Business Drivers Interest Rate CyclePresentation Transcript
THE ROLE OF DIRECTORS IN RISK MANAGEMENT Directors’ Forum Maine Association of Community Banks November 28, 2007
Jim Clarke, Ph.D. 610-688-9466 [email_address]
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.
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.
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.
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.
The Board’s Role should start with a strong ALCO tradition!
ALCO Process – The Role of the Board
ALCO Process – Stay Disciplined
ALCO Process – Liquidity & Interest Rate Risk
ALCO Process – The Agenda
Critical Information for Decision Making
Apply Techniques to Current Environment
It has been a tough year – be patient!
ALCO Process – Start with the Role of Board
Senior Management’s Role
Daily decision making
managing assets & liabilities
Managing risk on an ongoing basis
Establishing policy – we review a new one every meeting.
setting risk limits
Good ALCO Tradition
Lay out a meeting agenda – this forces discipline into the meeting!
Stay with the agenda each meeting – this will re-enforce the important issues!
The chair must maintain enforcement of agenda and a sensible time frame for the meeting!
Make sure the meeting addresses the critical issues – asset funding or cash allocation!
Making ALM Decisions Based on Critical Data
1. What is the interest rate forecast? There is plenty of free information.
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 .
3. What is the bank’s interest rate risk exposure? Is the bank asset or liability sensitive?
Now we are ready to make decisions- Deploying cash – 2002 to 2004, and funding assets – 2005 & 2006!
ALCO Meeting Agenda
Interest rate forecast!
National & local business conditions-you make loans!
Cash flow pro forma – what is my liquidity?
Interest rate risk report – know your sensitivity!
Decision making – What Theory tells us?
Managing Assets through the 1 st quarter 2007
Managing Liabilities through the 1 st quarter 2007
The May 2007 Yield Curve Exemplifies the Toughest Environment: The worst of all possible worlds for Banks [Almost – 1979 to 1981 was the worst]
Market Interest Rates – The Current Yield Curve
Current Versus Recent High
Yield Curve Versus Recent Low
The last eight years have been a clinic for the ALCO!
This is the August futures market forecast before sub prime crisis was understood!
Critical Data: November View String of rate cuts ahead - 4.00% by May
Interest Rate Summary
Interest rates are a critical variable in bank asset/liability management!
We need to establish a forecast for rates at the ALCO meeting.
If you expect rates to rise:
shorten assets and lengthen liabilities
If you expect rates to fall:
Lengthen assets and shorten liabilities
Financial Risk and CAMELS Ratings
Credit Risk – A in CAMELS
Interest Rate Risk – S in CAMELS
Embedded Option Risk – S in CAMELS
Market Risk – S in CAMELS
Marketability Risk – L in CAMELS
Liquidity Risk – L in CAMELS
Currency Risk - S in CAMELS
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
Why do we see capital ratios erode?
Loan problems Non performing become write offs!
Rapid balance sheet growth Typical for large mortgage originators
A leverage transaction gone bad – usually occurs because interest rate environment changes!
Asset Quality – “A” in CAMELS
Diversifying risk – increase portfolio size and risk will decrease.
Bank Loan Portfolio is the primary source of credit risk.
How feasible to diversify:
Residential Mortgage Portfolio
Commercial Real Estate
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
Asset Quality-Loan Portfolio is the Key
Non real estate collateral
Monitoring is critical
2% to 18% Commercial & Industrial Loans
15% to 45% Commercial Real Estate Loans
% of equity
5% to 15% HELOC
Loan to value
New Products – IO & negative amortizing ARMs
25% to 85% 1-4 Family RML
% of equity
5% to 25% Construction Loans Comment % of Bank’s Loan Portfolio Loan Category
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
Interest Rate Risk – “S” in CAMELS
Define: The impact on the Bank’s financial statements from a change in market interest rates:
Income Statement Impact on Net Interest Margin
Balance Sheet Impact on Market Value Capital
Types of Interest Rate Risk
Re-pricing Risk (Gap Analysis)
Basis Risk (Different between indexes)
Yield Curve Risk (How does the yield curve shift?)
Market or Price Risk (Market value capital)
Option Risk (Call, Prepayment, Caps)
Impact on Financial Statements
NIM = II/AA – IE/AA
Asset – Liabilities = Capital
Income Statement Impact
Asset Sensitivity – Assets respond more to a change in rates than liabilities.
Liability Sensitivity – Liabilities respond more to a change in rates than assets.