Fundamentals of Sound Risk Management in Community Banks

Agenda

• Key Elements of Sound Risk Management Programs

• Examples of Key Elements in Liquidity Risk Management

• Tools and References

Why Are We Talking About This?

Risk Management Key Elements

• Board and Senior Management Oversight

• Policies, Procedures, and Risk Limits• Risk Measurement, Monitoring, and

MIS• Internal Controls

Board And Senior Management Oversight

• Primary Board Responsibilities: Possess working knowledge and remain

informed of risks inherent in institution’s activities

Review and approve appropriate policies to limit key risks

Periodically evaluate and approve risk exposure limits

Board And Senior Management Oversight

• Primary Management Responsibilities: Ensure business lines are adequately staffed

with employees having sufficient expertise Provide adequate supervision of daily business

activities Respond appropriately to risks arising from

changes in competitive environment and/or market innovations

Ensure that the proper infrastructure and internal controls are in place prior to embarking on new activities or products

• Key Issues Regarding Liquidity Risk Oversight Include: Cashier/CFO and ALCO expertise Appropriate risk limits in liquidity risk

management policiesConsideration of liquidity crisis events in

contingency funding plan and processPlanning processes, MIS, and measurement

tools to effectively carry out board guidance

Board And Senior Management Oversight

Policies, Procedures, and Risk Limits

• Generally, Policies Should: Provide for proper identification,

measurement, monitoring, and control of key risks

Delineate accountability and authority Address new activities prior to

implementation

Policies, Procedures, and Risk Limits

• Example: Key Asset/Liability Management Policy Components: Delegation of clear lines of authority

(ALCO/CFO) Quantifiable liquidity risk limits Specifications for measuring and reporting

liquidity risks Guidance for completion and review of

contingency funding plans

Risk Measurement, Monitoring, and MIS

• Adequate Measurement and Monitoring Require Reporting Mechanisms That: Sufficiently address all material risk areas Contain appropriate and reasonable inputs Communicate consistency with established

limits, goals, and expected performance Provide accurate, timely, and sufficiently

detailed information to identify adverse trends and current risk exposures

Risk Measurement, Monitoring, and MIS

• Liquidity Risk Measurement Traditionally Focused on Analyzing Several Common Ratios: Loans to deposits Noncore funding dependence “Liquidity ratio” Unpledged investments to total assets

• Limitations of Traditional Ratios: Definition differs from reality:

» noncore “core” and core “noncore”» illiquid securities and liquid loans

Static, point-in-time, not forward looking Based upon contractual maturities and do

not incorporate behavioral expectations Does not measure anticipated funding

needs or access to funds

Risk Measurement, Monitoring, and MIS

Weak Risk Measurement Tools Lead to Weak Risk Management

• Alternatives to Traditional Ratios: Trended ratios adjusted for:

» large deposits considered core» small deposits demonstrating noncore

features Liquidity gap reports Sources and uses reports and projections

Risk Measurement, Monitoring, and MIS

Total Potential Outflows/ Day Days Week Week Week Month Month Months

Funding erosion 1 2-7 2 3 4 2 3 4+

Federal funds purchased

Uncollateralized borrowings

Non-maturity deposits:

Retail CDs under $100,000

Jumbo CDs

Brokered CDs

Subtotal

Off-balance sheet funding requirements

Loan commitments

Backup lines

Other off-balance sheet items

Total Potential Outflows

Risk Measurement, Monitoring, and MIS

Total Potential Sources to Cover Outflows

Day Days Week Week Week Month Month Months1 2-7 2 3 4 2 3 4+

Overnight funds sold Unencumbered securities Residential mortgage loans Consumer loans Business loans Fixed/Other assets Unused borrowing capacity Brokered funds capacity

Subtotal Net cash flows

Coverage Ratio Cumulative Coverage Ratio

Risk Measurement, Monitoring, and MIS

Internal Controls

• Preventative Controls: Segregation of duties Approvals Dual controls Access limitations Contingency plans

• Detective Controls: Audits Management reporting Activity logs

Scenario Analysis and Contingency Funding Plan

• Types of Adverse Scenarios: Institution specific:

» asset quality concerns/capital loss» unavailable borrowing lines» operational risk/fraud» reputation risk event

Systemic:» uncertainty in market:

– FFP and borrowing lines (market disruption)– breakdown of brokered deposit markets

» systemic credit crisis

Scenario Analysis and Contingency Funding Plan

Business As Usual

Less Likely

Unexpected

Bank Specific

Each scenario requires the liquidity manager to assess and plan for potential funding shortfalls Systemic

Adverse Scenarios

• Contingency Funding Plan Components: Quantitative:

» based on adverse scenario analysis – significant enough to cause problems

» estimates need to be reasonable » is there over-reliance upon any one source?

Scenario Analysis and Contingency Funding Plan

• Contingency Funding Plan Components: Qualitative:

» description of stress scenarios» steps to declare a crisis, trigger events » contact information for critical team members» responsible parties to initiate external

communication » reporting requirements: what, when, how

Scenario Analysis and Contingency Funding Plan

Summary

• Key Elements of Risk Management: Must be specific to each institution’s risk

profile Needs to be in place prior to commencing

activity• Sound Liquidity Risk Management

Practices: Appropriate risk limits Scenario analysis and contingency plan

References

• Risk Management References: Reserve Bank’s Web site SR Letter 95-51 Commercial Bank Examination Manual Trading/Capital Markets Examination

Manual

Fundamentals of Sound Risk Management in Community Banks

Questions?