat of high inflation, whereas the Fed is more concerned about the prospect of deflation]. They can’t even agree amongst themselves about what’s the best way to do things. I’m becoming more and more convinced that all of the models we use are basically useless… It’s surprising that we’ve had this huge crisis that the mainstream didn’t predict. It’s gone on for years, which the mainstream absolutely didn’t predict. I would have thought this was a basis for a fundamental rethink about what we used to think we believed. But that hasn’t happened.


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Models have limitations: input data variables

Models have logical assumptions; can be limited by “programmers” process. (i.e. business analyst vs. 20 year lender)

Model logic and outcomes are often tested from a regression standpoint, meaning the models statistically line up to match events of the past and not necessarily looking forward to future potential risk

Regulators will be comparing you against peer banks in the terms of relative risk assessment identification and best practices.



Supplemental – F.R.E.D.https://fred.stlouisfed.org/


Supplemental – F.R.E.D.


Supplemental – F.R.E.D.Microsoft

Add-In








Supplemental – Other Resources





CRE

https://www2.colliers.com

https://www.irr.com/research/#!offset=0&limit=24&

http://www.nreionline.com/

www.usrealco.com

http://www.us.jll.com

https://www2.colliers.com/

https://www.irr.com/research/#!offset=0&limit=24&

http://www.nreionline.com/

http://www.usrealco.com/

http://www.us.jll.com/

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Thank You


Documents

LOAN PORTFOLIO MANAGEMENT - YEAR 2 · 3. Maintaining a strategy to ensure capital adequacy and contingency planning Should have contingency plans for capital preservation, i.e. raise