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Risk Management and Value Creation
20111
2
William C. Handorf, Ph. D.
Professor of Finance
The GeorgeWashington University
Consultant
Banks
Central Banks
Expert Witness
Director and Vice Chair
Federal Home Loan
Bank of Atlanta
Director
Federal Reserve Bank
of Richmond; Chair
Baltimore Branch
Federal Home Loan
Bank System
Regulator
Federal Deposit
Insurance Corporation
Federal Home Loan
Bank Board
Lender
National Bank of Detroit
Officer, United States Army
Current Experience
2
Brasil’s Banking Sector
between 2011 and 2016
2 Biggest Threats
for Banks:
1. ______________
2. ______________
2 Biggest
Opportunities for
Banks:
1. ______________
2. ______________
3
4
Past Problem Sectors in US
Emerging Market Debt - “Countries Do Not Go Bankrupt”
Agricultural Sector - “We All Need Food”
Oil Sector - “We Must Have Oil”
Commercial Real Estate - “You Have Collateral”4
5
US Home Prices: Case Shiller
Composite 10 Cities
Annual Price Change
2001: 8.2%
2002: 15.3%
2003: 14.0%
2004: 18.7%
2005: 15.1%
2006: -0.4%
2007: -11.5%
2008: -19.4%
2009: -0.1%
2010 -2.2%
2011 Decreasing
6
Housing Problem History
• Home prices rise quickly after dot.com bust and low interest rate engineered by the central bank encouraged ARM loans
• Investors earn 50+% returns with 10% annual appreciation and encourage speculators to purchase more property
• Mortgagors need “innovative” loans and “piggy-back” loans to afford a home prior to even higher prices
• Wall Street encourages brokers to originate more high-yield loans for MBS
• MBS losses trigger “dominoes” to fall
7
Ignoring the “Five C’s of Credit”
Loan Purpose Analysis
Amount, Use and
Term of Request?
Character of Debtor is Key
Loan Repayment Analysis
Sources of Repayment?
Capacity and Capital
Important
Loan Structure
Analysis Pricing,
Collateral and Conditions?
Structure is Function
of Risk
Loan Monitoring Analysis
Timely Payment and
Conditions Satisfied?
Systems and
Review Critical
7
8
Economic Financial Managerial
Liquidation
Bank Failure
8
9
Recent US “Failures” due to
Housing Loan Losses• AIG
• Bank United
• Bear Stearns
• Citibank
• Downey
• Fannie & Freddie
• GMAC
• Indy Mac
• Lehman Brothers
• Wachovia
• WAMU
• 200 + Smaller Banks
• Who will fail next Friday?
9
10
Bank Failure and Management
High number and percentage of loans to insiders
Passive Board of Directors
Lack of coherent business plan
Quick growth funded by high cost funds offset by high yield assets
High dividend payouts and stock repurchase programs
Shrinkage to maintain capital ratios leading to larger losses given fixed non-interest costs
Ineffective risk management
Fraud 10
Red Flags
Late Financial Reports
Rapid Growth
Unexplained New Activity
Profit or Production Based Bonuses
Weak Controls
High Management Turnover
Ineffective Audit
Weak Board11
12
Focus on Board Responsibilities
• Assess Performance
– Internal Controls
– Management
– Operations
– Credit Rating
– Regulatory Rating
– Share Value
• Approve ALM Policies
• Develop and Implement Business Plan
• Adopt Rigorous Risk Management Program
13
Bank Failure and the Economy
Economic Recession
High and/or Increasing
Unemployment
High “Real” Interest Rates
Regional “Boom to Bust”
Low Confidence in Banks
or the Central Bank
13
14
Bank Failure and
Asset/Liability Management
Low Capital
Losses
Loan Problems
Concentrated Portfolio
Loss of Cost Control
Quick Growth
Liquidity
Non Core Fund Reliance
Lack of Good Collateral
Bad Press & Run
High-yield Assets
High Sensitivity 14
15
Empirical Analysis of Recent
US Bank Failure• Leading Causes
– High problem loans to capital and ALLL
– Large losses
• High provision
• Losses on securities
– High non current loans
– Portfolio concentration in high risk ADC loans
– Risk Index < 3
– Low capital
– High non-core funding
• Other Factors
– Prior quick growth
– High yield assets 15
16
Risk Index (RI) is number of standard deviations bank is
from their capital ratio declining below a stated threshold
The Risk Index
RI = (Capital Ratio + Mean ROA − Stated Threshold) ROA Sigma
As Risk Index declines, probability of capital problems
increase due to:
Low Capital Ratio
Low (or negative) mean ROA
High Volatility of Earnings from
Bad Loans, Shifting Strategy,
Sensitivity, Illiquidity, etc.
171717
Tier 1
Equity
Average
ROA
ROA
Sigma
Risk
Index
Probability
< 5%
Comerica 11.39 0.77 0.59 12.1 0.3
BB&T 9.93 0.97 0.53 11.1 0.4
Bank America 7.83 0.71 0.41 8.6 0.7
SunTrust 8.33 0.39 0.87 4.3 2.7
The Risk Index Applied
Implied Probability Tier 1 Equity < 5% in One Year
RI = (Equity + ROA – 5.0%) Sigma ROA
18
Risk Index Inferences
Normal Distribution
Use Normal Table
Little Regulatory Concern > 10 Sigma
Non-normal (but symmetrical)
Probability = .5 [(1(RI)2]
Risk Index Probability
10 .5%
5 2.0%
3 5.5%
2 12.5%
1 50.0%
Value Creation
Coordinated Approach
Of Implementing Strategy
Create Value
ROE>COEAchieve Good
Regulatory Rating
Maintain Debt
AAA/BBB Grade
19
202020
Value Creation
ROE > COE
Price/Book Premium
Asset Growth
Value Destruction
ROE < COE
Price/Book Discount
Asset Shrinkage
ROE = LM x ROA
NIE = AE x NIA
COE =8% to 20%
Share Value:
Return on Equity v. Cost of Equity
20
212121212121
Market Pricing
21
22222222
Price-earnings v. Price/Book
• Price/Book = Price/EPS x EPS/Book Value
Price/Book = Price-earnings Ratio x ROE
• The PE Ratio conveys information about future
growth in earnings
• Return on Equity (ROE) conveys information
about current earnings
• Market Value Added equals the market value of
the bank’s stock minus the book value of equity
provided by shareholders
22
23232323
Implications of Selling at a
Price/book Premium or Discount
• A Discount Increases ROE
on a Market Value
Perspective while a
Premium Decreases ROE
• Assume a Bank is Earning
ROE Book @ 5.0%, then
ROE Market is:
– 150% P/B: 3.3%
– 100% P/B: 5.0%
– 75% P/B: 6.7%
– 50% P/B: 10.0%
– 25% P/B: 20.0%
23
24242424
Cost of Equity or
Required Return on Equity
Arbitrary
8%
12%
20%
Bond Premium Model
Long-term Debt Yield
+ Equity Premium
Capital Asset Pricing Model
Treasury Bond Yield + Beta
(Market Premium) 24
2525
Moody’s (1, 2, 3)
Aaa: Best Quality
Aa: High Quality
A: Upper Medium
Baa: Medium Grade
Ba: SpeculativeElements
B: Lack Desirable Investment Quality
C: Extremely Poor Prospects; May be in Default
Bond Rating Agencies
S & P (+ , -)
AAA: Extremely Strong
Capacity
AA: Very Strong
Capacity
A: Strong Capacity
BBB: Adequate Capacity
BB: Uncertainties Could
Lead to Default
B: Vulnerable
D: In Default
2626
Studies of Bank Bond Ratings:Probability of Default and Loss Given Default?
Higher Grade
High Capital
High ROA
Low Earnings Variability
Large Companies
Low Risk Portfolio
Effective Management
2727
Moody’s Financial Strength
Ratings –
A: Exceptional
B: Strong
C: Good
D: Adequate to
Vulnerable
E: Very Weak
Likelihood bank will
require assistance?
B+ TD
B Bank Hawaii
B- BB&T
C+ Bank China
C Capital One
C- Citibank
D+ Bank India
D Bank Ireland
D- California B&T
E+ Bank Moscow
2828
Bank Credit Ratings
and Financial Strength
Bank Credit Rating Strength
Morgan Chase Aa1 B
Bank America Aa3 C-
Citibank A1 C-
BB&T A1 B-
E-Trade Ba3 D-
Bradesco Baa2 B-
Banco Paulista B1 E+
29292929
The Regression Slope is Beta
HPR= [P(1) + D - P(0)] /P(0)
Holding Period Return: Holding Company
-15
-10
-5
0
5
10
15
-15 -10 -5 0 5 10 15
Holding Period Return: Index
Beta
Beta represents the
Systematic risk of a
Bank Holding Company
(HC)
HC Sigma/Index
Sigma Correlation
of HC to Index
Implications of Beta
Average Risk @ 1.0
Low-risk @ < 1.0
High-risk @ > 1.0 29
30
Applying CAPM in US and Brasil
• Cost of Equity = Long-term Risk-free Yield + Beta (Market Risk Premium)
• Average Risk US Bank
– Cost of equity = 3.20% + 1.00(5.50%) = 8.70%
• Average Risk Brasilian Bank
– Cost of equity = 6.20% + 1.00(7.70%) = 13.90%
• The required return to create value is higher in Brasil due to higher long-term interest rates and a higher market risk premium.
30
Valuation Example
• US Bank (Citi) with ROE @ 6.4% and Beta
@ 2.55
– Cost of equity = 3.20% + 2.55(5.50%) = 17.23%
– Bank is destroying value and sells at P/B discount
• Brasilian Bank (Bradesco) with ROE @
24.2% and Beta @ 1.60
– Cost of equity = 6.20% + 1.60(7.70%) = 18.52%
– Bank is creating value and sells at P/B premium
31
32323232
Price/book Ratios and Financial
Metrics
• P/B = 1.90 - .63(Beta); R2 = 17%
– Higher Beta (risk) leads to lower valuation
• P/B = 0.72 + .06(ROE); R2 = 54%
– Higher Return on Equity leads to higher valuation
• P/B = 1.45 + .07 (ROE – COE); R2 = 68%
– Higher spread between ROE and COE leads to
higher valuation
32
3333
Basel III
• Banks will require
more capital, more
equity capital, buffer
capital, systemic
capital and counter-
cyclical capital
• Banks will require
more long-term
funding and short-
term, marketable
investment securities.33
343434
Liquidity Concerns
• Reputation and credit rating of the bank
• Proportion of assets invested in securities, especially short-term, high-grade and marketable instruments
• Proportion of securities pledged
• Proportion of securities within the available-for-sale portfolio or trading portfolio v. held-to-maturity
• Proportion of funds provided by core deposits and long-term borrowed money
• Unused lines of credit available from central bank or correspondent bank
• Cash budget or liquidity gap report with stress test for sources of funds
• Focus on contingent funding plan or CFP
34
353535
Liquidity Issues
• Unexpected withdrawal of deposits and an
inability to borrow funds
• Collateral deterioration and inability to
pledge assets or suffer lower advance rate
• Market panic leads to absence of bid price
to sell investment securities
• Unexpected takedown of credit lines by
borrowers
35
36
Basel III Liquidity Ratios
• Liquidity Coverage Ratio: A bank must have
high quality, unencumbered liquid assets to
withstand a 30-day period of market stress.
• Net Stable Funding Ratio: A bank must have
long-term stable sources of funding relative to
potential calls on its resources.
3636
373737
Implications of Higher Liquidity
Rules
• Need invest in more short-term, high-grade marketable securities
• Need fund more assets with long-term debt
• The implications are relatively similar given a steeply upward sloping yield curve; ROA should decline
37
383838
Determine ROA Impact of Liquidity
• 100 million bank needs to move 1% of assets short-term and lose interest income @ 4.0% to enhance liquidity
– Bank 1: ROA @ 1.00% with 20% marginal income tax rate
– Bank 2: ROA @ 2.00% with 40% marginal income tax rate
38
Financial Impact of Higher
Liquidity
• Bank 1 (ROA = 1.00%)
– Net Income @ 1,000,000
– Interest Lost @ -40,000
– Income Tax @ 8,000
– Net Income @ 968,000
• The 1% higher liquidity rule decreases ROA by 3.2%
• Clearly, higher liquidity coverage ratio adversely affects valuation
• Bank 2 (ROA = 2.00%)
– Net Income @ 2,000,000
– Interest Lost @ -40,000
– Income Tax @ 16,000
– Net Income @ 1,976,000
• The 1% higher liquidity coverage ratio decreases ROA by 1.2%
• The impact is not as severe for the high-profit bank able to offset lost interest income with lesser tax obligations
39
Stable Long-term Bank Funding
“Letras Financeiras”
Interest Cost
Currency
Term and Yield Curve
Expectations
Liquidity Premium
Credit Premium
Credit Rating
Issuance Cost & Fees
Control
Covenants
Collateral
Banco do Brasil S. A. (Incorporated in the Federative Republic of Brazil with limited liability)
US$200,000,000
8.375% Notes due Five Years
US$200,000,000
9.375% Notes due Ten Years
issued under the
US$1,000,000,000GLOBAL-MEDIUM TERM NOTE PROGRAM
40
41
Purpose of Capital
o Provide Cushion for Loss
o Inspire Confidence
o Limits Growth Potential
o Limits Risk Exposure
o Affects Loan-to-one Borrower
o Impacts Return on and Cost of Equity
41
42
Cost of Capital
K(o) = K(e) x W(e) + K(d) x W(d)(1-t)
Where: K(o): is cost of capital
K(e): is cost of equity
K(d): is cost of debt
W: is weight of funds by equity and debt
t : is tax rate
Bank Application
Cost of Capital : 10% (.10) + 6%(.90)(1-.35) = 4.51%
Any bank with a lower cost of capital retains a strategic advantage over competitors
Cost of Capital
42
Leverage and Cost of Capital
Leverage
Cost of debt < cost of equity
Interest on debt creates tax shield
Affects leverage multiplier and ROA; hence affects ROE
Increasing Capital
Use less low-cost debt and more high-cost equity; lose tax shield on debt
Improve credit rating; lower cost of debt
Decrease beta; lower cost of equity
ΒL= ΒU(1+(1-Tax)(D/E))
43
44
Capital Issues
What is capital?
How much capital is needed?
Basel II Issues
Probability of Default (PD)
Loss Given Default (LGD)
Exposure at Default (EAD)
Correlation (R)
Basel II Guidance
ALLL = Expected Losses
Capital > Unexpected Losses
44
45
Basel II Model
45
46
Implied Residential Mortgage
Loan Risk Weights
10% LGD 30% LGD
.25% PD 5 14
.50% PD 8 23
1.00% PD 13 38
5.00% PD 33 99
10.00% PD 45 136
25.00% PD 58 174
46
Bank Lending and Capital Rules
Pre-Basel Capital
Banks need capital equal to 5% of Loans
1988 Basel Accord
Banks need risk-based capital equal to
4% of Mortgage Loans: 50% Risk Weight
Basel II (Standardized)
Banks need risk-based capital equal to
2.8% of Mortgage Loans; 35% Risk Weight
BANK FOR INTERNATIONAL SETTLEMENTS
47
48
Credit Modeling Problems
Data May Not Reflect:
Severe economic contraction
Sharp change in interest rates
or value of currency
New tax or bankruptcy laws
Shift in GAAP
Fraud
New Loan Structure
48
49
Capital Impact on ROA and ROE
• 100 million bank needs
1% more equity capital;
replace debt @ 8.0% with
new stock
– Bank 1: ROA @ 1.00%
(20% tax rate); increase
capital from 9% to 10%;
ROE @ 11.11%
– Bank 2: ROA @ 2.00%
(40% marginal tax rate);
increase capital from 10%
to 11%; ROE @ 20.00%
49
Financial Impact of Higher Capital
• Bank 1 (ROE = 11.11%)
– Net Income @ 1,000,000
– Interest Saved @ 80,000
– Lost Tax Shield @ -16,000
– Net Income @ 1,064,000
• Projected ROE
– 1,064,000/10,000,000
– ROE Decreases to 10.64%
• ROA increases from 1.00% to
1.064%
• LM declines from 11.11 to 10.0
– The 1% higher capital
decreases ROE by 4.23%
• Bank 2 (ROE = 20.00%)
– Net Income @ 2,000,000
– Interest Saved @ 80,000
– Lost Tax Shield @ -32,000
– Net Income @ 2,048,000
• Projected ROE
– 2,048,000/11,000,000
– ROE Declines to 18.62%
• ROA increases from 2.00% to
2.048%
• LM declines from 10.0 to 9.09
– The 1% higher capital lowers
ROE by 6.90%
50
51
Risk Management• Ensure Every Key Risk to
Bank is Identified
Measured and Controlled
• Focus on Factors that have
High Impact and/or
Probability
• Assess Potential Impact of
Remote “Black Swan”
Events
• Approve Risk Appetite
Statement
– Prioritize Risks
– Identify Acceptable Risk
Vision
Statement
Objectives Measures Milestones
Goals
Mission
Statement
The Business Plan
52