Risk Management and Value Creation

20111

2

William C. Handorf, Ph. D.

Professor of Finance

The GeorgeWashington University

Consultant

Banks

Central Banks

Expert Witness

Director and Vice Chair

Federal Home Loan

Bank of Atlanta

Director

Federal Reserve Bank

of Richmond; Chair

Baltimore Branch

Federal Home Loan

Bank System

Regulator

Federal Deposit

Insurance Corporation

Federal Home Loan

Bank Board

Lender

National Bank of Detroit

Officer, United States Army

Current Experience

2

Brasil’s Banking Sector

between 2011 and 2016

2 Biggest Threats

for Banks:

1. ______________

2. ______________

2 Biggest

Opportunities for

Banks:

1. ______________

2. ______________

3

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Past Problem Sectors in US

Emerging Market Debt - “Countries Do Not Go Bankrupt”

Agricultural Sector - “We All Need Food”

Oil Sector - “We Must Have Oil”

Commercial Real Estate - “You Have Collateral”4

5

US Home Prices: Case Shiller

Composite 10 Cities

Annual Price Change

2001: 8.2%

2002: 15.3%

2003: 14.0%

2004: 18.7%

2005: 15.1%

2006: -0.4%

2007: -11.5%

2008: -19.4%

2009: -0.1%

2010 -2.2%

2011 Decreasing

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Housing Problem History

• Home prices rise quickly after dot.com bust and low interest rate engineered by the central bank encouraged ARM loans

• Investors earn 50+% returns with 10% annual appreciation and encourage speculators to purchase more property

• Mortgagors need “innovative” loans and “piggy-back” loans to afford a home prior to even higher prices

• Wall Street encourages brokers to originate more high-yield loans for MBS

• MBS losses trigger “dominoes” to fall

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Ignoring the “Five C’s of Credit”

Loan Purpose Analysis

Amount, Use and

Term of Request?

Character of Debtor is Key

Loan Repayment Analysis

Sources of Repayment?

Capacity and Capital

Important

Loan Structure

Analysis Pricing,

Collateral and Conditions?

Structure is Function

of Risk

Loan Monitoring Analysis

Timely Payment and

Conditions Satisfied?

Systems and

Review Critical

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Economic Financial Managerial

Liquidation

Bank Failure

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Recent US “Failures” due to

Housing Loan Losses• AIG

• Bank United

• Bear Stearns

• Citibank

• Downey

• Fannie & Freddie

• GMAC

• Indy Mac

• Lehman Brothers

• Wachovia

• WAMU

• 200 + Smaller Banks

• Who will fail next Friday?

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Bank Failure and Management

High number and percentage of loans to insiders

Passive Board of Directors

Lack of coherent business plan

Quick growth funded by high cost funds offset by high yield assets

High dividend payouts and stock repurchase programs

Shrinkage to maintain capital ratios leading to larger losses given fixed non-interest costs

Ineffective risk management

Fraud 10

Red Flags

Late Financial Reports

Rapid Growth

Unexplained New Activity

Profit or Production Based Bonuses

Weak Controls

High Management Turnover

Ineffective Audit

Weak Board11

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Focus on Board Responsibilities

• Assess Performance

– Internal Controls

– Management

– Operations

– Credit Rating

– Regulatory Rating

– Share Value

• Approve ALM Policies

• Develop and Implement Business Plan

• Adopt Rigorous Risk Management Program

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Bank Failure and the Economy

Economic Recession

High and/or Increasing

Unemployment

High “Real” Interest Rates

Regional “Boom to Bust”

Low Confidence in Banks

or the Central Bank

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Bank Failure and

Asset/Liability Management

Low Capital

Losses

Loan Problems

Concentrated Portfolio

Loss of Cost Control

Quick Growth

Liquidity

Non Core Fund Reliance

Lack of Good Collateral

Bad Press & Run

High-yield Assets

High Sensitivity 14

15

Empirical Analysis of Recent

US Bank Failure• Leading Causes

– High problem loans to capital and ALLL

– Large losses

• High provision

• Losses on securities

– High non current loans

– Portfolio concentration in high risk ADC loans

– Risk Index < 3

– Low capital

– High non-core funding

• Other Factors

– Prior quick growth

– High yield assets 15

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Risk Index (RI) is number of standard deviations bank is

from their capital ratio declining below a stated threshold

The Risk Index

RI = (Capital Ratio + Mean ROA − Stated Threshold) ROA Sigma

As Risk Index declines, probability of capital problems

increase due to:

Low Capital Ratio

Low (or negative) mean ROA

High Volatility of Earnings from

Bad Loans, Shifting Strategy,

Sensitivity, Illiquidity, etc.

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Tier 1

Equity

Average

ROA

ROA

Sigma

Risk

Index

Probability

< 5%

Comerica 11.39 0.77 0.59 12.1 0.3

BB&T 9.93 0.97 0.53 11.1 0.4

Bank America 7.83 0.71 0.41 8.6 0.7

SunTrust 8.33 0.39 0.87 4.3 2.7

The Risk Index Applied

Implied Probability Tier 1 Equity < 5% in One Year

RI = (Equity + ROA – 5.0%) Sigma ROA

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Risk Index Inferences

Normal Distribution

Use Normal Table

Little Regulatory Concern > 10 Sigma

Non-normal (but symmetrical)

Probability = .5 [(1(RI)2]

Risk Index Probability

10 .5%

5 2.0%

3 5.5%

2 12.5%

1 50.0%

Value Creation

Coordinated Approach

Of Implementing Strategy

Create Value

ROE>COEAchieve Good

Regulatory Rating

Maintain Debt

AAA/BBB Grade

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202020

Value Creation

ROE > COE

Price/Book Premium

Asset Growth

Value Destruction

ROE < COE

Price/Book Discount

Asset Shrinkage

ROE = LM x ROA

NIE = AE x NIA

COE =8% to 20%

Share Value:

Return on Equity v. Cost of Equity

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Market Pricing

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Price-earnings v. Price/Book

• Price/Book = Price/EPS x EPS/Book Value

Price/Book = Price-earnings Ratio x ROE

• The PE Ratio conveys information about future

growth in earnings

• Return on Equity (ROE) conveys information

about current earnings

• Market Value Added equals the market value of

the bank’s stock minus the book value of equity

provided by shareholders

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Implications of Selling at a

Price/book Premium or Discount

• A Discount Increases ROE

on a Market Value

Perspective while a

Premium Decreases ROE

• Assume a Bank is Earning

ROE Book @ 5.0%, then

ROE Market is:

– 150% P/B: 3.3%

– 100% P/B: 5.0%

– 75% P/B: 6.7%

– 50% P/B: 10.0%

– 25% P/B: 20.0%

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Cost of Equity or

Required Return on Equity

Arbitrary

8%

12%

20%

Bond Premium Model

Long-term Debt Yield

+ Equity Premium

Capital Asset Pricing Model

Treasury Bond Yield + Beta

(Market Premium) 24

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Moody’s (1, 2, 3)

Aaa: Best Quality

Aa: High Quality

A: Upper Medium

Baa: Medium Grade

Ba: SpeculativeElements

B: Lack Desirable Investment Quality

C: Extremely Poor Prospects; May be in Default

Bond Rating Agencies

S & P (+ , -)

AAA: Extremely Strong

Capacity

AA: Very Strong

Capacity

A: Strong Capacity

BBB: Adequate Capacity

BB: Uncertainties Could

Lead to Default

B: Vulnerable

D: In Default

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Studies of Bank Bond Ratings:Probability of Default and Loss Given Default?

Higher Grade

High Capital

High ROA

Low Earnings Variability

Large Companies

Low Risk Portfolio

Effective Management

2727

Moody’s Financial Strength

Ratings –

A: Exceptional

B: Strong

C: Good

D: Adequate to

Vulnerable

E: Very Weak

Likelihood bank will

require assistance?

B+ TD

B Bank Hawaii

B- BB&T

C+ Bank China

C Capital One

C- Citibank

D+ Bank India

D Bank Ireland

D- California B&T

E+ Bank Moscow

2828

Bank Credit Ratings

and Financial Strength

Bank Credit Rating Strength

Morgan Chase Aa1 B

Bank America Aa3 C-

Citibank A1 C-

BB&T A1 B-

E-Trade Ba3 D-

Bradesco Baa2 B-

Banco Paulista B1 E+

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The Regression Slope is Beta

HPR= [P(1) + D - P(0)] /P(0)

Holding Period Return: Holding Company

-15

-10

-5

0

5

10

15

-15 -10 -5 0 5 10 15

Holding Period Return: Index

Beta

Beta represents the

Systematic risk of a

Bank Holding Company

(HC)

HC Sigma/Index

Sigma Correlation

of HC to Index

Implications of Beta

Average Risk @ 1.0

Low-risk @ < 1.0

High-risk @ > 1.0 29

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Applying CAPM in US and Brasil

• Cost of Equity = Long-term Risk-free Yield + Beta (Market Risk Premium)

• Average Risk US Bank

– Cost of equity = 3.20% + 1.00(5.50%) = 8.70%

• Average Risk Brasilian Bank

– Cost of equity = 6.20% + 1.00(7.70%) = 13.90%

• The required return to create value is higher in Brasil due to higher long-term interest rates and a higher market risk premium.

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Valuation Example

• US Bank (Citi) with ROE @ 6.4% and Beta

@ 2.55

– Cost of equity = 3.20% + 2.55(5.50%) = 17.23%

– Bank is destroying value and sells at P/B discount

• Brasilian Bank (Bradesco) with ROE @

24.2% and Beta @ 1.60

– Cost of equity = 6.20% + 1.60(7.70%) = 18.52%

– Bank is creating value and sells at P/B premium

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Price/book Ratios and Financial

Metrics

• P/B = 1.90 - .63(Beta); R2 = 17%

– Higher Beta (risk) leads to lower valuation

• P/B = 0.72 + .06(ROE); R2 = 54%

– Higher Return on Equity leads to higher valuation

• P/B = 1.45 + .07 (ROE – COE); R2 = 68%

– Higher spread between ROE and COE leads to

higher valuation

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Basel III

• Banks will require

more capital, more

equity capital, buffer

capital, systemic

capital and counter-

cyclical capital

• Banks will require

more long-term

funding and short-

term, marketable

investment securities.33

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Liquidity Concerns

• Reputation and credit rating of the bank

• Proportion of assets invested in securities, especially short-term, high-grade and marketable instruments

• Proportion of securities pledged

• Proportion of securities within the available-for-sale portfolio or trading portfolio v. held-to-maturity

• Proportion of funds provided by core deposits and long-term borrowed money

• Unused lines of credit available from central bank or correspondent bank

• Cash budget or liquidity gap report with stress test for sources of funds

• Focus on contingent funding plan or CFP

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Liquidity Issues

• Unexpected withdrawal of deposits and an

inability to borrow funds

• Collateral deterioration and inability to

pledge assets or suffer lower advance rate

• Market panic leads to absence of bid price

to sell investment securities

• Unexpected takedown of credit lines by

borrowers

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Basel III Liquidity Ratios

• Liquidity Coverage Ratio: A bank must have

high quality, unencumbered liquid assets to

withstand a 30-day period of market stress.

• Net Stable Funding Ratio: A bank must have

long-term stable sources of funding relative to

potential calls on its resources.

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Implications of Higher Liquidity

Rules

• Need invest in more short-term, high-grade marketable securities

• Need fund more assets with long-term debt

• The implications are relatively similar given a steeply upward sloping yield curve; ROA should decline

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Determine ROA Impact of Liquidity

• 100 million bank needs to move 1% of assets short-term and lose interest income @ 4.0% to enhance liquidity

– Bank 1: ROA @ 1.00% with 20% marginal income tax rate

– Bank 2: ROA @ 2.00% with 40% marginal income tax rate

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Financial Impact of Higher

Liquidity

• Bank 1 (ROA = 1.00%)

– Net Income @ 1,000,000

– Interest Lost @ -40,000

– Income Tax @ 8,000

– Net Income @ 968,000

• The 1% higher liquidity rule decreases ROA by 3.2%

• Clearly, higher liquidity coverage ratio adversely affects valuation

• Bank 2 (ROA = 2.00%)

– Net Income @ 2,000,000

– Interest Lost @ -40,000

– Income Tax @ 16,000

– Net Income @ 1,976,000

• The 1% higher liquidity coverage ratio decreases ROA by 1.2%

• The impact is not as severe for the high-profit bank able to offset lost interest income with lesser tax obligations

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Stable Long-term Bank Funding

“Letras Financeiras”

Interest Cost

Currency

Term and Yield Curve

Expectations

Liquidity Premium

Credit Premium

Credit Rating

Issuance Cost & Fees

Control

Covenants

Collateral

Banco do Brasil S. A. (Incorporated in the Federative Republic of Brazil with limited liability)

US$200,000,000

8.375% Notes due Five Years

US$200,000,000

9.375% Notes due Ten Years

issued under the

US$1,000,000,000GLOBAL-MEDIUM TERM NOTE PROGRAM

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Purpose of Capital

o Provide Cushion for Loss

o Inspire Confidence

o Limits Growth Potential

o Limits Risk Exposure

o Affects Loan-to-one Borrower

o Impacts Return on and Cost of Equity

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Cost of Capital

K(o) = K(e) x W(e) + K(d) x W(d)(1-t)

Where: K(o): is cost of capital

K(e): is cost of equity

K(d): is cost of debt

W: is weight of funds by equity and debt

t : is tax rate

Bank Application

Cost of Capital : 10% (.10) + 6%(.90)(1-.35) = 4.51%

Any bank with a lower cost of capital retains a strategic advantage over competitors

Cost of Capital

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Leverage and Cost of Capital

Leverage

Cost of debt < cost of equity

Interest on debt creates tax shield

Affects leverage multiplier and ROA; hence affects ROE

Increasing Capital

Use less low-cost debt and more high-cost equity; lose tax shield on debt

Improve credit rating; lower cost of debt

Decrease beta; lower cost of equity

ΒL= ΒU(1+(1-Tax)(D/E))

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Capital Issues

What is capital?

How much capital is needed?

Basel II Issues

Probability of Default (PD)

Loss Given Default (LGD)

Exposure at Default (EAD)

Correlation (R)

Basel II Guidance

ALLL = Expected Losses

Capital > Unexpected Losses

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Basel II Model

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Implied Residential Mortgage

Loan Risk Weights

10% LGD 30% LGD

.25% PD 5 14

.50% PD 8 23

1.00% PD 13 38

5.00% PD 33 99

10.00% PD 45 136

25.00% PD 58 174

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Bank Lending and Capital Rules

Pre-Basel Capital

Banks need capital equal to 5% of Loans

1988 Basel Accord

Banks need risk-based capital equal to

4% of Mortgage Loans: 50% Risk Weight

Basel II (Standardized)

Banks need risk-based capital equal to

2.8% of Mortgage Loans; 35% Risk Weight

BANK FOR INTERNATIONAL SETTLEMENTS

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Credit Modeling Problems

Data May Not Reflect:

Severe economic contraction

Sharp change in interest rates

or value of currency

New tax or bankruptcy laws

Shift in GAAP

Fraud

New Loan Structure

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Capital Impact on ROA and ROE

• 100 million bank needs

1% more equity capital;

replace debt @ 8.0% with

new stock

– Bank 1: ROA @ 1.00%

(20% tax rate); increase

capital from 9% to 10%;

ROE @ 11.11%

– Bank 2: ROA @ 2.00%

(40% marginal tax rate);

increase capital from 10%

to 11%; ROE @ 20.00%

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Financial Impact of Higher Capital

• Bank 1 (ROE = 11.11%)

– Net Income @ 1,000,000

– Interest Saved @ 80,000

– Lost Tax Shield @ -16,000

– Net Income @ 1,064,000

• Projected ROE

– 1,064,000/10,000,000

– ROE Decreases to 10.64%

• ROA increases from 1.00% to

1.064%

• LM declines from 11.11 to 10.0

– The 1% higher capital

decreases ROE by 4.23%

• Bank 2 (ROE = 20.00%)

– Net Income @ 2,000,000

– Interest Saved @ 80,000

– Lost Tax Shield @ -32,000

– Net Income @ 2,048,000

• Projected ROE

– 2,048,000/11,000,000

– ROE Declines to 18.62%

• ROA increases from 2.00% to

2.048%

• LM declines from 10.0 to 9.09

– The 1% higher capital lowers

ROE by 6.90%

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Risk Management• Ensure Every Key Risk to

Bank is Identified

Measured and Controlled

• Focus on Factors that have

High Impact and/or

Probability

• Assess Potential Impact of

Remote “Black Swan”

Events

• Approve Risk Appetite

Statement

– Prioritize Risks

– Identify Acceptable Risk

Vision

Statement

Objectives Measures Milestones

Goals

Mission

Statement

The Business Plan

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