Asset Liability Mgmt. Banking Book Risk

Asset Liability Mgmt. Banking Book Risk Tom Haczynski SVP SunTrust Bank Market Risk Management July 2015

The views expressed in the following material are the author s and do not necessarily represent the views of the Global Association of Risk Professionals (GARP), its Membership or its Management. 2

Today s Agenda I. Asset/Liability Management 4-11 II. Interest Rate Risk 12-30 III. Conclusion 31 IV. Acknowledgements 32 3

I. Asset/Liability Management Asset/Liability Management ( A/LM ), the management of long-term balance sheet risks arising from core banking activities, focuses on two major areas of risk: Interest Rate Risk ( IRR ) Liquidity Risk Key Objective: Achieve the desired trade-off between risk and return Funds Transfer Pricing Non Interest Income/Expense Allocation Methodologies Capital Attribution 4

I. Asset/Liability Management Achieve the desired trade-off between risk and return GAAP-Based Income Statement: Performance Measurement ("PM") Methodologies: PM-Based Income Statement Interest Income Loan Interest Income FTP Credit for Funds Less: Interest Expense Funds Transfer Pricing ("FTP") FTP Charge for Funds Deposit Interest Expense Equals Net Int Income ("NII") FTP'd NII FTP'd NII Less: Loan Loss Provision Expected Loss ("EL") + Chge Offs Equals Adjusted NII U/W process creates grids for Pricing Models Adjusted NII Plus: Less: Equals Non Int. Income Non Int. Expense Net Inc Before Taxes Non Int Income/Expense Allocation Methodologies Methodologies: ProRata / Direct Costing / Full Absorption / Svce Level Agmts ("SLA's") Net Inc Before Taxes Less: Equals Income Taxes Net Inc After Taxes Income Taxes Net Inc After Taxes Less: Capital Charge (EC * Hurdle Rate) Net Inc After Capital Charge ("NIACC") Divided by Equity Capital Capital Allocation Methodology Regulatory (Advanced, Standard), EC Based Equals Return on Equity ("ROE") Product NIM, RAROC & NIACC = Bal Sheet Optimization 5

I. Asset/Liability Management Loan Pricing Example Loan A Loan B Interest Income 5.00% 7.00% Interest Expense -2.00% -3.00% Net Int Income ("NII") 3.00% 4.00% Loan Loss Provision -0.20% -0.40% Adjusted NII 2.80% 3.60% Non Interest Income 0.40% 0.40% Non Interest Expense -0.80% -1.00% Net Income Before Taxes 2.40% 3.00% Income Taxes 33% -0.80% -1.00% Net Income After Taxes 1.60% 2.00% Equity Capital 8.00% 16.00% Return on Equity ("ROE") 20.00% 12.50% 8

I. Asset/Liability Management Bank Risk Management Financial Intermediation involves a bank s use of its balance sheet to move funding from depositors (i.e., savers) to borrowers Savers and borrowers do not know each other; they know only the bank Liquidity Risk, Interest Rate Risk and Credit Risk are caused by the differing attributes of depositors and borrowers Short term, floating rate $ Long term, fixed rate $ Depositors Bank Borrowers Liquidity Risk Interest Rate Risk Credit Risk 11

II. IRR Definition II. Interest Interest Rate Risk Rate Risk in the ALM Context means Adverse Impacts From Changes in Interest Rates On: 1 2 Net Interest Income (NII) Economic Market Value of of Equity ( MVE ) (EVE) Represents major revenue source for commercial banks Key area of focus for investor community Current Income Focus Based on the discounted Net Present Value (NPV) of the cash flows from all on and off balance sheet items Not externally reported; indication of economic value Extremely important concept many have not heard about Long-Term Shareholder Focus 12

II. IRR Sources & Drivers Balance Sheet Change in the Loan or Deposit mix Acquisitions, divestitures Hedging activity Yield Curve Change in the absolute level of rates Change in the steepness Spread & Basis Risk Impact of risk on vs. risk off Index used to price the funding differs from index used to price the asset Option Risk Adjustable rate loans with caps or floors Loans which give borrowers the right to prepay IMDs which allow depositors to withdraw funds at any time 13

II. IRR Balance Sheet Composition Measuring the Interest Rate Gap 14

II. IRR Balance Sheet Composition Levers to Manage the Position Management can alter the rate sensitivity of the Balance Sheet based on desired objective. Objective: Reduce asset sensitivity Increase asset sensitivity Reduce liability sensitivity Increase liability sensitivity Approach: Buy longer-term securities Lengthen the maturities of loans Move from floating-rate to fixed-rate loans Enter into a Receive-Fixed-rate swap position Buy short-term securities Shorten loan maturities Make more loans on a floating-rate basis Terminate an open Receive-Fixed-rate swap position Attract longer-term deposits Issue long-term debt Attract short-term deposits Borrow more via purchased liabilities 15

II. IRR - Example A Tale of Two Banks Re-pricing maintains spread and price stability 16

II. IRR - Yield Curve Potential Shapes Normal Inverted Flat 17

II. IRR - Yield Curve Actual Shapes Steep Curve -- 28 Jul 2003 Inverted Curve -- 27 Nov 2006 6.0 5.5 Interest Rate (%) 5.0 4.0 3.0 2.0 Interest Rate (%) 5.3 5.0 4.8 1.0 0 5 10 15 20 25 30 4.5 0 5 10 15 20 25 30 Tenor (Years) Tenor (Years) Flat Curve -- 12 Jun 2000 8.0 Interest Rate (%) 7.5 7.0 6.5 6.0 0 5 10 15 20 25 30 Tenor (Years) 18

II. IRR - Yield Curve Recent Trends Generally, the term structure of interest rates is upwardly sloping. Yield curve reflects expectations -- Fed actions, growth/inflation rates, market supply and demand forces etc. Yield curve movements can dramatically impact NII and MVE. US Swap Curve (%) Swap Curve Steepness (%) 5 4 3 2 1-3.0 2.5 2.0 1.5 1.0 0.5-6/30/2010 6/30/2014 6/30/2015 2Y vs. 5Y 2Y vs. 10Y 19

II. IRR - Yield Curve Labor Market Trends 20

II. IRR - Yield Curve Inflation Trends Inflation is well-below both the 2% long-term goal and 2.5% top end of FOMC s target range. Energy prices keep headline inflation low; market-based expectations rise for the first time since Oct-2014. Sustained low inflation measures call into question when the timing of the first Fed Rate hike will occur. Source: BEA, Moody s Analytics 21

II. IRR - Yield Curve Expected First Fed Rate hike Mar-16 Jan-16 Nov-15 Oct-15 Aug-15 Jun-15 May-15 Mar-15 Jan-15 32 22 19 21 15 13 11 9 8 7 The The Federal Reserve should wait until the first half of 2016 before raising interest rates because inflation remains too low and there are "significant uncertainties as to the future resilience of economic growth," per the IMF on 7/2/2015 in its annual review of the U.S. economy. 22

II. IRR - Yield Curve Fed Actions Since 1990 Source: FRED, Federal Reserve Economic Data 23

II. IRR Sensitivity A/LM managers rely on a sensitivity framework to measure and monitor IRR. Framework consists of what-if analysis of significant factors that affect IRR across a wide range of potential interest rate environments and business scenarios. Uses include: Limit compliance Inform/educate committee members Develop strategies It is critical to highlight: Key assumptions and Sensitivity of results 24

II. IRR Sensitivity Process The analysis includes the following 4 steps: 1. Scenario key inputs & assumptions: Base case rate scenario Current position, new volumes, contractual behavior Optionality (e.g., loan prepayments, deposits withdrawn early, rate caps/floors) 2. Identify major drivers: Assets and Liabilities that will re-price over different time horizons Off-balance sheet items that have cash flow implications 3. Calculate NII & MVE @ Risk under the base case rate scenario 4. Select a new interest rate forecast, re-run the model and compare to Base Case Impact of technology 25

II. IRR Sensitivity Process (continued) SURPRISES! Accuracy & Sophistication Gap Analysis Crude Earnings Simulations More Robust NII Simulations; Static MVE Multi-Dimensional NII & MVE Scenario Analyses 1970 s 1980 s Late 80 s - 90 s 90 s Forward Indicators Estimates Estimates and Measures Advanced Measures 26

II. IRR NII Sensitivity Scenario Results 8% Year 1 NII Sensitivity 6% 4% 2% 0% -2% Prior Current -4% -6% 27

II. IRR NII Sensitivity Scenario Results 9 Box SCENARIO: Rates Lower Most Likely Rates Higher Volumes Lower Base Case Base Case- Most Likely Volumes Higher 28

II. IRR NII Sensitivity Scenario Results 35 Box SCENARIO: Deposit Beta Lower Down Shock Flattener Most Likely Steepener Up Shock Deposit Growth Lower Loan Growth Lower Base Case Loan Growth Higher Base Case-Most Likely Deposit Growth Higher Deposit Beta Higher 29

II. IRR NII Sensitivity Scenario Results 30

III. Conclusion An effective A/LM process creates value by optimizing the risk/return tradeoff relative to a multitude of competing constraints! Regulatory Client Needs Product Mix Liquidity Interest Rate Risk Infrastructure Capabilities 31

IV. Acknowledgements Aleem Gillani Al Kolesar Tony Santomero SunTrust Bank SunTrust Bank Citigroup 32