Turning the 5 C’s into an Risk Scoring Model - farin.com · Turning the 5 C’s into an Objective Risk Scoring Model 1 ... Giving a lender collateral means that you

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© 2015 FARIN & Associates Inc.

Turning the 5 C’s into an Objective Risk Scoring Model

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I. Loan GradingII. Reserve CalculationsIII. Stress Testing

Loan Portfolio Mgmt.

Loan Grading

Stress Testing

ALLL Reserve

Three Main Components

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“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

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RegulatoryDefinedRisks


Wikipedia Definitions:

Financial risk is often defined as the unexpected variability or volatility of returns and thus includes both potential worse‐than‐expected as well as better‐than‐expected returns. References to negative risk below should be read as applying to positive impacts or opportunity (e.g., for "loss" read "loss or gain") unless the context precludes this interpretation.

In one definition, "risks" are simply future issues that can be avoided or mitigated, rather than present problems that must be immediately addressed.[5]

Many events, including changes in prevailing interest rates, can have more than one potential outcome. The future is uncertain, but Risk is not the same as uncertainty.

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DefiningRisks

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The Three Inherent Risks to all Financial Intermediaries

All financial intermediaries rent money from depositors (Liabilities) who then expect it back on demand or at maturity dates rarely more than a few years in the future. Banks then lend or invest that money in variety of instruments (Assets) with maturity dates as long as 30 years.

Economists call this difference in maturity terms “Maturity Transformation”

1. Credit Risk – The obligation to pay back depositors regardless of whether loans are repaid

2. Interest Rate Risk – The timing and size of changes in the rates that they receive from their “Assets” rarely match the timing and size of rate changes for their “Liabilities”

3. Liquidity Risk – Not enough cash will be generated from “Assets” to meet deposit withdrawals or contractual loan fundings

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6 FED Reserve Types 9 OCC Types

Credit risk Credit risk

Liquidity risk Liquidity risk

Market risk (Interest rate risk) Interest rate riskPrice riskForeign exchange risk

Operational risk Transaction risk

Legal risk Compliance riskStrategic risk

Reputation risk Reputation risk

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© 2015 FARIN & Associates Inc. 7

Lessons learned from the recent economic crisis

What is prompting regulators to expect more of financial institutions in the future?

1. Examiners failed to take appropriate action even after repeatedly identifying weaknesses in troubled banks and credit unions.

2. Examiners and the Board of Directors didn’t understand the institution’s culture and the key motivators which led management to operate in a unsafe manner. a) Poorly designed incentive compensation plans.b) Institutions lacked the experience and expertise to offer the

products they offered.

3. Congress and the press have been critical of the regulators

TheChangingRegulatoryLandscape



4. Failed institutions didn’t have a proper risk management program in place (internal audit, loan review, annual IT security reviews, or testing of the institution’s compliance with regulatory laws and regulations).

5. Risk management staff were not truly independent of the functions they were there to review or audit.

6. Many failed institutions entered new markets, offered new products, or started acquiring loan participations in an attempt to grow without implementing adequate controls to offset or mitigate the increased risk they were undertaking.


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Common elements of institutions that experienced significant asset quality issues during the “economic crisis”.

1. Heavy concentration in other commercial real estate and acquisition, development, and construction (ADC) loans.

2. Experienced a period of tremendous growth funded with non‐core funding sources (brokered deposits, mismatched FHLB Advances, internet CDs).

3. High level of technical exceptions in commercial real estate loans (CRE) portfolios.

4. Policy exceptions: Policies were adequate but the institution didn’t follow them.





5. Inadequate policies and procedures a) Lack of adequate documented site inspections.b) Inadequate procedures to monitor construction loans.c) Placed too much reliance on the lead lender for participations purchased.d) Originated loans out of market or level of expertise.

6. Weak credit administration practicesa) Inadequate appraisals

• Use of “as completed” appraisals• Relied on in‐house appraisals performed by originating loan officer

b) Inadequate analysis of borrower cash flows including failure to properly calculate global debt service ratios.

• Placed too much reliance on net worth of guarantors.• Net worth doesn’t make loan payments, cash does.

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7. Ineffective risk management programs ‐ Loan review function failed to identify deficiencies in the institution’s underwriting policies and procedures and individual credits until it was too late.

8. Inadequate asset liability policies and procedures.9. Allowance for loan losses calculation was not prepared in

accordance with GAAP and regulatory guidelines. 10. Board failed to provide adequate oversight.


LoanGradingSystem

Interagency Policy Statement on the Allowance for Loan and Lease Losses

srletters/2006/SR0617

Loan Classification or Credit Grading Systems

The foundation for any loan review system is accurate and timely loan classification or credit grading, which involves an assessment of credit quality and leads to the identification of problem loans. An effective loan classification or credit grading system provides important information on the collectability of the portfolio for use in the determination of an appropriate level for the ALLL.

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Continued …… srletters/2006/SR0617

Because accurate and timely loan classification or credit grading is a critical component of an effective loan review system, each institution should ensure that its loan review system includes the following attributes:

1. To promptly identify loans with potential credit weaknesses.

2. To appropriately grade or adversely classify loans, especially

those with well‐defined credit weaknesses that jeopardize

repayment, so that timely action can be taken and credit

losses can be minimized.

3. To provide management with accurate and timely credit

quality information for financial and regulatory reporting

purposes, including the determination of an appropriate ALLL.”


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Underwriting Risk Scoring

Loan Grading

What is the relationship between Underwriting and Loan Grading ?

1. Approval2. Covenants3. Pricing

1. Performance2. Reserves

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Can you identify the Top 1/3, Middle 1/3, and Bottom 1/3 of these cans?

Impact of a compressed scale

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Things to consider when developing a Loan Grading System

How to pick a loan grading scale

5 6 7 8 9 10

Requires Split Classifications

Typically includes a Pass/Watch Category

Diminishing returns

Examiners are looking for more definition in the quality of the loan portfolio

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1. Pass - Extremely high quality, excellent financial condition and collateral coverage. No identifiable risk of loss.

2. Pass - Very strong quality, excellent financial condition, no identifiable risk of loss but lower in one or two aspects than loans graded as 1.

3. Pass - Mid-Grade loans showing good financial condition with few, if any, below average characteristics. Most loans in this category, if measured purely on a risk-of-loss basis, would be considered above average.

4. Pass - Mid-Grade loans showing average financial condition. Most loans in this category, if measured purely on a risk-of-loss basis, would be considered above average. This is due to “average” financial condition but strong collateral coverage.

5. Pass/Watch - Mid-Grade loans showing average financial condition but may be susceptible to changing economic conditions that would raise risk to a minor concern. Normal comfort levels can be achieved through monitoring financial statements & collateral coverage

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Regulatory Classified Loan Definitions:

A uniform agreement on the classification of assets and appraisal of securities in bank examinations was issued jointly on June 15, 2004, by the Office of the Comptroller of the Currency, the FDIC, the Federal Reserve Board, and the Office of Thrift Supervision.

6.Special Mention - A Special Mention asset has potential weaknesses that deserve management's close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects. Special Mention assets are not adversely classified and do not expose an institution to sufficient risk to warrant adverse classification.

7. Substandard - Substandard loans are inadequately protected by the current sound worth and repayment capacity of the obligor or the collateral pledged. Loans so classified must have a well-defined weakness or weaknesses that jeopardize liquidation of the debt. They are characterized by the distinct possibility that the bank will sustain some loss if the deficiencies are not corrected.

8.Doubtful - Loans classified Doubtful possess all of the weaknesses inherent in those classified Substandard with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently known facts, conditions andvalues, highly questionable and improbable.

9. Loss - Loans classified Loss are considered uncollectible and of such little value that continuance as bankable assets is not warranted. This classification does not mean that the loan has absolutely no recovery or salvage value but rather it is not practical or desirable to defer writing off this asset even though partial recovery may be effected in the future.

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1 2 3 4 5 6 7 8 9

Pass

Portfolio Grade Curve Shifted to Left


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The Traditional 5C's

1. Capacity to repay is the most critical of the five factors, it is the primary source of repayment ‐ cash. The prospective lender will

want to know exactly how you intend to repay the loan. The lender will consider the cash flow from the business, the timing of

the repayment, and the probability of successful repayment of the loan. Payment history on existing credit relationships ‐ personal

or commercial‐ is considered an indicator of future payment performance. Potential lenders also will want to know about other

possible sources of repayment.

2. Capital is the money you personally have invested in the business and is an indication of how much you have at risk should the

business fail. Interested lenders and investors will expect you to have contributed from your own assets and to have undertaken

personal financial risk to establish the business before asking them to commit any funding.

3. Collateral, or guarantees, are additional forms of security you can provide the lender. Giving a lender collateral means that you

pledge an asset you own, such as your home, to the lender with the agreement that it will be the repayment source in case you

can't repay the loan. A guarantee, on the other hand, is just that ‐ someone else signs a guarantee document promising to repay

the loan if you can't. Some lenders may require such a guarantee in addition to collateral as security for a loan.

4. Conditions describe the intended purpose of the loan. Will the money be used for working capital, additional equipment or

inventory? The lender will also consider local economic conditions and the overall climate, both within your industry and in other

industries that could affect your business.

5. Character is the general impression you make on the prospective lender or investor. The lender will form a subjective opinion as

to whether or not you are sufficiently trustworthy to repay the loan or generate a return on funds invested in your company. Your

educational background and experience in business and in your industry will be considered. The quality of your references and the

background and experience levels of your employees will also be reviewed.

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Understanding Pay vs Save Strategies

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LoanGradingSystem

Pay Strategies assess the borrowers ability to make the agreed upon loan obligations

Save Strategies try to limit losses if the borrower stops making payments


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Why do we spread financials ?

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Global Cash Flows

Understanding related entities

How does risk from one participant impact total Entity ?


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Turning the 5c’s into a science

What factors should be used :

Dual Loan Grading System

Comparative Analysis

Objective Analysis

Subjective Analysis

I. Objective Analysis

II. Comparative Analysis

III. Subjective Analysis

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Objective Analysis

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Current Ratio Total Current Assets ÷ Total Current Liabilities

This ratio is a rough indication of a firm’s ability to service its current obligations. Generally, the higher the current ratio, the greater the cushion between current obligations and a firm’s ability to pay them. While a stronger ration shows that the numbers for current assets exceed those for current liabilities, the composition and quality of current assets are critical factors in the analysis of and individual firm’s liquidity.

Quick Ratio Cash & Equivalents + Trade Receivables (net) ÷ Total Current Liabilities

Also known as the “acid test” ratio, this is a stricter, more conservative measure of liquidity than the current ratio. This ratio reflects the degree to which a company’s current liabilities are covered by its most liquid current assets, the kind of assets that can be converted quickly to cash and at amounts close to book value.

Debt/Worth Total Liabilities ÷ Tangible Net Worth

This ratio expresses the relationship between capital contributed by creditors and that contributed by owners. Basically, it shows how much protection the owners provided creditors. The higher the ratio, the greater the risk being assumed by creditors. A lower ratio generally indicates greater long‐term financial safety.

Debt Service Ratio Net Profit + Depreciation, Depletion, Amortization Expenses ÷ Current Portion of Long‐Term Debt

This ratio reflects how well cash flow from operations covers current maturities. Because cash flow is the primary source of debt retirement, the ratio measures a firm’s ability to service principal repayment and take on additional debt. Even though it is a mistake to believe all cash flow is available for debt service, this ratio is still a valid measure of the ability to service long‐term debt.

Objective Analysis

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Objective Measurements include

1. Current/Quick Ratios2. Debt to Net Worth3. Debt Service Coverage4. LTV5. Credit Scores

Objective Analysis

How to weigh ratios?

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Objective Analysis

Ratio's

Assigned

Grade Weighting

Risk

Grade

Current Ratio 5.0 12.5% 0.63

Quick Ratio 4.0 12.5% 0.50

Debt to Net Income 3.0 15.0% 0.45

EBITA 4.0 25.0% 1.00

LTV 5.0 20.0% 1.00

Credit Score 2.0 15.0% 0.30

100.0% 3.88

Can use different ratios and weightings for different industries/loan types

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Financial Ratio Benchmarks includes: NAICS codesNineteen classic financial statement ratios, clearly defined.

Common‐size balance‐sheet and income‐statement line items, arrayed by asset and sales size.

More than 769 industries are presented using the 2007 North American Industry Classification System (NAICS) codes.

RMA Mission StatementRMA is a member‐driven professional association whose sole purpose is to advance sound risk principles in the financial services industry.


Converting to a NAICS coding system

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Converting to a NAICS coding system

11 1150

111150 Corn Farming ‐ This industry comprises establishments primarily engaged in growing corn (except sweet corn) and/or producing corn seeds.

Industry Business Type


Advantages of Using NAICS codes1. Comparative Analysis2. Concentration Analysis3. Loan Portfolio Segmentation4. Stress Testing

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Subjective Measurements might include

1. Strength of Guarantors

2. Management Evaluation

3. Other Credit Quality Adjustments (5c’s)

Subjective Analysis

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What is the true value of a guarantee?

Subjective Analysis

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Management/Customer Evaluation

Subjective Analysis

Character is the general impression you make on the prospective lender or investor. The lender will form a

subjective opinion as to whether or not you are sufficiently trustworthy to repay the loan or generate a return

on funds invested in your company. Your educational background and experience in business and in your

industry will be considered. The quality of your references and the background and experience levels of your

employees will also be reviewed.

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Objective Subjective

Black Box Flexibility

Key – Finding the balance

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Lenders mitigate credit risk using several methods:

1. Risk Based Pricing Models – Charging higher interest rates to customers more likely to default

2. Covenants – Stipulations on the borrower that are written into the loan agreements

3. Tightening – Reducing the amount of credit extended

4. Diversification – Expanding the borrower pool to mitigate concentration risks

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I. Loan GradingII. Stress TestingIII. Reserve Calculations

Loan Portfolio Mgmt.

Loan Grading

Stress Testing

ALLL Reserve

Defining Stress Testing



Wikipedia Definition:Instead of doing financial projection on a "best estimate" basis, a company may do stress testing where they look at how robust a financial instrument is in certain crashes, a form of scenario analysis. They may test the instrument under, for example, the following stresses:

1.What happens if equity markets crash by more than x% this year?

2.What happens if interest rates go up by at least y%?

3.What if half the instruments in the portfolio terminate their contracts in the fifth year?

4.What happens if oil prices rise by 200%?

This type of analysis has become increasingly widespread, and has been taken up by various governmental bodies (such as the FSA in the UK) as a regulatory requirement on certain financial institutions to ensure adequate capital allocation levels to cover potential losses incurred during extreme, but plausible, events. This emphasis on adequate, risk adjusted determination of capital has been further enhanced by modifications to banking regulations such as Basel II. Stress testing models typically allow not only the testing of individual stressors, but also combinations of different events.

Text is available under the Creative Commons Attribution-ShareAlike License; additional terms may apply. See Terms of Use for details.Wikipedia® is a registered trademark of the Wikimedia Foundation, Inc., a non-profit organization.

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Stress test definition:The term stress testing describes a range of techniques used to assess the vulnerability of a portfolio to major changes in the economic environment or to exceptional but plausible events. Stress tests make risks more transparent by estimating the potential losses on a portfolio in abnormal markets. (1)

A simplified definition would be:Stress testing is a way to perform sensitivity analysis using “What if” alternative scenarios

(1) Blaschke, Jones, Majnoni, and Peria, 2001, "Stress Testing of Financial Systems: An Overview of Issues, Methodologies, and FSAP Experiences," IMF Working Paper WP/01/88.


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Top Ten regulatory examination issues:

1. Enterprise risk management process2. CRE classifications3. Troubled debt restructurings4. Strategic plans5. Liquidity6. Capital7. Stress Testing8. Commitment to internal audit9. Compliance and Loan Review10.Incentive compensation

The Changing Regulatory Landscape

= Loan Policy Components

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Dodd Frank Act Signed• July 21, 2010

Basel III

November 2010

SR 12-7

Statement to Clarify Stress Testing

by Community Banks • 5/14/2012

OCC 2012-33

Supervisory Guidance

Community Bank Stress Testing• 10/18/2012

FIL-49-2013

Annual Stress-Test Reporting Template• 10/21/2013



History of the Basel Accords

Formerly, the Basel Committee consisted of representatives from central banks and regulatory authorities of the Group of Ten countries plus Luxembourg and Spain. Since 2009, all of the other G-20 major economies are represented, as well as some other major banking locales such as Hong Kong and Singapore.

Politically, it was difficult to implement Basel II in the regulatory environment prior to 2008, and progress was generally slow until that year's major banking crisis caused mostly by credit default swaps, mortgage-backed security markets and similar derivatives. As Basel III was negotiated, this was top of mind, and accordingly much more stringent standards were contemplated, and quickly adopted in some key countries including the USA

Three Pillars of Basel II

• Pillar 1” Capital Requirements - of the new capital framework revises the 1988 Accord’s guidelines by aligning the minimum capital requirements more closely to each bank's actual risk of economic loss.

• Pillar 2 ” Supervisor Committee -Supervisors will evaluate the activities and risk profiles of individual banks to determine whether those organizations should hold higher levels of capital than the minimum requirements in Pillar 1 would specify and to see whether there is any need for remedial actions.

• Pillar 3” Market Discipline - leverages the ability of market discipline to motivate prudent management by enhancing the degree of transparency in banks’ public reporting to shareholders and customers.

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Dodd-Frank Act – The biggest changes in financial regulations in decades

While this legislation targets banks of certain size, the entire industry should be prepared for increased expectations as financial regulators become accustomed to seeing stress testing as part of risk management framework. Bank management will find it harder to demonstrate sufficient risk management processes without incorporating some elements of stress testing.

Requirements coming from Dodd-Frank:

1) Federal Reserve to provide at least three different sets of conditions for firms to stress test against

2) Federal Reserve to do annual stress test on bank holding companies over 50 billion in assets and non-bank financial firms under Federal Reserve supervision

3) Above firms required to do their own semi-annual stress tests

4) All other banks with assets greater than 10 billion required to do annual stress test

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Dodd-Frank Act – The biggest changes in financial regulations in decades

1. 2 Years after passage, more than 100 rules not yet finalized2. 9,000 pages of new or expanded regulations3. Major Provisions of Act include:

• Systemic Supervision (FSOC)• Increased Bank Supervision• Consumer Financial Protection Bureau• Limits on Bank Investments• Stricter Regulations on Mortgage loans• Deposit Insurance increased permanently to $250k• Interchange and Debit Card Processing

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Dodd-Frank Act


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OCC 2012-33Subject: Community Bank Stress TestingDate: October 18, 2012 To: Chief Executive Officers of All National Banks, Federal Savings Associations, Department and Division Heads, Examining Personnel, and Other Interested Parties

Stress Testing and Capital PlanningThe OCC expects every bank, regardless of size or risk profile, to have an effective internal process to (1) assess its capital adequacy in relation to its overall risks, and (2) to plan for maintaining appropriate capital levels. Stress testing can be a prudent way for a community bank to identify its key vulnerabilities to market forces and assess how to effectively manage those risks should they emerge.

If the results of a stress test indicate that capital ratios could fall below the level needed to adequately support the bank’s overall risk profile, the bank’s board and management should take appropriate steps to protect the bank from such an occurrence. This may include establishing a plan that requires closer monitoring of market information, adjusting strategic and capital plans to mitigate risk, changing risk appetite and risk tolerance levels, limiting or stopping loan growth or adjusting the portfolio mix, adjusting underwriting standards, raising more capital, and selling or hedging loans to reduce the potential impact from such stress events.

John C. Lyons Jr.Senior Deputy Comptroller and Chief National Bank Examiner

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OCC 2012-33Subject: Community Bank Stress TestingDate: October 18, 2012 To: Chief Executive Officers of All National Banks, Federal Savings Associations, Department and Division Heads, Examining Personnel, and Other Interested Parties

Sound risk management practices should include an understanding of the key vulnerabilities facing banks. For several years, supervisors have used the term “stress testing” in guidance and handbooks to refer to and encourage banks to incorporate this practice.1 Well-managed community banks routinely conduct interest rate risk sensitivity analysis to understand and manage the risk from changes in interest rates. Many community banks, however, do not have similar processes in place to quantify risk in loan portfolios, which often are the largest, riskiest, and highest earning assets.

The OCC, however, does consider some form of stress testing or sensitivity analysis of loan portfolios on at least an annual basis to be a key part of sound risk management for community banks. Community banks that have incorporated such concepts and analyses into their credit risk management and strategic and capital planning processes have demonstrated the ability to minimize the impact of negative market developments more effectively than those that did not use stress testing.


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New Guidance on Stress Testing – 10/18/2012

Stress Testing Methods and Approaches

Transaction stress testing is a method that estimates potential losses at the loan level by assessing the impact of changing economic conditions on a borrower’s ability to service debt.

Portfolio stress testing is a method that helps identify current and emerging risks and vulnerabilities within the loan portfolio by assessing the impact of changing economic9

conditions on borrower performance, identifying credit concentrations, measuring the resulting change in overall portfolio credit quality, and ultimately determining the potential financial impact on earnings and capital.


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Stress Testing Methods and Approaches

Enterprise-level stress testing is a method that considers multiple types of risk and their interrelated effects on the overall financial impact under a given economic scenario. These risks include, but are not limited to, credit risk within loan and security portfolios, counter-party credit risk, interest rate risk, and changes in the bank’s liquidity position.

Reverse stress testing is a method under which the bank assumes a specific adverse outcome, such as suffering credit losses sufficient to cause a breach in regulatory capital ratios, and then deduces the types of events that could lead to such an outcome. This type of analysis (e.g. a “break the bank” scenario) can help a bank consider scenarios beyond normal business expectations and challenge common assumptions about performance and risk mitigation strategies.


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Regardless of the testing method used, an effective stress test has common elements that a community bank should consider. These include

asking plausible “what if” questions about key vulnerabilities;

making a reasonable determination of how much impact the stress event or factor might have on earnings and capital; and

incorporating the resulting analysis into the bank’s overall risk management process, asset/liability strategies, and strategic and capital planning processes.


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Appendix B - Constructing a Basic Portfolio Level Stress Test into three sections:

Section 1 Estimated Loan Portfolio Stress Losses

Objective: This section estimates the potential loan losses over a two-year stress test horizon for the entire loan portfolio. There are four components in this section.

Loan Portfolio Categories

Quarter-End Loan Portfolio Balances

Stress Period Loss Rates

Stress Period Losses


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Section 2 Estimated Impact on Earnings

Objective: This section estimates the potential impact to net income from the stress scenario over the two-year period. There are five components in this section.

Pre-provision Net Income

Provision Expense to Cover Stress Losses

Provision to Maintain an Adequate ALLL

Income Tax Expense (Benefit)

Net Income


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Section 3 Estimated Impact of Stress on Capital

Objective: This section estimates the hypothetical impact on capital of the stressed environment. The example uses Tier 1 capital and the Tier 1 leverage ratios to help analyze the potential change in capital caused by a stress scenario. Banks can also review the changes in other relevant capital measures, such as the potential change in the common equity ratio, to assess the results of the stress test. This section has five components.

Tier 1 Capital

Net Change in Tier 1 Capital

Adjusted Tier 1 Capital

Quarterly Average Assets

Tier 1 Leverage Ratio


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1. Estimated Loan Portfolio Stress Losses

Loan Portfolios from Call Report Schedule RC-G

Quarter End as of Date $ Balances

Two – Year Stress Period Loss Rate %

Two – Year Stress Period $ Losses

Loans Secured by type of Real Estate

a. Construction and Development 100 20% 20

b. Farmland 50 8% 4

c. 1 – 4 Family Housing 100 4% 4

d. Multifamily Housing 75 16% 12

e. Nonfarm Nonresidential Property 100 8% 8

Agriculture Production and Farmer Loans 40 6% 2.4

Consumer Loans 60 14% 8.4

Commercial and Industrial 50 4% 2

All Other Loans 25 4% 1

Total 600 61.8


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2. Estimated Impact of Stress on Earnings

Descriptions Previous Two Years Actual Pro Forma Stress Period

Pre-Provision Net Income 34.5 30

Less Provision to Cover Two-Year Losses 12 61.8

Less Provision to Maintain Adequate ALLL 0 10

Income Tax Expenses (Benefit) 5.5 (14.6)

Net Income 16.5 (27.2)

3. Estimated Impact of Stress on Capital

Descriptions Previous Two Years Actual Pro Forma Stress Period

Tier 1 Capital $ 88 88

Net Change in Tier 1 Capital from Stress Period (Net Income from Step 2)

N/A (27.2)

Adjusted Tier 1 Capital $ 88 60.8

Quarterly Average Assets $ 800 738

Tier 1 Leverage Ratio % 11% 8.2%


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FIL-49-2013

The FDIC is issuing this notice to describe the reports and information required to meet the reporting requirements under Section 165(i)(2) of the Dodd-Frank Wall Street Reform and Consumer Protection Act for covered banks with total consolidated assets between $10 billion and $50 billion.

FIL 49-2013Subject: Annual Stress-Test Reporting Template and DocumentationDate: October 21, 2013


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The results of the stress test must include, under the baseline, adverse, and severely adverse scenarios:

• Description of types of risk included in the stress test• Summary description of the methodologies used• Explanation of the most significant causes for the changes in

regulatory capital ratios• The use of the stress test results


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Pop Quiz :

How would you answer the following question:

It took Rob 5 hours to travel to Madison, did he take the most direct route?


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Listed below are some of the common reasons financial institutions are not stress testing their portfolios1. Inadequate MIS systems

2. Insufficient data

3. Staffing/resource constraints

4. Failure to understand process

5. Unclear on how to incorporate process into the overall risk management framework

6. Examiners have not required them to do it yet

Why Banks Don’t Stress Test

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Identification and mitigation of risks

By identifying areas of concentrations in your loan portfolio, you will be able to develop scenarios that highlight risks and help you proactively mitigate risk.

Benefits of Stress Testing

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To build a stress testing process, you need to understanding the basic components:

1. Data - the “What”

2. Systems – the “How”

3. Personnel – the “Who”

4. Results – the “Where”

How to Start Stress Testing the Loan Portfolio – Components

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Understanding the Data – How complete is your data?

1. Do you capture data that allows you to segment your portfolio into meaningful categories1. Does your financial institution use standard business codes – for example

NAICS codes

2. Do you have collateral type indicators

3. Do you track geographical data for real estate collateral

2. How complete and accurate is the data in your systems of record

3. Do you have a MIS system that integrates data together from multiple systems of record


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Understanding the Systems – How are you processing the data?

1. What tools are you using to calculate loan grades1. Does your system grade with objective and subjective characteristics

2. What categories are you going to use in your “what if” scenarios

3. How are you going to adjust the financial input used in your grading system based on the specific scenario

2. How do you compare stress test results with actual results

3. How are you documenting the logic behind your stress tests


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Understanding the Systems – How are you processing the data?

Building the “What if” Scenarios1. Changes in Revenue

2. Changes in Expenses

– Interest Rate Changes

3. Changes in Collateral Values

– Collateral Types

– Geographic Factors

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DFAST Stress Testing

• Dodd-Frank Act Stress Test = DFAST

• Quarterly required stress tests for $10-$50 billion banks

• Projects multiple variables– GDP

– Interest rates

– Housing growth

– Employment

• Sets baseline forecast for comparison

• Establishes 2 potential stress events– Adverse event

– Severely adverse event

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Why should I care about DFAST Scenarios?

Focus on what is keeping you up at night


DFAST Scenario Narrative

Baseline Scenario:

• Moderate expansion in economic activity.

• Real GDP growth accelerates while the unemployment rate edges down to 5.25% by the fourth quarter of 2017.

• CPI inflation averages just over 2% per year.

• Short term Treasury rates begin to increase in the second quarter of 2015 and rise steadily thereafter reaching over 3% by year-end 2017.

• Both equity and property prices would appreciate, albeit at a modest rate, through 2016.

• Equity prices, nominal house prices, and commercial property prices all rise steadily throughout the scenario.

• The outlook for international variables features an expansion in activity, albeit one that proceeds at different rates across the four countries or country blocks being considered

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DFAST Scenario Narrative

Adverse Scenario:

• Weakening in economic activity combined with an increase in U.S. inflationary pressures that cause rapid increase in both short- and long-term U.S. Treasury rates.

• Bank funding costs react strongly to rising short-term rates. Commercial deposits should be viewed as being unusually drawn to institutional money funds, which re-price promptly. Consumer deposits should also be assumed to be drawn to higher-yielding alternatives.

• House prices and commercial real estate prices decline by approximately 13% and 16%, respectively to their level in the third quarter of 2014

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DFAST Scenario NarrativeSeverely Adverse Scenario:

• Substantial weakening in economic activity, characterized by a deep and prolonged recession

• Unemployment rate increases by 4% from its level in third quarter 2014 peaking at 10% in the middle of 2016.

• Short-term interest rates remain near zero through 2017; long-term Treasury yields drop to 1% in fourth quarter of 2014 and then edge up slowly over the remainder of the scenario period

• Significant reversal of recent improvements to the U.S. housing market. House prices decline by 25% during the scenario period relative to their level in the third quarter of 2014, while commercial real estate prices are more than 30% lower during the scenario period

• Corporate financial conditions tighten significantly in 2015 and the yield on investment grade corporate bonds is higher than the baseline until the fourth quarter of 2016.

• U.S. corporate credit quality deteriorates sharply.

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Understanding the Personnel – Who is involved in administrating and reviewing stress test?

1. Who is going to be responsible for deciding shocks or scenariosa) Where are they getting the economic information to create tests

b) Are the sources being used consistent from period to period

2. Who is involved in the different steps of the processa) Senior Management

b) Board

c) C-level management


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Understanding the Results – Where are results incorporated?

1. Changes in underwriting or loan review policiesa) Concentrations

b) Limit Setting

2. Are results used in the allowance provisioning calculations

3. Strategic or business planning processes


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How to Start Stress Testing the Loan Portfolio - Design

• Understanding available data and data sources

• Normalizing data into useable format

• Capture/update missing data

• Define Scenario variables

Data

• Create and document “What if” scenarios.

• Adjust grading inputs with scenario changes

• Grade portfolio based on new criteria

System• Reports generated that

highlight differences• Analyze and incorporate

results into processes• Proactively manage loan

portfolio

Results

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Keys to designing a successful stress test

1. Start simplea) Don’t design complex tests that require data that you don’t have a way

to capture or store

b) You don’t need 2,000 data points to stress test

2. Garbage “In” Garbage “Out”a) Focus on data from the systems of record

b) Make sure you can break results into usable information

3. Try to eliminate manual processes and data manipulation

4. Just Do It – If you wait until you have designed the perfect process, you will never get started

How to Start Stress Testing the Loan Portfolio - Design

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Incorporating Stress Testing Results

Stress tests can be utilized in a variety of ways. These include:

1. Risk Managementa) Changes in underwriting and loan review policies

b) Proactive management of loan portfolio

c) Concentrations / Set limits

2. Capital Planninga) Impact on ALLL provisions

b) Contingency plans

3. Strategic or business planning processes

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I. Loan GradingII. Stress TestingIII. Reserve Calculations Loan

Portfolio Mgmt.

Loan Grading

Stress Testing

ALLL Reserve

ALLL Methodology – Building the Reserve

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Three main components:

I. Fas 5/ ASC 450 Loss experience (Pools of like loans)II. Fas 5/ASC 450 Qualitative and Environmental FactorsIII.Fas 114/ASC 310-40 Impairments



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Assessment of Current ALLL Policy

1. Are the current policies, methodologies, and controls in compliance with GAAP

2. Has the Board of Directors approved the policy and methodology at least annually and anytime changes are made

3. Determine if ALLL policy and methodology address the standards established in supervisory guidance

4. Determine if management has written documentation that supports the ALLL methodology

5. Determine the adequacy of controls arounda) Documentationb) Board oversightc) Loan gradingd) Independent review and validation process

6. Assessment of the appropriateness of the recorded level of ALLL


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Just like a Grading system shouldleverage both objective and subjective components so do reserve Calculations

Objective Components Subjective Components

Loss Experience Look back period

Impairment Analysis Qualitative Factors


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Choosing a look back period

Understanding the current environment

When coming out of a economic boom cycle, like 2005 where loss experience was very low, the norm was to have long look back periods.

After 2008, when loss experience was high examiners started to shorten the look back periods

Most current examiners recommend a rolling 12 quarter look back period for loss history, as the market recovers look for these periods to start extending again


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Qualitative and Environmental Factors (Fas 5/ASC 450)

The subjective components of reserve analysis


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90 http://research.stlouisfed.org/fred2/


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Loan Impairment

Three approved FASB methods

1. PV of Future Cash Flows2. Value of Collateral less cost to sell3. Observable Market Price


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Is your ALLL reserve in the Ball Park?

How do you compare to your peers?


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Is your ALLL reserve in the Ball Park?

How do you compare to your peers?



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Red Flags : ALLL Estimation Process

1. ALLL Reserve based on budgeted amounts or target statistics or ratios2. Management applies an overall adjustment to bring the ALLL to a

predetermined percentage of total loans3. Adjustments are not consistent with the underlying factors4. Management frequently revises its overall methodology5. Using committed amounts vs outstanding amounts in calculation FAS 56. Double counting FAS 114 into FAS 5 Calculations7. Certain loans under FAS 114 deemed not impaired and no allowance required8. The ALLL is materially less or materially exceeds the amount supported by

ALLL methodology and documentation


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DefiningLoanMigrationAnalysis

Definition: Tracking the movement of loan quality and behavior over a time dimension.

Regulatory Insight

1. IPS on ALLL 2006 2. OCC Comptrollers Handbook3. FDIC Manual of Examination Policies


DefiningLoanMigrationAnalysis

Different Approaches

Bottoms Up

Top Down

Loan Migration Study• Track each loan individually• Allows Migration to be grouped

by multiple roll ups

ALLL Reserve• Track pools of loans• Back Testing

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LoanMigrationAnalysis


Cur Bal Loss Rate Q Factors Total Factors Reserve

1.a Construction, land development, and other land loans 5,200,000$ 2.500% ‐0.500% 2.000% 104,000$

1.b Secured by farmland 6,500,000$ 0.000% 0.750% 0.750% 48,750$ 1.c.1 Revolving, open‐end loans secured by 1‐4 family 750,000$ 1.000% 1.000% 2.000% 15,000$ 1.c.2.a Secured by first liens 18,500,000$ 0.250% 0.750% 1.000% 185,000$

1.c.2.b Secured by junior liens 1,500,000$ 0.750% 1.500% 2.250% 33,750$ 1.d Secured by multifamily (5 or more) residential 14,250,000$ 1.125% 1.000% 2.125% 302,813$

1.e Secured by nonfarm nonresidential properties 37,000,000$ 0.875% 1.250% 2.125% 786,250$ 3 Loans to finance agricultural production 7,000,000$ 0.125% 0.500% 0.625% 43,750$

4 Commercial and industrial loan 23,250,000$ 1.500% 0.500% 2.000% 465,000$ 6.a Credit cards 600,000$ 2.000% 1.000% 3.000% 18,000$

6.b Other revolving credit plans 1,500,000$ 2.000% 1.000% 3.000% 45,000$ 6.c Other consumer loans 2,450,000$ 2.000% 1.000% 3.000% 73,500$

8 Obligations of states and political subdivisions in U.S 2,500,000$ 0.000% 0.250% 0.250% 6,250$ 9 Other loans ‐$ 0.000% 1.500% 1.500% ‐$

10 Lease financing receivables (net of unearned income) ‐$ 0.000% 1.500% 1.500% ‐$

Totals 121,000,000$ 2,127,063$

Reserve to Total Outstanding Loans 1.76%

Description of Loan Pools

Most Common Loan Pooling Methods

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Cur Bal Loss Rate Q Factors Total Factors Reserve

1.a Construction, land development, and other land loans 5,200,000$ 2.500% ‐0.500% 2.000% 104,000$

1.b Secured by farmland 6,500,000$ 0.000% 0.750% 0.750% 48,750$ 1.c.1 Revolving, open‐end loans secured by 1‐4 family 750,000$ 1.000% 1.000% 2.000% 15,000$ 1.c.2.a Secured by first liens 18,500,000$ 0.250% 0.750% 1.000% 185,000$

1.c.2.b Secured by junior liens 1,500,000$ 0.750% 1.500% 2.250% 33,750$ 1.d Secured by multifamily (5 or more) residential 14,250,000$ 1.125% 1.000% 2.125% 302,813$

1.e Secured by nonfarm nonresidential properties 37,000,000$ 0.875% 1.250% 2.125% 786,250$ 3 Loans to finance agricultural production 7,000,000$ 0.125% 0.500% 0.625% 43,750$

4 Commercial and industrial loan 23,250,000$ 1.500% 0.500% 2.000% 465,000$ 6.a Credit cards 600,000$ 2.000% 1.000% 3.000% 18,000$

6.b Other revolving credit plans 1,500,000$ 2.000% 1.000% 3.000% 45,000$ 6.c Other consumer loans 2,450,000$ 2.000% 1.000% 3.000% 73,500$

8 Obligations of states and political subdivisions in U.S 2,500,000$ 0.000% 0.250% 0.250% 6,250$ 9 Other loans ‐$ 0.000% 1.500% 1.500% ‐$

10 Lease financing receivables (net of unearned income) ‐$ 0.000% 1.500% 1.500% ‐$

Totals 121,000,000$ 2,127,063$

Reserve to Total Outstanding Loans 1.76%

Description of Loan Pools

Most Common Loan Pooling Methods

Impact of Pooling Segmentation


Outstanding Loan Balances 2011 2012 2013 2014 2015

Enterta inment and Recreation 4,710,087$ 4,485,797$ 4,272,188$ 4,068,750$ 3,875,000$

Health Care Services 2,000,000$ 3,000,000$ 5,189,375$ 5,462,500$ 5,750,000$

Profess ional Services 3,000,000$ 3,875,000$ 4,000,000$ 3,875,000$ 5,000,000$

Restaurant and Lodging 5,000,000$ 4,250,000$ 3,750,000$ 3,000,000$ 2,000,000$

Reta i l 2,850,000$ 3,063,750$ 3,293,531$ 3,540,546$ 2,750,000$

Transportation 2,750,000$ 3,000,000$ 2,750,000$ 3,250,000$ 3,875,000$

Totals 20,310,087$ 21,674,547$ 23,255,094$ 23,196,796$ 23,250,000$

Net Losses 2011 2012 2013 2014 2015

Enterta inment and Recreation ‐$ 100,000$ 150,000$ 50,000$ ‐$

Health Care Services ‐$ ‐$ ‐$ ‐$ ‐$

Profess ional Services ‐$ ‐$ ‐$ 50,000$ ‐$

Restaurant and Lodging 500,000$ 200,000$ 300,000$ 70,000$ ‐$

Reta i l ‐$ 50,000$ ‐$ ‐$ ‐$

Transportation ‐$ ‐$ ‐$ 50,000$ ‐$

Totals 500,000$ 350,000$ 450,000$ 220,000$ ‐$

Loss Rates 2011 2012 2013 2014 2015

Enterta inment and Recreation 0.00% 2.23% 3.51% 1.23% 0.00%

Health Care Services 0.00% 0.00% 0.00% 0.00% 0.00%

Profess ional Services 0.00% 0.00% 0.00% 1.29% 0.00%

Restaurant and Lodging 10.00% 4.71% 8.00% 2.33% 0.00%

Reta i l 0.00% 1.63% 0.00% 0.00% 0.00%

Transportation 0.00% 0.00% 0.00% 1.54% 0.00%

Gross Loss Rate 2.46% 1.61% 1.94% 0.95% 0.00%

Weighted Avg 33.33% 0.81% 0.54% 0.64% 0.32%

Rolling Loss Rate 2.05% 2.00% 1.50%

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Breakdown of C&I Portfolio Loss Analysis


51


Segmented Loan Pools Cur Bal Loss Rate Q Factors Total Factors Reserve

Enterta inment and Recreation 3,875,000$ 2.323% 0.500% 2.823% 109,385$

Heal th Care Services 5,750,000$ 0.000% 0.500% 0.500% 28,750$

Profess iona l Services 5,000,000$ 0.430% 0.500% 0.930% 46,503$

Restaurant and Lodging 2,000,000$ 5.013% 0.500% 5.513% 110,251$

Reta i l 2,750,000$ 0.544% 0.500% 1.044% 28,708$

Transportation 3,875,000$ 0.513% 0.500% 1.013% 39,245$

23,250,000$ 362,843$

Marginal Savings Analysis for Reserves – Pool Segmentation

Pooled at Call Code $465,000Pooled at Industry Level $362,843Marginal Savings of Pooling Decision $102,157



Red Flags : ALLL Estimation Process

1. ALLL Reserve based on budgeted amounts or target statistics or ratios2. Management applies an overall adjustment to bring the ALLL to a

predetermined percentage of total loans3. Adjustments are not consistent with the underlying factors4. Management frequently revises its overall methodology5. Using committed amounts vs outstanding amounts in calculation FAS 5/ASC 4506. Double counting FAS 114/ASC 310 into FAS 5/ASC 450 Calculations7. Certain loans under FAS 114/ASC 310 deemed not impaired and no allowance

required8. The ALLL is materially less or materially exceeds the amount supported by ALLL

methodology and documentation

ALLL Methodology – Reserve Validations

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Current Baseline Forecast of PV of Future LossesRolling Loss History

CECL Method

ASC 450 (FAS 5)

Assigned at Loan

Pool level

1. Economic/External Conditionsa. Local / National Economic conditionsb. Collateral Valuationc. Impact of Competition / Legal

2. Portfolio Performancea. Impacts/Effects of Concentrationsb. Changes in Loan Quality, PDs, NPAsc. Change in Portfolio Volume or Nature

3. Internal Processesa. Changes in Lending/Underwriting Policiesb. Changes in Loan Review Processc. Changes in Staff Depth/Experience

ASC 310 (FAS 114)

Qualitative Factors

New Supportable Forecasting Requirement

PV Future Losses

1. Loan Pool Performance2. Projected Loan Performance

a. Economic Conditionsb. Borrower Financials

3. Time Value of Money a. Discounted Cash Flowb. Fair Market Value of Collateral



Accomodation and Food Services

Risk Grade < 6 6 < 12 12 < 18 18 < 24 24 < 30 30 < 36 36 < 42 42 < 48 > 48

1 Pass ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐

2 Pass ‐ 200,000 ‐ ‐ ‐ ‐ ‐ ‐ 500,000 700,000

3 Pass 500,000 400,000 150,000 500,000 600,000 250,000 150,000 375,000 850,000 3,775,000

4 Pass 125,000 ‐ 400,000 250,000 750,000 100,000 600,000 450,000 100,000 2,775,000

5 Special Mention ‐ ‐ ‐ 250,000 ‐ ‐ ‐ 300,000 500,000 1,050,000

6 Substandard ‐ ‐ ‐ ‐ ‐ 500,000 ‐ ‐ 350,000 850,000

7 Doubtful ‐ ‐ 150,000 ‐ ‐ ‐ ‐ ‐ 125,000 275,000

8 Loss ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐

Totals 625,000 600,000 700,000 1,000,000 1,350,000 850,000 750,000 1,125,000 2,425,000 9,425,000

C&I $ Balances

Age of Loan in Months Grand

Totals


Risk Grade < 6 6 < 12 12 < 18 18 < 24 24 < 30 30 < 36 36 < 42 42 < 48 > 48

1 Pass ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐

2 Pass ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐

3 Pass ‐ ‐ ‐ ‐ 50,000 ‐ ‐ ‐ ‐ 50,000

4 Pass ‐ ‐ 15,000 ‐ ‐ ‐ ‐ ‐ 25,000 40,000

5 Special Mention ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ 10,000 10,000

6 Substandard ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ 15,000 15,000

7 Doubtful ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐

8 Loss ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐

Totals ‐ ‐ 15,000 ‐ 50,000 ‐ ‐ ‐ 50,000 115,000

C&I $ Losses


Totals


Risk Grade < 6 6 < 12 12 < 18 18 < 24 24 < 30 30 < 36 36 < 42 42 < 48 > 48

1 Pass 0.00000% 0.00000% 0.00000% 0.00000% 0.00000% 0.00000% 0.00000% 0.00000% 0.00000% ‐

2 Pass 0.00000% 0.00000% 0.00000% 0.00000% 0.00000% 0.00000% 0.00000% 0.00000% 0.00000% ‐

3 Pass 0.00000% 0.00000% 0.00000% 0.00000% 8.33333% 0.00000% 0.00000% 0.00000% 0.00000% 1.325%

4 Pass 0.00000% 0.00000% 3.75000% 0.00000% 0.00000% 0.00000% 0.00000% 0.00000% 25.00000% 1.441%

5 Special Mention 0.00000% 0.00000% 0.00000% 0.00000% 0.00000% 0.00000% 0.00000% 0.00000% 2.00000% 0.952%

6 Substandard 0.00000% 0.00000% 0.00000% 0.00000% 0.00000% 0.00000% 0.00000% 0.00000% 4.28571% 1.765%

7 Doubtful 0.00000% 0.00000% 0.00000% 0.00000% 0.00000% 0.00000% 0.00000% 0.00000% 0.00000% ‐

8 Loss 0.00000% 0.00000% 0.00000% 0.00000% 0.00000% 0.00000% 0.00000% 0.00000% 0.00000% ‐

Totals 0.00000% 0.00000% 2.14286% 0.00000% 3.70370% 0.00000% 0.00000% 0.00000% 2.06186% 1.220%

C&I Loss Rate


Totals


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TheLoanPolicy

Updated Loan Policy

Board Approval

Staff Training

Compliance Testing

Changes in Institution

Change in Business

Conditions

Regulatory Changes

At minimum an Annual Cycle

A living document that is continually reviewed and updated as changes occur


The Loan Policy

Risks of an inadequate Loan Policy

1. If lending authorities, loan-to-value limits, and other lending limitations are not revised when circumstances change, a bank could be operating within guidelines that are too restrictive, too lenient, or otherwise inappropriate in light of the banks current situation and environment

2. May not reflect best practices or regulatory requirements3. Imprudent lending decisions could have a ripple effect on asset quality

problems and poor earnings4. Increase a financial institutions vulnerability to adverse movements in

interest rate movement, down turn in local economy, or other negative economic events

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Elements of an Effective Loan Policy

1. Reflect the size and complexity of a financial institution and its lending operations

2. Tailored to its particular needs and characteristics3. Revisions should occur as circumstances change4. Policy should be flexible enough to accommodate a new lending

activity without a major overhaul

TheLoanPolicy


The Loan Policy

Compliance Testing of the Loan Policy

Conducting compliance testing as part of the updating and audit processes will help identify whether staff is aware of and adhering to the provisions of the loan policy.

Specific areas that may benefit from review are:

• Ranges for key numerical targets, such as LTV or loan portfolio segment allocations

• Responsibility for monitoring and enforcing loan policy requirements

• Documentation requirements for various classes of loans• Remedial measures or penalties for loan policy infractions• Preparation and content of loan officer memorandums• Individual and committee lending authorities

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The Loan Policy

Compliance Testing of the Loan Policy

Conducting compliance testing as part of the updating process

Types of testing should include:

1. Testing the entire loan portfolio and individual loans against limits set in the loan policya) Loan to Collateral limits by collateral typeb) Concentration by business c) Concentrations by market

2. Approval signatures3. Required Documentation4. Policy exception tracking requirement


The Loan Policy

Signs that your Loan Policy is Out-of-Date

1. The policy has not been revised or reapproved in more than a year2. Multiple versions of the policy in circulation3. The table of contents is not accurate4. The policy is disorganized or contains addendums from prior years that have

never been incorporated into the body of the policy5. The policy contains misspelling, typos, and grammatical errors6. Officers and directors who no longer serve are listed, or new ones are not.7. Designated trade territory includes areas no longer served, or new areas are

omitted8. Discontinued products are included, or new products are not addressed9. New regulations are not addressed10. Review of lending decisions identifies:

• Actual lending practices vary significantly from those outlined in the policy• Numerous exceptions to policy requirements have been approved• Policy limits are being ignored

Documents

Turning the 5 C’s into an Risk Scoring Model - farin.com · Turning the 5 C’s into an Objective Risk Scoring Model 1 ... Giving a lender collateral means that you