“Stress Test” for Community Banks?

External Credit Stress Testing
What Community Banks Need to Know
March 3, 2015
Introductions
Greg Dingens
EVP and Head of Investment Banking | Monroe Financial Partners, Inc.
 25 years experience in investment banking
 Former Managing Director and the head of the Chicago Investment Banking Advisory practice at
both Merrill Lynch and Lehman Brothers
 Also: General Partner, Siena Capital Partners I, L.P. - private investment fund that invests in
community banks
Shawn O’Brien
President | QwickRate
 Leads the strategy for the premier non-brokered CD marketplace and accompanying products
 Serves on the Board of Directors of National Bank of St. Anne (Illinois)
 Previously worked at HomeStar Bank & Trust in Manteno, Illinois
 Works closely with the ICBA as a Preferred Service Provider
2
What Is A Stress Test?
Definition
The results of conducting a series of
“what if” scenarios to assess the
vulnerability of your loan portfolio to
exceptional but plausible credit stress.
“Stress Test”
for Community Banks?
Can Mean Many Different Things…
3
Credit Stress Testing
for
Today’s Topic:
community banks
per
Regulatory Agencies
4
Why Should You Care?
1 Stress Tests Are Coming!
Clear regulatory mandate (the execution… less clear)
2 Best Practices – Demonstrate Risk Management
Proactively get ahead of regulatory curve
3 You Might Learn Something
Identify vulnerabilities; plan for BASEL III
5
Polling Questions:
Answer from your
smartphone or tablet.
Type in your Browser:
http://etc.ch/isfV
6
Polling Question:
Did you conduct a
stress test in 2014?
Poll
7
Background: Regulatory Framework
“A bank must have in place sound
stress testing processes for use
in the assessment of capital
adequacy. Stress testing should
involve identifying possible
events or future changes in
economic conditions that could have
unfavorable effects on a bank’s
credit exposures and assessment
of the bank’s ability to withstand
such changes.”
Basel Capital Accord 2001
8
6 FED Risk
Types
8 OCC Risk
Types
Credit risk
Credit risk
Liquidity risk
Liquidity risk
Market risk
Interest rate risk
Price risk
Operational risk
Transaction risk
Legal risk
Compliance risk
Strategic risk
Reputation risk
Reputation risk
The Big Bank Stress Tests
Big Banks: EXPLICIT Mandatory Testing
Dodd-Frank Act Requirements
Federal Reserve to provide at least three different “scenarios” for
1 firms to stress test against
– Exhaustively detailed set of assumptions, variables and outputs
Federal Reserve to do annual stress test on bank holding
companies over $50 billion in assets and non-bank financial firms
2 under Federal Reserve supervision
– And firms above required to do their own semi-annual stress tests
All other banks with assets greater than $10 billion required to do
3 annual stress test
9
The DFAST Bank Testing
For Banks $10 billion to $50 billion:
19 pages of instructions
27 different macroeconomic
variables
Mandatory templates with
over 100 line item outputs
10
Divining Regulatory Expectations
Statement to
Clarify Supervisory
Expectations for
Stress Testing by
Community Banks
Issued Jointly By
the Federal Reserve,
OCC and FDIC
May 14, 2012
11
Community banks are not required or
expected to conduct the types of
stress testing specifically articulated
in the initiatives…directed at larger
organizations.
In particular, community banks are not required or
expected to conduct the enterprise-wide stress tests
required of larger organizations under the …DoddFrank Act
Divining Regulatory Expectations
Statement to Clarify Supervisory Expectations for
Stress Testing by Community Banks
Issued Jointly By the Federal Reserve, OCC and FDIC
May 14, 2012
The agencies continue to emphasize that…
all banking organizations, regardless of size, should have
the capacity to analyze the potential impact of adverse
outcomes on their financial condition.
12
Divining Regulatory Expectations
OCC Guidance
Comptrollers Handbook, December 2011
“While institutions with large and complex portfolios may use sophisticated
financial models, institutions with less complex portfolios can use less
sophisticated techniques. It is critical to ask the “what if” questions and
incorporate the answers into the risk management process.”
“Lenders may conduct less complex stress tests by evaluating borrower “what
ifs” … The lender can then aggregate the results at the portfolio and firm-wide
levels.”
“As the bank’s knowledge of stress testing grows, it should strive to make the
analysis more robust by simultaneously stressing a number of related
variables.”
13
Divining Regulatory Expectations
Stress Testing and Capital Planning
The OCC expects every bank, regardless of size or risk profile, to have an
effective internal process to (1) assess its capital adequacy in relation to
its overall risks, and (2) to plan for maintaining appropriate capital levels.
Stress testing can be a prudent way for a community bank to identify its key
vulnerabilities to market forces and assess how to effectively manage those
risks should they emerge.
14
Divining Regulatory Expectations
Stress Testing and Capital Planning
If the results of a stress test indicate that capital ratios could fall below the level
needed to adequately support the bank’s overall risk profile, the bank’s board
and management should take appropriate steps to protect the bank from
such an occurrence. This may include establishing a plan that requires 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, and selling or hedging loans to reduce the potential impact from
such stress events.
John C. Lyons Jr.
Senior Deputy Comptroller and Chief National Bank Examiner
October 2012
15
Punchline!
Regardless of the testing method used, an effective stress test has
common elements that a community bank should include:
1
Asking plausible “what
if” questions about
key vulnerabilities
(primarily loan losses
for community banks);
2
Making a reasonable
determination of how
much impact the
stress event or factor
might have on earnings
and capital; and
OCC Supervisory Guidance October 18, 2012
16
3
Incorporating the
resulting analysis into
the bank’s overall risk
management process,
asset/liability
strategies, and
strategic and capital
planning processes.
Polling Question:
Has your regulator asked to
review your stress test?
Poll
17
Stress Test Methods
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Method
Description
Community
Banks?
Transaction stress
testing
Individual loan level analysis,
borrower ability to pay analysis
No
Enterprise-level
stress testing
Multiple variable, environmental
risk
No
Portfolio stress
testing
Loan category analysis against
peer and historical loss
experiences
YES
Reverse stress
testing
What stress level of losses
“breaks the bank”?
YES
Stress Test Methods
Test Should Reflect Community Bank
“A community bank’s approach to stress testing should fit its unique loan
portfolio strategy, size, loan types, composition, operations and management.
Given the smaller scale and lesser complexity of most community banks,
assessing portfolio risk and capital vulnerability can be relatively simple.”
Concentration, Especially in CRE, May Merit Further Analysis
“In some cases, a bottom-up, loan-by-loan analysis may help... For more complex
portfolios … management may link commercial mortgages to debt service
coverage and long-to-value ratios to project potential loss under possible adverse
circumstances. Construction loans may be sensitive to particular variables such
as selling rates, leasing activity, or oversupply.”
OCC Supervisory Guidance October 18, 2012
19
Beyond The Portfolio Test?
The regulators have NOT provided guidance around WHEN a bank
may need more sophisticated, transaction-level analyses.
However, reading the tea leaves…
If your bank has very high concentrations in certain loan categories
1.
2.
– E.g. 300% Investor CRE / capital
If your bank has experienced loan losses well above your peers in
certain loan categories
– E.g. in the 80th percentile of your peer group
If you are a larger, more sophisticated bank
3.
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– E.g. trending closer to the $10 billion Dodd-Frank limit
The Regulators’ 3 Tests
21
Test 1
Test 2
Test 3
Peer Group
Loss Experience
Bank Historical
Loss Experience
Reverse
Stress Test
The bank’s Peer Group
Loss Experience has
been gathered,
evaluated and applied
to the subject bank’s
loan portfolio under
varying scenarios
of stress.
The bank’s actual
Historical Loss
Experience has been
gathered, evaluated
and applied to the
bank’s current loan
portfolio under varying
scenarios of stress.
The “Reverse Stress
Test” has been applied
to the bank’s own
balance sheet,
calculating the losses
required to reduce
the bank’s capital
to critically
undercapitalized levels.
Basic Portfolio Stress Test Framework
Step 1:
Estimate Loan Portfolio
Losses
Step 2:
Estimate Earnings
Offset / Impact
Step 3:
Estimate Impact on
Capital Levels
Calculate potential
stressed losses over
2-year period for entire
portfolio
Calculate earnings
available to
fund losses
Apply net impact
to capital levels
1. Core Operating
Earnings (PTPC)
2. Provisions required to
(a) fund losses and (b)
maintain ALLL levels
3. Taxes and other items
4. Net Income
1. PF Impact to Tier 1 &
Total Capital
2. Calculate and compare
relevant capital ratios
1.
2.
3.
4.
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Loan Categories
Period End Balances
Stress Loss Rates
Stress Losses
Determining Loss Rates
UBPR Peer Analysis to Establish Benchmarks
PEER GROUP 3: $300 mm to $1 billion
90th Percentile
2008
2009
2010
2011
2012
WORST
AVG 2 YEARS
Real Estate Loans
1.56
3.45
2.95
2.34
1.39
C onstruction & Land Development
4.37
9.17
9.69
7.92
5.26
1-4 Family C onstruction
4.75
10.84
8.77
8.67
3.30
Other C onstruction & Land
3.84
9.23
9.90
8.44
5.59
0.10
0.43
0.29
0.24
2.34
7.28
7.27
7.40
0.21
1.87
1.65
2.06
1.72
1.36
1.23
1.72
0.23
3.53
2.70
1.72
Net Losses by Type of LN&LS
Secured by Farmland
23
-
Single & Multifamily Mortgage
1.02
2.50
2.41
2.03
1.39
Home Equity Loans
0.90
2.05
1.98
1.94
1.39
1-4 Family Non-Revolving
1.04
2.89
2.62
2.30
1.45
Multifamily Loans
0.25
2.03
2.85
2.38
1.11
Non-Farm Non-Residential Mtg
0.59
1.42
1.77
1.64
1.37
Owner Occupied Nonfarm Nonresidential
0.46
1.25
1.62
1.60
1.23
Other Nonfarm Nonresidential
0.60
1.84
2.24
2.26
1.64
Agricultural Loans
0.11
0.36
0.43
0.17
0.08
C ommercial and Industrial Loans
2.49
4.82
4.11
3.62
2.60
Loans to Individuals
2.39
3.75
3.08
2.29
1.99
All Other Loans & Leases
1.79
2.27
1.64
1.24
1.67
6.40
18.86
19.61
19.13
0.72
4.91
4.03
5.51
5.23
3.41
3.22
4.50
0.79
8.93
6.83
4.06
Polling Question:
Do you track & compare
peer credit data?
Poll
24
Peer Credit Stress Test Example
Example: $800 million bank with $615 million in loans and $75 million in Tier 1 Capital
Key Assumptions: 2-year Loss Rates?
Gather Data & Create a Range:
• Bank’s actual experience
• UBPR PG experience
• Sort by geography, size, etc.
25
Peer Credit Stress Test Example
Example: $800 million bank with $615 million in loans and $75 million in Tier 1 Capital
Step 1. Estimated Loan Portfolio Stress Losses
90th PCT Loss Range
Quarter End
Loan Portfolios from Call Report Schedule
$Balances
RC-C
Loans secured by type of real estate
a. Construction and development
$
75.0
b. Farmland
50.0
c. 1-4 family housing
125.0
d. Multifamily housing
75.0
e. Nonfarm nonresidential property
125.0
Agricultural production
40.0
Commercial and industrial
100.0
Consumer loans
15.0
All other loans
10.0
Total
$
615.0
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Two-Year
Stress Loss
Rate %
18.9%
0.7%
5.5%
5.2%
3.4%
0.8%
8.9%
6.8%
4.1%
6.5%
Two-Year Stress
$ Losses
$
$
14.1
0.4
6.9
3.9
4.3
0.3
8.9
1.0
0.4
40.3
Peer Credit Stress Test Example
Key Assumptions:
Core Operating Earnings
Pre-Tax Pre-Provision
• Net Interest Income
• Core Non-Int Income
• Core Non-Int Expense
• OREO write-downs / costs
27
Peer Credit Stress Test Example
Step 2. Estimated Impact of Stress on Earnings
Core Operating Earnings (PTPC)
Less provision to cover two-year losses
Less provision to maintain adequate ALLL
Less OREO losses
Pretax Income
Income tax expense (benefit)
Net Income
28
Previous Two
Years Actual
28.0
12.0
4.0
12.0
4.5
7.5
Pro Forma 2 Year
Stress Period
28.0
40.3
(1.0)
4.0
(15.3)
(5.7)
(9.5)
Peer Credit Stress Test Example
Key Questions
• What Do These Results Suggest?
• What Actions May Be Required?
29
Peer Credit Stress Test Example
Step 3. Estimated Impact of Stress on Capital
Tier 1 Capital $
Net change in Tier 1 Capital from stress period
(net income from Step 2)
Pro Forma Tier 1 Capital $
Quarterly Average Assets $
30
Quarter End $
Balances
75.0
Pro Forma Stress
75.0
N/A
75.0
792.0
(9.5)
65.5
782.5
Tier 1 Leverage Ratio %
9.5%
8.4%
Total Capital
Total Risk Based Assets
90.0
710.0
80.5
700.5
Total RBC Ratio
12.7%
11.5%
Reverse Credit Stress Test
What Level of Losses Will It Take to “Break” the Bank?
31
Don’t Forget Basel III
1. Higher Overall Levels of Common Equity Required
 Leverage & Tier 1 capital creativity is frowned upon
2. New enforcement powers: restrictive rules around
shareholder distributions, buybacks and bonuses, all
limited by capital levels
 Capital Conservation Buffer
Common
Equity =
KING
3. More detailed and conservative approach to weighting the
risk of assets (administratively burdensome)
 Larger denominator = MORE CAPITAL
More Capital &
RESULT
32
More
Administration
Benefits of Stress Testing
1
Identification and mitigation of risks
– Changes to underwriting policies
– Portfolio concentrations and limits
– Credit oversight and proactive management of loans
2
Capital planning
– Understanding / assessing future capital needs
• Especially with BASEL III
– Impact on ALLL provisions
– Prepare contingency plans
3
Best practices: Demonstrate risk management
– Relatively easy to comply (but for data)
33
Polling Question:
Is your board aware
of the new stress test
requirements?
Poll
34
Getting Started – 3 Tips
1. Start Simple
Fit to organization: simplicity as a base, with increasing
sophistication if/as warranted
Pick the few critical variables that matter
• Loss rates by category
• Core Operating Earnings
Go deeper if results suggest red flags
35
Getting Started – 3 Tips
2. Conclusions Are Only As Good As The
Assumptions
Assumptions based on observable data carry much
greater credibility
• Actual bank experience
• Peer data
Design results with usable output in mind
36
Getting Started – 3 Tips
3. Just Do It
Don’t wait until you have designed the perfect process
Let the process evolve and inform your model
37
Questions?
Monroe Financial Partners
Greg Dingens
Shawn O’Brien
EVP & Head of Investment Banking
gd@monroefp.com
(312) 506-8752
President
shawn.obrien@qwickrate.com
(815) 468-3445
Serving Community Banks
Since 1968
Premier Non-Brokered CD
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• Experienced Investment Banking
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• Affiliated Asset Management
38
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