Download Building an Effective Stress Testing Process

Building an Effective Stress Testing
Process
June 27, 2017
11:00AM PDT
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Presented by:
Kevin Kirksey
Principal, Strategic Solutions
Group
ALM First Financial
Advisors, LLC
2911 Turtle Creek Blvd.
Suite 500
Dallas, Texas 75219
P: 214.451.3486
E: [email protected]
Agenda
• Regulatory imperative & history of stress
testing
• Data science and right-sizing models
• Using results to optimize business strategy
• Policy architecture and best practices in
documentation
2
Failed Model Rigor
• Long-term Capital Management
• Lost $4.6 billion in less than 4 months
• Required a $3.6 billion recapitalization
• Underestimated risk correlation and impact of leverage
• Lehman Brothers ceased operations after 158 years due to
losses from Financial Crisis
• Chapter 11 filing one of the largest and most complex in history
• Creditors filed approximately $1.2 trillion in claims against Lehman
• Banca Monte dei Paschi di Siena (BMPS) is the oldest
surviving bank in the world
• Performed poorly in stress tests from EBA
• Distressed loans forcing BMPS to receive a bailout of approximately
€9B
3
Depositories are Risky
• Financial industry is driven by modeling probability to evaluate
risk
• Success and compensation are determined by appropriate risk
evaluation
• Financial depositories invest in risk
• Model purpose needs to be well defined
• “I know that history is going to be dominated by an improbable
event, I just don’t know what that event will be.”
• Nassim Taleb, The Black Swan: The Impact of the Highly Improbable
• Banking is complex given our global and interconnected
economy
• Gut decisions and experience are not sufficient for devising strategy
• Models are more transparent
• Financial models can be faulty and need to be assessed for
model risk
4
Adequacy of Models
• Due to the importance of modeling in an institution,
financial models should be challenged regularly
• Models should adequately identify and quantify risk
• Data inputs must be priority
• Reports should be:
• Timely
• Accurate
• Comprehensive
• Model complexity must match the complexity of the
instruments being modeled
• With more model inputs, one should test for multicollinearity
5
Importance of Capital
• Absorb losses
• Expected versus unexpected losses
• Capital designates the percentage of assets that a financial
institution can stand to lose without becoming insolvent
• Promote public confidence
• Confident institution will survive to provide benefits in the future
• Instills confidence in the financial system as a whole
• Restricts excessive asset growth must
• Balance sheet growth mush be funded with both capital and
liabilities
• Overarching intention is to reduce systemic risk
• High-risk outliers
• Protect depositors and insurance funds
6
How Much Capital Does a
Depository Need?
• There is no single correct answer except “it depends”..
• It depends on the viewpoint of the party making the
assessment
• Generally, depositories are subject to four different capital
gauges:
• Regulatory capital requirements
• Are usually the most binding and all encompassing
• Rating agency capital requirements
• Many small to mid-sized institutions should not be concerned
• Investor-determined capital requirements
• Are really ROE requirements
• Probabilistic economic capital requirements
• Are analytically difficult but can be very insightful
7
Why is Excess Capital a Bad Idea?
• It’s expensive
• It carries more risk for investors than debt securities or
deposits
• Suppliers of capital generally ask for higher returns – why?
• Capital suppliers bear the bulk of the risk from a financial
institution’s:
• Loan book
• Investments
• Operations
• A financial institution holding excess capital must earn
higher profits, all else equal, to generate the same
return on equity for capital providers
• The government’s deposit guarantee makes excess
capital less valuable and transfers risk from the
government to the investor
8
Bank Captial Ratios
Bank Capital Ratios
16
14
12
10
8
6
Total Risk-Based Capital
Tier 1 Risk-Based Capital
Equity to Assets
Core Capital (Leverage)
Source: FDIC
9
Return on Average Equity for all
U.S. Banks
18
16
14
12
10
8
6
4
2
0
-2
Source: Federal Reserve Bank of St. Louis
10
Credit Union Historical Net Worth
Ratio
Net Worth
12
11.5
11
10.5
10
9.5
9
Source: NCUA
11
The Aftermath of the 2008
Financial Crisis
•
•
•
•
•
•
Estimated cost of crisis $12.8 trillion
8.8 million jobs lost and household wealth declined $19.2 trillion
Stock market initially lost $35 trillion but leveled off at $12 trillion
Losses on U.S. residential mortgage loans topped $2 trillion
Home equity declined by $7 trillion
Federal government debt increased from $9.2 trillion to $13.6
trillion from the end of 2007 through September 2010
• Citigroup, Morgan Stanley, Bank of America, Goldman Sachs,
JPMorgan Chase, and Wells Fargo received nearly $7.2 trillion
worth of assistance that was spilt between capital injections from
the Treasury and loans from the Fed
• Estimates losses from the government of $24 billion due to
capital injection paybacks plus interest
12
Response to 2008 Financial Crisis
• Troubled Asset Relief Program (TARP)
• Temporary Liquidity Guarantee Program (TLGP)
• FDIC increased deposit insurance coverage to $250,000
• Housing Economic Recovery Act of 2008 (HERA)
• Treasury’s rescue of Fannie Mae and Freddie Mac
• Basel III
• Requires banks to maintain certain leverage ratios and minimum
capital requirements
• Dodd-Frank Act Stress Test (DFAST)
• Designed to increase financial stability and prevent future
devastation from financial crises
• Attributed as the most significant legislative change to US
financial regulation since the Glass-Steagall Act
• Comprehensive Capital Analysis & Review (CCAR)
• Requires large bank holding companies with consolidated assets
greater than $50 billion to submit a proposed capital plan on an
annual basis to the Fed
13
Regulatory Imperative
• Stress tests were created after the 2008 financial
crisis when banks were found to be overleveraged
and overexposed to a bubbling real estate market
• Self-regulation failed in the banking industry
• Citi’s market cap fell $10B when failed stress test
• Can outsized ROE exist? AAA bond with AAA CDS wrapper
• Basel III: $250B+ banks (SCAP)
• Dodd-Frank: $50B+ banks (CCAR)
• Joint guidance: $10B+ banks (DFAST)
• Ranks ahead of all risks except cyber security and AML currently
• NCUA: $10B+ credit unions
• Threshold could be lowered
14
Quantitative Stress Testing
Analysis
• Stress testing is a forward-looking quantitative
evaluation of adverse macroeconomic environments
that could impact a financial institution’s financial
condition and capital adequacy
• Used to:
• Ensure capital is sufficient to withstand an economic
downturn
• Ensure integrity in the capital planning process
• Evaluate credit risk
• Risk assessments are based on assumptions related to
potential adverse external events
• Examples include:
• Changes in real estate or capital markets prices
• Unanticipated deterioration in a borrower’s repayment capacity
15
Dodd-Frank Act Stress Testing
(DFAST)
• Project balance sheet, net income, and post-stress capital
levels and regulatory ratios over a nine-quarter “planning
horizon” generally using a set of capital action assumptions
• The projections are based on three supervisory
macroeconomic scenarios required by the Dodd-Frank Act
•
•
•
•
Baseline
Adverse
Severely adverse
Idiosyncratic
• Projections are created annually by the Federal Reserve
• The adverse and severely adverse scenarios are not
forecasts but rather hypothetical scenarios designed to
assess the strength of the organization and their resilience
to an unfavorable economic environment
16
Capital Adequacy & Stress Testing
• Scenarios:
• Baseline, adverse, and severely adverse
• Variables include:
•
•
•
•
•
•
•
•
•
Economic activity
Unemployment
Exchange rates
Home prices
Incomes
Interest rates
Market volatilities
GDP growth
Inflation rates
17
Stress Testing Disclaimer
IF YOU PERFORM STRESS TESTING AS MERELY A THEORETICAL
EXERCISE TO MEET REGULATORY EXPECTATIONS, YOU MAY NOT
KNOW IF STRESSED RETURNS ARE WORTH THE CAPITAL
ALLOCATED OR IF CAPITAL IS DIVERSIFIED ENOUGH
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CPST Data Action Items
•
•
•
•
•
•
•
•
•
•
•
Identify and document data constraints proactively
Refresh data dictionary and regulatory mapping
Refine ownership and security governance
Optimize centralized datamart and warehouse architecture
Improve data capture at origination
Enhance loss mitigation documentation
Back-test and validate over full economic cycle
Align business unit heads with flexible reporting tools
Consider reputational issues, e.g. AML, cybersecurity, ATMs
Enhance statistical relevance to idiosyncratic risk modeling
Yearly roadmap with goals for improvement
• IT Steering Committee
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Implementing CPST Results
• Depositories can employ the results from stress tests for risk
management and strategic planning processes
• The board of directors and senior management can rely on
stress testing model results and documented capital plan to:
•
•
•
•
•
Clarify position to the regulators
Diagnose areas needing strategic and operational improvement
Examine the risk appetite statement and ERM framework
Evaluate lending concentrations at the portfolio level
Assess the adequacy of capital and the allowance for loan and lease
losses (CECL)
• Increase effective challenge across multiple models and
departments
• Reconcile with the member experience and
philosophy
• Material business plan changes and variances
20
Documenting the Deposit
Franchise
• Intramonth liquidity/operational failures
• Steady-state liquidity and dividend pricing betas
• Review incentive structures and cross-sell performance
for deposit products to prevent cannibalization
• Brick and mortar branch strategy
• Can increased technology help drive growth?
• NPS, teller line abandonment, % mobile transactions, wallet
share metrics, insured/uninsured bifurcation, cost to acquire
• Trends after mobile updates and payment enhancements
• Enhanced cybersecurity as mitigating factor
21
Recovery Lag / Collections Data
• Bankruptcy chapter and
dates
• Repossession and
auction timelines
– Kill switch and lojack
• Litigation
• Regulatory reform
• Foreclosure vs. short sale
and deed-in-lieu
• REO to rental
• Modification
Data Sources
Data Element
Period cap/floor
First period cap/floor
Lookback days
IO Term
Current debt-to-income ratio
Current credit score
Current LTV ratio
Original LTV ratio
Original credit score
Source
Loan agreement
Loan agreement
Loan agreement
Loan agreement
Borrower financials
Borrower credit report
Appraisal
Underwriting/Credit dept
Underwriting/Credit dept
Update Frequency
At origination
At origination
At origination
At origination
Annually
Annually
Annually
At origination
At origination
• Start and end dates
• Loss mitigation notes
22
Data Governance
Data Governance: Roles, Responsibilities & Procedures
Responsibilities
Review data collected from critical
business areas
Ensure data dissemination to
appropriate parties
Create and manage a data
dictionary
Create policies and procedures
Establish and monitor quality
review
Support data systems
Procedures
Data should be captured from all aspects of the organization;
lending, risk, retail, etc.
Captured data should be disseminated between all departments
for monitoring and use. Lending should have quick access to
credit data and risk should communicate frequently with lending
and retail to develop appropriate frameworks.
Data
Analyst
Chief Risk
Officer
IT
Manager


Data dictionary should include descriptions of data elements
along with element size and any default values.
Policies and procedures should be incorporated as part of the full
data governance and should be managed by the Risk Department.

Reviews on the procedures and quality of data collected should
be performed as part of an annual internal audit.
Data systems should be updated and maintained to ensure
efficiency in the collection and dissemination of data.



23
Non-Financial Risk Appetite
Examples - Operational
Operational Risk Appetite
Risk Type
Low Risk
Moderate Risk
High Risk
Severe Risk
Loss volume, legal
Internal Fraud - Embezzlement, employee
action, regulatory
theft, policy abuse
comments
Loss < 25k
Loss $25k - $50k
Loss $25k - $250k
Loss > $250k
Loss volume, legal
External Fraud - Theft from ATM or
action, regulatory
institution, cybercrime, money laundering
comments
Loss < $500k
Loss $500k - $1M
Loss $1M - $1.5M
Loss > $1.5M
Productivity loss 5% 10%
Productivity loss >
10%
Business Disruption - Failure of IT or
utilities
Observable KPI
Age of assets,
maintenance frequency, Productivity loss < Productivity loss 2% warranty coverage,
2%
5%
vendor contingency
Workplace Safety - Active shooter, natural
Productivity loss < Productivity loss 5% Workforce productivity
disaster, hazardous environment
5%
10%
Productivity loss 10% - Productivity loss >
15%
15%
24
Non-Financial Risk Appetite
Examples – Reputation
Reputation Risk Appetite
Observable Risk
Social media feedback
Community involvement
Low Risk
> 4 stars on Yelp
Moderate Risk
> 3 stars on Yelp
High Risk
> 2 stars on Yelp
Executive pay out of
Discriminatory lending
line with area economy practices
ATMs experience
software malfunction
Business partner accused of
unfair practice
Outdated mobile
banking platform
Extended website outage
Severe Risk
< 2 stars on Yelp
Offered rates invalidate
mission statement
Fraudulent account openings
25
NCUA & CFPB
Required Actions
As-of date for capital plan and NCUA stress test data
NCUA releases stress test scenarios
Credit union submits capital plan to NCUA
NCUA provides NCUA-run stress test results to credit union
NCUA accepts or rejects credit union's capital plan
Credit union submits stress test capital enhancement plan, if required
Credit union submits revised capital plan, if required
Credit union requests authority to conduct stress tests
NCUA approved or declines credit union's request to conduct stress tests
Deadline
December 31. 2016
February 28, 2017
May 31, 2017
August 31, 2017
August 31, 2017
November 30, 2017
November 30, 2017
November 30, 2017
December 31, 2017
*A credit union will be subject to the capital planning and stress testing requirements in the following
calendar year if their assets are greater than $10 billion on March 31 of the current calendar year.
• Real estate settlement procedures act (RESPA)
• Credit card disclosures
• Overdraft practices
• “disparate impact” proof
• Unfair, deceptive, or abusive act (UDAAP) policy
• Foreign national borrowers
• Stratify data by race, gender, ethnicity, age, etc.
26
Capital Triggers & Action Plan
Summaries
Condition
PCA Net Worth Ratio
Normal
Adequate
≥ 10.00%
≥ 7.50% to 10.00%
Breach
> 6.50% to 7.50%
≤ 6.50%
Severe Breach
Action
Post-Stress PCA Net
Worth Ratio
Actions
Reporting & Monitoring
Normal capital management activities
Identify capital actions
Normal reporting cycle
Normal reporting cycle
< 6.00%
Initiate moderate capital actions
Capital action plan presented to CMC &
ICCAP Oversight Committee
< 5.00%
Initiate significant capital actions
Capital action plan presented to CMC &
ICCAP Oversight Committee
Pros
Cons
Stakeholder
Timing
Implementation
Feasibility in
Stress
Reduce discretionary
compensation
Immediate capital impact by eliminating
accruals
Could result in loss of talent
Human Resources
1 month
High
Adjust salaries
Improves capital
Could result in loss of talent
Human Resources
3-12 months
High
Reduce other expenses
Immediate savings
1 month
High
Sell portfolio loans
Immediate reduction in capital utilization
3-12 months
Low
Sell investments
Immediate reduction in capital utilization
1 month
Medium
Reduce deposit rates
Immediate reduction in interest expense
Human Resources
SVP, Finance; SVP
Loss on sale and future earnings
Finance Lending
Lower liquidity & lower future
CIO
earnings
Lower liquidity & member
SVP, Finance
outflow
1 month
High
Increase lending rates
Increase interest income
3-12 months
High
Loan originiation
SVP, Finance
27
Capital Planning Committees
• Board of Directors (Capital Mgmt. Co. for
oversight/enforcement)
• Internal Capital Adequacy Committee
• ERM Co. (ERM policy, capital policy, capital plan)
• Credit Co.
• ALCO (budgeting, pro forma IRR)
• Stress Testing Working Group
• IT representation (data stewards, reporting champions)
• Audit Committee
• Process assessment, validation
• Chief Risk Officer
• Model Risk Management (inventory, intended use, change
logs)
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Credit or Risk?
• Robust modeling capabilities allow for more
effective evaluation of credit risk
• Once a solid credit modeling framework has been
established, applications of results increase
substantially
• All credit outputs have similar foundations but
assumptions a modified to fit desired output
• Increased data requirements to receive meaningful
outputs
29
CPST Checklist (Systems & Human
Capital)
• Multi-dimensional credit risk analysis at a point in time
• Forward-looking analysis in prescribed baseline, adverse,
and severely adverse scenarios (bottom-up approach)
• Data warehouse/data lake + governance
• Transparent and auditable results (proxy data as needed)
• Relentless devotion to model development, data science,
and scenario analysis with deep industry experience
• Capital plan and ERM policy documentation and review
• Technical writers for appendices required under DFAST
• Commitment to board education and strategic advisory
• Peer collaboration and regulatory acceptance of
champion model
30
Conclusions
• Market conditions can deteriorate rapidly, minimizing time
to adjust strategies
• Success is determined by an institution’s ability to evaluate and
invest in risk
• Model risk should be scrutinized
• Stress testing is used to ensure capital is sufficient to
withstand an economic downturn and to enhance integrity
in the capital planning process
• The degree of stressing ranges from the complex DoddFrank Annual Stress Testing (DFAST) to a more simple
method of incorporating credit risk projections in the EV
analysis
• Regulators and strategic plans require documentation
• It all starts with aligning data science with business philosophy
31