Earnings at Risk
Perspectives From a Former Regulator on the IRR Regulatory Environment 2016 Mega Conference May 4th, 2016
Dale Sheller, Financial Strategist – Financial Strategies Group [email protected]
1
Long‐Term Assets on the Rise
Source: Call Report Institutions < $1B Assets Maturing/repricing > 5 years
2
Trending Across the Country Share of Banks with Long‐term Assets Representing 30% or More of Earning Assets
Source: Call Report Institutions < $1B Assets Maturing/repricing > 5 years
Share of Community Banks 0 to 10% 10 to 25% 25 to 50% 50 to 75% 75 to 100% 3
Why the Concern?
Source: Call Reports *Assets maturing/repricing > 5 years. Consistent sample of Call filers under $1B in assets as of 2Q04 only. 4
Heightened Regulatory Focus on Interest Rate Risk •
FDIC Supervisory Insight ‐ December 2009 “Nowhere to Go but Up: Managing Interest Rate Risk in a Low‐Rate Environment”
http://www.fdic.gov/regulations/examinations/supervisory/insights/siwin09/Interest_Rate_Risk.html
•
FFIEC Advisory on Interest Rate Risk – January ’10
http://www.ffiec.gov/pdf/pr010710.pdf
•
FFIEC Supervisory Guidance ‐ Interest Rate Risk Management: FAQ – January ’12
http://www.ffiec.gov/PDF/01‐12RR_FAQs.pdf
•
FDIC FIL 46 – October ‘13 Managing IRR in a Challenging Rate Environment
https://www.fdic.gov/news/news/financial/2013/fil13046.html
•
FDIC Supervisory Insight Winter 2013 & Winter 2014
http://www.fdic.gov/regulations/examinations/supervisory/insights/index.html
5
1996 Joint Agency Policy Statement on IRR • Established guidance on prudent IRR management principles • Program tailored to the bank • Board and senior management oversight • Comprehensive risk management process • Corrective action
6
FFIEC Advisory on Interest Rate Risk January 2010
o Board and Senior Management responsibilities – Board: understand IRR and be regularly informed about IRR exposures… Director Education. – Management: implement policies, procedures, controls and sufficiently detailed reporting processes
o IRR Analysis Should Assess Stress Scenarios – – – – – –
Earnings at Risk to measure short‐term risk Economic Value of Equity (EVE) to measure long‐term risk Rate shifts of 300 & 400 basis points – 12 & 24 month horizon Parallel & non‐parallel yield curve shifts Immediate shocks & ramped shifts Capture scenario cash flows and optionality
o Model & Process Validation – – – –
Model itself must be validated (integrity of software, code, math, etc.) Reports should be Back‐Tested Review of Assumptions Assumptions should be institution specific and stress tested
7
IRR Advisory on IRR Risk Management FAQ (2012) • Responds to the most common questions from 2010 IRR Advisory. • 12 Questions were answering regarding the following topics: o Risk Management/Oversight o Measuring and Monitoring IRR o Rate Scenarios o Internal Controls and Validation o Assumptions
8
9
Establishing Policy Limits
“Limits should not be so low as to frequently require exception approval or refinement, and they should not be set so high as to allow for an unacceptable level of IRR.”
•
•
Thresholds and limits should reflect current market conditions and balance sheet posture. For example, what was an achievable margin ten years ago may not be realistic in the current environment. Limits should reflect the unique characteristics of the bank, it’s business model, market area, etc.
10
Risk Limits for What?!? • Earnings at Risk o Percentage Change in Net Interest Income o 12 and 24 month Time Horizons o Limits for Each Interest Rate Scenario
• Capital at Risk / Economic Value of Equity • •
Percentage Change in EVE Limits for Each Interest Rate Scenarios
11
Risk Limit Considerations • Reflect the Institution’s Risk Tolerances & Profile • Consider Complexity, Earnings, & Capital • Change with Risk Profile & Conditions • Promote Discussion on Risk Mitigation Strategies
12
Does the Board Fully Understand Their Policy Limits? Policy Limits: Allows NII to fall 10/20/30/40% for +/‐100/200/300/400bps scenarios
EAR Model Results at Policy Limits Base Case
+200
+300
+400
$139,000
$139,000
$139,000
$139,000
$5,000
$4,000
$3,500
$3,000
NIM
3.60%
2.88%
2.52%
2.16%
Non‐interest Income
$900
$900
$900
$900
Provisions Expense
$125
$125
$125
$125
Overhead
$4,000
$4,000
$4,000
$4,000
Net Income
$1,200
$350
($100)
($600)
ROAA
0.87%
0.25%
(0.07%)
(0.43%)
8%
2%
(1%)
(4%)
Average Assets Net Interest Income
Return on Capital
13
OCC Range of Practices Memo: Risk Limits
14
Net Interest Change: All IRRM Clients 553 Institutions
• Average Net Interest Change for all IRRM Clients: o Unchanged Rates = 0.09% o +300bps = 2.37% o Non‐Parallel (+400/+100bps) = 2.31% •
Average Median Max Min StDev
‐0.09% ‐0.05% 10.50% ‐10.44% 1.87%
Average Median Max Min StDev
2.31% 1.54% 37.93% ‐24.66% 6.03%
Note: For non‐parallel simulations, cash flow prepays are driven by long‐end shift
Average Median Max Min StDev
2.37% 1.80% 21.90% ‐10.07% 4.52%
15
EVE Volatility & Liquid Assets Ratio: All IRRM Clients 553 Institutions
•
Average EVE Volatility for all IRRM Clients: o o
•
+300bps = ‐7.24% • 1 StDev Range = ‐22.5 to 8.05% Non‐Parallel = 2.20% • 1 StDev Range = ‐12.47 to 16.87
Average Median Max Min StDev
‐7.24% ‐7.13% 48.52% ‐50.70% 15.29%
Average Liquid Asset Ratio: o
11.31% • 1 StDev Range = 5.16 to 17.46%
Average Median Max Min StDev
11.31% 9.94% 38.50% ‐0.29% 6.15%
Average Median Max Min StDev
2.20% 0.91% 47.75% ‐40.37% 14.67%
16
Trend Analysis – NIC and EVE •
The average IRRM client continues to see NIC projections exceeding 2% for a +300bps environment. Banks are generally well positioned from an earnings‐at‐risk standpoint for rising interest rates.
•
EVE volatility for IRRM clients has dropped notably over the past seven quarters. This is partly due to strategic changes in duration differentials between assets and liabilities, and partly due to more thorough historical analysis of NMD which produces longer average lives.
17
Supervisory Expectations for Independent Review • Adequacy of the internal control systems • The appropriateness of the risk measurement system • The accuracy and completeness of data inputs • The reasonableness and validity of scenarios • The validity of the risk measurement calculations
18
The Iron Triangle of The Validation Process Independent Review of Processes: Validates the Process
Board Education? A Robust Model? Stress Testing? Assumptions Reviews? Policy Limits? ALCO Minutes?
Back-Test: Validates the Results
“…the independent review should involve assessing the institution’s measurement system of IRR, including the reasonableness of assumptions, the process used in determining assumptions, and the back‐testing of assumptions and results.” …FFIEC
Model Validation: Validates the Model Math
19
Developing an In‐House Independent Review Eleven step guide to developing an in‐house independent ALCO review
“Banks are expected to monitor the effectiveness of their key internal controls either as a part of the internal audit process or by means of an appropriate independent review, and managing IRR is no exception.”
20
Model Validation
21
A Back‐Test should compare the 12 month projection for Net Interest Income to the actual NII over that period to determine the reasonableness of the IRR forecast. Variances within 10% are considered good and within 5% are considered very good. The Back‐Test should be analyzed to determine if the variances are due to volume/rate differences or bad assumptions
22
IRR Management Process
23
The Board is Ultimately Responsible • “…a successful governance framework is grounded in an informed and involved board of directors…” FDIC Supervisory Insights Winter 2014 o o o o o
Written Policies Risk Limits Management Resources Monitoring & Control Procedures Risk Mitigation
24
Effective Corporate Governance • Board of Directors o o o o o
Ultimately responsible for IRR of the institution Approve IRR or A/L policy including establishment of appropriate risk limits Must understand and be regularly informed about levels and trends of IRR exposures Oversees the establishment and implementation of IRR management & mitigation processes Board minutes should reflect director participation in IRR discussion
• Senior Management o o o o o
Execute board‐approved strategies, policies and procedures Maintain systems for measuring IRR, valuing positions and assessing risk Produce detailed reporting on level and trend of IRR exposure Establish internal control structure ALCO minutes should reflect a demonstration of sound processes that quantify risk to earnings & capital
25
What to Expect During an IRR Exam •
Expectations contained primarily in two documents: o 1996 Joint Agency Policy Statement on Interest Rate Risk o 2010 Interagency Advisory on IRR
•
Effective IRR requires… o Informed Directors o Capable Management o Appropriate Internal Resources
“Bankers should be prepared to discuss the results of their IRR measurement system … and be able to describe key assumptions and assumptions development”
It isn’t enough to simply produce reports… management must demonstrate understanding “Well‐documented board and ALCO minutes” will help examiners understand the bank’s risk management practices, etc.
26
Sensitivity to Market Risk Report Comment • Conclusion statements on level of support from earnings and capital, and management practices • Balance sheet structure and positioning • Potential impact to earnings and capital • Risk Management Practices o Identifying, measuring, monitoring, and controlling risk o Independent Review and Validation processes
27
Are We Exam Ready??? •
Director Education
•
Regular (Quarterly) ALCO Meetings to Review & Discuss Reports
•
Regular (Quarterly) Standard & Non‐Standard Stress Tests
•
Annual Validation
•
Annual Assumptions Review
•
Annual Review of Investment & ALCO Policies
– Ensure directors have a basic understanding of IRR and the bank’s ALCO processes – Provide directors with access to educational resources on interest rate risk – Board minutes should reflect director participation in IRR discussions – ALCO minutes should reflect a demonstration of sound processes that quantify risk to earnings & capital – – – –
‐100bp, +100bp, +200bp, +300bp, +400bp, Non‐Parallel (e.g. +400bp/+100bp Bear Flattener) Ramped Rate Shifts & Immediate Rate Shocks 12 & 24 Month Horizons Earnings at Risk & Economic Value of Equity
– Obtain most recent Validation Letter for Model (validates the “math” of the model) – Back‐Test your reports over a 12 month period (validates the results) – Independent Review of ALCO Process (validates the process)
– Use Back‐Test to determine if assumptions are generally reasonable – Periodically perform analysis to ensure assumptions reflect institution’s profile and activities (e.g. Loan Prepayments, NMD Sensitivities, Open‐Close Study, Decay Analysis, Surge Balances, etc.) – Annual Sensitivity Testing (aka, “assumptions stress test” – e.g. increase NMD betas, shorten NMD average lives by 50%, run a migration simulation from NMD to CD’s, etc.)
28
Dale Sheller, Financial Strategist – Financial Strategies Group [email protected]
1
Long‐Term Assets on the Rise
Source: Call Report Institutions < $1B Assets Maturing/repricing > 5 years
2
Trending Across the Country Share of Banks with Long‐term Assets Representing 30% or More of Earning Assets
Source: Call Report Institutions < $1B Assets Maturing/repricing > 5 years
Share of Community Banks 0 to 10% 10 to 25% 25 to 50% 50 to 75% 75 to 100% 3
Why the Concern?
Source: Call Reports *Assets maturing/repricing > 5 years. Consistent sample of Call filers under $1B in assets as of 2Q04 only. 4
Heightened Regulatory Focus on Interest Rate Risk •
FDIC Supervisory Insight ‐ December 2009 “Nowhere to Go but Up: Managing Interest Rate Risk in a Low‐Rate Environment”
http://www.fdic.gov/regulations/examinations/supervisory/insights/siwin09/Interest_Rate_Risk.html
•
FFIEC Advisory on Interest Rate Risk – January ’10
http://www.ffiec.gov/pdf/pr010710.pdf
•
FFIEC Supervisory Guidance ‐ Interest Rate Risk Management: FAQ – January ’12
http://www.ffiec.gov/PDF/01‐12RR_FAQs.pdf
•
FDIC FIL 46 – October ‘13 Managing IRR in a Challenging Rate Environment
https://www.fdic.gov/news/news/financial/2013/fil13046.html
•
FDIC Supervisory Insight Winter 2013 & Winter 2014
http://www.fdic.gov/regulations/examinations/supervisory/insights/index.html
5
1996 Joint Agency Policy Statement on IRR • Established guidance on prudent IRR management principles • Program tailored to the bank • Board and senior management oversight • Comprehensive risk management process • Corrective action
6
FFIEC Advisory on Interest Rate Risk January 2010
o Board and Senior Management responsibilities – Board: understand IRR and be regularly informed about IRR exposures… Director Education. – Management: implement policies, procedures, controls and sufficiently detailed reporting processes
o IRR Analysis Should Assess Stress Scenarios – – – – – –
Earnings at Risk to measure short‐term risk Economic Value of Equity (EVE) to measure long‐term risk Rate shifts of 300 & 400 basis points – 12 & 24 month horizon Parallel & non‐parallel yield curve shifts Immediate shocks & ramped shifts Capture scenario cash flows and optionality
o Model & Process Validation – – – –
Model itself must be validated (integrity of software, code, math, etc.) Reports should be Back‐Tested Review of Assumptions Assumptions should be institution specific and stress tested
7
IRR Advisory on IRR Risk Management FAQ (2012) • Responds to the most common questions from 2010 IRR Advisory. • 12 Questions were answering regarding the following topics: o Risk Management/Oversight o Measuring and Monitoring IRR o Rate Scenarios o Internal Controls and Validation o Assumptions
8
9
Establishing Policy Limits
“Limits should not be so low as to frequently require exception approval or refinement, and they should not be set so high as to allow for an unacceptable level of IRR.”
•
•
Thresholds and limits should reflect current market conditions and balance sheet posture. For example, what was an achievable margin ten years ago may not be realistic in the current environment. Limits should reflect the unique characteristics of the bank, it’s business model, market area, etc.
10
Risk Limits for What?!? • Earnings at Risk o Percentage Change in Net Interest Income o 12 and 24 month Time Horizons o Limits for Each Interest Rate Scenario
• Capital at Risk / Economic Value of Equity • •
Percentage Change in EVE Limits for Each Interest Rate Scenarios
11
Risk Limit Considerations • Reflect the Institution’s Risk Tolerances & Profile • Consider Complexity, Earnings, & Capital • Change with Risk Profile & Conditions • Promote Discussion on Risk Mitigation Strategies
12
Does the Board Fully Understand Their Policy Limits? Policy Limits: Allows NII to fall 10/20/30/40% for +/‐100/200/300/400bps scenarios
EAR Model Results at Policy Limits Base Case
+200
+300
+400
$139,000
$139,000
$139,000
$139,000
$5,000
$4,000
$3,500
$3,000
NIM
3.60%
2.88%
2.52%
2.16%
Non‐interest Income
$900
$900
$900
$900
Provisions Expense
$125
$125
$125
$125
Overhead
$4,000
$4,000
$4,000
$4,000
Net Income
$1,200
$350
($100)
($600)
ROAA
0.87%
0.25%
(0.07%)
(0.43%)
8%
2%
(1%)
(4%)
Average Assets Net Interest Income
Return on Capital
13
OCC Range of Practices Memo: Risk Limits
14
Net Interest Change: All IRRM Clients 553 Institutions
• Average Net Interest Change for all IRRM Clients: o Unchanged Rates = 0.09% o +300bps = 2.37% o Non‐Parallel (+400/+100bps) = 2.31% •
Average Median Max Min StDev
‐0.09% ‐0.05% 10.50% ‐10.44% 1.87%
Average Median Max Min StDev
2.31% 1.54% 37.93% ‐24.66% 6.03%
Note: For non‐parallel simulations, cash flow prepays are driven by long‐end shift
Average Median Max Min StDev
2.37% 1.80% 21.90% ‐10.07% 4.52%
15
EVE Volatility & Liquid Assets Ratio: All IRRM Clients 553 Institutions
•
Average EVE Volatility for all IRRM Clients: o o
•
+300bps = ‐7.24% • 1 StDev Range = ‐22.5 to 8.05% Non‐Parallel = 2.20% • 1 StDev Range = ‐12.47 to 16.87
Average Median Max Min StDev
‐7.24% ‐7.13% 48.52% ‐50.70% 15.29%
Average Liquid Asset Ratio: o
11.31% • 1 StDev Range = 5.16 to 17.46%
Average Median Max Min StDev
11.31% 9.94% 38.50% ‐0.29% 6.15%
Average Median Max Min StDev
2.20% 0.91% 47.75% ‐40.37% 14.67%
16
Trend Analysis – NIC and EVE •
The average IRRM client continues to see NIC projections exceeding 2% for a +300bps environment. Banks are generally well positioned from an earnings‐at‐risk standpoint for rising interest rates.
•
EVE volatility for IRRM clients has dropped notably over the past seven quarters. This is partly due to strategic changes in duration differentials between assets and liabilities, and partly due to more thorough historical analysis of NMD which produces longer average lives.
17
Supervisory Expectations for Independent Review • Adequacy of the internal control systems • The appropriateness of the risk measurement system • The accuracy and completeness of data inputs • The reasonableness and validity of scenarios • The validity of the risk measurement calculations
18
The Iron Triangle of The Validation Process Independent Review of Processes: Validates the Process
Board Education? A Robust Model? Stress Testing? Assumptions Reviews? Policy Limits? ALCO Minutes?
Back-Test: Validates the Results
“…the independent review should involve assessing the institution’s measurement system of IRR, including the reasonableness of assumptions, the process used in determining assumptions, and the back‐testing of assumptions and results.” …FFIEC
Model Validation: Validates the Model Math
19
Developing an In‐House Independent Review Eleven step guide to developing an in‐house independent ALCO review
“Banks are expected to monitor the effectiveness of their key internal controls either as a part of the internal audit process or by means of an appropriate independent review, and managing IRR is no exception.”
20
Model Validation
21
A Back‐Test should compare the 12 month projection for Net Interest Income to the actual NII over that period to determine the reasonableness of the IRR forecast. Variances within 10% are considered good and within 5% are considered very good. The Back‐Test should be analyzed to determine if the variances are due to volume/rate differences or bad assumptions
22
IRR Management Process
23
The Board is Ultimately Responsible • “…a successful governance framework is grounded in an informed and involved board of directors…” FDIC Supervisory Insights Winter 2014 o o o o o
Written Policies Risk Limits Management Resources Monitoring & Control Procedures Risk Mitigation
24
Effective Corporate Governance • Board of Directors o o o o o
Ultimately responsible for IRR of the institution Approve IRR or A/L policy including establishment of appropriate risk limits Must understand and be regularly informed about levels and trends of IRR exposures Oversees the establishment and implementation of IRR management & mitigation processes Board minutes should reflect director participation in IRR discussion
• Senior Management o o o o o
Execute board‐approved strategies, policies and procedures Maintain systems for measuring IRR, valuing positions and assessing risk Produce detailed reporting on level and trend of IRR exposure Establish internal control structure ALCO minutes should reflect a demonstration of sound processes that quantify risk to earnings & capital
25
What to Expect During an IRR Exam •
Expectations contained primarily in two documents: o 1996 Joint Agency Policy Statement on Interest Rate Risk o 2010 Interagency Advisory on IRR
•
Effective IRR requires… o Informed Directors o Capable Management o Appropriate Internal Resources
“Bankers should be prepared to discuss the results of their IRR measurement system … and be able to describe key assumptions and assumptions development”
It isn’t enough to simply produce reports… management must demonstrate understanding “Well‐documented board and ALCO minutes” will help examiners understand the bank’s risk management practices, etc.
26
Sensitivity to Market Risk Report Comment • Conclusion statements on level of support from earnings and capital, and management practices • Balance sheet structure and positioning • Potential impact to earnings and capital • Risk Management Practices o Identifying, measuring, monitoring, and controlling risk o Independent Review and Validation processes
27
Are We Exam Ready??? •
Director Education
•
Regular (Quarterly) ALCO Meetings to Review & Discuss Reports
•
Regular (Quarterly) Standard & Non‐Standard Stress Tests
•
Annual Validation
•
Annual Assumptions Review
•
Annual Review of Investment & ALCO Policies
– Ensure directors have a basic understanding of IRR and the bank’s ALCO processes – Provide directors with access to educational resources on interest rate risk – Board minutes should reflect director participation in IRR discussions – ALCO minutes should reflect a demonstration of sound processes that quantify risk to earnings & capital – – – –
‐100bp, +100bp, +200bp, +300bp, +400bp, Non‐Parallel (e.g. +400bp/+100bp Bear Flattener) Ramped Rate Shifts & Immediate Rate Shocks 12 & 24 Month Horizons Earnings at Risk & Economic Value of Equity
– Obtain most recent Validation Letter for Model (validates the “math” of the model) – Back‐Test your reports over a 12 month period (validates the results) – Independent Review of ALCO Process (validates the process)
– Use Back‐Test to determine if assumptions are generally reasonable – Periodically perform analysis to ensure assumptions reflect institution’s profile and activities (e.g. Loan Prepayments, NMD Sensitivities, Open‐Close Study, Decay Analysis, Surge Balances, etc.) – Annual Sensitivity Testing (aka, “assumptions stress test” – e.g. increase NMD betas, shorten NMD average lives by 50%, run a migration simulation from NMD to CD’s, etc.)
28
