Lecture Materials Session 4 BANK PERFORMANCE ANALYSIS AND CAPITAL PLANNING

Transcription

1 Lecture Materials Session 4 BANK PERFORMANCE ANALYSIS AND CAPITAL PLANNING David Koch President & CEO FARIN Financial Risk Management Madison, Wisconsin dkoch@farin.com August 12, 2016

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3 BANK PERFORMANCE ANALYSIS & CAPITAL PLANNING SESSION 4: RISK MEASUREMENT & CAPITAL PLANNING Dave Koch Farin & Associates, Inc. 1

4 Four Sessions Session 1: Planting the tree Balance Sheet and Income Statement Session 2: The tree top ROE Tree ROA Tree Net Operating Income Tree Session 3: The tree roots Net Int Margin/EA Tree Interest Inc/AA Tree Interest Inc/EA Tree Int Exp/AA Tree Int Exp/IPL Tree Non Interest Margin/AA Tree Non Op Margin/AA Tree Taxes CAMELS Session 4: Reforestation UBPR & Risk Measurement Capital Planning 2

5 Risk Management and Performance What Risks Do We Take That Impact Our Financial Performance and Expose Our Roots? Credit Risk Liquidity Interest Rate Concentration 3

6 Managing Risk Managing risk is not just about identifying, assessing, and monitoring all the things that could go wrong. It also is about understanding all the things that need to go right for a bank to achieve its mission and objective of safely and profitably serving its customers and community. Carolyn G. DuChene Deputy Comptroller Operational Risk OCC 4

7 Regulators, peers and my performance expectations WHERE DO I TAKE RISK? 5

8 Financial Risk Assessment Risk forms Strategic risk Regulatory risk Interest rate risk Credit risk Liquidity risk Market risk Operations risk Risk monitoring tools CAMELS Ratings Other regulatory ratios UBPR\FPR reports Canary ratio Peer comparisons Internal projections of future performance More risk in the projections Better indicator of risk in plans 6

9 Regulatory Risk Assessments OCC Canary Ratios Developed set of key metrics for early warning identification 3 Categories, 15 ratios Credit Risk Interest Rate Risk Liquidity Risk Each ratio compared to threshold level If within tolerance, assigned a 0 rating Outside tolerance receives 1 rating Score 8 is HIGH risk institution 7

10 Canary Ratios 8

11 Canary Ratios Low Risk < 8 9

12 Historical Ratio Analysis CAMELS or CANARY ratings review past performance Compared to peer levels Compared to threshold levels But, no weighting for institutional risk appetite and strategy Assumes same thresholds for all institutions No weighting for different measures in a given risk area No consideration for operating plans or environment A very basic litmus test Good starting point Not good for board use without explaination 10

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14 Overview The CAMELS rating system is used to: Assess the soundness of financial institutions on a uniform basis Identify those institutions requiring special supervisory attention Monitor aggregate trends in overall soundness of financial institutions 12

15 Overview Originally adopted by the FFIEC in 1979 Revised in 1997 to address the changes in the industry and in supervisory procedures Increase the emphasis on quality of risk management practices Addition of the Sensitivity to Market Risk component Decrease peer comparison emphasis 13

16 Overview of Risks Manage Risks Posed from: Credit Risk the potential that a borrower will fail to repay the bank as agreed Market Risk Changes in performance due to adverse movements in market rates or prices, such as interest rates, foreign exchange rates, or equity prices. Liquidity Risk potential that a bank may be unable to meet its obligations as they come due, because of an inability to liquidate assets or obtain other funding. 14

17 Overview of Risks Manage Risks Posed from: Operational Risk the potential that inadequate information systems, operational problems, breaches in internal controls, fraud, or unforeseen catastrophes will disrupt bank operations or otherwise result in unexpected losses. Legal Risk the potential for operational disruption or other negative effects from unenforceable contracts, lawsuits, adverse judgments, or noncompliance with laws and regulations. Compliance risk falls under the legal risk umbrella. Reputational Risk the potential for negative publicity from a bank s business practices to cause a decline in the customer base, costly litigation, or revenue reductions. 15

18 Structure & Framework Six Component Ratings of CAMELS: Capital Adequacy Asset Quality Management Earnings Liquidity Sensitivity to Market Risk Component and Composite Ratings Strong Satisfactory Less than Satisfactory Unacceptable Critically Deficient 16

19 Component Ratings Ratings process has always contained elements of subjectivity and examiner judgment Reasonably applied based on the examiner s experience, knowledge, and familiarity with the institution Each component rating based on a qualitative and quantitative analysis of specified factors and interrelationship with other components 17

20 Calculating Your CAMELS? Historical Weightings by Component Ideally you could assess your own values for each and apply weightings Compare your values to the regulators and tune 18

21 UBPR Ratios Tab/Page 1 of UBPR Covers Many CAMELS ratios Earnings and Profitability E Margin Analysis E & S Loan & Lease Analysis A Liquidity L Capitalization C Why do CAMELS ratings matter? Lower rated banks are assessed higher premiums for insurance than higher rated Think health insurance 19

22 Capital Adequacy - Key Financial Ratios Effective 1/1/2015 these will switch to the 4 new ratios discussed in ALM section Total risk based capital /risk weighted assets Tier 1 capital/ risk weighted assets Leverage Ratio Other Ratios Asset Growth Rates Capital Growth Cash dividends/net income 20

23 Asset Quality - Key Financial Ratios Also referred to as Credit Risk Key measures Noncurrent Loans/Total Loans Net Loans/Average Total Loans ALLL/Net Loan Losses ALLL/Noncurrent Loans Total Capital/Noncurrent Loans Total Capital/Noncurrent Loans Net Income b4 taxes/net loan losses 21

24 Credit risk the potential variation in net income and market value of equity resulting from nonpayment or delayed payment. Three Question need to be addressed: What has been the loss experience? What amount of losses do we expect? How prepared is the bank? 22

25 CAMELS Credit ratios - Purpose What has been the loss experience? - History Net loss to average total LN&LS Gross losses to average total LN&LS Recoveries to avg tot LN&LS Recoveries to prior period losses. Net losses by type of LN&LS How prepared are we? Management Loss Provision to: average assets and avg tot LN&LS LN&LS Allowance to: net losses and total LN&LS Earnings coverage of net loss What amount of losses do we expect? - Projected Non current LN&LS to tot loans Total P/D LN&LS incl nonaccural Non curr restruc LN&LS / GR LN&LS Curr Non curr restruct / GR LN&LS Past due by loan type 23

26 Credit risk ratios Credit risk ratios on Page 7 24

27 Credit risk ratios Credit risk ratios on Page 8a 12/31/ /31/2014 % of Non-Current LN&LS by Loan Type BANK PG (%) BANK PG (%) Coml & Indust LNS-90+ Days P/D Nonaccrual Total DAYS P/D Loans to Individuals-90+ Days P/D , Nonaccrual Total , DAYS P/D C dit C d Pl 90 D P/D Total LN&LS-90+ Days Past Due Nonaccrual Total DAYS P/D

28 Liquidity - Key Financial Ratios No guidance or primary ratios used in examination Supplemental ratios Loans/deposits Brokered deposits/total deposits Net noncore funding dependence Fed Funds Purchased/total assets FHLB Advances/Total assets Pledged securities/total securities Heavy emphasis on cash flow based liquidity projections 26

29 Liquidity risk Banks can acquire liquidity in two distinct ways: By liquidation of assets. Composition of investments Maturity of investments By borrowing. Core deposits Volatile deposits the variation in net income and market value of equity caused by a bank's difficulty in obtaining cash at a reasonable cost from either the sale of assets or new borrowings. 27

30 Liquidity risk ratios: Page 10 Strong core deposits Weak ST investments to ST non core 28

31 Liquidity risk ratios: Page 11 Liquidity risk ratios on Page 11 Note that 81% of the securities portfolio is in MBS Impact on future liquidity if rates rise? 29

32 Earnings - Key Financial Ratios Major components of Tree Diagram Focus on the quality of earnings as well as the level What are the trends and risks? 30

33 Sensitivity to Market Risk - Key Financial Ratios Again no formal ratios or peer comparisons Too many independent variables Looking for quality of measurement systems for Earnings at risk Value at Risk Looking for quality of management of risk Results match performance ALCO minutes discuss meaningful issues Changes in plans are assessed for risk PRIOR to implementation 31

34 Market risk Market risk arises from changes in: Interest rates Foreign exchange rates Equity and security prices. the risk to a financial institution s condition resulting from adverse movements in market rates or prices. 32

35 Interest rate risk Example: $10,000 4 Yr car loan at 4.5% 1 year CD at 1.5% Spread 3.0% But for How long? What happens when interest rates rise in the next year? What if the rates were to fall?. the potential variability in a bank's net interest income and market value of equity due to changes in the level of market interest rates 33

36 Foreign exchange risk Foreign exchange risk arises from changes in foreign exchange rates that affect the values of assets, liabilities, and off-balance sheet activities denominated in currencies different from the bank s domestic (home) currency. This risk is often found in off-balance sheet loan commitments and guarantees denominated in foreign currencies; foreign currency translation risk. the risk to a financial institution s condition resulting from adverse movements in foreign exchange rates. 34

37 Equity and security price risk Large banks must conduct value-at-risk analysis to assess the risk of loss with their trading account portfolios. change in market prices, interest rates and foreign exchange rates affect the market values of equities, fixed income securities, foreign currency holdings, and associated derivative and other off-balance sheet contracts. 35

38 Operational risk Typical ratios focus on: total assets per employee total personnel expense per employee noninterest expense ratio There is no meaningful way to estimate the likelihood of fraud or other contingencies from published data A bank s operating risk is closely related to its operating policies and processes and whether it has adequate controls measures the cost efficiency of the bank's activities; i.e., expense control or productivity. 36

39 Operational risk ratios: Pg.. 3 Total Assets/ # of employees Personnel Exp / # of employees Efficiency ratio Overhead less non int income / Avg Assets 37

40 Capital risk The more risk taken, the greater is the amount of capital required. Appropriate risk measures include all the risk measures discussed earlier as well as ratios measuring the ratio of: tier 1 capital and total risk based capital to risk weighted assets, equity capital to total assets, dividend payout, and growth rate in tier 1 capital. closely tied to asset quality and a bank's overall risk profile 38

41 Legal risk Legal risk include: Compliance risks Strategic risks General liability issues the potential that unenforceable contracts, lawsuits, or adverse judgments can disrupt or otherwise negatively affect the operations or condition of banking organization 39

42 Reputational risk Reputational risk is the potential that negative publicity regarding an institution s business practices, whether true or not, will cause a decline in the customer base, costly litigation, or revenue reductions. 40

43 Management Quality - Key Ratios No firm ratios subjective management refers to a host of factors necessary to operate a bank in a safe and sound manner. It includes the quality and character of individuals who guide and supervise the bank, encompassing their: knowledge, experience, and technical expertise; leadership, organizational, and administrative skills; planning skills and adaptability; and honesty and integrity. 41

44 Keys to Managing Ratios Regulatory analysis focuses on 2 factors: 1. Level of performance What is the actual current or recent past performance level and is it OK? 2. Trend in performance How has the trend in performance changed and is it cause for concern Combination of both results in rating Not sure of the weighting between level vs. trends May change based on situation Management assessment loosely based subjective assessment of internal controls, processes, reporting, and ability to communicate effectively with examiners. Think about a levee to hold back flood water When current levels are low, low risk room to take on more If flooding is predicted, the trend in water levels is what matters more Management s approach to handling this is the understanding of both factors 42

45 Balanced Assessment 43 Balance Weight Balance Weight 65% 35% Historical CAMELS Forecast Weight Component Weight 25% C 15% 20% A 25% 25% M 25% 10% E 15% 10% L 10% 10% S 10%

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