Vision 2014: Capital Allocations - The Mystery Of It All

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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

2 © 2014 Experian Information Solutions, Inc. All rights reserved. Experian Public.

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?


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


Interest rate

Cost of funds / cost of deposits (FTP)

Non interest income / expense

Risk expense

Capital at risk

What fuels the returns? Critical attributes


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


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


Regulatory evolution


What do THEY want to see? Tools used for protecting capital

Rating system

Application

of economic capital

Performing

migration analysis


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


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


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


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


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


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


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


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


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:

http://3.bp.blogspot.com/-b2pz37QuFdk/Tl46PHzCE6I/AAAAAAAABm4/2f5TwnMY9PU/s1600/mystery_box.jpg



We’ve come full circle

Risk factors periodically measured

Risk factor measurements adjusted directionally consistent

Capital allocations adjusted accordingly

Pricing adjusted


Capital allocations How its been done and what to expect

from the regulators

Rachael Bauco

Sterling National Bank


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


http://www.snb.com/payroll



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


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%


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%


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


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



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



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



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%


Uses

Portfolio analysis

Commercial loan pricing

Incentive compensation

Stress testing

ALLL qualitative factors

Requirements

Robust MIS

Some statistical knowledge

Economic capital uses and requirements


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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Vision 2014: Capital Allocations - The Mystery Of It All