How Regulators Gauge Capital Adequacy Under Stress

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  • 1. Liz Williams, Managing Director, CEIS Review Mike Lubansky, Director of Consulting Services, Sageworks
  • 2. To ask a question during the webinar, feel free to enter it into the chat box along the right hand side of your screen. Slides are available there, too. We will email you if we can’t get to your question during the presentation. Link to download slides Area to enter questions or write-in poll answers
  • 3.   An Independent consulting firm serving lending institutions regarding their loan portfolios since 1989 Experience providing the following services: ◦ Loan Review Programs ◦ Loan Loss Reserve Methodology Validation or Refinement ◦ Loan Portfolio Stress Testing ◦ Consulting  Credit Risk Process Review  Loan Policy Maintenance  Loan and Credit Seminars
  • 4.     Financial information company that provides credit and risk management solutions to financial institutions Data and applications used by thousands of financial institutions and accounting firms across North America Provides banking industry resources including whitepapers, webinars, templates and videos on SageworksAnalyst.com Awards ◦ Named to Inc. 500 list of fastest growing privately held companies ◦ Named to Deloitte’s Technology Fast 500
  • 5.  Elizabeth (Liz) Williams Elizabeth is Managing Director of Special Projects & “Complex” Reviews at CEIS Review, Inc., where she is responsible for various projects for clients involving “complex” portfolios, process and procedure, loan loss reserve methodology, stress testing and other specific needs.  Mike Lubansky Mike is a director of consulting services at Sageworks, where he oversees product development, research and implementation in the banking market. He often presents on risk management, most recently to the FFIEC on stress testing methodologies.
  • 6.   Does your institution currently perform any of the following stress tests? When evaluating capital adequacy, have examiners cited your stress testing results?
  • 7.       What is Stress Testing Stress Testing & Capital Adequacy Regulations CRE Stress Tests Top Down Stress Tests Expected Thresholds Basel III Implications
  • 8.      Perform loan-, portfolio- or institution-level analysis Develop scenarios of stressed environments: baseline, adverse and severely adverse Apply stress scenarios and calculate estimated impairment View potential impact on the financial institution’s earnings and capital Determine complexity of stress tests according to bank size, loan portfolio characteristics and risk appetite
  • 9.  “Bottom up” Analysis 1. 2. 3. 4.  Apply set of assumptions to a sample of individual transactions Determine impact on key ratios for each transaction Aggregate results at the portfolio level Extrapolate results across portfolio (depending on sample size) “Top down” Analysis 1. Segment the portfolio into homogeneous pools 2. Evaluate impact of a scenario(s) on each pool 3. Aggregate results for each pool at total portfolio
  • 10.  Individual Transactional Analysis o Typically performed at underwriting / approval o Sensitize cash flow or other indicators o Assess impact on risk of migration to criticized / classified /default o Not focus of today’s discussion
  • 11. • Interagency Guidance on CRE Concentrations 2006 • Portfolio stress testing key “in establishing a risk management framework that effectively identifies, monitors and controls CRE concentration risk.” • “…sophistication …should be consistent with the size, complexity, and risk characteristics of its [the bank’s] CRE loan portfolio.” • Primarily describes “bottom-up” analysis • CCAR Requirements for 19 Largest Banks 2009 • Annual “top down” analysis - assess capital adequacy under adverse economic conditions • Dodd-Frank – Requirements for Banks > $10 Billion in assets 2011 • Expands CCAR-like “top down” process to larger number of banks • Implementation deferred to 2013 ($10 billion to $50 billion in assets)
  • 12. • OCC Comptroller’s Handbook - “Concentrations of Credit” – Update 2011 • “Banks of all sizes will benefit by supplementing stress testing of significant individual loans with portfolio and firm-wide stress testing. The overall goal is to quantify loss potential and the impact on earnings and capital adequacy.” • Combination of “bottom-up” and “top-down” analysis • Interagency Expectations for Stress Testing by Community Banks 2012 • Confirmed that Dodd-Frank and CCAR requirements would not apply • Reiterated that “all banking organizations, regardless of size, should have the capacity to analyze the potential impact of adverse outcomes on their financial condition….The agencies note that such existing guidance, including that covering interest rate risk management, commercial real estate concentrations, and funding and liquidity management (among others), continues to apply.” • Combination of “bottom-up” and “top down” analysis • Other Agency-Specific Publications 2012 • FDIC –Supervisory Insights – “Stress Testing Credit Risk at Community Banks” • OCC – “New Stress Testing Guidance and CRE Stress Test Tool” • More specific comments regarding processes
  • 13.  Bottom up stress tests typically focus on CRE portfolio, using one or a combination of these factors: o o o o o o o o o o „debt-service coverage „loan-to-value ratios and capitalization rates „property net operating income „collateral value depreciation (regional and local) „CRE sector performance „interest-rate levels on variable-rate loans „contractual terms that may introduce refinancing or repayment risk „occupancy status and„lease rates „unit absorption rates for real estate developments „economic factors such as changes in local employment and house prices
  • 14.  234 Loans in sample as of 1/31/2012  65% of Pass-rated CRE, Multifamily & Construction  C&I loans with real estate collateral treated as CRE  Includes loans reviewed between Dec. 2010 and March 2012  Coverage increases every quarter  Income properties (263 loans, 84% of exposure): o 154 Multifamily o 23 Retail o 22 Industrial o 35 Office & Other Stress Segments Other Income Properties 31% (% Total Exposure) Construction 9% (Retail 11%; Industrial OwnerOccupied 4% 10%; Guarantor 3% Office & Other 9%) Income - MF (State 1) 25% Income - MF (Elsewhere) 11% Income - MF (State 2) 17%
  • 15. Grade Migration Assumptions Assumed Migration Depends on Recourse, LTV and DSCR Full Recourse Grade LTV < Benchmark % LTV ≥ Benchmark % Pass Marginal Pass Special Mention (Appropriate DSCR Thresholds) (Appropriate DSCR Thresholds) Classified (Substandard or Doubtful) Less Than Full Recourse Grade LTV < Benchmark % LTV ≥ Benchmark % (Appropriate DSCR Thresholds) (Appropriate DSCR Thresholds) Pass Marginal Pass Special Mention Classified (Substandard or Doubtful)
  • 16.  DSC recalculated with higher rates  Up to +300 bps by 50 bps steps  Apply standard grade migration assumptions to adjusted DSC and current LTV  122 loans maturing or resetting by 3/31/17 treated as interest sensitive  53% of exposure (26 loans) reset after 2014  93% of exposure (101 loans) remain Pass up to +150 bps  Falls to 63% Pass (70 loans) at +300 bps  Over half the migration is to Special Mention rather than Classified  No potential impairments estimated Scenario I - Interest Rate Sensitivity Potential Grade Migration 100% 80% 60% 40% +50 bps +100 +150 +200 +250 +300 bps bps bps bps bps Classified 0% 0% 2% 6% 9% 17% SM 2% 2% 4% 7% 9% 21% 98% 97% 93% 88% 81% 63% Pass
  • 17. Flexible scenario Impact at loan and summary level
  • 18. Capital levels
  • 19. “For most community banks, a simple stressed loss-rate analysis based on call report categories may provide an acceptable foundation to determine if additional analysis is necessary.” OCC Supervisory Guidance– Community Bank Stress Testing– 10/18/2012   Segment the portfolio into pools with similar risk characteristics Develop “stressed” loss rates for each segment; consider: ◦ Bank’s historical loss rates over several stress periods ◦ Peer / market loss rates over several stress periods ◦ Results of any “bottom up” stress testing   Calculate Stress Period Loss amounts (2-year timeframe) Estimate Earnings impact, apply to Tier 1 Capital ratios
  • 20. 1. Estimate Portfolio Losses Over the Stress-Test Horizon Stress Period Loss Rates, Two Yrs Est. Portfolio Balances, in $ Construction & Development Moderate Case Stress Severe Case Stress Stress Period Losses, Two Yrs Moderate Case Stress, in $ Severe Case Stress, in $ 124 14.0% 25.0% 17 31 22 2.5% 5.0% 1 1 Residential Mortgage 372 2.9% 6.5% 11 24 Other Loans 125 5.0% 10.0% 6 13 Totals 643 35 69 Commercial Real Estate 2. Estimate Revenues and Impact of Stress on Earnings Moderate Case Stress, in $ Severe Case Stress, in $ Pre-provision net revenue (over two years) 31 25 Less Provisions 35 69 Less Tax Expense (Benefit) -1 -13 Net After-Tax Income -3 -31 Moderate Case Stress, in $ 88 -3 85 850 10% Severe Case Stress, in $ 88 -31 57 816 7% 3. Estimate Impact of Stress on Capital Beginning Tier 1 Capital Net Change in Tier 1 Capital Ending Tier 1 Capital Estimated Average Assets Estimated Tier 1 Leverage Ratio Capital levels
  • 21.    Easier to pull together a top down stress test, requires little loan-level data Requires market data to assess possible range of loss rates loan type Could consider Reverse Stress Test  Institution back-solves to see what loss rates scenarios cause the institution to breach capital thresholds  Management considers how likely those conditions are, makes contingency plans, or takes other steps to mitigate the identified risks
  • 22.  With capital levels under stress calculated, the institution can estimate appropriate ratios  Tier 1 capital ratio = (Total Equity - Revaluation Reserves) / Risk Based Assets  Total capital ratio = (Tier 1 Capital + Tier 2 Capital) / Risk Based Assets Minimum Well Capitalized Adequately Capitalized Undercapitalized Significantly Undercapitalized Tier 1 capital ratio 4.0% ≥ 6.0% ≥ 4.0% < 4.0% < 3.0% Total capital ratio 8.0% ≥ 10.0% ≥ 8.0% < 8.0% < 6.0% Current
  • 23.  If stress tests indicate capital ratios could fall below thresholds, the institution would have to make a plan that might include: 1. 2. 3. 4. 5. 6. 7. 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, selling or hedging loans to reduce the potential impact from such stress events.
  • 24.  “The Basel Committee is raising the resilience of the banking sector by strengthening the regulatory capital framework… The reforms raise both the quality and quantity of the regulatory capital base and enhance the risk coverage of the capital framework. They are underpinned by a leverage ratio that serves as a backstop to the risk-based capital measures, is intended to constrain excess leverage in the banking system and provide an extra layer of protection against model risk and measurement error.” Basel III: A global regulatory framework for more resilient banks and banking systems
  • 25.  Community banks will start transitioning on January 1, 2015 Year (as of Jan 1) Now 2015 2016 2017 2018 2019 Minimum common equity tier 1 capital ratio N/A 4.5% 4.5% 4.5% 4.5% 4.5% Common equity tier 1 capital conservation buffer N/A N/A 0.625 % 1.25% 1.875 % 2.5% Minimum common equity tier 1 capital ratio plus capital conservation buffer N/A 4.5% 5.125 % 5.75% 6.375 % 7.0% Phase-in of most deductions from common equity tier 1 (including 10 percent & 15 percent common equity tier 1 threshold deduction items that are over the limits) N/A 40% 60% 80% 100% 100% Minimum tier 1 capital ratio 4.0% 6.0% 6.0% 6.0% 6.0% 6.0% Minimum tier 1 capital ratio plus capital conservation buffer N/A N/A 6.625 % 7.25% 7.875 % 8.5% Minimum total capital ratio 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% Minimum total capital ratio plus conservation buffer N/A N/A 8.625 % 9.25% 9.875 % 10.5% Leverage ratio 4.0% 4.0% 4.0% 4.0% 4.0% 4.0%
  • 26. Liz Williams Managing Director-Special Projects, CEIS Review, Inc. 888-967-7380 lwilliams@ceisreview.com http://ceisreview.com/ Mike Lubansky Director of Consulting Services, Sageworks 866.603.7029 ext. 651 mike.lubansky@sageworks.com www.sageworksanalyst.com