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Building an Effective Stress Testing Process June 27, 2017 11:00AM PDT Insert Your Photo Here – If no photo available, center contact details on page. 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 18 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 19 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) 28 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