Download Class Materials - Washington Bankers 2013

Washington Bankers Association
Executive Development Program
Turning ALCO into a Profit Center
Thomas Farin
President
Farin & Associates Inc.
[email protected]
www.farin.com
© 2012 FARIN & Associates Inc.
1
Agenda
• Setting up a Dynamic A/L
Process
– Interest Rate Risk
• Dynamic Income at Risk
• Dynamic Value at Risk
– Liquidity Risk
• Liquidity Coverage Ratio
• Dynamic Sources and
Uses
• Contingency Funding
Plans
• Non-Maturity Deposits
– Analysis
– Strategies
• Loan Pricing – A Focus on
Mortgages
• Assessing Capacity to
hold FRMs
• Structural Tools for
Supporting FRMs
– Non-Maturity Deposits
– FHLB Advances
• Using ALCO to Evaluate
Risk/Return Tradeoffs
between Alternative
Strategies
• Effect of Core Studies
© 2012 FARIN & Associates Inc.
2
Why is a Capital Plan Important
• We will have new capital
requirements
• Defines the long-range
targets we are going to
shoot for in the annual
budget and extended
planning process
• Develops annual goals
that mark progress along
the way to setting
strategic goals
• Your capital plan feeds:
– Core funding growth goals
– Non-Regulatory core
funding goals
– Goals for overall level of
investments
– Goals for overall level of
loans
– Goals for business plan or
strategy we will be
evaluating and stress
testing
© 2012 FARIN & Associates Inc.
3
Effective Capital Plan
• Horizon
• Step 2 – Set Annual Goals
– 5 Year Horizon – note:
regulators appear to be
requiring 9 quarters …
• Step 1 – Long-Range Financial
Goals
– Reconcile earnings,
capitalization, growth, and
dividend policy
– Equalize LT growth - core,
loans, & assets
– Balance sheet mix
– Lead to achieving financial
goals
– Provide framework for drilling
down in greater detail
• Step 3 – Build the Business
Plan
– Using your A/L & Planning
model
– Attempt to hit annual goals set
in Step 2
• Loans, investments, NE assets
• Core, non-Core, other, capital
– Included in ABA Liquidity
Toolbox - Tool 1
© 2012 FARIN & Associates Inc.
4
XYZ Bank
• Case study institution that
runs all the way through
the ABA Liquidity Toolbox.
• Dealing with asset quality
problem, short-term
earnings issues, liquidity
issues and potential
capital issues
• ABA Toolbox
1. Capital plan
2. Core Funding Plan
3. Asset-Based Liquidity
Buffer
4. Non-Core Funding
5. Policy Statement, Policy
Limits and Measurement
System
© 2012 FARIN & Associates Inc.
5
© 2011 Farin
Capital Plan - History
Ending balance sheet numbers
for As of: date
Net income for year ending on
As of: date
Three years of historical ratios.
Not crucial to operation of model,
But helpful in reviewing trends.
© 2012 FARIN & Associates Inc.
6
© 2011 Farin
Capital Plan – Step 1 - SFG
Set and Reconcile Long Range Goals
Strategic Financial Goals are
long-range financial goals you
hope to achieve within five years.
Mutuals not used to setting ROE goals
Could compute ROE goal as follows
•ROE Target
•Core Capital/Asset Target
•Suggested ROA target calculated from ROE
target and capital/asset target
•Goal for ROA
•Dividend payout percentage
•Organic capital growth calculated from ROE
and dividends
•Sets suggested Loan Growth rate
•Sets suggested regulatory core growth
rate
•Enter goal for Loan Growth
•Goal for Investments/Assets
•Goal for Non-Earning Assets/Assets
•Goal for Regulatory Core Growth
•Goal for Non-Regulatory Funding/Assets
•Goal for Other Liabilities/Assets
ROEgoal = ROAgoal / Capital/Assetsgoal
© 2012 FARIN & Associates Inc.
7
Capital Plan – Step 1 - SFG
The organic capital growth rate is
calculated as follows:
OCGR = ROE * (1 – Div/Inc)
Set and Reconcile Long Range Goals
•ROE Target
•Core Capital/Asset Target
•Suggested ROA target calculated from ROE
target and capital/asset target
•Goal for ROA
•Dividend payout percentage
•Organic capital growth calculated from ROE
and dividends
•Sets suggested Loan Growth rate
•Sets suggested regulatory core growth
rate
•Enter goal for Loan Growth
•Goal for Investments/Assets
•Goal for Non-Earning Assets/Assets
•Goal for Regulatory Core Growth
•Goal for Non-Regulatory Funding/Assets
•Goal for Other Liabilities/Assets
Unless capital actions are taken, over the
long haul, goals for capital growth, asset
growth, loan growth, and core funding
growth need to be the same for the balance
sheet to remain in the relative state set by
the goals.
© 2012 FARIN & Associates Inc.
8
Capital Plan – Step 1 - SFG
Goals for loan growth and core funding Set and Reconcile Long Range Goals
•ROE Target
growth will normally match those in
•Core Capital/Asset Target
balanced column. Exceptions would be •Suggested ROA target calculated from ROE
target and capital/asset target
if the institution plans to inject new
•Goal for ROA
capital or repurchase existing capital.
•Dividend payout percentage
•Organic capital growth calculated from ROE
and dividends
•Sets suggested Loan Growth rate
•Sets suggested regulatory core growth
rate
•Enter goal for Loan Growth
•Goal for Investments/Assets
•Goal for Non-Earning Assets/Assets
•Goal for Regulatory Core Growth
•Goal for Non-Regulatory Funding/Assets
•Goal for Other Liabilities/Assets
© 2012 FARIN & Associates Inc.
9
Capital Plan – Step 2 – Annual Goals
Strategic Financial Goal
Most recent historical result
Annual goals
(blue)
Forecast
Calculated
results
(black)
History
Strategic Financial Goal Set in Step 1
Annual goals section layout – You are setting annual goals that step you from your
current/recent results in the direction of achieving your Strategic Financial Goals.
© 2012 FARIN & Associates Inc.
10
Capital Plan – Step 2 – Annual Goals
Investments
Note: the goals for investments/assets, non-earning assets/assets and annual
loan growth collectively drive growth in total assets. None of the ending numbers
are valid until all three sets of goals have been entered.
The strategic financial goal for investments should consider the tradeoffs between
liquidity risk and return. XYZ management feels recent levels of investments are
too low to meet asset-based liquidity needs. Therefore they set a higher SFG. This
SFG may need to be revisited when work on Tool 4 is complete.
Annual goals for investments should consider how fast the institution can reasonably
be expected to move in the direction of the goal. XYZ management feels that the
SFG can be achieved within three years.
© 2012 FARIN & Associates Inc.
11
Capital Plan – Step 2 – Annual Goals
Non-Earning Assets / Assets
Note: the goals for investments/assets, non-earning assets/assets and annual
loan growth collectively drive growth in total assets. None of the ending numbers
are valid until all three sets of goals have been entered.
The strategic financial goal for non-earning assets should be for normal times.
XYZ management feels recent levels of non-earning assets are higher than normal
as a result of asset-quality problems. Therefore they set a lower SFG.
Annual goals for non-earning assets/assets should consider how fast the institution
can reasonably be expected to move in the direction of the goal. XYZ management
feels that the level will increase in the first year because of asset quality issues,
then return to normal by the end of year four.
© 2012 FARIN & Associates Inc.
12
Capital Plan – Step 2 – Annual Goals
Loan Growth Rate
Note: the goals for investments/assets, non-earning assets/assets and annual
loan growth collectively drive growth in total assets. None of the ending numbers
are valid until all three sets of goals have been entered.
The strategic financial goal for loan growth will normally equal the goal for internal
capital growth unless you wish to raise or retire capital. XYZ management does not
intend to take capital actions so they set the SFG equal to internal capital growth.
Annual goals for loan growth should consider loan demand and the institution’s
financial condition. XYZ management needs to shrink loans and assets in the
first two years in order to maintain capital/assets while losing money. Once earnings
come back on stream, they can begin growing loans, reaching the SFG by year
five.
© 2012 FARIN & Associates Inc.
13
Capital Plan – Step 2 – Annual Goals
Core Growth Rate
Note: Goals for core growth rate are independent of any other goals in the model.
On the other hand, the goal for Non-Reg Core/Assets is dependent on this setting.
The strategic financial goal for Core Growth will normally equal the goal for internal
capital growth unless you wish to raise or retire capital. XYZ management does not
intend to take capital actions so they set the SFG equal to internal capital growth.
Annual goals for core growth should consider asset growth and what management
wishes to do to the Non-Regulatory Core/asset ratio. XYZ management has set
annual core growth goals above the asset growth rate in years 1-4 as they wish
to reduce their reliance on non-core funding. They reach the SFG in year 5. If the
core growth rate is too high, Non-Regulatory Core/Assets could go negative.
© 2012 FARIN & Associates Inc.
14
Capital Plan – Step 2 – Annual Goals
Other Liabilities/Assets
Note: Goals for Other Liabilities/Assets is independent of any other goals in the model.
On the other hand, the goal for Non-Reg Core/Assets is dependent on this setting.
The strategic financial goal for Other Liabilities/Assets will normally be based on
current/recent results. The effect of this goal is trivial but it is necessary to balance
the balance sheet. XYZ management set the SFG equal to the recent/history
result.
Annual goals for Other Liabilities/Assets will normally be set equal to the SFG. XYZ
management has set Other Liabilities/Assets goals equal to the SFG for all 5 years.
© 2012 FARIN & Associates Inc.
15
Capital Plan – Step 2 – Annual Goals
ROA Goals
Note: Goals for ROA are independent of any other goals in the model. This screen plus
the following screen covering capital actions drive growth in capital, Note that ROA
Is an input to this model. Use your bank’s planning model to develop the plan to meet
these goals.
The model recommends an ROA SFG based on the ROE and capital/asset goals.
You will normally accept this recommendation. XYZ’s ROA goal is that calculated by
the model based on their ROE and capital/asset goal.
Annual goals for ROA should consider evolution of your bank’s financial condition
over time. XYZ management set negative ROAs in years 1 and 2 to reflect the
evolution of their asset quality problem. By year 5 they hope to reach the SFG for ROA.
© 2012 FARIN & Associates Inc.
16
Capital Plan – Step 2 – Annual Goals
Capital Actions
Note: Goals for Dividends/Income combined with ROA goals and new capital drive
growth in capital in this model.
The SFG for dividends/income should represent the percentage of net income to be
paid to stockholders. Mutuals should leave this set to 0%. XYZ management, a C
corporate set the SFG to 33%, the expectations of their stockholders.
Annual goals for dividends/income should be mindful of the SFG but also the institution’s
ability to maintain adequate capital. XYZ management set dividends/income to 0%
in years 1 and 2 to preserve capital. It is set at 33% for the three remaining years.
Institutions planning to inject new capital (positive number) or buy back capital (negative
number should enter the amount in thousands in column H.
© 2012 FARIN & Associates Inc.
17
Capital Plan – Step 2 – Annual Goals
Capital/Assets
Note: Numbers appearing on this screen are calculated based on other inputs. There
Is no need for input in this area. However should results be unsatisfactory, additional
tuning of other inputs may be necessary.
The SFG for Capital/Assets will be the core capital ratio needed to meet regulatory
capital minimums plus a buffer needed to absorb risk that management feels appropriate
based on stress testing and other factors. XYZ management set the SFG at 9.0%
Annual results for capital/assets will be a byproduct of total assets and total capital
projections earlier in the model. XYZ management finds the set of assumptions entered
into this model (if achieved) will allow it to reach its SFG for capital/assets by year 4
of the plan.
© 2012 FARIN & Associates Inc.
18
Capital Plan – Step 2 – Annual Goals
ROE
Note: Numbers appearing on this screen are calculated based on other inputs. There
Is no need for input in this area. However should results be unsatisfactory, additional
tuning of other inputs may be necessary.
The SFG for ROE will be the ROE needed to meet investor expectations. For mutuals,
it will be their desired internal capital growth rate. XYZ management set the ROE SFG
at 12% to achieve investor expectations.
Annual results for ROE are calculated by multiplying the ROA goals set earlier by the
calculated equity multiplier. XYZ management finds the set of assumptions entered
into this model (if achieved) will allow it to reach its SFG for ROE in year 5 of the plan.
© 2012 FARIN & Associates Inc.
19
Capital Plan – Step 2 – Annual Goals
Non-Regulatory Core/Assets
Note: Numbers appearing on this screen are calculated based on other inputs. This is
the model’s balancing account. If the annual numbers go negative, you will need to
reduce the core funding growth rate or take actions to grow assets.
The SFG for Non-Regulatory Core/Assets will be a level consistent with a bank’s policy
limit while providing adequate borrowing capacity to deal with liquidity stress events.
XYZ set their SFG at 20%, ½ of the policy limit in their liquidity policy.
Annual results for ROE are calculated by subtracting total liabilities and capital from total
assets on the previous screens. The difference is the amount of non-regulatory core
funding needed to balance the balance sheet. The fact XYZ’s goals for core funding
growth exceed its goals for asset growth is the primary reason its ratio is dropping over
time. The SFG is reached in year 3.
© 2012 FARIN & Associates Inc.
20
Capital Plan – Step 3
Develop Your Plan
• The result of this exercise is a high level set of goals
• The final step is to use your planning model to develop
a detailed plan to reach these goals.
– This plan is, of course, your business plan that will be used in
to assess liquidity in the context of the business plan.
– It will also be the business plan to which you will apply stress
tests in stressing your institution’s liquidity under liquidity
stress events and interest rate risk using the stress tests we
will discuss.
© 2012 FARIN & Associates Inc.
21
Wouldn’t It Be Nice If:
• We built our budget or
business plan for 2012
• We extended it for two
additional years to see the
long-term effect
• We modeled the plan through
multiple rate environments to
test income at risk
• We ran value at risk analysis
(EVE) at the beginning and
end of the plan
• We evaluated liquidity risk in
the plan using sources/uses
• We ran liquidity stress tests on
the plan
• We were not satisfied with the
results (risk/risk or risk/return),
we modified strategies and ran
the same tests
• We chose the version of the
plan with the best risk/risk and
risk/return tradeoffs
• On a quarterly basis we rolled
the plan forward a quarter and
repeated the same process,
tweaking the plan as
necessary
© 2012 FARIN & Associates Inc.
22
Questions Answered
• Would it make sense to portfolio fixed-rate
mortgages?
• Would it make sense to ladder out my investment
portfolio?
• Do I really need to extend my CDs to manage my
interest rate risk? … or …
• Would an effective strategy for pricing my nonmaturity deposits turn out to effectively hedge my
interest rate risk?
Would you like to turn your ALCO process into a profit center rather
than just a regulatory compliance cost?
© 2012 FARIN & Associates Inc.
23
Developing the Plan
• In order to move on to budgeting and planning to
meet the goals we’ve established (annual and
strategic) we need to get some tools on the table
–
–
–
–
Liquidity risk analysis tools
Interest rate risk analysis tools
Core funding analysis tools and strategy
Loan pricing used to identify well priced loans
© 2012 FARIN & Associates Inc.
24
Stress Tests - What Are They Talking About?
Stress tests
• Interest rate risk
• Credit Risk
• Liquidity Risk
IRR
Credit
Liquidity
Food for thought question: We know that a rising rate environment could affect
our case institution’s bottom line because of interest rate risk. But how might the
bottom line also be affected by credit risk and liquidity risk? What if the institution
is already weakened by asset quality problems?
© 2012 FARIN & Associates Inc.
25
Stress Test Objective
• Test whether an institution
has sufficient capital to
remain Well Capitalized
after a severe stress
Says to us:
– New capital regulations will
set minimums
– Stress tests will define
cushions
• Recently verbalized
regulatory approach
– Simple enough to be done
in a spreadsheet
– Note that the OCC released
Community Bank Stress
Test Guidelines in October
2012.
© 2012 FARIN & Associates Inc.
26
Dynamic Interest Rate Risk
• Interest Rate Risk
– Income at risk (IAR) is dynamic if it is evaluated by
stressing a plan or strategy
• Income at risk testing involving holding the balance sheet
constant is static measurement of income at risk
– EVE (VAR) is a static measure of IRR
– EVE becomes dynamic if tests are performed on a
balance sheet resulting from a plan or strategy
Note: Any static measure can be converted it to a
dynamic measure by performing the analysis on
forecast balance sheets.
© 2012 FARIN & Associates Inc.
27
Dynamic IAR
Comparison of Alternative Strategies
Income at Risk - ROA
Expected and
alternative rate
environments.
Rate Env Pol Limit Stgy 1 Stgy 2 Stgy 3 Stgy 4
+300 bp
-25%
0.8% 0.72% 0.96% 0.92%
Expected Maximum 1.20% 0.72% 1.14% 1.18%
-200 bp
1 Yr Extend 2 Yr
Budget Strategic
-25% 1.56% 0.72% 1.32% 1.38%
Income at risk
policy limits.
Same metric used
to measure return
is used to measure
risk (ROA)
Question for stakeholders: If
ROA is the primary metric we use
to measure return, how much of
ROA are we willing to have at risk
under alternative rate
environments?
© 2012 FARIN & Associates Inc.
28
Dynamic IAR
Comparison of Alternative Strategies
Income at Risk - ROA
Expected and
alternative rate
environments.
Rate Env
Unacceptable:
Lousy return!
Pol Limit Stgy 1 Stgy 2 Stgy 3 Stgy 4
+300 bp
-25%
0.8%
0.72%
0.96%
0.92%
Expected Maximum
1.20%
0.72%
1.14%
1.18%
-200 bp
1.56%
0.72%
1.32%
1.38%
-25%
IAR modeling can eliminate
poor strategies based on their
risk and return, limiting choices
to strategies with acceptable
risk/return tradeoffs.
Unacceptable:
Too much risk!
But what’s missing in this analysis?
© 2012 FARIN & Associates Inc.
Acceptable
risk/return
tradeoffs!
29
Static Value at Risk
Today
Horizon
Remaining life of all instruments
Immediate & Permanent
Rate Shocks
Current Balance Sheet
In static value at risk analysis, all cash
flows over their remaining lives are
generated for every financial instrument
on the balance sheet for each rate
environment. Discount rates are then
used to mark the cash flows to market.
© 2012 FARIN & Associates Inc.
30
Dynamic Value at Risk
Today
Horizon
Typically 2-3 Years
A dynamic value at risk analysis uses the
same approach as a static value at risk
analysis except it is performed on the
balance sheet that exists at the end rather
than the beginning of the planning horizon.
Rate shocks
Expected rate
environment
Current balance sheet and forecast balance sheet are different
reflecting the effect of the plan or strategy.
© 2012 FARIN & Associates Inc.
31
Value at Risk Limits
(Results Could Be from Static or Dynamic Testing)
OTS TB-13a Rating
Post-Shock
NPV Ratio
100 - 200 bp
Minimal (1)
200 - 400 bp
Minimal (1)
Over 400 bp
Moderate (2)
6.0% to 10%
0 - 100 bp
Minimal (1)
13.21%
71.6bp
Minimal (1)
Minimal (1)
Moderate (2)
Significant (3)
4.0% to 6.0%
Minimal (1)
Moderate (2)
Significant (3)
High (4)
Under 4.0%
Moderate (2)
Significant (3)
High (4)
High (4)
Over 10%
March-09
Ratios
Post Shock NPV
Post Shock Sensitivity (bp Chg from Flat)
Chg from Book (Shock - Book)
% Chg from Book
Interest Sensitivity Measure
I & P -300
12.91%
(101.2)
12.14%
I & P -200
13.32%
(60.9)
I & P -100
13.64%
(28.9)
Flat rates
13.92%
-
I & P 100
13.67%
(25.1)
I & P 200
13.21%
(71.6)
I & P 300
12.46%
(146.3)
0.77%
6.38%
1.18%
9.71%
1.50%
12.34%
1.79%
14.71%
1.54%
12.65%
1.07%
8.82%
0.32%
2.67%
Book Equity
How would you feel of your plan moved you from here to here?
© 2012 FARIN & Associates Inc.
32
Liquidity Risk
• Definition: The risk that an institution is
unable to produce enough sources of funds
to meet anticipated or unanticipated uses of
funds.
– Sources: Loan and Investment Payments,
Saleable Assets, Borrowings, Deposit growth
– Uses: Loan originations, investment purchases,
deposit and borrowing outflows
© 2012 FARIN & Associates Inc.
33
Sound Liquidity Practices
•
•
•
•
•
Governance – BOD
and management
Appropriate strategies,
policies, procedures
Cash flow oriented
measurement systems
Intraday collateral and
liquidity management
Diverse mix of present
and potential funding
sources
•
•
•
Adequate levels of
highly liquid
marketable securities
Comprehensive
contingency funding
plans addressing
adverse events
Internal controls and
audit requirements
© 2012 FARIN & Associates Inc.
34
Evolving Framework
• Movement away from
– Static measures
– Balance sheet liquidity
measures
• Movement toward
– Dynamic measures
• Loans/shares or
loans/assets
• Non-core funding
dependency
• Liquid
Investments/assets
• Current balance sheet
• Business strategy or
plan
• Unexpected triggering
events
– Fail well capitalized
status
– Securitization markets
freeze up
– Corporate CU placed
into receivership
• Requires contingency
funding plans
© 2012 FARIN & Associates Inc.
35
Measurement Framework
Liquidity Measurement Goals:
• Assess impact of plan on liquidity position
• Ensure adequate sources to meet
unanticipated (stressed) needs
– Highly liquid securities
– External Borrowings
• Integrate Contingency Funding Plan into
Liquidity Assessment
– Define and assess stress events that impact plan
cash flows
© 2012 FARIN & Associates Inc.
36
Measurement Framework
Primary Measurement
• Liquidity Coverage Ratio
–
–
–
–
Measures adequacy of asset-based liquidity buffer
Is a stress test
Proposed by Basel
Not yet implemented by US regulatory agencies
• Forecast Sources and Uses of Fund (Liquidity Gap)
– Assess risk in plan
– Relies on institution goals for key performance ratios as
guides to plan
– Measures size and trend in combined asset and liability
based liquidity buffers (unused borrowing capacity)
– Can be stress tested
© 2012 FARIN & Associates Inc.
37
How Much Asset-Based
Liquidity is Enough?
– Numerator
• Options
– Peer group data –
inconsistent with guidance
– Some standardized
measure – Basel LCR
• Basel LCR
• Cash & Due From
• Highly Liquid
Unencumbered
Marketable Securities
– Denominator
• Deposit Runoff
• Cut off from Non-Core
Funding
• Line Draw Downs
• Less Cash Inflows –
Limited
– Test - Do you have
sufficient cash to survive a
30 day stress?
– Guideline
• Maintain LCR >= 100%
© 2012 FARIN & Associates Inc.
38
Using LCR to Set Limits
Actual XYZ Exposure – Tool 4
XYZ Policy Limits – Currently operating in red light zone. Note that the LCR
could be calculated on forecast balance sheets in business plan showing time
frames for moving into compliance. Static measure – how do we convert to
dynamic?
© 2012 FARIN & Associates Inc.
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Liquidity Gap Report
• Liquidity Gap Report
– Summary of Cash Flow sources and uses impact
on liquidity – Dynamic by its nature
• Use a forecast (Plan) for growth assumptions
• Use starting cash flows to project inflows and outflows
– Apply Contingency Funding Plan Stress Tests &
assess liquidity needs
• Impact of missing deposit growth by 10%
• What if loan repayments accelerate or slow?
• What happens to total ratio if access to key funding
sources is gone?
– Brokered CDs
– FHLB
40
© 2012 FARIN & Associates Inc.
40
MB&T Liquidity Gap
Liquidity Report
Mar-2010 (Q)
Jun-2010 (Q) Sep-2010 (Q)
Dec-2010 (Q)
(Dollars i
Total Inflows
Cumulative Inflows
Total Outflows
Cumulative Outflows
Cash Flow Surplus (Deficit)
Cum Cash Flow Surplus (Deficit)
60,017,242
60,017,242
55,254,540
55,254,540
4,762,702
4,762,702
86,191,620
146,208,862
92,655,515
147,910,055
(6,463,894)
(1,701,193)
Total Inflows
Cash & Overnight Investments
Less: Overnight Borrowings
Available HLUM Securities
Unused Borrowing Capacity
Total Available for Liquidity
Total Outflows
Total Liquidity Gap
Total Liquidity Sources/Uses
Total Liquidity Gap/Assets
60,017,242
86,191,620
10,005,990
3,542,100
5,866,988
7,782,965
13,717,820
20,143,612
89,608,040 117,660,297
55,254,540
92,655,515
34,353,500
25,004,783
162.17%
126.99%
11.54%
8.71%
56,850,228
203,059,090
52,084,214
199,994,268
4,766,014
3,064,822
56,850,228
8,308,110
9,585,959
22,342,316
97,086,613
52,084,214
45,002,399
186.40%
15.87%
54,627,817
257,686,908
52,433,319
252,427,587
2,194,498
5,259,320
54,627,817
10,502,610
9,467,251
25,815,670
100,413,348
52,433,319
47,980,029
191.51%
17.28%
Periodic Liquidity Gap
© 2012 FARIN & Associates Inc.
41
MB&T Liquidity Gap
Cumulative Inflows
Cash & Overnight Investments
Less: Overnight Borrowings
Available HLUM Securities
Unused Borrowing Capacity
Cumulative Available for Liquidity
Cumulative Outflows
Cumulative Liquidity Gap
Cum Liquidity Sources/Uses
Cumulative Liquidity Gap/Assets
60,017,242 146,208,862 203,059,090
10,005,990
3,542,100
8,308,110
5,866,988
7,782,965
9,585,959
13,717,820
20,143,612
22,342,316
89,608,040 177,677,539 243,295,475
55,254,540 147,910,055 199,994,268
34,353,500
29,767,484
43,301,207
162.17%
120.13%
121.65%
11.54%
10.36%
15.27%
257,686,908
10,502,610
9,467,251
25,815,670
303,472,439
252,427,587
51,044,851
120.22%
18.38%
Policy set around Cumulative Liquidity Gap/Asset
Cumulative Liquidity Gap
© 2012 FARIN & Associates Inc.
42
Liquidity Policy Limits
• Limits should indicate base plan levels of risk
• As stress tests are added, a second level of limits
are required to:
– Reflect levels of sources required to survive liquidity
stress events
– Outline likely actions
• In addition to limits, trigger ratio ranges set to act
as early warning signals to plan goals
© 2012 FARIN & Associates Inc.
43
Liquidity Gap/Asset Policy Limits
12 Month Liquidity
Gap/Asset Ratio
Threat Level
=> 15%
Green Light
>= 10% and <15%
Yellow Light
< 10%
Red Light
© 2012 FARIN & Associates Inc.
Actions
No actions required, continue
normal monitoring and
reporting
Develop options for asset or
liability changes in plan to
return to Green within 6
months.
Immediate plan changes to be
implemented and impact of
Contingency Funding Plan
assessed for realistic stress
events. Monitoring monthly
until return to Yellow
44
Stress Events
• Regulators want to know
how long you can last if
things turn from good to
bad and bad to worse…
• Purpose is to determine
how you will survive
severe liquidity stresses
• Capital Scenario Outline:
– MB&T projects a drop
below “Well Capitalized”
level
• Highly likely given credit
concerns and capital levels
– Events are sequenced over
time reflecting likely
changes to business plan
– Timeline of events…
© 2012 FARIN & Associates Inc.
45
MB&T Stress Test
© 2012 FARIN & Associates Inc.
46
Stressed Liquidity Gap/Assets
Stressed Limits
© 2012 FARIN & Associates Inc.
47
CFP for Capital Failure
Numbers 3, 5, and 6 are already in base business plan
Number 4 and further implementation of 5 are in stress scenario
© 2012 FARIN & Associates Inc.
48
CFP for Cascading Events
These items are all implemented as capital failure scenario continues to unwind.
© 2012 FARIN & Associates Inc.
49
CORE DEPOSIT ANALYSIS
© 2012 FARIN & Associates Inc.
50
Two Most Crucial A/L Assumptions
• Pricing Betas – the extent
to which a change in
market rates is passed
along to deposit
customers
– Income at risk analysis
– EVE analysis
• Decay rates – the speed
at which non-maturity
deposits decay off books
over time
– EVE analysis
– Liquidity analysis
• What is the greatest
commonly expressed fear
about NMD funding?
© 2012 FARIN & Associates Inc.
51
Non-Maturity Deposits
• Segmentation Strategies
• Actual Behaviors
– Rates on some of these
accounts respond
moderately and slowly in
response to changes in
market rates
– Balances are retained for
long periods of time in spite
of rate behavior
– Acts like: Stable supply,
semi-fixed rate, long-term
– Actual Counterpart –
laddered portfolio of fixedrate long-term CDs
– Rates respond very slowly to
changes in market rates on
non-rate sensitive portion
– Rates respond more quickly to
changes in market rates on
rate sensitive portion
– Weighted average cost moves
relatively slowly in response to
changes in market rates
– Lots of barrier to entry options
•
•
•
•
Product design
Tiers
Transactional
Channel
Is the ‘term’ of non-maturity deposits important
as we head into a rising rate environment?
© 2011 Farin & Associates, Inc
© 2012 FARIN & Associates Inc.
52
Non-Maturity Deposit Life
• Key Concept
– Non-maturity deposits don’t
all ‘mature’ at the same time
– Instead, balances in
accounts decay off the
books over time
– Decay rates can be
statistically measured
– Once measured, decay
rates can be used to
forecast cash flows coming
off pools of non-maturity
deposits
For all these reasons, your decay rates
could be dramatically different than
national averages.
• Cash Flow Decay rates
affected by:
– Life events – death, divorce,
population turnover
– Satisfaction with the
institution
– Movements in market rates
and your pricing strategy.
– Economic events – local
(plant closings), and
national (911, stock market
health, economic outlook,
etc.)
– Technology
– Interaction between CSRs
and customers
– Flight to quality
– Relationship between CD
and NMD rates
53
© 2011 Farin & Associates, Inc
© 2012 FARIN & Associates Inc.
53
Pricing Betas
• The Goal
• The Science
– Predict the effect of movements in
market rates on how you will price
a core deposit account
• The Art
– Use a statistically valid set of
historical data
– Understand that this is a modeling
tool and does not represent how
the institution actually prices
• Application
– A/L Modeling
– Pick/plot a representative
set of market rates for
dates studied
– Plot your actual pricing on
account you are evaluating
for study dates
– Regress lines against each
other to find best fit varying
• Lags
• Betas
– From best fit take off
•
•
•
•
• Income at risk
• Value at risk
© 2012 FARIN & Associates Inc.
Index (market rate)
Lag
Beta
Spread
54
Pricing Betas
• For example, if market rates increase 200 bp and
your beta for MMDAs is 0.5 (50%) then the beta
would predict you will raise MMDA rates by 100 bp
200 bp X 0.5 = 100 bp
• Betas can be:
– SWAG’d
– Derived statistically from historic data
– Examiners prefer the latter
• Betas can also be modified by use of segmentation
strategies.
© 2011 Farin & Associates, Inc
© 2012 FARIN & Associates Inc.
55
Pricing Betas
a = 0.4%
b = .75
Y = a + bx = Rate Paid
56
© 2012 FARIN & Associates Inc.
56
Pricing Betas
Questions:
1. Which of these cost of funds profiles would you prefer to have with rising rates?
2. What would that information allow you to do with asset and funding allocation?
57
© 2012 FARIN & Associates Inc.
57
How Betas Play Out in Industry
1.0
0.2
0.9
Premium MMDA & CDs
Regular Savings
58
© 2012 FARIN & Associates Inc.
58
Example Pricing Beta Study
Passbook Savings
•
•
•
•
•
•
Benchmark/beta/lag testing
Equation to actual comparison
Rates paid for I&P and gradual rate moves
Tuning
Premium MMDA example
Strategy example
© 2012 FARIN & Associates Inc.
59
Ranked by Correlation
Treasuries, Agencies, FHLB Advances – 3, 6, 12, 24, 36, 60 months lagged 0-12 months
= 234 combinations
© 2012 FARIN & Associates Inc.
60
Rate Paid vs. Equation
Passbook Savings
© 2012 FARIN & Associates Inc.
61
Forecast Rates – I&P Shocks
© 2012 FARIN & Associates Inc.
62
Cash Flow Decay Rates
•
• The Goal
– Predict the cash flows
coming off a pool of nonmaturity deposits
• The Art
– Use a statistically valid set
of historical data
– Pick a time frame covering
at least ½ of a rate cycle
• Application
– A/L Modeling
• Value at risk
• Liquidity
The Science
– Pick a grouping of non-maturity
deposit accounts at an
appropriate level of aggregation
– Plot runoffs that occurred to a set
of accounts over the study period.
– Separate normal from ‘abnormal
runoff or growth’
– Calculate decay rate for normal
runoff
– Calculate decay rate for abnormal
balances
– Use decay rates to generate
potential cash flows.
– From best fit take off
•
•
•
•
© 2012 FARIN & Associates Inc.
Index (market rate)
Lag
Beta
Spread
63
Decay Rate Methods
• Account No Method
• Origination Date Method
– Begin with a set of accounts
and balances
– Track what happens to
balances of these accounts
over time
– No new money considered
– Weaknesses
• Lots of data and account
numbers needed
• Over long horizons
characteristics of accounts at
beginning of study may be
inconsistent with the accounts
you have now
1. Total Balances BOM
2. Total Balances EOM
3. New Account EOM Balances
4. Old Account EOM Balances (#2-#3)
5. Chg in Old Balances (#1-#4)
6. Decay Rate (#5/#1 * 12)
12,000
12,200
400
11,800
200
20.00%
– Weaknesses
• Not recognized as industry
standard
– Strengths
– Strengths – Recognized as
industry standard technique.
• Account numbers not
needed
• Over long horizons sample
moves with changes in
customer characteristics.
Note: in most cases both methods will yield roughly the same results.
© 2012 FARIN & Associates Inc.
64
But before we calculate
decay rates, we need
to deal with surges
All US banks on UBPRCD
Stock
Surge – Fast
Decay
Core – Slow
Decay
Non-Maturity
Deposits as a
Percent of Assets
Relative pricing of
non-maturity
deposits vs. CDs
65
© 2012 FARIN & Associates Inc.
65
Rolling Decays as Surge
Indicators
Decay rate on outstanding study balances
Decay rate on outstanding study accounts
Marginal (12 month rolling) decay rate
© 2012 FARIN & Associates Inc.
66
After Surge Adjustment
After surge adjustment (20% surge) the marginal decay rate
tracks along the cumulative average decay rate.
© 2012 FARIN & Associates Inc.
67
Average Balances
Before and After
Surge
© 2012 FARIN & Associates Inc.
68
Non-Surge Decays
© 2012 FARIN & Associates Inc.
69
Decay Rates
Surge Balance Burnout
Truncation
Assumption: 20% of balances are surge balances
© 2012 FARIN & Associates Inc.
70
Savings / Money Market Case
• Savings
–
–
–
–
• Money Markets
Single tiered product
No current tier differentials
$34 million in balances
Projected growth of 2% per year
as long as rates remain low
• Primarily funds flowing out of
CDs
– Generally priced in 33rd
percentile
– Some surge balances
–
–
–
–
Single tiered product
Limited tier differentials
$90 million in balances
Projected growth of 2% per
year as long as rates remain
low
• Primarily funds flowing out
of CDs
– Generally priced in 25th-33rd
percentile
– Some surge balances
© 2012 FARIN & Associates Inc.
71
Savings/MM Sector Audit
Rate board Rates
Download rates
No significant evidence of exception pricing in this example.
Note that on NMDs what happens with weighted rates over time is a better input into pricing beta
calculations than offer rates, because many institutions utilize exception pricing.
© 2012 FARIN & Associates Inc.
72
New Product - Defensive
New product with $50K barrier to entry priced defensively – cut existing rates
• Saves $13 thousand per year
• Increases core deposit intangible by $28 thousand
• Is it worth it? – most would answer “No” and keep their new product powder dry
73
© 2012 FARIN & Associates Inc.
73
New Product – Defensive (+200)
0.38
0.31
0.25
0.35
0.50
0.35
0.50
0.75
0.09
0.14
0.19
0.17
0.25
0.37
0.75
© 2012 FARIN & Associates Inc.
74
New Product – Defensive (+200)
Wtd cost was 0.135% - Strategy 1 Beta is 0.37, Strategy 2 Beta is 0.305
Saves 13 bp, $65 thousand. Increases core intangible by $312 thousand
© 2012 FARIN & Associates Inc.
75
New Product – Offensive (+200)
Betas same as
previous slides
Intangible increases $456 thousand
Beta – 1.0
Marginal cost of new funds, 2.096%, 200 bp below benchmark
76
© 2012 FARIN & Associates Inc.
76
New Product – Offensive (+200)
Institution Decay Rates
OTS
Institution specific decays:
Money Markets – 15% (OTS was 19.89%)
Savings – 10% (OTS77was 15.44%)
© 2011 Farin & Associates, Inc
© 2012 FARIN & Associates Inc.
77
Impact – One Customer
Higher EVEs under all rate environments and increased asset sensitivity due to:
• Increased duration of NMDs (lower decay rates)
• Higher spreads to benchmarks (higher average benchmark cost)
This leads to an opportunity …
© 2012 FARIN & Associates Inc.
78
Opportunities
• Reduce reliance on LT CDs – High cost, will they
be there?
• Lengthen investment portfolio
• Lengthen loan portfolio
– Keep mortgages you’ve been selling
– Offer commercial and agriculture customers a fixedrate option
© 2012 FARIN & Associates Inc.
79
EFFECTIVE LOAN PRICING
© 2012 FARIN & Associates Inc.
80
Pricing Cash Flows
• When we price a loan
– We are pricing a bundle of cash flows
– A good loan pricing model puts an A/L wrapper around
a loan or a bundle of loans being priced. Approach
and results should be consistent with:
• A/L model results
• Profitability system results
• Market results – Assuming loan is sold
© 2012 FARIN & Associates Inc.
81
Loan Pricing – Interest Rate Risk
•
•
Interest Rate Risk
– When you are pricing loans you
are pricing cash flows not
maturities.
– With fixed-rate loans, pieces
reprice as cash flows come in.
Few reprice at maturity.
– Principal cash flows are often
uncertain
• Prepayment options
– Variable rate loans reprice
To manage interest rate risk,
institutions need to match funding
to the repricing of the loans of
loans. Two approaches:
– Simplistic – match based on
duration
complex – Match fund
x– More
individual repricing flows.
– While in the real world you may not
x match, in making pricing decision,
we should assume matching.
• When cash flow pieces come in
• When contractual repricing occurs,
but …
• Variable rate loans may not
respond immediately or completely
at reset points
• Reset frequency
• Restrictions on adjustments (caps)
X – Approach taken in this series
© 2012 FARIN & Associates Inc.
82
Market Curve Usage
CurveNo
1
5
6
9
10
14
16
20
21
29
37
40
66
84
87
90
91
95
98
99
100
119
126
127
128
134
137
138
CurveName
US Treasury
Prime
Fed Funds
Balloon MBS
Libor
FHLMC FR MBS
UST Strip
FNMA FR MBS
GNMA FR MBS
Interest Rate Swap
Indexed AAA Corporate Bond
AAA Auto Index
11th District COFI
Average FHLB ADV
Cost of Savings Index
Indexed AAA MUNI Bond
Indexed Agency Bond
National COFI
REPO (Overnight)
Retail CD Avg
US CMT (H.15)
AAA Commercial Equipment
Indexed A Corporate Bond
Indexed B Corporate Bond
Indexed A- MUNI Bond
FR MBS
Balloon MBS Synthetic
GNMA II ARMS
• Curves Used for
– Risk Free Curves
– Investment Benchmarks
– Wholesale Funding Curves
• Requirements
– Broad range of benchmarks.
– Updated very frequently
© 2012 FARIN & Associates Inc.
83
Cash Flow Matching Example
Fully
Ammortizing
20 Year
Comm. R/E
Funding
© 2012 FARIN & Associates Inc.
Investments
84
Cash Flow Matching Example
5/20
Comm. R/E
Balloon
Funding
© 2012 FARIN & Associates Inc.
Investments
85
Comparison – Investment Benchmark
Fully Amortizing 20 Yr FRM
5/20 Yr Balloon
+ 0.957
© 2012 FARIN & Associates Inc.
86
Credit Risk - Which History to Use?
• Was history from 2005-2007 a legitimate
predictor of recent credit losses?
• Are 2008-2010 losses a legitimate predictor of
losses of newly originated loans in 2011?
• Do we even have legitimate loss history for loans
originated today?
– Changes in collateral coverage
– Changes in underwriting standards
– Changes in kinds of loans originated
© 2012 FARIN & Associates Inc.
87
Comparison – Investment Benchmark
Fully Amortizing 20 Yr FRM
5/20 Yr Balloon
© 2012 FARIN & Associates Inc.
88
Loan Pricing – Servicing
Arguments
Servicing Cost
– Marginal Origination Cost
• Cost of originating the next
loan
– Marginal Servicing Cost
• Cost of servicing the next
loan
– Direct Overhead Allocation
• Fixed costs directly related to
loan production
– General Overhead Allocation
• President’s salary, human
resources, etc.
– Economist – Continue to
produce widgets until marginal
revenue equals marginal cost
– Accountant – Without overhead
allocation, you end up with
profitable loans and an
unprofitable institution
OTS Cost Assumptions
–
–
–
–
–
–
–
–
0.20% - FR Mortgages
0.38% - ARMs
0.20% - Multi & Non-Res
0.20% - Const & Land
0.20% - Second Mtg.
0.20% - Commercial
0.20% - Consumer
1.00% - Credit Card
• Is there a better source for
generic servicing costs
© 2012 FARIN & Associates Inc.
89
Comparison – Investment Benchmark
Fully Amortizing 20 Yr FRM
5/20 Yr Balloon
- 0.034
© 2012 FARIN & Associates Inc.
90
Loan Pricing – The Basics
Option Risk – Dealing with uncertain cash flows
• We imbed options in loan contracts that allow
customers to modify cash flow characteristics of
loans when they consider it to their advantage to do
so
– Prepayments
• Basic prepayment levels – death, divorce, transfer,
upgrades, etc.
• Incentive driven prepayments
– Customer prepays to refinance at a lower rate
– Customer can’t afford to move or upgrade because of
interest rate jump
– Up to the customer to execute the option
– In some cases, subject to penalty – primarily commercial
contracts
– Adjustable rate mortgage caps
• Annual caps, lifetime caps
• Automatically executed by the institution
• Loan floors
• Ideally the institution is compensated with rate for
making the option available.
© 2012 FARIN & Associates Inc.
91
Option Risk – What Is It
• 15 year FRM example showing remaining principal under different
rate environments
– Falling – 25% CPR – 2.75 year duration
– Flat – 8% CPR – 4.64 Year duration
– Rising – 5% CPR – 5.21 Year Duration
15 Year FRM
Remaining Principal
120,000.00
100,000.00
80,000.00
5% CPR
8% CPR
60,000.00
25% CPR
40,000.00
20,000.00
1
14
27
40
53
66
79
92 105 118 131 144 157 170
Month
© 2012 FARIN & Associates Inc.
92
Comparison – Investment Benchmark
Fully Amortizing 20 Yr FRM
5/20 Yr Balloon
+ 0.925
© 2012 FARIN & Associates Inc.
93
Internal Profitability Measures
(ROE)
• How institutions make money
– Loan Yield 6.0%
– Funding Cost
2.0%
– Spread
4.0%
• Who owns the spread?
– Loan Officer?
– Funding Provider?
– Treasury Function?
© 2012 FARIN & Associates Inc.
94
Funds Transfer Pricing
•
•
Internal profitability benchmark
•
Evaluates whether a loan is profitable
within context of balance sheet
•
Most relevant when
–
–
•
You are trying to decide whether you
can make money originating a loan
Anytime you are trying to asses the
profitability of a relationship, product or
profit center
–
–
–
–
–
–
–
–
–
•
Dollar contribution to profit (ROA)
Return on required capital (RAROC)
•
Cash flow characteristics
Cost Curve
Pricing – Rates and fees
Operating expenses
Credit risk adjustment
Additional option risk adjustments
Capital Requirement (RAROC)
Capital Goal (RAROC)
Institution Tax Rate
Calculated adjustments
–
–
–
–
–
Can focus on:
–
–
Required inputs
Pretax Spread ($ or %)
After tax spread ($ or %)
RAROC
Spread to RAROC Goal
Test – Is spread positive (good) or
negative (bad)?
Not considered
–
–
–
Risk free curve
Investment benchmark curve
Capital requirement
© 2012 FARIN & Associates Inc.
95
Selecting a FTP Curve
•Not Recommended - Your
Cost of Funds Curve
–Penalizes loan function for
inefficient funds gathering,
rewards for efficient funds
gathering. Could force you to
price out of the market.
–Fails to reward and provide an
incentive for funds providers to
gather funds efficiently.
–History based curve is used to
price newly originated
instruments.
•Recommended - Your true
wholesale funding
alternative
•
•
•
•
FHLB Advance
Jumbo/Brokered/I-net CD
AAA corporate
Swap Curve
–Use the one that comes closest
to your true wholesale funding
cost.
–Credits deposit gathering
functions for sub-wholesale
deposits. Levels the playing field
for lending functions.
© 2012 FARIN & Associates Inc.
96
Transfer Pricing Components
•Return on Equity
(RAROC) for the transaction is calculated by:
–Summing net interest income
contribution from loan and
investment
–Adding fees and subtracting
allocated operating expenses.
–Net income is divided by capital
required to calculate Return on
Capital (ROE)
•So FTP income can be
measured with
–Net Income (ROA)
–RAROC
6% -
Loan
Spread – Loan
5% -
FTP Curve
Spread – Option Risk
4% -
Spread – Rate Risk
3% Spread - Deposit
2% -
Deposit
1 Yr
7 Yr
Balance
Rate
FTP Rate Spread
Net Int Inc
Loan
100,000
6.00%
5.00%
1.00%
1,000
Deposit
80,000
2.00%
3.00%
1.00%
800
Total
1,800
Fees
500
Expenses
1,000
Net
1,300
Capital Requirement (8%)
8,000
ROE
16.25%
© 2012 FARIN & Associates Inc.
97
Capital Allocation
•Why assign a capital requirement
to a loan?
–Relates profitability of an entity
(loan) to a primary earnings
measurement ratio.
–Allows for adjustments in return
based on differential capital needs
for different loans and
investments.
•What capital allocation model
should I use?
–Leverage Requirement
•Core capital requirement
•Internal capital goals
–Risk Based Requirement
•Should you bother with a capital
allocation model?
•Basel I
•Basel II
•Internal Model
–Will adding this level of
complexity have a material effect
on analysis or decisions?
–Is capital a constraint
•
•
Regulatory requirements
Self-imposed requirements
© 2012 FARIN & Associates Inc.
98
RAROC (ROE) Calculation
Fully Amortizing 20 Yr FRM
5/20 Yr Balloon
Swap cost of funds
Core hedges portion
of option risk
ROE is after tax
Assigned capital
requirement
© 2012 FARIN & Associates Inc.
99
Price to Same ROE
+ 0.637%
1. Will the customer pay an additional 0.637% to lock his Comm. R/E loan rate
for 20 years?
2. Will the availability of the product allow you to attract customers you might not
otherwise get?
© 2012 FARIN & Associates Inc.
100
Acme Commercial R/E Loan
© 2012 FARIN & Associates Inc.
101
Acme Commercial R/E Loan
Rate needed
to hit ROE Goal
Problem: No sale
Options:
• Rate
• Points
• Point buy down
• Relationship
© 2012 FARIN & Associates Inc.
102
Relationship – Add LOC
Up from 10.5%
© 2012 FARIN & Associates Inc.
103
Relationship – Add Bus Checking
Up from 10.95%
© 2012 FARIN & Associates Inc.
104
Relationship – Add Bus Checking Fees
Up from 11.79%
© 2012 FARIN & Associates Inc.
105
Origination Fee on Comm R/E
Up from 12.04%
© 2012 FARIN & Associates Inc.
106
Funding Fixed-Rate Mortgages
• FHLB Advances
• Deposits
– Long-Term CDs
• Recently Expensive
• Will lag the market in rising
rate environments
• Uncovered Options
– Relatively cheap now
– Will lead deposit rates in rising
rate environment
– Can be purchased
• With no imbedded options
• With options granted to the
FHLB (cheaper)
• With imbedded options
granted to the member (more
expensive)
– Non-Maturity Deposits
• Cheap source of long-term
funding especially when
rates are up.
• But do you bet the whole
shop on the results of a
core study?
– Can raise exactly what you
need, at a known rate, when
you need it
– Requires collateral
• SWAPs, CAPs and other off
balance-sheet instruments
© 2012 FARIN & Associates Inc.
107
Option Risk – What Is It
• 15 year FRM example showing remaining principal under different
rate environments
– Falling – 25% CPR – 2.75 year duration
– Flat – 8% CPR – 4.64 Year duration
– Rising – 5% CPR – 5.21 Year Duration
15 Year FRM
Remaining Principal
120,000.00
100,000.00
80,000.00
5% CPR
8% CPR
60,000.00
25% CPR
40,000.00
20,000.00
1
14
27
40
53
66
79
92 105 118 131 144 157 170
Month
© 2012 FARIN & Associates Inc.
108
Option Risk – Wholesale Institution
• Funding
7.0%
6.0%
Rate
5.0%
– Raised in bond market
4.0%
– If bullet funding is used to
3.0%
2.0%
fund instruments with
1.0%
significant option risk,
0.0%
-4.0% -3.0% -2.0% -1.0%
Flat
1.0% 2.0% 3.0% 4.0%
institution can be damaged
-1.0%
Rate Environment
Yield - Mortgages
Cost - Bullet Funding
however rates move
Unhedged Spread
Hedged Spread
– Operate with relatively
Unhedged - Zero or negative spreads in
narrow spreads so option
adverse rate environments
risk has a material bottom
Hedged – sacrifice spread to hedge option risk
line effect
Wholesale Institutions (Freddie, Fannie, FHLBs, etc.) must give up some of the
spread in order to hedge this risk using tools like, Swaps, Caps, structured debt
instruments (callable bonds), and the like.
That means investment views of profitability must consider option risk.
© 2012 FARIN & Associates Inc.
109
Option Risk – Retail Institution
NMD Extension Risk Hedge - Segmentation
– Mostly raised from
consumers
– Operate with wider spreads
and are willing to live with
moderate spread
fluctuations
– It can be argued that nonmaturity deposits inherently
hedge some option risk.
• But should I not make a
loan when the option risk
adjusted benchmark is
above market rates if I
elect to keep and have
already hedged the option
risk with non-maturity
deposits?
7.0%
6.0%
5.0%
Rate
• Funding
4.0%
3.0%
2.0%
1.0%
0.0%
-4.0%
-3.0%
-2.0%
Yield - Mortgages
-1.0%
Flat
1.0%
Rate Environment
Cost - NMD
2.0%
3.0%
4.0%
Spread
Unhedged prepayment risk
What this means is retail institutions with
inherent NMD deposit option risk hedges
may not need fully load option risk
adjustments in profitability analysis.
© 2012 FARIN & Associates Inc.
110
Blended Funding Using FHLB Advances
• Concept
– Use FHLB Advances to provide structural support
under fixed-rate loans
• Partially matched cash flows
• Prepayment protection
– Supplement FHLB Advances with non-maturity
deposits to plug funding gap taking advantage of:
•
•
•
•
Low cost
Pricing betas affected by segmentation
Decay rates
Inherent extension risk hedge
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Mortgage Retention Case
• Original interest rate risk
analysis showed
institution as fairly liability
sensitive
– Sell mortgages
– Keep investments short
– Reach out for long-term
funding
• Institution is interest rate
risk neutral after funding
strategy is in place
• Also very liquid – (low
yield investments)
• Strategies
– Base – No change in
strategy
– Mortgage 1 – Retain fixedrate mortgages
– Mortgage 2 – hedge some
of the risk in fixed rate
mortgages with FHLB
Advances
• IAR Rate Environments
– Global Insight
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• Low
• Base
• High
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Global Insight Base
65% probability
Base GI rate environment used in reports and in income at risk calculations.
Long term rates lift off gradually rising approximately 200 bp by end of 2014.
Short-Term rates steady for two years then move up by 200 bp in year 3.
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Global Insight High
Rates begin to move upward almost immediately, peaking 2 ½ years into forecast,
before trending back down. Short-term rates and long-term rates up 500 bp.
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Global Insight Low
25% probability
Low GI rate environment assumes a further rate drop then gradual lifting of long-term
rates with a spike occurring near end of 3rd year. Short-Term rates flat for 2 ½ years.
Then rising in last six months.
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Mortgage Strategy – IAR – 3 Yr
- With Advances
- W/O Advances
(25%)
(65%)
(10%)
Which strategy would you select?
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Mortgage Strategy - VAR
With FHLB
Advances
W/O FHLB
Advances
Mortgage 1
Mortgage 2
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ALCO Policy Limits
Dynamic capital ratios projected
from business plan or strategy
Earnings Goals
Dynamic income and economic
value at risk limits from business
plan or strategy
Dynamic liquidity risk limits from
business plan or strategy
Dynamic credit limits from
business plan or strategy
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ALCO Decision Tool
Base – OTS Core Assumptions:
• Capital is a bit below goals
• Earnings are only 75% of goal
• Income at risk and value at risk show
significant liability sensitivity
• Liquidity risk is minimal.
• Credit risk is in in yellow range due to
lingering asset quality problems
Base 3 year business plan. OTS assumptions used for core funding. Most results
are at the end of 3 years. Some average over 3 years.
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ALCO Decision Tool
Base – Institution Specific Core Assumptions:
• Capital still is a bit below goals
• Earnings are 80% of goal
• Income at risk and value at risk show
moderate liability sensitivity
• Liquidity risk is still minimal
• Credit risk is still in in yellow range due to
lingering asset quality problems
Note: All we have done here is substitute institution specific core funding assumptions
for OTS assumptions.
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ALCO Decision Tool
Base – Institution Specific Core
Assumptions, Deposit Segmentation
• Capital is closer to goals
• Earnings up to 90% of goal
• Income at risk and value at risk
is fairly neutral
• Liquidity risk is still minimal
• Credit risk is still in yellow range due
to lingering asset quality problems
Note: Major change from previous results is that we modeled the segmentation
strategies we plan to implement as rates go up.
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ALCO Decision Tool
Revised – Institution Specific Core
Assumptions, Deposit
Segmentation, Mortgage Strategy
with FHLB Adv.
• Capital is above goals
• Earnings are at 100% of goal
• Income at risk and value at risk
show moderate liability sensitivity
in business plan
• Liquidity risk is up with one
liquidity ratio going into yellow
range and two others moving closer
to yellow
• Credit risk is still in in yellow range
due to lingering asset quality
problems
Major change from previous example is that our interest rate risk position (moderate
asset sensitivity) allows us to reach out the yield curve on asset side of balance sheet
(loans and securities) to enhance yield, at a cost to liquidity.
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Questions?
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