vision 2014: capital allocations - the mystery of it all
DESCRIPTION
In light of regulatory changes, deploying economic capital through a capital allocation strategy can assist a bank in a competitive market and in effectively pricing its loans.TRANSCRIPT
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Capital allocations — the mystery of it all The interconnection of ALLL, commercial risk rating and relationship pricing Rachael Bauco Sterling National Bank
John Robertson Experian
#vision2014
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It doesn’t! Understand how capital impacts the return
when pricing a loan
Understand the key influencers
Institute capital allocation methodology for
monitoring yesterday, today and tomorrow
Why does it have to be a mystery?
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Margin compression
Relationship management
Risk management
Performance measurement
Return on shareholders equity
Business and marketing strategy
REGULATORS!!
Why have bank’s amplified their interest in capital? Strategic reasons
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Interest rate
Cost of funds / cost of deposits (FTP)
Non interest income / expense
Risk expense
Capital at risk
What fuels the returns? Critical attributes
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Pretty simple, really Single loan profitability
Interest rates
Non-interest income
Cost of funds
Non interest expense
Risk premium
Net income
ROA
ROE or RAROC
Totals Average assets %
O/S balance 100,000.00
Interest rate (V 100) 4.25%
Interest income 4,250.00 4.25%
Non-interest income 1,000.00 1.00%
Gross revenue 5,250.00 5.25%
Cost of funds 1,330.00 1.33%
Non-interest expenses 1,932.00 1.93%
Risk expense 0.3000% 300.00 0.30%
Total expenses 3,562.00 3.56%
Profit before tax 1,688.00 1.69%
Federal tax (34.0%) 573.97 0.57%
State tax (2.0%) 33.76 0.03%
Total tax 607.68 0.61%
Profit after tax 1,080.32 1.08%
ROA 1.08%
Average assets 100,00.00
ROE (8.0000) 14.14
ROA target 1.50
Additional fees 576.00
Additional basis points 57.60
Proposed
loan profitability
detail report
Loan: Proposed
Type: Commercial LOC
Grade: Average
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Basel Committee on Banking Supervision’s objective is to enhance understanding of key supervisory issues and improve the quality of banking supervision
Basel I published a set of minimum capital requirements which is now widely viewed as outmoded
Basel II
► Introduced "three pillars" concept
● Minimum capital requirements
● Supervisory review
● Market discipline
Basel III
► Mandatory capital conservation and a discretionary countercyclical buffer
► Minimum leverage ratio and two required liquidity ratios
What’s important to the regulators? Protect the stakeholders and themselves
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Regulatory evolution
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What do THEY want to see? Tools used for protecting capital
Rating system
Application
of economic capital
Performing
migration analysis
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IRB standards requires granularity in risk ratings within specific asset classes
Adequate systems to capture the data supporting the grades
First rating looks to the borrower’s risk and the potential loss
Facility rating differentiates risk associated with types of loans which becomes instrumental in supporting ALLL calculations and capital estimates
Foundation of the loan grading system which should be used in the subsequent loan review process and drive ongoing dynamic grading
Dual risk rating
DUAL RISK RATING
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Methodologies used to determine grades is constantly evolving, as are the technological capabilities
Automated grading of every loan with the traditional methodology with updated collateral management and values is where the state- of-the-art is right now
Reactive loan grading – even dynamically – is soon not going to be enough
Predictive rules and grades
More consistency in the loan grading approach
Proactive view of the portfolio losses
The latest FASB proposal includes the CECL Model
► Current Expected Credit Loss model
Reactive to predictive
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FASB standard combining historical and projected loss expectations.
Replace the incurred loss approach with a Current Expected Credit Loss model
CECL would require banks to use
► Historical information
► Current conditions
► Reasonable and supportable forecasts to estimate expected shortfalls over the life of a loan
► Creates consistent measurement approach for all financial assets
► Mirrors the OCC’s risk-based, forward-looking approach
CECL model concept
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Financial assets measured at amortized costs (loans – non-equities)
Management makes an ongoing estimate of the cash flows from the contractual obligations it expects it will not collect (also know as estimated losses)
► These are not impaired loans or impairment calculations
► These are detailed predictive factors (and grades) with loss estimates for generally performing loans
FASB proposed components include
► General risk factors
► Specific risk factors
CECL model fundamental components
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FASB components
General risk factors Start with the historical loss
rates by type
Add the traditional qualitative factors used by regulators to increase the ALLL percentages
Specific risk factors Drill-down on the general factors
at the borrower/loan level
Economic indicators
Credit profiles may be credit scores for consumers, but FS ratios for commercial
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Migration analysis – directional consistency
The directional consistency component may require additional ALLL allocations
An increase in the loss percentage would indicate a change in the risk profile of the portfolio and thus the expected loss amount for the loans within it
A change in the risk experience requires a change in the capital requirement
Pricing should be adjusted to reflect the additional risk and as a result of an increased capital allocation
Reserve allocations Directional consistency of expected loss
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The primary value of economic capital is its application to decision-making and overall risk management
Economic capital is the amount of money which is needed to secure the survival in a worst case scenario, it is a buffer against expected shocks in market values
Economic capital is a measure of risk, not of capital held
Enhances risk management efforts by providing a common indicator for risk
Provides a pricing metric that includes expected and unexpected losses
Broadens the evaluation of the adequacy of capital in relation to the bank's overall risk profile
If it’s good enough for the Phoenicians Economic capital
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Probability of default (PD)
Per rating grade, the risk presented by the borrower
Loss given default (LGD)
Facility rating differentiates risk associated with different loans (and types of loans) to the same borrower
Exposure at default (EAD)
The amount outstanding
Expected losses ($) = PD(%) * LGD(%) * EAD($)
Prominent factors for determining economic capital Credit risk parameters
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Mystery box
Commercial
exposures
Economic
capital factor
%
LGD N – (LGD PD) 1 + (M – 2.5) b
= N-1(PD) + R N-1(CL)
1 – R 1 – 1.5 b
Retail
exposures
Economic
capital factor
%
LGD N – (LGD PD) = N-1(PD) + R N-1(CL)
1 – R
Once each parameter is filled out for each desired loan segmentation bucket,
the economic capital factor can be calculated:
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We’ve come full circle
Risk factors periodically measured
Risk factor measurements adjusted directionally consistent
Capital allocations adjusted accordingly
Pricing adjusted
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Capital allocations How its been done and what to expect
from the regulators
Rachael Bauco
Sterling National Bank
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Headquartered in Montebello, NY with locations throughout the greater New York City metropolitan region
Successful merger between Provident New York Bancorp and legacy Sterling Bancorp in Fall 2013 created a strong, diversified and growing institution
$6.7 billion in assets
www.sterlingbancorp.com
Sterling National Bank
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Sterling National Bank
Dual risk rating
Probability of Default – What is the risk that the obligor will default?
Loss Given Default – What is the risk of loss if the obligor defaults?
Expected Loss – What is the expected loss of the specific portfolio?
Economic capital
What is the unexpected loss of the specific portfolio?
Results interpretation
Requirements and uses
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Portfolio Probability of Default
For a given portfolio and risk rating at a point in time, what were the balances that became 90 days delinquent within the next year?
The average quarterly results establish the base for:
► Probability of default and obligor rating
First step Determine Probability of Default
Portfolio A Risk
Rating
Portfolio
Balances at
beginning of
period
90 Day
Delinquency
Probability of
Default
1 $ 1,000,000 $ 10 0.00%
2 $ 1,000,000 $ 500 0.05%
3 $ 1,000,000 $ 1,000 0.10%
4 $ 1,000,000 $ 1,500 0.15%
5 $ 1,000,000 $ 3,000 0.30%
6 $ 1,000,000 $ 10,000 1.00%
7 $ 1,000,000 $ 25,000 2.50%
8 $ 1,000,000 $ 100,000 10.00%
8,000,000$ 141,010$ 1.8%
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What are the net losses if a default occurred? This establishes the Loss Given Default and facility rating
► Note that facility type and collateral contribute to actual losses
What is additional exposure available at default? Exposure at Default
► These three inputs provide the base for Expected Loss in the portfolio
► Values are updated semi annually
Next… Determine Loss Given Default
Portfolio A
Risk Rating
Portfolio
Balances at
beginning of
period
90 Day
Delinquency
Probability of
Default
Loss Given
Default
Expected Loss =
Probability of
Default x Loss
Given Default
1 $ 1,000,000 $ - 0.00% 25% 0.00%
2 $ 1,000,000 $ 500 0.05% 25% 0.01%
3 $ 1,000,000 $ 1,000 0.10% 25% 0.03%
4 $ 1,000,000 $ 1,500 0.15% 25% 0.04%
5 $ 1,000,000 $ 3,000 0.30% 25% 0.08%
6 $ 1,000,000 $ 10,000 1.00% 25% 0.25%
7 $ 1,000,000 $ 25,000 2.50% 25% 0.63%
8 $ 1,000,000 $ 100,000 10.00% 25% 2.50%
8,000,000$ 141,000$ 1.8% 25% 0.44%
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Expected Loss
Represents an average amount to smooth out the credit cycle
Used to ensure adequate loan pricing to cover risk costs
Amounts established in ALLL to cover expected losses
Expected Loss
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Unexpected loss represents the risk that actual loss is different than expected
Economic capital is the amount needed to absorb unexpected losses at a specific confidence level
Additional input required:
► Asset correlation
● How does the asset type correlate to the general economy?
● Higher correlation means there is a larger probability that there will be smaller or larger losses than the expected average
● Higher correlation results in higher capital requirements
► Confidence level
● Risk of insolvency over a certain period of time, i.e. 99.9% or 99.99%
● A lower risk of insolvency translates into a higher confidence level and higher capital requirements
Input for The Mystery Box
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Unexpected loss represents the risk that actual loss is different than expected
Economic capital is the amount needed to absorb unexpected losses at a specific confidence level
Additional input required:
► Remaining term / maturity
● The longer the remaining term of a portfolio, the higher likelihood of unexpected losses and higher capital required
► Over the cycle loss given default
● Average losses over time
► Downturn loss given default
● Losses experienced in economy stress / downturn
Input for The Mystery Box
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The Mystery Box results
Portfolio A Portfolio
Balances EAD PD
Downturn
LGD OTC LGD Asset corr
Remaining
Term (years)
Confidence
Level
EC %
(Unexpected
Loss)
EL %
1 $ 1,000,000 $ 1,005,000 0.00% 31% 25% 25% 2.5 99.99% 0.54% 0.00%
2 $ 1,000,000 $ 1,005,000 0.05% 31% 25% 25% 2.5 99.99% 2.65% 0.01%
3 $ 1,000,000 $ 1,005,000 0.10% 31% 25% 25% 2.5 99.99% 3.78% 0.03%
4 $ 1,000,000 $ 1,003,750 0.15% 31% 25% 25% 2.5 99.99% 4.64% 0.04%
5 $ 1,000,000 $ 1,003,750 0.30% 31% 25% 25% 2.5 99.99% 6.52% 0.08%
6 $ 1,000,000 $ 1,002,500 1.00% 31% 25% 25% 2.5 99.99% 11.20% 0.25%
7 $ 1,000,000 $ 1,002,500 2.50% 31% 25% 25% 2.5 99.99% 15.89% 0.63%
8 $ 1,000,000 $ 1,001,250 10.00% 31% 25% 25% 2.5 99.99% 22.72% 2.50%
8,000,000$ 8,028,750$ EC % 8.51%
EL % 0.44%
PD % 1.76%
Economic capital required is different
among risk ratings
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Portfolio A has higher risk, but higher return
First scenario assumes equal capital allocation; Portfolio A appears to have better return than Portfolio B
Second scenario applies different capital allocations given risk of portfolios
► Despite lower return of Portfolio B, RAROC is better with Portfolio B given lower capital requirements
What is the impact on loan portfolios?
First Scenario Portfolio A Portfolio B
Balances $8,000,000 $8,000,000
Net interest margin 1.50% 1.15%
Net income $120,000 $92,000
Less: Expected losses $35,250 $17,625
Capital 8.51% 8.51%
RAROC 12.45% 10.92%
Second Scenario Portfolio A Portfolio B
Balances $8,000,000 $8,000,000
Net interest margin 1.50% 1.15%
Net income $120,000 $92,000
Less: Expected losses $35,200 $17,600
Capital 8.51% 6.66%
RAROC 12.46% 13.96%
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Uses
Portfolio analysis
Commercial loan pricing
Incentive compensation
Stress testing
ALLL qualitative factors
Requirements
Robust MIS
Some statistical knowledge
Economic capital uses and requirements
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Understand the implications of risk on capital and ultimately on pricing
Devise a transition plan before your next exam
Employ a methodology for monitoring yesterday, today, and tomorrow
Knowledge is power… but only if you act upon it!
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