Friday, May 22, 2015

A few Case Studies…the importance of an adequate Contingency Funding Policy!

As we noted in late March Regulators are focusing on Liquidity, or more appropriately stated, they are sharply focusing on stressed liquidity and the adequacy of Contingency Funding Policies. The presence of an acceptable policy is not an option, regardless of the present liquidity on the balance sheet.  In the past few weeks we have received request from bankers to help shape an acceptable policy “ASAP” in response to examinations.

Liquidity is always a more pressing issue in a highly loaned bank with little on balance sheet liquidity. Also, even in a bank with fewer loans coupled with a “long” investment portfolio with significant interest rate risk liquidity might be a concern.  But, in recent weeks, a couple of banks with loan to deposit ratios of less than 55%; at least 45% on balance sheet liquidity; portfolios with less than 3.5 years duration; and above all else  excellent asset quality, were scrambling to create an adequate policy. 

The point of citing these examples is to drive home the point that every bank, regardless of its current risk or liquidity profile, should spend the time to create a good contingency funding policy. The policy should include an inclusive list of various scenarios that might lead to liquidity “stress” or a varying degree of “crises”.  Then, it should systematically list the steps that could be taken to meet the emergency.

Keep in mind, there are three “stress events” related to the loss of deposits that should be covered.  The first is a “Severe Stress Event” that reduces deposits by 20% while reducing borrowings and lasts one year. The second is a “Moderate Stress event” that reduces deposits by 10% and ability to borrow and last three months. The third is a “Mild Stress Event” that merely reduces deposits by 5% and lasts for a couple of weeks.

At one point it seemed that the “Severe Stress Event” was most scrutinized and at the end of the day if the Cumulative Net Surplus in the 181-365 days period was NEGATIVE or marginally positive, it was time to trot out the Contingency Funding Policy! But now, even if your numbers are solidly positive in the last time bucket, it is still imperative that the policy be updated, accurate, reasonable, comprehensive, and most importantly, an effective tool to provide the liquidity needed.
Every AMG report contains all three Liquidity Stress Tests, and, we have sample Contingency Funding Polices and the experience to help meet current expectations. Call AMG at 800.226.1923 if you need help with any of these issues.

Thursday, April 9, 2015

Exam Prep: Liquidity Stress Testing - How Much is Enough?

Banking regulators seem to be increasingly focused on liquidity, or more appropriately stated, they seem to be increasingly focused on stressed liquidity.  Stressed liquidity, of course, is when the balance sheet is stressed by an immediate decrease in deposits coupled with a reduction in the capacity to borrow.  The concept of stressed liquidity was extremely important during the early years of the credit crisis beginning in 2007 and continuing until banks either failed or worked-out their credit issues.  This was followed by a “lull” in regulatory scrutiny, but recent increases in the ratio of loans-to-deposits have brought renewed interest in the concept.
There are three “stress scenarios” that are “triggered” by the loss of deposits:
  • The first is a “Mild Stress Event” that merely reduces deposits by 5% over a period of a couple of weeks.
  • The second is a “Moderate Stress event” that reduces deposits by 10% and ability to borrow over a three month period.
  • The third is a “Severe Stress Event” that reduces deposits by 20% and the ability to borrow over a one-year time frame.
The “Severe Stress Event” is the most scrutinized.  At the end of the day (or the end of the exam) if the Cumulative Net Surplus in the 181-365 days period is NEGATIVE, or marginally positive, be prepared to produce your Contingency Funding Policy! Even if your numbers are solidly positive in the last time bucket, it is still imperative that this policy be updated, accurate, reasonable, comprehensive, and most importantly, an effective tool to provide the liquidity needed.

Tuesday, February 24, 2015

Stress Testing Assumptions

Now that we have established defensible, institutionally relevant assumptions for your bank, it is necessary that your bank periodically stress tests each assumption. This is critical to understanding how sensitive the bank's balance sheet is relative to a change in a certain assumption. 

Referring back to the last Supervisory Insights issued by the FDIC (Winter 2014), here is how they view this process:

"The objective of sensitivity analysis is to isolate the impact a single assumption may have on the results of the IRR measurement system. This is accomplished by changing one assumption (e.g., increasing the decay rate or the beta factor by X percent) and re-running the analysis to compare results.)" 

Since 2008-2009, the traditional deposit mix of banks has changed. Time deposits have fell out of favor to non maturing Money Market and NOW accounts. In response to regulators concerns on this topic, BancPath has included a new report titled "Assumption Stress Tests". In this section of the report, we use four tests to gauge the sensitivity of changes in assumptions to the balance sheet. 

The four tests are:
1) change in net interest income due to a change in deposit mix (back to pre 2008 mix) 
2) dynamic market value of equity in response to a change in deposit mix 
3) interest rate risk profile in response to changes in deposit betas  
4) shortening the duration of non-maturing deposits and the effect on Market Value of Equity

We continue to look for ways we can serve our clients better. If you would like to learn more about what we do, contact us.

Friday, January 30, 2015

Exam Prep- Developing Key Assumptions for IRR Analysis

By Clay Wells

In the latest edition of the FDIC’s Supervisory Insights (Vol. 11, Issue 2), the article “What to Expect During an Interest Rate Risk Review” discussed the importance of having accurate and vetted Asset/Liability model  assumptions. It stated this topic would be one of the focal points of upcoming examines, and our clients have confirmed this assertion.

The same Supervisory Insights published for Winter 2014, fittingly contained an article titled “Developing the Key Assumptions for Analysis of interest Rate Risk”. One line describes what we here at AMG have been telling our clients for years:

“…use of unsupported or stale assumptions is one of the most common IRR issues identified by FDIC examiners”

Model assumptions are the most important factor relating to accuracy and meaningful IRR analysis in any Asset/Liability report. In the past, some institutions relied on third party assumptions that were derived from industry standards, and therefore had no significant connection to the actual behavior of an individual institution.  In the last few years, it has become necessary for banks to incorporate 
assumptions into their A/L model based off their own historical behavior in 3 assumption areas:

     1)      Asset Prepayment
     2)      Non-maturity deposits (deposit retention rate and deposit betas)
     3)      Driver Rate (at AMG we use current offering rate in our BancPath model)

At AMG, Asset Prepayment is determined using Mortgage Backed Securities that are similar in term and rate to each individual loan in the bank’s portfolio. A factor is then applied to refine the accuracy of the prepayment.

Non maturity deposit assumptions include betas (deposit pricing relative to changes in interest rates) and deposit retention and decay rates. These are determined using historical deposit data either obtained through longevity on our system (we need a minimum number of periods to make it statistically valid) or though past deposit data provided by the customer.

We use the current rate the bank has booked loans and paid on CDs in the prior period as our Offering Rate. Driver Rates have historically been problematic in that they introduce “basis risk” into the modeling process, leaving one more bias to be resolved when analyzing results. Using your actual offering rates eliminate this additional risk and reflects the banks pricing behavior accurately.

In closing, be sure to inquire with your Asset/Liability provider about the method used in creating assumptions, and be sure to provide them with the necessary historical data to make those assumptions robust. This will lead to a more meaningful, accurate Asset/Liability model and give you more confidence next time examiners come knocking. 

Friday, December 5, 2014

What If Analysis

What If Analysis

By Sean Doherty

We sometimes hear concerns from clients (and their regulators) of the impact a change in the mix of the deposit base might have on the earnings of an institution in a rising rate environment. "What would happen..." they ask, "...if we had a percentage of our non-maturing deposits shift back to a more traditional time deposit if rates were to increase 200 basis points?"

We have developed our "What-If?" tool to easily address this question, and others like it. This is an Excel workbook that we populate with the most recent results of a client's income simulation and market value of equity calculations, and allows for a quick 2 variable analysis. This approach handles most of the questions  that tend to come up in the course of an ALCO or Strategic Planning meeting. More complex issues are handled with more detailed forecasting methods in the modeling process.

This process starts with a picture of the balance sheet as it looks currently....
We can then test a 10% reduction of MMDA Balances that get reallocated to Time Deposits at a new rate of 0.75% over the next 12 months, which is input into the "What If" Report like this:

Which results in changes to the Income Simulation and MVE calculations as follows:

And a Balance Sheet Change that looks like this (changes are in blue):

These types of mix and rate changes are easy to accomplish with this tool, and can be run as often as necessary. Since this is updated and sent to clients with every new data set, it is always current and ready to go. It is Fast, Easy, and Reliable...

If you are a client and are using this tool, let us know your thoughts as to how we might improve on this. If you would like to be a client and have access to this and many other tools we have developed to assist in the management of your balance sheet, call us, we would appreciate the opportunity to get to know you and your organization better.


Friday, November 21, 2014

Deposit Decay Rates

by Sean Doherty

There is an ongoing debate within the industry (both financial and regulatory) about the validity of using Decay Rates to calculate the value of Non-Maturing Deposits (NMD) in the required Economic Value of Equity analysis from the 2010 Interagency Advisory on Interest Rate Risk.

Decay Rates imply that a certain amount of a financial institutions deposits will mature or "disappear" from the balance sheet over a period of time. While this may be true of any specific account, it cannot be said to be true for balances as a whole. In fact, a look at deposit trends for the industry would indicate that overall deposit balances are increasing, not declining.

So where did this assumption come from? Back in the day, when the first models were being developed (OTS and others), there was an attempt to value these deposits in an effort to more fully understand the long term sensitivity of a balance sheet. This was both a necessary and valuable contribution to our understanding of these deposit relationships.
During this time, a theory began to be discussed as how to best measure these deposits, and it appears that one of the classic mistakes in statistics was made, extrapolating to the general population the characteristics of a specific case. Since Deposit Studies were rare and expensive, this seemed to be a good compromise, and over time, this thinking has become the standard. Some will even refer to this as "best practice", however, "saying so doesn't make it true". Oftentimes, this is an excuse for the vendor to throw a number into their model to get a value, any value.

Further, as rates became volatile, and valuations using this methodology became volatile as well, the issue of deposit life began to take center stage. Modelers and regulators had difficulty in accepting the fact that any NMD could have a life beyond "x" years, and so "Truncation" became the buzzword. Truncation is an arbitrary number of years, after which ALL NMD are said to disappear. This is typically done so that the valuations generated from the analysis fit into the real world deposit premiums being paid in acquisitions. As rates have generally declined over the last two decades, these "deposit premiums" have declined as well. Non Maturing Deposits are simply not as valuable in a low rate environment as they are in a high rate environment, and acquirers rightly justify these lower premiums using this logic.

Having said this, Deposit Premium is NOT what is required to be calculated in the 2010 Advisory. As modelers, and as bankers, in order to comply with this requirement, we are asked to value the "Replacement Value" of these liabilities, not the value that another institution places on them. And this is where we believe much of the misunderstanding resides. Accountants, model validators, auditors and many examiners (because they have been taught the "best practices" sited above) confuse Deposit Premium with Replacement Value. There are many things that go into the Deposit Premium including, franchise value, expected credit losses, OREO, fixed assets, depreciation costs, non-interest income sources, expense management, etc. So in essence, the value of the entire organization, both tangible and intangible, is encapsulated in the Deposit Premium calculation.

Replacement Value, on the other hand, is the value of any particular asset or liability at today's rates (and shocked rates as well). So each component part of the balance sheet is valued on its own merits, without regard to credit risk on assets. To measure this, an institution must be able to accurately measure the amount of time current NMD deposits have been in the bank, as well as the ability of the institution to retain these deposits over a number of years. So "industry standards"  do not apply. If you are currently using some made up numbers, or numbers that are not specific to your institution, then be prepared to explain their relevance to your organization. In most cases this is a futile effort.

We all understand that these deposits have value beyond the one day contractual obligation of the depositor. We have spent many years and an incredible amount of resources to ensure that our clients get this correct. including a detailed Deposit Study and Retention Analysis to determine at which point on the curve your particular liabilities should be valued. Don't take  "Best Practices" as the answer for your institution. More on this in a our next post...

Saturday, September 6, 2014

Do Bankers Still Need to be Good at Math?

by AMG

Late last month, Barry Ritholtz had a great piece on Bloomberg View called "Learn Math or Get Left Behind."  In the article, Ritholtz laments the demise of math skills in America, and discusses the detrimental effects that "innumeracy" (the mathematical equivalent of being illiterate) can have on investing.  While his audience for this post is the retail equity investor, I see the same issues cropping up with bank management teams.  Many bankers, especially younger ones, assume that since we now have technology that can do the rote calculations, banking is no longer a profession that requires superior math skills.

That is a VERY dangerous assumption.

Think about the core business of banking.  Too often we get distracted by the logistics of banking, which includes things like compliance, IT, marketing, budgets, board meetings, loan relationships, and the local chamber of commerce golf tournament.  Don't get me wrong, all of those are essential to running a successful community bank.  However, the core of banking is much simpler.  Banks are just financial intermediaries, a middle man sitting between savers of capital and spenders of capital.  We sit in the middle of these transactions so that we can provide efficiency and risk management to the transactions.  If a widget maker in need of $100,000 had to gather $1,000 from 100 different people, the system would never work.  What if he goes bust, and I am out my precious $1,000?  How much should I charge for that kind of risk?

Banks are just a big math problem.  What is the probability that this loan gets repaid?  How much do I lose if it goes bad?  How much will it cost me to fund it?  How likely are those rates to change, and by how much?  Yes, a fancy piece of software can do the calculations for you.  But do you understand what it is telling you?

Bankers don't need to be full blown quants.  However, a firm conceptual grasp of statistics and probabilities is, in my opinion, a basic requirement.  Here is an excerpt from Ritholtz:

Every now and again, events occur that cause me to shake my head in dismay at people’s math skills. When the weather forecast is a 90 percent chance of a sunshine, and it rains, that doesn’t mean the forecast was wrong; rather, it was one of those cases where the low probability event occurred. Some people seem to believe that 90 percent and 100 percent are the same. Obviously, they are not.
People fall into this trap with events that have a nonzero probability of occurring. Nonzero means there is the possibility of occurrence, however unlikely.

This is an important concept that gets missed by a lot of banks.  Banking is not a zero sum game.  Yes, an individual transaction may be zero sum, where there is a clear winner and a clear loser.  However, that does not mean that if we are on the losing end of a transaction that we should not have done it.  A certain percentage of our loans will go bad - that is a mathematical certainty.  If we have no losses, then we are turning away too many borrowers.  Some of our bonds will show unrealized losses.  Do we factor in the added earnings we accumulated before that unrealized loss showed up?  An interest rate hedge may cost us money (as does life insurance if you happen to stay alive).  The trick is not to win every individual transaction, but instead to understand the balance sheet as a whole, and make sure that there is a logical reason for fitting that individual transaction into bigger picture. 

Asset Liability Management should be that process in a bank, but too often it gets treated as another "compliance meeting" that we have to do for examiners.  Instead, treat ALM for what it really is - the lifeblood of the institution.  Make sure you understand the probabilities, that you are prepared for all of those events that have a nonzero probability of occurring, and that you don't get tricked by our natural lizard brains. And as always, let us know if we can help.


Thursday, August 21, 2014

Which Rate Scenario is Most Important?

by AMG

One of the inherent flaws of modeling complex systems (such as bank balance sheets) is the tendency to run too many scenarios to try to account for as many potential outcomes as possible.  We create a "can't see the forest for the trees" situation.

With literally thousands of variables, there is a real danger to over-simplifying the environment in trying to reduce it to a clean and simple model that gives us "right" and "wrong" answers to our strategy questions.  To combat this, we keep adding scenarios until pretty soon we drown in the depth of the analysis, and we come out less informed than when we started.  I have seen banks that run hundreds of different interest rate scenarios so that they can be sure they have modeled every possible scenario and can be properly prepared.  But, guess what?  They still won't get it right, and will have done nothing but irritate and confuse the bank's decision makers.

We ran a post back in 2012 that discussed the "which rate scenarios to model" question.  I stand by that post, as it still covers what we believe are the essential scenarios without going overboard.  However, that still leaves 21 separate rate scenarios.  When evaluating a bank's exposure, which is most important? 

In discussing this question earlier this week, we had an interesting conversation.  We came back to a concept that should be familiar to both investors and credit risk managers.  We need to evaluate not only the outcome given a scenario, but also the probability of that scenario happening.  So, can rates fall by another 300 basis points?  Technically, yes, as the 30 year bond still yields above 3.00%.  That would mean rates falling across the yield curve to 0%, and the 30 year Treasury yielding about 0.20%.  I'm guessing your net interest income looks VERY ugly in this scenario.  Does that mean we need to immediately put on a hedge to protect us from a 300 basis point rate drop?  No, of course not, because the probability of that happening is extremely low.

So, given that basic approach, which scenarios should be getting extra attention?  That will depend on your interest rate conviction, but for what it is worth, here are the scenarios that I personally have been focusing on with clients:

  • Flat rates:  Even though bank balance sheets have extended out on the curve, the majority of both assets and liabilities still reside on the shorter end.  While there will be some fluctuations within a small range, these rates will not move meaningfully until the FPOMC begins hiking the Fed Funds target rate.  We are likely still a year away, meaning flat rates are the most likely scenario over the next year.  In addition, I think it is always wise to start by evaluating what kind of risk is "baked in" if everything stays the same.
  • Rates ramp up by 200 basis points in 1 year:  There is no magic to this scenario - it simply matches the basic pace at which the Fed has increased rates in the past.  Until told otherwise, I am expecting well telegraphed rate increases of about 0.25% per Fed meeting until the rate is back to "normal" (whatever that may mean now).  With 8 FOMC meetings per year, that works out to 2.00% over 12 months.  Now, could the pace be different this time?  Of course it could, especially given how extreme the Fed's accommodation has been through this cycle.  But, this is the best idea we have at the moment.  Also, we know that the FED is not starting this increase immediately.  However, if we continue to monitor this scenario, we should have an idea of how our balance sheet will react once the move starts.
  • Curve flattening:  As Grant explained in his post, we have a decent chance of seeing long term rates stay low even if the Fed does hike overnight rates.  In fact, this is exactly what we "typically" see during a Fed tightening.  I also think this is worth watching because it is precisely where many banks are vulnerable at the moment.  Higher short term rates will directly impact funding costs, and a lesser increase out on the curve means that the longer asset base will not benefit to the same degree.

My approach is to spend a little more time on these three scenarios, and then look through the others just make sure there is nothing too ugly in the forecast.  And, of course, this list will change as circumstances change.  The point is, though, that we at some point need to pick a few outcomes to which we can manage, and continue monitoring all of the others.  This allows us to manage the risk while having some scenarios in which if we are right, we can optimize the balance sheet to benefit and generate a better return.

Tuesday, August 19, 2014

Guest Post: A Case for Low Rates

The following is a guest post from Grant LacKamp of Country Club Bank Capital Markets Group.  The Capital Markets Group, like AMG, is a part of Country Club Bank.  Grant specializes in fixed income securities portfolios, specifically for financial institutions.  Grant can be reached by email, or you can connect with him on LinkedIn.

A Case for Lower Rates Regardless of Fed Action

Beginning last fall, the Federal Reserve began winding down its trillion dollar asset purchase program, also known as QE3, and should complete its monthly purchase of securities by October of 2014.  Although the Fed tells us that this is NOT tightening, it certainly has changed ones outlook on when short-term rates may begin to move higher.  The Fed officials tell us that the first rate change will likely take place in the summer of 2015, but thanks to a previous post by Dallas below, we know that the Fed has consistently missed its target as far as future interest rates are concerned.  That being said, regardless of if the Fed should act next summer and begin to tighten by moving up their overnight rate, the case can certainly be made that rates will not move to levels seen prior to 2008 for a long, long time.

By this point, we are all aware that the Great Recession of 2008 was created by the overindulgence of debt, not only by the American public, but by consumers, corporations, banks, and governments across the globe.  Looking at the graph below of Total Public Debt (including households, corporations, banks, and the government), it’s clear that we have really barely begun to digest all of the debt that we’ve taken on since the onset of the 1980’s. 


This massive amount of debt we’ve taken on coincides with the 30-Year bull market that we’ve seen in Treasuries.  As total debt has increased over the last 30 years, we’ve consistently seen lower highs and lower lows from a yield perspective on the 10-Year Treasury.  This is simply a coincidence right?  Wrong.  As we have taken on more and more debt, it has subsequently taken much smaller fluctuations in interest rates to throw the brakes on the economy and inflation.  This is because that small change in interest rates has a much larger effect on a household balance sheet, a corporate balance sheet, a bank balance sheet, and a government balance sheet.  With the enlarged amount of debt on the books, it takes a much smaller change in interest rates to have a much more resounding impact. 

Think of this as a set of speakers in your home.  If you’ve got a crowd coming over to watch the big game and you have a set of small speakers for your surround sound, you’re going to have to crank those things up so that everyone can hear.  If you’ve got a set of wall sized – wave makers, it takes a very small move of the volume knob to blow out a set of eardrums. 


Should the Fed indeed begin to raise the short-end of the yield curve next summer, anticipate a flattening of the yield curve with shorter rates moving up to meet longer rates as we saw in 1994 and 2004, only at much lower levels than we’ve seen before.  Interest rates will continue to hit lower highs and lower lows and the bond bull market will rage on until balance sheets (both public and private) are able to digest the debt levels they’ve take on.

 Should this fit with your interest rate bias, then we continue to recommend adding the following items to the investment portfolio to add interest rate and prepayment protection:

·         Agency Non-Callable Bullets

·         Municipals, both Taxable and Tax-Free

·         Newer Issue, Lower Coupon 15 and 20 Year Amortizing MBS

·         Discounted Callable agencies and step-ups


Let us know how we can help.


Grant LacKamp

Assistant Vice President

Country Club Bank

Tuesday, July 15, 2014

The Logistics of a Fed Rate Hike

by AMG

Although we are still squinting towards the horizon to see the eventual rate increase from the FOMC, the market is definitely telling us that we have shifted from "ZIRP Forever!" to "ZIRP for a couple more years!"  A subtle shift, but a meaningful one nonetheless.  We can see the evidence in the belly of the yield curve, with volatility arriving first in the 5 year area and now in the 3 year (chart via US Department of the Treasury):

As you can see, the 3 year yield has been rising steadily since the spring of 2013.  (And as an aside, isn't it really hard to fathom the 3 year yielding 5% again?)

Since the timing of the rate increase is slowly gaining clarity, I thought this post from Sober Look (More clarity from the FOMC on the mechanics of liftoff) would be helpful.  The post is short and worth the read, but here is a quick snippet:

The latest FOMC minutes provided some clarification on the approach the Fed is expected to take as it begins normalizing short term rates in the US. Here is a quick overview of the Fed's strategy and potential implications.
The Fed has chosen the interest rate on excess reserves (IOER) as the primary tool to control interest rates during the normalization process. While working with IOER is certainly more effective than the Fed Funds rate, there are a some drawbacks.

CLICK HERE for the rest