measuring & managing earnings & value at risk - financial risk … · 2016-06-20 ·...

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© 2013 FARIN & Associates Inc.

Measuring & Managing

Earnings & Value at Risk

Presented By:

David W. Koch

Chief Operating Officer

FARIN & Associates, Inc..

[email protected]

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Asset/Liability Management

Definition:

“asset/liability management” is the processes of

acquiring and deploying funds to maximize the

earnings, and value of the institution, while

controlling financial risks.

Key Issues:

• Set Direction to Meet Capital Plan Goals for

Earnings, Growth and Capital

• Measure All Financial Risks to Plan

• Measure Risk based on Return!

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Interest Rate Risk

• Definition:

– The risk that changes in market interest rates will affect

Income & Market Value of Assets & Liabilities.

– 2 part definition:

• Income (Earnings at Risk)

• Market Value (Value at Risk)

– EVE, NEV, MVPE

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MEASURING EARNINGS @ RISK

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Interest Rate Risk Redefined

• Income Portion of Definition

– Reinvestment risk is the risk that as one instrument matures and

is replaced with another, the funds being reinvested will carry a

different interest rate than the funds in the original instrument.

• Example - a customer‟s $10,000 90-day CD yielding 6% is about to

mature. Tomorrow we‟ll pay her $10,150 P&I. If we wish to continue

to fund the asset supported by the CD, we‟ll have to replace the

$10,000. In order to do so we‟ll have to pay prevailing market rates,

which might mean something other than 6%. At that point the

$10,000 reprices. Our cost of funds may rise or fall.

– Reinvestment risk is not a problem as long as it‟s occurring at

approximately the same speed on both assets and liabilities.

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ALCO‟s Primary Responsibilities

• Set Direction of Balance Sheet Growth and Pricing to Meet Capital Plan Goals for – Earnings

– Capitalization

– Growth

• Ensure Adequate Level of Net Interest Income/Net Income Under Current Plan and Economic Outlook

• Assess Risk to Capital, Earnings and/or Growth from

– Interest Rate Risk

– Liquidity Risk

– Credit Risk

• Unacceptable Risk in any of the above raises Regulatory Risk!

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ALCO‟s Primary Responsibilities

• Examine Balance Sheet Structure – Loan/Investment & Deposit/Borrowing Mix

– Growth rates

– Controlled through Loan & Deposit Pricing

– Investment Portfolio Management

• Earnings impact

• Liquidity Needs

– Wholesale Funding

– Capital Utilization

• Risk Measurement and Management • Interest Rate Risk

• Liquidity Risk

• Credit Risk

• Regulatory Risk

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What Causes Interest Rate Risk?

• Four Reasons Why or When Financial Instruments

Are Rate Sensitive

– Maturity

• Example: 90 day CD with P&I due at maturity

– Amortization

• Example: 30 year fixed rate mortgage reprices gradually as the

principal and interest payments are received.

– Prepayment

• Example: 11% fixed rate mortgage with market rates of 8%. It

reprices when owner refinances to obtain a better rate.

– Contractual repricing terms on arm or variable rate loan

• Example: 30 year ARM with annual resets.

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Interest Rate Risk is Caused by Changes in Actual vs. Expected Cash Flow

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ALCO Controls for IRR

• Loan and Deposit Pricing

– Most powerful ALM tool you have!

• Mix Optimization

• Wholesale Alternatives

– Borrowings/Investments

– Synthetics/Derivatives

• Determination of Required/Desired Capital Level

– Setting a Firm Target Creates a Single Priority to

assess other variables

• Growth vs. Earnings vs. Lower Capital (Higher Leverage)

• Higher Leverage means lower capital/assets but creates

higher shareholder return

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ALCO Measurement Systems

ALCO Must:

• Develop measurement systems that:

– Project the future earnings of the institution over a short horizon

(2-3 years)

– Test the performance of earnings in a variety of interest rate

scenarios

– Assess the long-term earnings risk profile (EVE/NEV) of the

balance sheet

– Develop strategies to minimize undesirable risks or manage risks

taken

• Develop Processes that

– Maximize financial performance under all foreseeable economic

conditions

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Income at Risk Measurement Tools

Picking the Right Tool to match the job…

What is the job again??? • Gap Analysis

– Measures dollar volume difference between rate sensitive (repricing) assets and liabilities

• Income Simulation – Projects reinvestment and repricing of cash flows in

different rate scenarios to estimate effect on net interest income and net income

– Measures impact of interest rate changes on earnings

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Gap Analysis

• Inventories Timing of Repricing of RSA & RSL

– Future divided into time bands (buckets)

– Balances slotted based on

• Cash flows (fixed)

• Scheduled repricing (variable)

– Total RSA & RSL totaled by time band

– Control ratios are

• Gap/Assets (+/-10%)

• RSA/RSL (0.8 - 1.2)

• Goal of GAP: Provide a Proxy on Earnings at Risk

• Advantages

– Easy data availability

– Can be done manually

– Inexpensive

• Disadvantages

– How soon but not how much

– Fails to consider option risk

– Not a good market value tool

– Difficult to explain to boards &

non-financial managers

– Measures risk but not return

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ALCO Decisions

• Describing the Basic Balance Sheet Positions…

– Asset Sensitive: More assets reprice than liabilities

• If rates increase Income should increase

• If rates decrease Income should decline

– Liability Sensitive: More liabilities reprice than assets

• If rates decrease Income should increase

• If rates increase Income should drop

– Is it possible to have a neutral position?

• Option risks make this nearly impossible for retail financial

institutions

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Examining IRR Measures

• Let‟s look at a sample institution

– $900 MM Commercial bank

• 85% Loan/Assets

• 10% NIB Funding

• 17% Checking & Savings

• 56% CDs

• 9% Capital

– Gap Analysis used as primary IRR tool

• As of date = June 2006

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Mr. Peabody‟s Wayback Machine

• June 2006 Questions

– Market rates were high

– Rate Predictions:

• Uncertain rate movements

• Generally hoping for lower short term rates

• 50/50 bet on next move

• Impact on ALCO

– What IRR profile do we want in this situation?

– How should we measure our risks?

• Questions in today‟s environment

– When are rates going to rise? Which rates?

– Are rates more likely to rise than fall?

– How will margin be impacted?

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Case Study – Gap

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Month 1 Month 2 Month 3 2nd Quarter 3rd Quarter 4th Quarter

Total RSA 371,634,902 22,487,784 14,125,103 41,131,542 33,236,705 41,011,583

Total RSL 52,728,663 96,652,568 7,002,470 151,943,964 135,255,369 108,188,666

Gap (RSA-RSL) 318,906,240 (74,164,784) 7,122,634 (110,812,421) (102,018,664) (67,177,083)

Cum RSA 371,634,902 394,122,686 408,247,789 449,379,332 482,616,037 523,627,620

Cum RSL 52,728,663 149,381,230 156,383,700 308,327,663 443,583,032 551,771,699

Cum Gap (RSA-RSL) 318,906,240 244,741,456 251,864,090 141,051,669 39,033,005 (28,144,078)

RSA/RSL 7.05 0.23 2.02 0.27 0.25 0.38

Cum RSA/RSL 7.05 2.64 2.61 1.46 1.09 0.95

Gap/Assets 37.76% -8.78% 0.84% -13.12% -12.08% -7.95%

Cum Gap/Assets 37.76% 28.98% 29.82% 16.70% 4.62% -3.33%

Positive Gap at 1 month indicates VR loans and extra Cash investments

Negative cumulative gap at 1 yr. says little chg. in earnings projected

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Actual Rate Movements Treasury Rate Comparisons

4.00

4.20

4.40

4.60

4.80

5.00

5.20

5.40

1 M

onth B

ill -

BEY

3 M

onth B

ill -

BEY

6 M

onth B

ill -

BEY

1 Yea

r T-B

ill R

ate

18 M

onth T

-Bill

Rat

e

2 Yea

r Note

Yie

ld

3 Yea

r Note

Yie

ld

5 Yea

r Note

Yie

ld

10 Y

ear Note

Yie

ld

30 Y

ear Ext

rapola

ted B

ond Yie

ld

2006M06 2006M12 2007M06

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Actual Change in NIM

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Actual NIM drops from June 06 by nearly 10%

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Components of NIM Change Changes in Net Int Margin Components

-0.40%

-0.30%

-0.20%

-0.10%

0.00%

0.10%

0.20%

0.30%

0.40%

Mar 2006-YTD Jun 2006-YTD Sep 2006-YTD Dec 2006-YTD

Ch

g in

NIM

-0.50

-0.40

-0.30

-0.20

-0.10

0.00

0.10

0.20

0.30

0.40

0.50

Ch

g in

Ma

rke

t R

ate

s

Chg in Int Inc/AA Chg in Int Exp/AA Chg in NIM/AA Chng in 6 Mo Treas Chg in 1 Yr Treas Chg in 10 Yr Treas

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Change in Interest Expense Killed Margin!


Issues in Trends

• Prior graph shows:

– Lines Graph – Changes in Qtrly. interest rates

– Int. Inc.. and Int. Exp. both rise in 2nd Qtr.

– Int. Exp. rises faster than Int. Inc..

– Result - NIM Declines 10%

• Institution raised deposit costs when rates

had actually decreased - PRICING

• It‟s not enough to measure WHEN something

reprices but HOW MUCH it will reprice

• Modeling risk requires realistic assumptions

on institution pricing actions

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MODELING INCOME @ RISK

Income Simulation

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Static Income Simulation

• Definition

– Projecting financial statements assumes a constant

balance sheet. No change in level or mix.

– Measure effect of rate changes on income by running

multiple rate environments.

– Income at risk = Projected changes in income in the

different rate environments

– Policy limits set to minimize rate change effect one key

metric used in measuring return

• Example – Drop in Net Interest Income should not be more

than 15% of base level if rates move against institution.

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Static Income Simulation

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Today

Current Balance Sheet and

Forecast Balance Sheet are the Same

Usually run against Gradual and/or

Immediate & Permanent

Rate movements

Typically 1-3 Years

Horizon

Income is a flow that occurs over

time. To test income at risk you

must run a forecast. In static

income at risk the balance sheet

composition is held constant

throughout the forecast.


Dynamic Income Simulation

• Definition

– Projection of institution‟s financial statements based on

a set of assumptions.

• Total Assets may change

• Loan/Investment & deposits/borrowings levels change

• Consistent with Budgeting and Liquidity management

– Measure effect of rate changes on income by

measuring multiple rate forecasts.

– Income at risk is measured by fluctuations in income

measurement under the different rate environments

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Measuring Earnings at Risk

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Measuring Earnings at Risk

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Dynamic Income Simulation

• Advantages

– Model used for dynamic

income at risk analysis can be

used for multiple purposes.

• Budgeting

• Strategic Planning

• Interest Rate Risk Analysis

• Liquidity Risk

– Measures most important

management issue:

• short and medium term

earnings –

• the effect of rate changes

performance

• ROA, ROE, EPS, etc.

• Disadvantages

– Cost of software

– People costs for skills to

manage

– Data and Time Intensive

• Ideally your plan should be

incorporated into model.

• As we see more regulatory

action on Enterprise Risk

Management, expect more

acceptance and expectation for

integrated plans and risk

management…

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Fallacies of Static IAR

• “By keeping the balance sheet Static we are

testing the IRR in the existing Balance Sheet”

– Not really, The fact that we are replacing cash flows means

we are forecasting a dynamic position that simply has no

change in mix from current levels.

• “Using forecasted data ‘clouds’ the output”

– How is a plan that does not represent what we are actually

implementing help me in making decisions?

• “Management can manipulate assumptions and

change the appearance of risk”

– If ALCO is run properly, then this is easily validated by

regular back tests to ensure actions are consistent with

plans.

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Static vs. Dynamic IAR

Balance Sheet Comparison

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Projected Growth

Static Bal Sheet


Static vs. Dynamic IAR

Income Stmt Comparison

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Growth

Static

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Implementing Dynamic ALCO

• Focus on Production, not Income.

• Focus on How Results are Generated not just the

results

• Must prove that you manage the forecasts :

– Be able to demonstrate accurate projections

– Document variances, causes and impacts on

performance

– Prove timely actions are taken and projections are

rerun showing new performance levels

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FFIEC IRR ADVISORY

The time has come to do more in ALCO

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Joint Agency Policy on IRR

• First Adopted in 1996 – Added the S component to CAMEL Rating

– Developed Qualitative Assessment process for Examination

• No Uniform Supervisory Measure

• Major Components – Board & Senior Management Oversight Roles

– Risk Management Processes • Controls & Limits

• Identification & Measurement

• Monitoring & Reporting

• Internal Audit & Review

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Joint Agency Policy Statement 5 Areas of Risk To Model

1. Repricing Risk: Impact of mismatch of repricing timing or amount on earnings/capital

2. Basis Risk: How different balance sheet components respond to market rate movements due to driver response – Example: Libor vs. Prime movements

3. Yield Curve Risk: Recognition that Yield Curves do not move the same amounts for all maturities (non-parallel movements)

4. Price Risk: Changes in market values of financial instruments and the impact on the market value of capital.

5. Option Risk: Changes to cash flows resulting from rate movements

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2010 FFIEC IRR Guidance

• 2010-1A IRR Regulatory Guidance

– Issued December 2009

• Restatement of 1996 Joint Agency Policy Statement on Interest Rate Risk – FIL-52-96 Joint Agency Policy Statement: Interest Rate Risk

– http://www.fdic.gov/news/news/financial/1996/fil9652.html

• 3 Major Issues:

– Effective Policies & Governance

– Effective Measurements

– Meaningful & Adequate Reporting

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2010 FFIEC IRR Guidance

• What to Measure – To obtain “Well Managed” rating, must measure both

earnings & economic value at risk

– Must extend simulation of Income at Risk to minimum

of 2 years.

– If you are using dynamic balance sheet modeling, you

must also run a static balance sheet.

• Why? Minimize Assumption Risk

• Must be able to prove your model is effective at measuring

real risks

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Extended Income Simulation

• Looking beyond a year…

– In Base & Flat rates, Interest Income Declines in

Yr. 2 from Yr. 1 levels

– As rates increase, why does the Expense rise

faster than Income as rates increase?

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KEYS TO BUILDING A VALID

MODEL

Managing Internal Assumptions

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Assumptions in Modeling

• Internal Assumptions: Those inputs that ALCO

can control

– Offering rates

– Growth & mix projections

• External Assumptions: Assumptions that

influence results that are outside of ALCO control

– Future interest rate levels

– Loan prepayment speeds

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ALCO Model Keys

• Models depend on accurate assumptions

• Most critical of all assumptions is the speed of cash flows

coming due and repricing - CONTROLLABLE

– More asset flows, faster the response to rate movements

• Recent years have seen regulatory pressure to Validate

models

– Model Validation is designed to ensure proper flows, management

assumptions, and market assumptions

• Ideally, ALCO and Budget processes would share

assumptions and monthly variances validate projected

flows vs. actual

– Can be used to directly impact earnings and production

expectations

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Production Based ALCO

• Interest Rate Risk Levels are linked directly to the

speed of flows

– More asset flows, faster the response to rate

movements

• Model Validation is a process designed to ensure

proper flow and management assumptions, but

• If ALCO and Budgets are to meet, then the

projected flows directly impact earnings and

production expectations

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Example:

• Community Bank with 100 million loan portfolio

• Current Interest Rate Risk shows Asset Sensitive

– More assets reprice than liabilities

• Budget is to maintain loan levels

How much volume does the loan department have to

produce to stay even?

• New loans must equal the amount or renewing, maturing

and loan repayments

• Using the modeling as a production guide helps keep

ALCO accurate and loan department on plan

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• ALM Model Projected Runoff by quarter

• Review of cash flows acts as a “validation” step for reasonableness each ALCO meeting – Normal run-off for this bank is $1.6 million/month

– 1st Qtr showing nearly $2 million/month – Data issues!

• Similar report showing planned originations, including renewals, helps set targets and drive discussion of – Products (Fixed/Variable, Balloon/Full Amortizing, etc)

– Rates (Need to integrate good pricing model)

– Strategy (Liquidity needs, deployment of excess funds)

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Q1 Q2 Q3 Q4


Balance Sheet Comparison

• 90 Day Look-Back

– Total Assets on Track with plan

– Loan Growth Short of plan

• Look for discussion

• Re-projection

– Change in Mix

• Investments for Liquidity

• Loans off due to Increase

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Actual Projected

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Income Statement Comparison

• 90 Day Look-Back

– Loan Income off projection – Loss of Volume

– Investments off - Mix

– Interest Expense On Target – Total

• Change in Mix shows swap in source of funds/costs

– Review minutes for discussion of strategy

• Meet plan or revise

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Actual Projected


Common Issues in ALCO Models

• Bad input data skews projected cash

flow/repricing information

– Begin monitoring cash flows behind Income at Risk

results

– Explain and document all discussions of variance and

production (minutes)

• Deposit repricing rates versus expected or past

performance don‟t match

• Little time spent assessing “What-if” or real world

plans

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Deposit Assumptions in IRR Model

• Major source of margin concern centers on

deposit rate movements in rising rates.

• Following analysis tracked actual rates to

historical through last rising rates

• Comparison of margin performance to projection

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Historical Rate Comparison

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Current concern is that rates will move as they did in „04-‟07

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Model Assumptions: Deposit Rates

Account Flat Rates Pricing Rule Rising 3%

Rates over 12

months

Shock +2%

Immediate

Savings 0.05% Move by 50% of rate

change

1.55% at end

of 1 yr

1.05% in 1

month

NOW 0.05% Move by 50% of rate

change

1.55% at end

of 1 yr

1.05% in 1

month

MMDA 0.25% Move by 75% of rate

change

2.5% at end of

1 yr

1.75% in 1

month

Rewards 1.13% Move by 50% of rate

change

2.98% at end

of 1 yr

2.48% in 1

month

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Sample Bank NMD Rates

50

MMDA rates reached a “cap” in last rate rise

Checking rates mirrored MMDA and new

Rewards Account introduced as cost control

Measure

Savings rates are on life support…

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Rate Comparison Actual to Forecast

Actual Real Changes

‘04-’07

Actual %

change

Savings 0.00% 0%

NOW 2.5% 58%

MMDA 2.0% 48%

Rewards ??? ???

Projected Projected %

Change

Savings 50%

NOW 50%

MMDA 75%

Rewards 50%

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Need to rethink deposit rate changes in model then

rerun income @ risk to determine true sensitivity

Areas of pricing concern:

Savings – significantly different real response than projected

MMDA – Moderately overstated

NOW – reasonable but how does the addition of Rewards

account change response this time?


EXTERNAL RATE FORECASTS

What Rate Projections Do I Use?

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What Rate Projections Should I Use?

• Most ALCO‟s focus on

rate shocks

– Little Probability

– Misstate earnings levels

• Some use rate ramps

– No bearing to real rate

movements

– When rates change impacts

performance

• Often one “index” used to

control all offering rates

– “simplify” the model

– Ignores Basis Risk

• Budgets built on single

rate forecast

– off track when Fed moves

– Assuming 100% probability

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FFIEC IRR Guidance

• What Interest Rates To Measure? – Traditional measures have been shocks

• +/- 100, 200, & 300 basis points

• Not enough stress, implied a 400 bp test

– Rate movements must be both severe and

plausible

• Must recognize current cycle and possibility for scenario

• Should consider changes in slope, & twists in curve

• Who defines plausible?

• Are parallel shocks plausible?

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Historical Rate Comparison

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Global Insight – December 2012 Forecast

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Probability

Base: 60%

High: 20%

Low: 20%

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Rate Forecasts – Best Practices

• Policy must address actions when outside limits

in relative rate probability

– If rate forecast probability < 10%, no actions required

– If rate forecast probability > 10% but < 20%, ALCO

prepares list of possible strategies, timeline & impact

– If rate forecast probability > 20%, immediate actions

taken to return to compliance

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Value at Risk Concept

• Consider 401K or

Personal Investments

• Value of Bonds goes

UP when Rates go

DOWN…why?

– Bonds are fixed rates

that will earn More as

compared to new rates,

creating “Market Value”

greater than “Book

Value”

– Only real value if you

SELL the asset

• Aren‟t the financial

instruments on a balance

sheet the same as your

401K investments?

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Price Rates


Interest Rate Risk

• Market Value Portion of Definition

– Market value risk is the risk that a change in market

interest rates will raise or lower the market value of

instruments in an institution‟s portfolio.

• Example: you just purchased a new five year treasury yielding

5%. Immediately after purchase, 5 year treasury rates move

to 6%. Because A potential purchaser would expect to earn

6% and your treasury pays 5%, you would need to make up

the difference of 1%. That‟s 1% per year for 5 years or a

discount on sale of approximately 5%.

– Market value risk is not a problem as long as the

market value of both assets and liabilities is moving in

the same direction and at approximately the same

speed.

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Interest Rate Risk

• Market Value of Capital (Equity)

– Present value of expected cash flows from assets

– Less: present value of expected cash flows from

liabilities

– Plus: present value of expected cash flows from off-

balance sheet activities

• Sum divided by the present value of assets =

Present Value of Equity Ratio (capital/assets or

EVE/NEV Ratio)

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Measuring Value at Risk

• Duration Analysis

– A measure of an instrument‟s change in value for

every 1% change in market rates

• Discounted Cash Flow Analysis

– Valuing the estimated future cash flows based upon

time value of money

– Re-project cash flows for each interest rate scenario

and value

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Duration

• Measures An Instrument‟s

Price Sensitivity

– Weighted average of PV of

an instrument‟s cash flows

– Can be used in simple

valuation formula

(chg MV = - D x chg MR)

• Can Be Used To Measure

Price Sensitivity Of:

– An instrument

– A portfolio of similar

instruments

– A portfolio of dissimilar

instruments

• Advantages

– Single price sensitivity index

– Easily calculated

• Disadvantages

– Not good for evaluating

effect of rate shocks on

income

– Does not consider option

risk

– Difficult to explain to boards

and non-financial managers

– Measures risk but not return

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Duration - Teeter Totter Approach

1455

1240

1052

888745

621

0

200

400

600

800

1000

1200

1400

1600

Year

1

Year

2

Year

3

Year

4

Year

5

Year

6

NPV - Cash Flows

64

Year Cash

Flow

Pres

Value

1 1,600 1,455

2 1,500 1,240

3 1,400 1,052

4 1,300 888

5 1,200 745

6 1,100 621

Total 8,100 6,000

Analysis is for a

$6,000 loan paying 6

equal annual principal

payments plus

interest on remaining

balance at 10% rate.

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Duration

Period Payment NPV Wtd NPV

1 1,600 1,455 1,455

2 1,500 1,240 2,480

3 1,400 1,052 3,156

4 1,300 888 3,552

5 1,200 745 3,725

6 1,100 621 3,726

Total 8,100 6,000 18,092

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•Duration Calculation –Project Amount & Timing of

Cash Flows

–Calculate Net Present Value

of Cash Flows -

(PV = FV / (1+i)n)

• n - payment number

• i - discount rate

• PV - market value

• FV - future cash flow

–Weight NPVs by timing

(Period x NPV)

–Calculate Duration

(Wtd NPV/NPV)

Analysis is for a $6,000 loan paying 6

equal annual principal payments plus

interest on remaining balance at 10%

rate. Cash flows marked to market using

a 10% discount rate.

Duration = 18,092 / 6,000 = 3.015 Years


Duration To Price

66

Effect of Rate Changes on Price

$90

$95

$100

$105

$110

-3% -2% -1% 0% 1% 2% 3%

Rate Change (%)

Pri

ce

Value - SD

Chg MV = - D x Chg MR

-6.030% = -3.015 x 2%

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Option Risk Issue

67

Effect of Rate Changes on Price

$90

$95

$100

$105

$110

-3% -2% -1% 0% 1% 2% 3%

Rate Change (%)

Pri

ce

Value - SD

Chg MV = - D x Chg MR

-6.030% = -3.015 x 2%

Formula assumes these are independent variables. What if they aren‟t?


Option Risk

• Definition

– The risk that a party to a financial

instrument will exercise its

imbedded options causing cash

flows to vary by rate environment.

• The IRR Issue

– If cash flows cash flows vary with

rate environment analysis of IRR

is complicated – along with the

ability to hedge IRR.

• Convexity

– As a result of imbedded options,

market values track along a curve

rather than a straight line.

• Examples of Imbedded Options

– Prepayment Options in Consumer

Loans

– Annual and Lifetime Caps in ARMs

– Early Withdrawal Options In CDs

– Bump Rate CDs

– Options To Convert From ARMs to

Fixed-rate Mortgages

– Step-up Bonds

– Derivative Mortgage-Backed

Securities

– Callable Bonds and FHLB

Advances

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Option Risk

• Newly Issues 30 Yr.. FHLMC Prepay Estimates

– Note that in rising rates, prepayments decline on 4% coupon by

75% in up 2% but little change up 3%

• Moderately Seasoned 30 Yr.. FHLMC Prepay

Estimates

– Note how 4%+ coupons have slower base prepayments

– Less volatility (33% drop in up 2%) due to slower starting

levels

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Option Risk

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Convexity Risk

71


Convexity Risk

75

85

95

105

115

125

-3% -2% -1% 0% 1% 2% 3%

MBS

Advance

72

MBS prepayments increase in falling rate environment –

shortening duration, decelerating rise in value.

MBS prepayments decrease in rising

rate environment – lengthening duration,

accelerating drop in value.

MBS D = Advance D

Rates

Duration

Duration is

Dependent on

Market rates.

2/22/2013

37


Question

• How does the data on mortgage loan

prepayments impact the cash flow projections on

a mortgage?

• Is one “shape” better than another?

73

Note the White

Pants on the

horns


Question

74

Interest Rate Movements

Cash

flo

w L

ife

of L

oa

n (

yrs

)

-3% -2% -1% 0 1% 2% 3%

4

6

8

10

6% Mortgage made in higher rates

4% Mortgage made @ bottom of rates

2/22/2013

38


ISSUES IN VAR ANALYSIS

Valuing Cash Flows – The Key Assumption

75


Static Value at Risk

76

Today

Current Balance Sheet

Immediate & Permanent

Rate Shocks

Remaining life of all instruments

Horizon

In static value at risk analysis, all cash

flows over their remaining lives are

generated for every financial instrument

on the balance sheet for each rate

environment. Discount rates are then

Used to mark the cash flows to market.

2/22/2013

39


Modified Discounted Cash Flow

77

PV – Present Value FV – Future Value I – Periodic Discount Rate n – Count of Future Period

Discount Rate

A bird in the hand …

Year Cash

Flow

Pres

Value

1 1,600 1,455

2 1,500 1,240

3 1,400 1,052

4 1,300 888

5 1,200 745

6 1,100 621

Total 8,100 6,000

PV = FV (1+i)n

Static Value at Risk

1,200 / (1 + 0.1)5 = 745

(10% discount rate)

Looks the same as

Duration Calculation?


Keys to Value at Risk

• Elements effecting Value at Risk

– Remaining term to maturity or repricing

• Longer term = greater volatility

– Rate on similar investments vs. your rate

• Called the Discount Rate

• Greater the difference the greater the change in value

• (Your rate – discount rate) * remaining term gives you an idea of the

change in value.

• Issues impacting Value at Risk

– How do non-maturity deposits work?

• No stated maturity

• Rates don‟t change when market rates move

• Creates “Value” as offer rates LAG market rates

78

2/22/2013

40


Market Value Basics

79

SAMPLE Market Value SummaryAssets Book Value -100 bp Flat +100 bp +200 bp +300 bp

Total Cash 5,000 5,000 5,000 5,000 5,000 5,000

5 Year Bond 1,000 1,050 1,000 950 900 850

… … … … … … …

Total Investments 25000 26795 26500 25750 25000 24250

Market to Book 1.00 1.07 1.06 1.03 1.00 0.97

Mortgage-Fixed 45,000 47,275 46,500 44,265 42,850 40,975

Market to Book 1.00 1.05 1.03 0.98 0.95 0.91

Mortgages - Variable 18,750 18,850 18,775 18,750 18,595 18,495

Market to Book 1.01 1.00 1.00 0.99 0.99

Total Loans 185,000 195,545 193,450 191,133 188,563 182,258

Market to Book 1.00 1.06 1.05 1.03 1.02 0.99

Nonearning Assets 4,250 4,250 4,250 4,250 4,250 4,250

Total Assets 219,250 231,590 229,200 226,133 222,813 215,758

Market to Book 1.00 1.06 1.05 1.03 1.02 0.98


Market Value Basics

80

SAMPLE Market Value SummaryLiabilities Book Value -100 bp Flat +100 bp +200 bp +300 bp

Non-Interest Checking 18,000 17,575 15,000 14,375 13,295 12,750

Short Term CDs 85,000 89,828 88,500 87,173 85,845 85,181

Long Term CDs 40,000 38,330 37,950 37,191 36,432 35,294

Total CDs 125,000 128,157 126,450 124,364 122,277 120,475

Market to Book 1.00 1.03 1.01 0.99 0.98 0.96

Savings 45,000 44,255 42,750 41,932 40,028 39,195

Market to Book 1.00 0.98 0.95 0.93 0.89 0.87

MMDA 18,750 18,850 18,485 18,010 17,798 17,538

Market to Book 1 1.01 0.99 0.96 0.95 0.94

Total Non-Maturity 63,750 63,105 61,235 59,942 57,826 56,733

Market to Book 1.00 0.99 0.96 0.94 0.91 0.89

Borrowings 0 0 0 0 0 0

Equity 12,500 22,753 26,515 27,453 29,415 25,800

Total Liabilities & Equity 219,250 231,590 229,200 226,133 222,813 215,758

Equity/Assets 5.70% 9.82% 11.57% 12.14% 13.20% 11.96%

2/22/2013

41


Reading a Market Value Report

81

NPV Ratio after

200 bp shock

Interest Sensitivity Measure

0-100 bp 100-200 bp 200-400 bp Over 400 bp

Over 12% Minimal (1) Minimal (1) Minimal (1) Moderate (2)

8% to 12% Minimal (1) Minimal (1) Moderate (2) Significant (3)

4% to 8% Minimal (1) Moderate (2) Significant (3) High (4)

Below 4% Moderate (2) Significant (3) High (4) High (4)


Modified Discounted Cash Flow

82

PV =

PV – Present Value

FV – Future Value

i – Discount Rate

t – Time

t ( FV Cash Flows )

( 1 + i ) ∑

i - the discount rate (the rate of return that could be earned on an

investment in the financial markets with similar risk.)

2/22/2013

42


Discount Rate

• General Approach

– Assets: What is the current return for a set of similar

cash flows in today‟s market?

• When rates are higher today than our return, assets are priced

lower than “book”

– Liabilities: How much would it cost me today to

purchase similar funding?

• Combination of retail rates and wholesale rates?

• Higher costs today = lower price

• Remember lower liability prices are GOOD

– Assets = Liabilities + Equity

– Less Liability = Higher Equity

83


Arriving At Discount Rate

• In valuing a financial instrument, you should always look

at it through the eyes of a potential acquirer who will ask:

– If I was to acquire this asset (or funding) in an alternative way,

what would I expect to earn or pay?

– Does the alternative have essentially the same risks and servicing

costs? If not, I need to adjust for the difference.

• How should Deposits be Viewed?

– EVE/NEV is an Institutional Analysis, not a customer viewpoint.

– If we value an asset based on wholesale alternatives with

adjustments, why not use the same for deposits?

84

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43


Valuing Financial Instruments

• Sources for Discount Rate

– What‟s the right answer for which source for the

discount rate?

– Is there a method to selecting between multiple

choices?

• Discount Rate Progressions

– Market (Wall Street) Price

– Market Proxy

– Competitive Market Average

– My Rate (Last Resort)

85



• If the security or debt instrument I choose is a

less than perfect match to my deposit or

borrowing, what risks and costs might I need to

adjust for?

– Interest rate risk

– Option risk

– Credit risk

– Servicing cost

86

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44



• Is the valuation method fundamentally the same

for both assets and liabilities? Yes, because:

– A financial instrument is a contract, given in exchange

for cash, that calls for repayment of the cash (principal

& interest) in the future.

• It is someone‟s asset (the holder of the contract).

• And someone else‟s liability (the issuer of the contract).

– The instrument has the same value regardless of

whether you are the issuer of the contract or the holder

of the contract.

87


Applying The Discount Rate

88

Discount Rate changes based on slope of the yield curve. Remember that as we look ahead at forecast of rates

2/22/2013

45



• General rule: When valuing a fixed-rate financial

instrument, use a yield curve when ever possible:

– It‟s how the market does it.

– It makes it much easier to value seasoned portfolios.

– Considers the slope of market rates in the time-value

calculation

89


30 Yr. Mortgage Example

• 30 Yr. 60 Day Delivery Rate = 3.75%

– Average Duration: 7 Yrs.

• 7 Yr. Treasury Rate Risk = 1.0%

– Treasury = Risk Free Curve

– Duration Match accounts for Interest Rate Risk

• What is the 1.75% spread covering?

– Credit Risk

– Option Risk (Extension/Prepayment)

• Option risk less with shorter remaining terms

– Lower spread to treasury widening to 1.75% on long

end of the curve

90

2/22/2013

46



• Two 15 year FRMs, one 14 years from

maturity, the other 8 years away.

91

15 Yr FRM Cash Flows

0

200,000

400,000

600,000800,000

1,000,000

1,200,000

1,400,000

1 2 3 4 5 6 7 8 9101112131415

Year

Cash

Flo

w

0.0%

1.0%

2.0%

3.0%4.0%

5.0%

6.0%

7.0%

Yie

ld

New Loan

Old Loan

Disc Rate

Dold Dnew



• Does it make sense to use the same discount

rate in valuing the loan 8 years from maturity as

the loan 14 years away?

• If they were both issued at the same rate and

were valued today, which loan would be most

likely to be sold at a premium?

• Do you value a new 5 Yr. bond the same way you

value a 10 Yr. bond with 5 Yrs remaining?

92

2/22/2013

47


MAJOR ASSUMPTION AREAS

Managing the Non-Maturity Deposit Portfolio

93


Two Most Crucial A/L Assumptions

• Pricing Betas – the extent

to which a change in

market rates is passed

along to deposit

customers

– Income at risk analysis

– EVE analysis

• Decay rates – The speed

at which non-maturity

deposits decay off books

over time

– EVE analysis

– Liquidity analysis

• What is the greatest

commonly expressed fear

about NMD funding?

94

2/22/2013

48


Pricing Betas & Decay Rates – Oh My!

95

OTS Core

Deposit

Assumptions

Thank

goodness

he‟s retiring

OTS was the primary source of pricing betas and decay rates for the industry

for over 25 years. The OTS NPV model was run for the last time on 12/31/11 data.

OTS assumptions were developed 30 years ago and haven‟t changed materially since.


Pricing Betas

• Definition – A pricing beta is an index that is used to

predict the effect of an increase in market rates on rates

paid on a product.

• For example, if market rates increase 200 bp and your

beta for MMDAs is 0.5 (50%) then the beta would predict

you will raise MMDA rates by 100 bp

200 Bp X 0.5 = 100 Bp

• Betas can be:

– SWAG‟ d

– Derived statistically from historic data.

– Examiners prefer the latter

• Betas can also be modified by use of segmentation

strategies.

96

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49


Pricing Betas – Statistical

• The Science

– Pick/plot a representative set of

market rates for dates studied.

– Plot your actual pricing on

account you are evaluating for

study dates

– Regress lines against each

other to find best fit varying

• Lags

• Betas

– From best fit take off

• Index (market rate)

• Lag

• Beta

• Spread

• The Goal

– Predict the effect of

movements in market rates on

how you will price a core

deposit account

• The Art

– Use a statistically valid set of

historical data

– Understand that this is a

modeling tool and does not

represent how the institution

actually prices

• Application

– A/L Modeling

• Income at risk

• Value at risk

97


Pricing Betas

• For example, if market rates increase 200 bp and your

beta for MMDAs is 0.5 (50%) then the beta would predict

you will raise MMDA rates by 100 bp

200 Bp X 0.5 = 100 Bp

• Betas can be:

– SWAG‟ d

– Derived statistically from historic data.

– Examiners prefer the latter

• Betas can also be modified by use of segmentation

strategies.

98

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50


Modeling Non-Maturity Accounts

• Rate projections in many ALM Models

– Assume a relationship between market rate

movements and offer rate

• For every 1% change in Short-Term Treasury offer rate moves

by .25% with a 3 month lag

• Some use a direct formula between long-term treasury rates

and offer rate

– Correlations are statistically low and offer little bearing on reality

– Use of long-term rate is to see stability usually found in share

accounts

– Some change formula for rates up/down

99


Importance of Offer Rate Paid

• Example $200 Million Passbook Account

• Rate paid in +200 impacts equity by $7.6 million.

(181,619 – 173,993)

• With less volatile liabilities, what strategies are possible

for asset mix?

Rate Paid Formula -200 bp Flat Rates +200 bp

50% Change in Offer Rate for

1% Change in Treasury Rate

196,030,129

Price = 97.11

187,585,268

Price = 92.93

181,619,164

Price = 89.97

Formula that steps rates when

Fed Funds changes & max

rate of .75%

194,727,952

Price = 96.46

186,217,771

Price = 92.25

173,993,975

Price = 86.19

100

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51


MMDA vs. Market Rates

101

Q. Which of these market rate trends looks most like our MMDA pricing (dark blue line)?

A. None

Why?

• We don‟t move MMDAs by full change in market rates, and

• Deposit rate changes lag behind movements in market rates

Volatility

Lag


MMDA vs. Market Rates

102

What we want to learn

• Which market rate gives us the best fit (correlation)

• How many months of lag gives us the best fit to the market rate (lag)

• What % of the change in market rates gets passed along to the depositor (beta)

• What is the starting spread between the market rate and the deposit account rate (spread)

These are all current inputs to your A/L model !!!!

Volatility

Lag

2/22/2013

52


MMDA vs. 2 Year Treasury

103

Steps:

1. 2 year Treasury is best fit

2. Lagging 5 months matches timing of rate moves (red line) – too volatile

3. Lagging 5 months with 0.53 beta matches timing and volatility (green line)


MMDA vs. 2 Year Treasury

104

Steps:

1. 2 year Treasury is best fit

2. Lagging 5 months matches timing of rate moves

3. Lagging 5 months with 0.53 beta matches timing and volatility (red line)

4. Setting spread = -0.828% lays lines on top of each other (green line)

2/22/2013

53


Pricing Beta Conclusions

• Applications

– A/L Modeling

• Income at Risk

• Value at Risk (core deposit

intangible)

– Branch Valuation

• Credibility Issues

– Do you really price MMDAs

off 2 year Treasury?

– What issues rise when

historical betas are used to

predict the future?

• Betas affected by

– Growth/Shrinkage

Strategies

– Tier Structure – Betas for

different tiers will be

different

– Segmentation Strategies

• Account Groupings

– Consumer Preferences

– Competitive/economic

environment

• Betas Apply to

– Non-maturity deposits,

– But also to CDs

105


Modeling Non-Maturity Deposits

• If you can prove no direct correlation in rate movement to

market rates, then…

• …how long do non-rate sensitive funds stay with you?

– Many have contracted to perform Core Deposit Study.

– Some Use Regulatory approaches

– Some Assume no long-term funding

• Thoughts for modeling:

– If you practice proper pricing using tiers, does that change the

assumption used on each tier versus an average?

– How are the changing market demographics likely to impact the

future portfolio of non-maturity accounts?

106

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54


Modeling Non-Maturity Deposits

• If you can prove no direct correlation in rate movement to

market rates, then…

• …how long do non-rate sensitive funds stay with you?

– Many have contracted to perform Core Deposit Study.

– Some Use Regulatory approaches

– Some Assume no long-term funding

• Thoughts for modeling:

– If you practice proper pricing using tiers, does that change the

assumption used on each tier versus an average?

– How are the changing market demographics likely to impact the

future portfolio of non-maturity accounts?

107


Cash Flow Decay Rates

• The Science

– Pick a grouping of non-maturity

deposit accounts at an

appropriate level of

aggregation

– Plot runoffs that occurred to a

set of accounts over the study

period.

– Separate normal from

„abnormal runoff or growth‟

– Calculate decay rate for normal

runoff

– Calculate decay rate for

abnormal balances

– Use decay rates to generate

potential cash flows.

• The Goal

– Predict the cash flows coming

off a pool of non-maturity

deposits (the term)

• The Art

– Use a statistically valid set of

historical data

– Pick a time frame covering at

least ½ of a rate cycle

• Application

– A/L Modeling

• Income at risk

• Value at risk

108

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55


Decay Rates

109

Surge Balance Burnout Truncation

Assumption: 20% of balances are surge balances


Impact – One Customer

110

Higher NPVs under all rate environments and increased asset sensitivity due to:

• Increased duration of NMDs (lower decay rates)

• Higher spreads to benchmarks (higher average benchmark cost

Question – “Can we develop pricing strategies that reduce pricing betas and

slow decay rates?

2/22/2013

56


What Should You Do?

1. Get a handle on how your

deposits actually behave

(core funding study)

– Betas – CDs and NMDs

– Decay Rates – NMDs

2. Develop your core funding

strategy for rising rates

– Product introductions

– Pricing strategies

3. Model your business plan

interest rate risk given

– Behaviors from study

– Core funding strategy for rising

rates

4. Evaluate your interest rate risk

based on modeling performed

in previous step. If you find:

– Significant asset sensitivity –

extend assets and shorten

term funding

– Neutral to moderate – you are

set – tune a bit if you like

– Significant liability sensitivity –

lengthen liabilities and shorten

assets

111


What Should You Do?

5. Define the role Non-Core Funding plays in your business plan

– As a benchmark tool for making pricing decisions

• FHLB Advances were used extensively in my presentation as benchmarks in

determining whether deposits were well or poorly priced. They were also

used as discount rates in market value calculations.

– As a structural tool – to cost-effectively mitigate interest rate risk

• When using non-core funding as a structural tool, it is very helpful to be able

show examiners modeling results that support its use as an interest rate risk

management tool.

– As a profitability enhancement tool – when non-core funding is

significantly cheaper than core

• When using non-core funding for this purpose it is important you document the

analysis to support the use of non-core funding as a substitute for core.

– As a contingent funding tool – for dealing with liquidity stress events.

112

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57


Key Assumptions Summary

• Institutions with large balances

of non-maturity deposits must

understand their behaviors

– Account pricing actions

(Institution‟s option)

– Customer actions

(customer option)

• These funds may represent a

hedge on longer term asset

risks if history repeats

• Demographics are shifting

which may change the core life

of new account holders

• Tier rate programs and

introduction of premium

accounts can skew decay rates

• Discount rate assumptions are

a critical component to value at

risk calculation and should:

– Reflect true market rates for

instrument being valued

– Be based on a curve rather

than a single point when

possible

– NOT be your offering rate

unless you are the only one to

offer the product

113


EVE POLICY CONSIDERATIONS

Managing EVE

114

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58


ALCO Policy Establishing EVE/NEV Limits

• Original Guidance Came From OTS TB-13a NPV

IRR Guidelines

– http://www.ots.treas.gov/bltn_thrift.html

– Pick TB-13a – Final from list

• Limits Were Based On Two Factors

– An institution‟s level of market value risk as measured

by EVE Ratio

• More Risk (Lower EVE Ratio), Less Room in the Limit

• Less Risk (Higher EVE Ratio), More Room for Risk OK

– The quality of its practices for measuring market risk

• Do they have a good measurement system

• Do they Understand their measurement system and risks

115


Value At Risk Limits

• Measured Post Shock EVE Ratio – Found Lowest

Level of EVE/NEV Ratio for a +/- 2% shock

• Compared the change in the Ratio from Flat to the

Decline and limited the amount it could decline

Post-Shock

NPV Ratio

Interest Sensitivity Measure

0-100 bp 100-200 bp 200-400 bp Over 400 bp

Over 10% Minimal (1) Minimal (1) Minimal (1) Moderate (2)

6% to 10% Minimal (1) Minimal (1) Moderate (2) Significant (3)

4% to 6% Minimal (1) Moderate (2) Significant (3) High (4)

Below 4% Moderate (2) Significant (3) High (4) High (4)

116

OTS guideline for S in CAMELS

2/22/2013

59


EVE Policy Limit Conversion

• FDIC, OCC and NCUA prefer limits be set with % change

in equity values

– Less effective as this fails to consider HOW MUCH capital

remains, only looks at VOLATILITY

• Below is an example that could be used to express OTS

Table in % change limits

– Assumes Current EVE ratio (Flat Rates) of 12%

117

Example of OTS TB 13 A Limits Converted to % Change for OCC

For a +2/-2% shock Green Yellow Red

After Shock EVE Ratio > 10% and the % change in EVE

ratio is: <= 40% of Base EVE Ratio 40-60% of Base EVE Ratio > 60% of Base EVE Ratio

After Shock EVE Ratio < 10% but >= 6% and the %

change in EVE ratio is: <= 25% of Base EVE Ratio 25-50% of Base EVE Ratio > 50% of Base EVE Ratio

After Shock EVE Ratio < 6% but >= 4% and the % change

in EVE ratio is: <= 15% of Base EVE Ratio 15-30% of Base EVE Ratio > 30% of Base EVE Ratio

After Shock EVE Ratio is < 4% and the % change in EVE

ratio is: <= 10% of Base EVE Ratio 10-25% of Base EVE Ratio > 25% of Base EVE Ratio


Combined S Ratings Guidelines

118

2/22/2013

60


Subjective Portion of Rating Quality of Institution’s Practices

• Oversight by board and senior

management.

• Prudence of limits – do they

allow institution to have

sensitivity that would merit a 3

rating or higher?

• Adherence to limits –

exceptions, have limits been

broadened to bring institution

into compliance?

• Quality of system for measuring

NPV sensitivity.

• Quality of system for measuring

earnings sensitivity.

• Integration of risk management

with decision making.

• Investments and derivatives –

policies and procedures.

• Size, complexity, and risk

profile – is risk measurement

system of appropriate

capability?

119


Measuring Risk in Today‟s World • New Guidance requires a minimum of 2 year horizon for

earnings at risk

– Many risks are hidden in 1 year forecasts

– Should be at least a 2 year look into future

• Allows for Dynamic Balance Sheet

– But requires a Static View as well for now

• Requires a Current EVE/NEV to assess long term

mismatch in earnings

– Misses impact of strategies to manage other risks

• Mentions EVE/NEV as a Dynamic tool to capture long-

term risks in short term solutions but not required

– How would you treat me if I said “Let‟s buy long term assets and

fund with short liabilities…”

120

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61


DYNAMIC EVE

121


Dynamic Value at Risk

122

Today

Current balance sheet and forecast balance sheet are the different

reflecting the effect of the plan or strategy.

Rate shocks.

Typically 2-3 Years

Horizon

A dynamic value at risk analysis uses the

same approach as a static value at risk

analysis except it is performed on the

balance sheet that exists at the end rather

than the beginning of the planning horizon.

Expected rate

environment

2/22/2013

62


Dynamic Value at Risk (VAR)

• Calculation Technique

– Run a computer simulation run of one or more management strategies in a single rate environment.

– Run a VAR Test on forecast balance sheet

• Application In IRR Management

– Used to evaluate effect of a strategy on future VAR.

– Only effective way to test the long-term effect of changes in rates on a strategy.

– Can be used as tool in comparing risk-return tradeoffs of alternative strategies.

123

Rate

s

Rate

s

Rate

s

Time

Time

Time

Today 2-3 Years

Static

VAR

Dynamic

IAR

Dynamic

VAR


Dynamic EVE

• The typical EVE run on a

current balance sheet

shows mismatch of what is

owned/owed today

• Looking out 1 Yr.. at new

balance sheet AND potential

new interest rates provides a

look at what MIGHT happen

if we continue to follow our

plan

124

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63


Dynamic EVE

• Provides an answer to potential long-term

earnings concerns often missed by short-term

income simulation alone.

• Allows for a look at what the Current EVE might

look like if they follow their planned course.

• It is critical that in using Dynamic EVE, the

projected interest rates used represent the

realistic possibilities (stressed but real) to test

both income and potential EVE

125


Summary

• EVE/NEV is a critical measurement for ALCO to

incorporate

– Captures full horizon of risk

– Expected by examiners more than ever

• Use EVE/NEV as a decision making tool on

potential strategies

– Acts a an early warning indicator

– Helps weed out “Quick Fix” ideas

126

2/22/2013

64


Summary

• EVE/NEV Assumptions & calculations must be

understood and appropriate

– Core Deposit Assumptions

• Pricing response in rate changes

• Assumed average life/duration/decay

– Discount Rate Methodology

• Defensible for your underwriting

• Consistent with your approach to pricing

– Optionality sources

• Prepay speeds

• Callable assumptions

127


Summary

• Commit to education for Board and ALCO on

appropriate use of EVE/NEV

• Incorporate EVE/NEV with Earnings at Risk and

other ALCO risks to assess risk/return

opportunities as well as risk/risk scenarios

128

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65


INCOME & VALUE @ RISK

Forecast Value @ Risk with Income @ Risk

129


Using ALCO for Decision Making

• ALCO is charged with managing many competing

risks

– Interest Rate Risk

– Liquidity Risk

– Capital Risk

– Credit Risk

• Effective ALCO‟s manage the relationship

between these risks and prioritize goals

• Develop plans that achieve trade-offs in risks

versus return

130

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66


Using ALCO for Decision Making

Example:

• Current earnings levels

are too low

• Capital levels are OK, but

under pressure to

increase

• Income & value at risk in

compliance with board

policy (interest rate risk)

• Highly liquid

ALCO Question:

• How do we increase

earnings and capital

without moving outside

board established policy

limits?

Approach:

• Develop scenarios and

run in simulation model to

assess risk vs. return

tradeoff

131


Combining Earnings and Forecast EVE

• Note that the difference

in Earnings at Risk

from Static (Red) to

Dynamic (Blue)

has a major impact on

ALCO decision

132

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67



• Current EVE Ratio (Red Line) shows sufficient EVE under

all shocks

• No big changes in EVE in Today‟s balance sheet

133



• EVE Ratios for 1 Yr. (bars) and 2 Yr. (Lines) Calculated under all 3

Projected Rate Forecasts

• All Ratios Still Above Policy Levels

• No major risks building into the institution from rates or terms in plan

134

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68



• % Change in EVE Ratios for 1 Yr.. (bars) and 2 Yr.. (Lines) show that

over 1 Yr.. size of bet is increasing to yellow risk level

• Decreases back to Green un Yr.. 2

135


Using ALCO for Making Decisions

CAMEL Component Ratio Base Plan Strategy 1 Strategy 2Core capital

Ratio 8.25% 8.31% 8.65%

Tier 1 Leverage8.25% 8.31% 8.65%

Risk Based

Capital 11.35% 12.07% 12.33%

Earnings ROA-0.30% 0.55% 0.80%

Income at Risk-10.55% -18.50% -25.50%

Current EVEMinimal Minimal Minimal

Forecast EVEMinimal Minimal Moderate

Liquidity Gap

Ratio - Base 18.38% 14.55% 12.25%

Liquidity Gap

Ratio - Stressed 10.75% 1.85% -2.50%

LCR Ratio107.85% 102.23% 98.75%

Non-Core

Funding/Assets 20.15% 25.75% 33.45%

Interest Rate Risk

Liquidity Risk

Capital Risk

Risk/Return Risk/Risk Decision Matrix 1 YR Forecast

136

2/22/2013

69


Strategy Comparison

• Strategy 1 increased ROA to positive levels but

below targets. Capital ratios improve but liquidity

levels and income at risk levels worsen

• Strategy 2 improves earnings more than 1 but

income at risk levels outside board levels and

liquidity drops too far under board ranges

• This layout of results helps all to see the real cost

of any ideas under consideration.

• No Risk, No Return!

137


Putting the session to work

• Validate the projected

cash flows in your ALM

model

– Garbage in, garbage out

• Review critical data

elements

– Maturity/Balloon & Call

Dates

– Floors, repricing margins,

index

• Review key ALCO

assumptions

– Growth in balances and mix

– Rates paid on Non-maturity

accounts

• Add “Severe & Plausible”

rate movements

138

measuring & managing earnings & value at risk - financial risk … · 2016-06-20 ·...

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