Federal Reserve Bank Surveillance and Early Warning System

Federal Reserve Bank Surveillance and Early Warning System Kevin Bertsch Deputy Associate Director Surveillance, Financial Trends & Analysis Section Division of Banking Supervision & Regulation Board of Governors of the Federal Reserve System

Overview State Member Bank Watchlist Program SR-SABR Model Bank Holding Company Surveillance Programs Distribution of Surveillance Results BOND Notifications PRISM Application 2

Federal Reserve Supervisory Responsibilities Direct oversight of state member banks Roughly 10 percent of U.S. banks by Number About 15 percent of U.S. Bank Assets Supervisor of BHCs Supervisory interest in roughly 80 percent of banks by number These banks hold more than 95 percent of bank assets in the U.S. U.S. Activities of Foreign Banking Organizations 3

Role of Surveillance Identify deterioration between on-site examinations in a timely manner Assist in allocating supervisory and examination resources Support pre-exam planning Identify banking industry trends

Surveillance Process Compile measures of risk, condition, and performance Flag outliers and provide results to Reserve Banks Reserve Banks determine action for most screen failures But written analysis or on-site exams required if change or deterioration is substantial 5

Federal Reserve Surveillance Programs State Member Bank Watch List Program (SR 06-2) Small Bank Holding Company Surveillance Program (SR 02-01) [Large] BHC Surveillance Program (SR 95-43) 6

State Member Bank Watch List 7

State Member Bank Watch List Criteria SR-SABR Rating of 1D, 1F, 2D, or 2F CAMELS composite, Management component, or Risk Management rating worse than or equal to 3 Specialized exam ratings in either of the worst two categories 8

Additions to Watchlist Reserve Banks and Board staff may add banks that do not meet above criteria For example, de novo banks, banks reporting rapid asset or loan growth or significant changes in business mix may be added to the watchlist 9

Follow-up Requirements Assess the financial condition and risk profile of each watchlist state member bank Determine whether safety and soundness examination should be accelerated--if yes, commence within 60 days Prepare a surveillance write-up for each Watch List bank within 30 days 10

System Bank Monitoring Screens Capital levels Dividends Asset growth Loan quality Loan concentrations Liquidity Capital Markets Activities

The SR-SABR Model

SR-SABR Model SR-SABR Model (Supervision and Regulation Statistical Assessment of Bank Risk Model) assigns a two-component rating to each bank: The first component is the current CAMELS rating The second component is a letter reflecting the model s assessment of the relative strength or weakness of a bank compared to other banks with similar CAMELS rating

Interpreting SR-SABR Letter Grades A denotes strong financial and supervisory indicators compared to other like-rated banks F signifies particularly weak financial and supervisory indicators compared to other similarly-rated banks 14

SR-SABR Combines Results from Three Separate Econometric Models Two models assign an adverse change rating The first model estimates the probability of an adverse rating change for banks currently rated CAMELS 1 or 2 The second model estimates the probability of an adverse rating change for banks currently rated CAMELS 3, 4, or 5 The third model assigns a viability rating, which represents the probability that a bank will fail or become critically undercapitalized within the next two years Overall SR-SABR rating is the worst of either the adverse change or the viability rating

Variables in the SR-SABR Model Financial ratios computed from Call Report data -- many from the Uniform Bank Performance Report Examination ratings

Adverse Change Rating-- Supervisory Variables For banks rated 1 or 2 Management Component Worse than Composite CAMELS rating For banks rated 3, 4, or 5 Composite CAMELS rating Asset Quality Component Rating Management Component Rating Liquidity Component Rating Sensitivity to Market Risk Component Rating 17

Adverse Change Rating-- FinancialVariables Tier 1 Leverage Ratio Nonperforming assets to Equity plus loan loss reserves Loans past due 30 to 89 days Loans past due 90 days or more Asset Growth Pre-tax return on average assets Asset Growth 18

Definition of Adverse Change Prior CAMELS New CAMELS 1 or 2 3 or worse 3 4 or worse 4 5 5 5 19

Assignment of Adverse Change Rating Adverse Change Probability Letter Grade <1% A 1-5% 5-15% 15-35% >35% B C D F 20

Capital Proxies Viability Rating Variables Equity Capital/Total Assets Earnings Proxies Return on Average Assets Asset Quality Proxies Loans Past Due 30-89 Days/Total Assets Loans Past Due 90+ Days/Total Assets Nonaccrual Loans/Total Assets Other Real Estate Owned/Total Assets

Viability Rating Variables (Continued) Liquidity Proxies Deposits over $100,000/Total Assets Book Value of Securities/Total Assets Diversification Proxies C&I Loans/Total Assets Residential Real Estate Loans/Total Assets Asset Size

Assignment of Viability Rating for 1- and 2-Rated Banks Failure Probability <0.05% 0.05-1% 1-3% 3-10% Letter Grade A B C D >10% F 23

SR-SABR Tools 1. SR-SABR Schedule of Risk Factors - Shows importance of model variables to model results. 2. SR-SABR Change Analysis Report - Identifies the changes in model variables that resulted in an adverse SR-SABR rating.

BHC Surveillance Programs Small BHC Surveillance Program Large BHC Surveillance Program 25

Small Bank Holding Company Surveillance Program Covers roughly 4,700 small bank holding companies with less than $1 billion in assets Distributed quarterly Reserve Banks follow-up within 45 days 26

Screen Criteria Supervision of small BHCs relies significantly on exams of bank subs conducted by primary supervisors So screens do not address financial condition of subsidiary banks Screens focus on issues directly related to the Holding Company and Nonbank Subs 27

Small BHC Screens Parent company Double leverage, cash flow, nonbank losses Intercompany transactions Management fees, dividends paid on losses by bank Leverage Increase in debt to equity, TPS and relatively weak banks, low consolidated capital ratios 28

Program Support Screens Complexity Nonbank revenue and assets, GLBA activities, parent and nonbank loans, debt to noninsiders Financial Holding Company Compliance 29

Follow-up Requirements Evaluate screen results and take appropriate action in 45 days Determine whether screen results indicate risk to insured depository subsidiaries If yes, contact BHC for more information, request corrective action plan, implement heightened off-site monitoring, or schedule on-site review Document follow-up actions 30

Large BHC Surveillance Program Covers roughly 400 top tier BHCs Distributed quarterly Reserve Banks complete a write-up for BHCs meeting exception criteria within 30 days Top 50 BHCs are excluded from write-up requirement 31

Exception Criteria Weighted CAMELS rating significantly worse than Depository Institution Component of BHC Rating (Ratings Screen) SR-SABR rating for lead bank is 1D, 1F, 2D, 2F, 3D or 3F and BHC is rated composite 1, 2, or 3 Weak financial performance (Financial Screen) Unrealized securities depreciation to tier 1 capital of 15 percent or more and adjusted tier 1 leverage ratio of 5 percent or less (Investment Activities Screen) 32

BHC Monitoring Screens Financial Parent Company Capital Markets 33

Distribution of Surveillance Results 34

Surveillance Contacts Designated contact in each Reserve Bank Contacts receive surveillance results for companies in their districts each quarter and communicate results to field examiners 35

BOND Notifications Quarterly financial and rating screens from the bank and BHC surveillance programs Daily Supervisory rating changes Daily Supervisory Risk assessment changes Quarterly changes in cross border exposures 36

PRISM Application Secure, web-based application for Federal Reserve examiners and analysts Bank, bank holding company, and crossborder exposure surveillance summaries Includes SR-SABR Schedules of Risk Factors and Change Analysis Reports Customized analysis and reports 37