Business Drivers Interest Rate Cycle


Published on

  • Be the first to comment

  • Be the first to like this

No Downloads
Total views
On SlideShare
From Embeds
Number of Embeds
Embeds 0
No embeds

No notes for slide

Business Drivers Interest Rate Cycle

  1. 1. THE ROLE OF DIRECTORS IN RISK MANAGEMENT Directors’ Forum Maine Association of Community Banks November 28, 2007
  2. 2. Jim Clarke, Ph.D. 610-688-9466 [email_address] <ul><li>Jim teaches asset/liability management in the Graduate School of Banking sponsored by America’s Community Bankers. He is responsible for much of Americas’ Community Bankers ALM education. He also conducts ALM seminars for the Financial Management Society, [FMS], Risk Management Association (RMA), and other national associations. </li></ul><ul><li>Jim conducts seminars on ALM for both state banking associations and individual banks. He annually conducts a “Current Issues in ALM” seminar for state bankers associations throughout the Midwest, central Atlantic states & New England. </li></ul><ul><li>Dr. Clarke is a frequent speaker at banking conventions on both ALM and strategic issues. Jim has written extensively in the area of ALM and bank strategies. </li></ul><ul><li>Jim has a B.A. in Economics from LaSalle College and a Ph.D. in Economics from the University of Notre Dame. He is a former faculty member in the Finance Department at Villanova University. He sits on the board of two community banks and an investment company. </li></ul>
  3. 3. The Board’s Role should start with a strong ALCO tradition! <ul><li>ALCO Process – The Role of the Board </li></ul><ul><li>ALCO Process – Stay Disciplined </li></ul><ul><li>ALCO Process – Liquidity & Interest Rate Risk </li></ul><ul><li>ALCO Process – The Agenda </li></ul><ul><li>Critical Information for Decision Making </li></ul><ul><li>Apply Techniques to Current Environment </li></ul><ul><li>It has been a tough year – be patient! </li></ul>
  4. 4. ALCO Process – Start with the Role of Board <ul><li>Senior Management’s Role </li></ul><ul><ul><li>Daily decision making </li></ul></ul><ul><ul><ul><li>managing assets & liabilities </li></ul></ul></ul><ul><ul><li>Managing risk on an ongoing basis </li></ul></ul><ul><li>Board’s Role </li></ul><ul><ul><li>Establishing policy – we review a new one every meeting. </li></ul></ul><ul><ul><ul><li>setting risk limits </li></ul></ul></ul><ul><ul><ul><li>Monitoring risk </li></ul></ul></ul>
  5. 5. Good ALCO Tradition <ul><li>Lay out a meeting agenda – this forces discipline into the meeting! </li></ul><ul><li>Stay with the agenda each meeting – this will re-enforce the important issues! </li></ul><ul><li>The chair must maintain enforcement of agenda and a sensible time frame for the meeting! </li></ul><ul><li>Make sure the meeting addresses the critical issues – asset funding or cash allocation! </li></ul>
  6. 6. Making ALM Decisions Based on Critical Data <ul><li>1. What is the interest rate forecast? There is plenty of free information. </li></ul><ul><li>2. What is the bank’s liquidity position? Requires a cash flow pro forma! Do you need cash, if not why play the aggressive deposit pricing game – there are times when you should consider shrinking the bank [2007]. </li></ul><ul><li>3. What is the bank’s interest rate risk exposure? Is the bank asset or liability sensitive? </li></ul><ul><li>Now we are ready to make decisions- Deploying cash – 2002 to 2004, and funding assets – 2005 & 2006! </li></ul>
  7. 7. ALCO Meeting Agenda <ul><li>Interest rate forecast! </li></ul><ul><li>National & local business conditions-you make loans! </li></ul><ul><li>Cash flow pro forma – what is my liquidity? </li></ul><ul><li>Interest rate risk report – know your sensitivity! </li></ul><ul><li>Decision making – What Theory tells us? </li></ul><ul><li>Managing Assets through the 1 st quarter 2007 </li></ul><ul><li>Managing Liabilities through the 1 st quarter 2007 </li></ul>
  8. 8. The May 2007 Yield Curve Exemplifies the Toughest Environment: The worst of all possible worlds for Banks [Almost – 1979 to 1981 was the worst]
  9. 9. Market Interest Rates – The Current Yield Curve
  10. 10. Current Versus Recent High
  11. 11. Yield Curve Versus Recent Low
  12. 12. The last eight years have been a clinic for the ALCO!
  13. 13. This is the August futures market forecast before sub prime crisis was understood!
  14. 14. Critical Data: November View String of rate cuts ahead - 4.00% by May
  15. 15. Interest Rate Summary <ul><li>Interest rates are a critical variable in bank asset/liability management! </li></ul><ul><li>We need to establish a forecast for rates at the ALCO meeting. </li></ul><ul><li>_________________________________ </li></ul><ul><li>If you expect rates to rise: </li></ul><ul><li> shorten assets and lengthen liabilities </li></ul><ul><li>If you expect rates to fall: </li></ul><ul><li> Lengthen assets and shorten liabilities </li></ul>
  16. 16. Financial Risk and CAMELS Ratings <ul><li>Credit Risk – A in CAMELS </li></ul><ul><li>Interest Rate Risk – S in CAMELS </li></ul><ul><li>Embedded Option Risk – S in CAMELS </li></ul><ul><li>Market Risk – S in CAMELS </li></ul><ul><li>Marketability Risk – L in CAMELS </li></ul><ul><li>Liquidity Risk – L in CAMELS </li></ul><ul><li>Currency Risk - S in CAMELS </li></ul>
  17. 17. Capital Risk – “C” in CAMELS 5.00% 4.00% Tier 1 Leverage Ratio 10.00% 8.00% Total RBC 6.00% 4.00% Tier 1 Risk Based Capital (RBC) Your Bank [Optimal] Well Capitalized Regulation Metric
  18. 18. Why do we see capital ratios erode? <ul><li>Loan problems  Non performing become write offs! </li></ul><ul><li>Rapid balance sheet growth  Typical for large mortgage originators </li></ul><ul><li>A leverage transaction gone bad – usually occurs because interest rate environment changes! </li></ul>
  19. 19. Asset Quality – “A” in CAMELS <ul><li>Diversifying risk – increase portfolio size and risk will decrease. </li></ul><ul><li>Bank Loan Portfolio is the primary source of credit risk. </li></ul><ul><li>How feasible to diversify: </li></ul><ul><li> Residential Mortgage Portfolio </li></ul><ul><li> HELOC </li></ul><ul><li> Commercial Real Estate </li></ul>
  20. 20. Monitoring Credit Risk – Note that Thrifts and Commercial Banks will have different standards! [0.70% to 1.25%] Allowances/ Loans [0.40% to 0.70%] Non Current/Loans [0.3% to 0.10%] Losses/Loans Comment Metric
  21. 21. Asset Quality-Loan Portfolio is the Key <ul><li>Non real estate collateral </li></ul><ul><li>Monitoring is critical </li></ul>2% to 18% Commercial & Industrial Loans <ul><li>Diversification </li></ul><ul><li>Underwriting </li></ul>15% to 45% Commercial Real Estate Loans <ul><li>% of equity </li></ul><ul><li>Sub Prime </li></ul>5% to 15% HELOC <ul><li>Loan to value </li></ul><ul><li>Geographic concentration </li></ul><ul><li>New Products – IO & negative amortizing ARMs </li></ul>25% to 85% 1-4 Family RML <ul><li>Portfolio concentration </li></ul><ul><li>Geographic concentration </li></ul><ul><li>% of equity </li></ul>5% to 25% Construction Loans Comment % of Bank’s Loan Portfolio Loan Category
  22. 22. Liquidity Risk – the “L” in CAMELS Good correlation to interest rate risk Short-Term Non Core Dependence Depends on bank size – but increasing across all peer groups! Net Non Core Dependence 50% to 85% 75% to 110% Loan/Asset or Loan/Deposit Comment [Mature Bank] Metric
  23. 23. Interest Rate Risk – “S” in CAMELS <ul><li>Define: The impact on the Bank’s financial statements from a change in market interest rates: </li></ul><ul><li>Income Statement  Impact on Net Interest Margin </li></ul><ul><li>Balance Sheet  Impact on Market Value Capital </li></ul>
  24. 24. Types of Interest Rate Risk <ul><li>Re-pricing Risk (Gap Analysis) </li></ul><ul><li>Basis Risk (Different between indexes) </li></ul><ul><li>Yield Curve Risk (How does the yield curve shift?) </li></ul><ul><li>Market or Price Risk (Market value capital) </li></ul><ul><li>Option Risk (Call, Prepayment, Caps) </li></ul>
  25. 25. Impact on Financial Statements <ul><li>Income Statement </li></ul><ul><li>NIM = II/AA – IE/AA </li></ul><ul><li>Balance Sheet </li></ul><ul><li>Asset – Liabilities = Capital </li></ul>
  26. 26. Income Statement Impact <ul><li>Asset Sensitivity – Assets respond more to a change in rates than liabilities. </li></ul><ul><li>Liability Sensitivity – Liabilities respond more to a change in rates than assets. </li></ul>Margin increases Margin decreases Liability Sensitive Margin decreases Margin increases Asset Sensitive Rates Decrease Rates Increase
  27. 27. How do we measure interest rate risk? <ul><li>Gap Analysis – Gap is determined from the balance sheet and measures the impact on the income statement. This is a traditional measure many banks use to measure IRR. </li></ul><ul><li>Simulation Analysis – Models each asset & liability as to the impact from a change in interest rates. Allows for a simulation of both the balance and income statement from a rise and fall in rates. </li></ul>
  28. 28. Regulator expects Board to set limits on IRR. -200 bps -100 bps base case +100 bps +200 bps Change in MV Capital Change in NII or Margin Change in Rates
  29. 29. Board’s Role in Monitoring Risk <ul><li>Monitor periodically – Quarter is routine, but more often if problems arise! </li></ul><ul><li>Review similar data when monitoring! </li></ul><ul><li>Don’t wait for an elephant to walk by – at that point it is too late! </li></ul><ul><li>Look for recurring variation – ask for explanation! </li></ul>