Friday, June 26, 2015

The effects of a depreciating investment portfolio


Since March 31, 2015, the 10-year Treasury has moved from 1.934 percent to 2.478 percent on June 10, 2015.  During this time, most banks have experienced a decrease in market value of their securities portfolio.  Additionally, the Fed continues to debate on when the time is right to start increasing the Fed Funds rate.  With news of consumer sentiment up, unemployment numbers down, and housing up, it is only a matter of time before we see our first increase.  What this all seems to be doing is causing some examiners to have anxiety about your investment portfolio and what is going to happen to your capital, liquidity, and earnings when rates rise.

Some of our clients have been asked by regulators to set policy parameters around the percent change of the investment portfolio as it relates to capital and earnings.  The basis for this recommendation comes from the OCC Bulletin 2004-29, or the FDICFIL-46-2013.  It looks as if the message behind this bulletin or FIL is to make sure bank management understands the risks within the portfolio as it relates to capital, liquidity, and earnings.  Given the way the investment portfolio works, it is very challenging to set parameters specifically on the investment portfolio as it relates to capital without also looking at what is happening on the liability side of the balance sheet.  This practice would place a bigger risk to the bank because when rates go up, you could be selling at the worst possible time, ultimately affecting capital, liquidity, and earnings.  In this bulletin, the OCC talks about the importance of monitoring depreciation within the investment portfolio and it does talk about the importance of measuring the overall EVE, or MVE for BancPath®, position, but it doesn’t say that there needs to be a policy parameter for the amount of depreciation in the portfolio as it relates to capital.  It warns of extending the duration of the portfolio to chase yields, and that management should be aware of what that practice might do to the overall position of the balance sheet in changing rates.

If you haven’t taken a look at your policy parameters as it relates to the condition of your bank or the position of your balance sheet, then it might be time for a revisit to reconfirm them or adjust them accordingly.  Additionally, to show to regulators that this has been thoroughly thought out, if your liquidity contingency funding policy doesn’t include the depreciation of the investment portfolio in a rising rate environment and how management would handle the change in liquidity from that impact, then I would recommend adding that scenario.  By taking these steps, regulators should get the impression of a comprehensive approach to managing the balance sheet and overall ALM.  Also, don’t be afraid to document in the minutes the discussion within ALCO about the steps you are taking to control the duration of the portfolio.

The BancPath® reports have the capability to handle these recommendations in an easy-to-use format.  The ALM world is continually evolving into more complexity, and we continue to strive to stay ahead of the curve.  If you are feeling the pressure from examiners, concerned about how you are positioned for a rising rate environment, or just want to know more, then you can reach us at (800) 226-1923.

Monday, June 22, 2015

Should you extend your liabilities?


A President of a $300 million dollar community bank recently asked about adding long-term advances to “lock in” some spread to current book yields on earning assets.  This is obviously a seeming reasonable question regarding a commonly used strategy.  The answer to this simple question, however, requires a deep understanding of the balance sheet and specifically a thorough understanding of the nature of Non Maturing Deposits (NMD) as well as a “rate call”, and almost some clairvoyance regarding the likelihood of asset prepayments.  In this analysis, however, let’s assume the banker thinks rates will increase and also thinks prepayments on both loans and investments will decrease as rates move up. So, it is just a matter of picking out some proper advances and pulling the trigger, right?  What about those NMD on the balance sheet?   Do they provide enough protection against rising rates, or, do we really need to add advances?

The specifics the banker laid out included a 10 million dollar advance in the five to 10 year range. At the time of the discussion the five year advance was in the neighborhood of 2.15% which increased the bank’s COF 6 basis points. This would increase the bank’s interest expense $180,000 a year, without raising the Interest Income a bit. Rate calls and insurance is expensive, even in today’s world of low rates. Can you afford and are you willing to take on this expense? Remember, when rates rise you can lag interest expense (Betas define rate sensitivity) and new assets will hit the books a higher rate increasing interest income.

First, before you dive headlong into extending your liabilities make sure have a clear picture of the current deposits on the balance sheet. In particular, get your arms around the nature and likely duration of NIB DDAs and the other transaction accounts (MM Savings and NOW). Even though it flies in the face of current wisdom, there may be more “protection” against increasing rates in these deposits than you think.

Even though the majority of community banks are funded with core deposits, more specifically non-maturity deposits (NMD) they get little respect when upward rate movement is discussed.  The good news is that NMD create the greatest value of any funding source and are generally the most stable.  The bad news is that they create the biggest headache when it comes to determining the value they place on the bank’s balance sheet and are the most scrutinized by examiners.  Unlike all other assets and liabilities that have stated pricing structures and maturities, NMDs are considered to be immediately reprice-able by management and to be immediately callable by the customer.  Since history has taught us that NMDs don’t immediately reprice or get called, we have to make assumptions to determine how these rate-sensitive deposits reprice and how long they will be around. 

Additionally, NMD have grown in recent years as opposed to “decaying”.  At least in the last five years or so, pricing has become practically irrelevant as NMD have increased.   If you are just looking at the volumes in your NMD accounts to create an assumption about their life expectancy, you might be getting misleading information.  In addition to this growing assumption dilemma, regulators are pushing to make sure those assumptions are accurate.  How do you know those assumptions are accurate when there hasn’t been an increase in rates since June 2006?

But, recent history should not obscure the stable nature of NMD over a long period of time.  It is obvious that balances may be larger than would be “normally” expected, thereby perhaps “temporarily” decreasing your COF (and perhaps increasing MVE), but the expected duration (time remaining on the books) of these accounts is probably far longer than the values we see in many current ALM Models.

So, back to our original premise, that when properly measured, NMD are probably less rate sensitive and most likely have more staying power than is often assumed. If your ALM model is telling you that NMD will run off as soon as rates rise and that they will be extremely rate sensitive (very high betas) you might want to closely examine these results. What assumptions are driving these conclusions, and do they make sense? Keep in mind the balance sheet may be less liability sensitive than your model says it is.

No one knows the future of rates, but if you do not properly value and measure the current balance sheet, then your COF may surge far more than necessary.  The AMG BancPath® model incorporates a deposit study within the context of the model to give you the information you need to use your bank’s specific assumptions.  If you have questions or want to know more, you can reach us at (800) 226-1923.

Wednesday, June 3, 2015

Basel III - Frequently asked questions answered by the regulators


Do you have questions about how the new Basel III rules are going to affect your bank?  You’re not alone.  The OCC, FRB, and FDIC have issued an FAQ to help get you started.  This FAQ covers issues various issues that other community banks have encountered when applying the new capital rules.  The following is a list of topics that the FAQ addresses:
·         Definition of Capital
·         High Volatility Commercial Real Estate (HVCRE) Exposures
·         Other Real Estate and Off-Balance Sheet Exposures
·         Separate Account and Equity Exposures to Investment Funds
·         Qualifying Central Counterparty (QCCP)
·         Credit Valuation Adjustment (CVA)
·         And a couple of other questions not covered by the above categories.
The majority of the questions help answer the issues in identifying and accounting for HVCRE.  The following link goes directly to the FAQ and supporting information. 
If the question isn’t answered with this FAQ about the new Basel III regulations, the page provides a list of contact information for your regional FDIC contact.

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.

Sean

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.