The Regulatory Mindset

Where the FDIC once gave broad latitude to the OCC, OTS and state chartering agencies, now everyone else is expected to take a back seat to the almighty insurer. In the eyes of some field examiners (FDIC and others), anything abnormal is bad. If your bank is funded from nontraditional sources or invested in nontraditional assets, the presumption is that you have taken on excessive risk. Don’t let examiners make sweeping assumptions and penalize you for the way your bank is structured. Choose which battles are worth fighting, then stand up and defend your position. If the worst case is a 2 or 3 rating in liquidity and a composite 1 or 2, consider swallowing your medicine with a smile. If the concern might result in a composite 3 rating (which will result in a regulatory order) that you feel is undeserved, fight to the last man. You should know your bank better than someone who comes in for two weeks every 18 months. A disagreement, handled professionally, is an opportunity to show just how well you know how your bank behaves.

Will the real Core Deposits please stand up?

The FDIC and other regulators had a favorite phrase in this era of excessive bank growth leading to explosive bank failure: CORE DEPOSITS. The idea is as old as the hills. Banks have three types of funding sources -- capital, core funds and non-core funds. Nothing wrong with that statement, right?

The problem shows its face when you try to define Core Deposits. The FDIC created its definition decades ago, when the FDIC insurance limit was $100,000 and there were no material non-deposit sources of funding other than capital. This decrepit definition of core deposits includes all nonmaturity deposits (regardless of balance) and certificates of deposit under $100,000. [$100,000 in 1980 dollars (the year the FDIC insurance limit was raised to $100K) = over $250,000 in 2008 dollars.]

Fast forward to the 21st century, where $100,000 just doesn't buy as much as it used to. I walk into my local Bank A with $150,000 and open one certificate of deposit, which is not counted as a core deposit due to its size. If, however, I open two CDs for $75,000 each, they are both counted as core deposits. Or, if I open a Money Market account with the $150K, the whole balance is treated as a core deposit. Whichever account type I choose, all of my $150K is covered by FDIC insurance at its new $250K level.

If I am a retiree on a budget, who relies on interest income to buy groceries, I may watch rates like a hawk, moving my money often to get the best rates in town. In that case, my $150K is not really a core deposit, as it will stay at Bank A only as long as it offers the best rate. On the other hand, if I am a small business owner, the $150K may be a small portion of a bigger financial picture, and my relationship with Bank A may include personal and business deposit and loan accounts. I may even be an investor in Bank A or sit on its board of directors. All of this suggests that my $150K may be a very solid core deposit, regardless of balance.

Why does all this matter? It matters because the FDIC uses Core Deposit data (and a variety of ratios that include Core Deposits) as benchmarks when examining banks. A bank that has too many non-core funding sources (jumbo CDs, FHLB borrowings, brokered deposits, etc.) will be criticized harshly, even if the bank exhibits a well-developed ability to operate safely with its particular funding mix. With expanded deposit insurance in place, there have been many calls for the FDIC to revise its definitions of Core Deposits. The agency has, so far, been unwilling to do so, partly because it uses the current definition to its advantage when it needs leverage against a bank that it doesn't like.

I don't have a Pulitzer-winning close to this post, and I do have to get back to the paying work. Let's just close with the thought that the FDIC is in many ways a dinosaur that is unable or unwilling to keep up with changing banking structures. Of course, this should be obvious to anyone who has been watching the bank failure count grow every Friday. The scary part is that the FDIC is spending much of its energy these days fighting for more regulatory authority, instead of addressing some of the fundamental weaknesses in its existing regulatory framework.

Appropriate Measurement of Earnings at Risk in Community Banks

Recent regulatory thought on interest rate risk has been divided into two primary areas of concern: Earnings at Risk (EaR) and Economic Value of Equity (EVE). EaR addresses the short term IRR concern, while EVE addresses the long term aspects of IRR. For the rest of this discussion, let us focus on Earnings at Risk.

Recently, we have had several clients report negative exam comments surrounding the lack of RSA / RSL(rate sensitive assets / rate sensitive liabilities) parameters in the banks’ interest rate risk policies. The comments read something like:

The bank’s IRR policy establishes adequate parameters for post-shock changes in ROA but does not establish parameters for the RSA / RSL position or changes to the Net Interest Margin. Management should update the IRR policy to provide operating parameters for RSA / RSL and the Net Interest Margin.

These examiner comments about RSA / RSL expose a lack of understanding about how interest rate risk measurement works and incorrectly imply a regulatory requirement to measure by antiquated standards.

An example of the weakness of RSA / RSL relative to Change in ROA: Consider two banks (A and B), each with total assets of $100 million. Bank A has $30 million of loans that adjust immediately with a change in NY Prime. Bank B has $30 million of loans that reprice annually, with repricing dates spread evenly across the coming year. The two banks are identical in all other respects.

The RSA / RSL ratio at the one year horizon is identical for the two banks, as each bank’s $30 million in loans will reprice within the first year. The banks’ changes in ROA are very different, however, due to the timing of the repricing. If Bank A’s interest rate risk position as measured by Change in ROA is completely neutral, Bank B would be very liability sensitive due to the slower repricing of its loan portfolio in a rising rate environment.

If you are feeling the heat from examiners who seem unable to break free from antiquated measurement systems, send me an email (jfair@americanplanning.com) and let's talk about how we can help.

Another Friday, Another Failure (or Seven)

With the 4th of July holiday looming, Black Friday came early this week -- the FDIC shuttered seven banks at the close of business Thursday. Six of these failures were in Illinois, bringing the state's total to 12 since January 2008 and moving the Land of Lincoln into second place behind Georgia (14) in the failure race.

The story behind this week's Illinois failures is that all six banks were controlled by the same family and had purchased huge volumes of trust preferred securities. The failures were a result of the forced writedown of the investments and the family's inability to raise enough outside capital to prop up the banks. Three other banks owned by the same family are struggling to stay afloat.

Show me your CAMELS, Mr. Lewis!

Last Thursday, the House Committee on Oversight and Government Reform released documents related to the Bank of America / Merrill Lynch fiasco. Included in these documents was a "restricted" internal Federal Reserve document that mentioned BofA's CAMELS rating. Those of us who have heard FDIC or other examiners give the boardroom speech about the "highly confidential nature of the CAMELS rating" know how serious regulators are about the secrecy of bank ratings, and with good reason. If the ratings were public, a bank with a less than satisfactory rating might be exposed to an old fashioned "run on the bank" -- something we all want to avoid.

Should it be a surprise that our elected officials can't keep a secret? It's no wonder why the CIA and FBI don't like dealing with the Hill!

As a result of this security breach and the witch hunt attitude echoing through the halls of Congress (not that the attitude is completely unjustified) over the financial crisis of 2008, look for less cooperation among the various regulators and their policitcal overlords in months to come. Add to the mix current attempts by the Obama administration to reform and rearrange the regulatory deck chairs and you get one very murky witches' brew in Washington.

By the way, BofA's CAMELS rating was a 2 (on a scale of 1-5, where 1 is best). Nothing to be ashamed of, but Bloomberg managed to make it sound bad, quoting a college finance professor as saying "For a big bank, a CAMELS of 2 is a questionable rating". Yet another reason the regulators don't want the ratings disclosed... (I wonder how many examination reports this finance professor has read lately?)

For more on the disclosure, see
http://www.bloomberg.com/apps/news?pid=20601087&sid=abkxoZue_3uo and
http://www.bloomberg.com/apps/news?pid=20601208&sid=adfHHDDmHmgU

(I have no idea how long these links will work.)

Welcome to my Blog

It took me a while to get into the blog bit, mainly because I don't have any desire to tell the world what I had for breakfast. Then I realized that I needed an easy place to post things that I had written for my clients, and that my corporate websites were not well set up for quick and easy updates. So here I am. I'll be posting some existing writings soon, then will try to keep the site reasonably current with things more important than what I had for breakfast.

You can subscribe to my blog using your favorite feed provider (I like Google Reader) by clicking the Subscribe Now button on the right side of the page, or you can just drop in at random to see what's happening. Glad you visited...

The Appropriate Measurement of Earnings at Risk in Community Banks

Recent regulatory thought on interest rate risk has been divided into two primary areas of concern: Earnings at Risk (EaR) and Economic Value of Equity (EVE). EaR addresses the short term IRR concern, while EVE addresses the long term aspects of IRR. For the rest of this discussion, let us focus on Earnings at Risk.

Recently, we have had several clients report negative exam comments surrounding the lack of RSA / RSL (rate sensitive assets / rate sensitive liabilities) parameters in the banks’ interest rate risk policies. The comments read something like:

The bank’s IRR policy establishes adequate parameters for post-shock changes in ROA but does not establish parameters for the RSA / RSL position or changes to the Net Interest Margin. Management should update the IRR policy to provide operating parameters for RSA / RSL and the Net Interest Margin.

These examiner comments about RSA / RSL expose a lack of understanding about how interest rate risk measurement works and incorrectly imply a regulatory requirement to measure by antiquated standards.

Measuring interest rate risk by a change in ROA is logical, since ROA is a measure of earnings, and earnings is one of the six CAMELS components. The last time I checked, the RSA / RSL ratio was not a CAMELS component. Our Interest Margin Sensitivity Analysis reports the post-shock projected Net Interest Margin, Change in ROA, Projected ROA and Change in Net Income. This seems like plenty of data for the Asset / Liability Management Committee to make informed decisions about risk positions and risk tolerances.

In my IRR discussions, I focus on the impact of a rate change on earnings, as that is what really matters. Yet, examiners want to take us back 20 years by looking at a simplistic ratio that tells us less about a bank’s true IRR exposures. The IMSA’s calculations take into account the impact of rate changes over a full year, while the RSA / RSL ratio is a snapshot calculation at the 365th day that ignores all temporary asset / liability mismatches that come and go between day 1 and day 364.

An example of the weakness of RSA / RSL relative to Change in ROA: Consider two banks (A and B), each with total assets of $100 million. Bank A has $30 million of loans that adjust immediately with a change in NY Prime. Bank B has $30 million of loans that reprice annually, with repricing dates spread evenly across the coming year. The two banks are identical in all other respects.

The RSA / RSL ratio at the one year horizon is identical for the two banks, as each bank’s $30 million in loans will reprice within the first year. The banks’ changes in ROA are very different, however, due to the timing of the repricing. If Bank A’s interest rate risk position as measured by Change in ROA is completely neutral, Bank B would be very liability sensitive due to the slower repricing of its loan portfolio in a rising rate environment.

Bank A happens to be a real APC client with virtually no exposure to rising rates. Its Change in ROA for a +100 basis point shock is -2 basis points, and its RSA / RSL is 0.82. We created Bank B from Bank A’s data, changing only the loan repricing characteristics. Bank B reports a RSA / RSL of 0.82 and a Change in ROA of -12 basis points. With a policy limit of a -25 basis point change for a +/- 100 basis point rate shock, Bank B is halfway between neutral and its policy limit.

Some data from the APC client base: I reviewed the interest rate risk reports for all of our clients, hoping to identify a set of RSA / RSL parameters that would match our standard Change in ROA policy limit of no more than a 25BP decrease in ROA for a 100BP instant and sustained rate shock. My plan was to satisfy our friendly examiners by setting some RSA / RSL policy parameters without unreasonably impairing management flexibility.

From our base of 36 clients, I selected the 30 for which we had a full 12 months of historical IRR data and pulled the most extreme monthly Change in ROA for each bank between June 2008 and May 2009. Each of these 30 observations was within the 25BP decrease in ROA policy limit (the maximum exposure in the group was 21BP), so it seemed logical to me that the corresponding RSA / RSL ranges would suggest appropriate limits for a new policy parameter designed to satisfy our examiners.

The result: 30 Change in ROA measurements provided RSA / RSL parameters ranging from 0.44 to 1.71. These ratios are much wider than the ranges most regulators seem to accept as reasonable (0.75 to 1.25). So what shall we do when faced with regulatory expectations to measure risk with an undersized and one-dimensional yardstick? It seems we have several choices:

1. Set “normal” RSA / RSL parameters: Adopt RSA / RSL parameters the examiners will like, which would put 24 of our 30 test banks in an “outside policy parameters” position at least once within the last year. In this scenario, these banks must begin to reduce interest rate risk to comply with an unreasonably strict policy or accept regular policy exceptions.

2. Set reasonable RSA / RSL parameters: We can suggest a range that works based on your bank’s historical behavior, but the parameters will probably be criticized during the next exam. At that point, we must begin the examiner education process, which is likely to continue at every exam.

3. Continue without RSA / RSL parameters: This will require that you continue to educate examiners about the reasons you do not set parameters on RSA / RSL, at least until this dinosaur (the ratio, not the examiner) finally tumbles into the tar pit.

We will be glad to help you implement whichever option you select. My goal in climbing onto this soapbox is to give you enough information to discuss the topic with your examiners and respond to their oral comments before they become written criticisms. If you sense an upcoming conversation with your examiners and feel the need for reinforcements, we’re only a phone call away.

Tilting at Windmills

Illiquidity is a dangerous thing. Banks have failed because of it, and banking regulators have every reason to be concerned about it. Now that we all agree on that point, let’s talk about some of the recent regulatory comments, suggestions, requirements and mindsets concerning liquidity:

The Crystal Ball Fallacy: It seems that some regulators believe that if we work hard enough, we can create a crystal ball that will tell us whether we can survive the next liquidity crisis. The stress tests recently completed by the government on the nation’s top 19 banks seem to assume that the next worst case scenario can be described, even though no one was able to predict the current crisis. If banks had been running some flavor of stress testing or contingency funding model in August 2008, would it have been a reasonable indicator of the risks that they would face in September? Probably not, because we had never experienced a market meltdown like the one created by Lehman’s failure and the other events of that week. The significant problems we have cannot be solved at the same level of thinking with which we created them. (Einstein) No one has stepped forward to tell bankers how to stress liquidity or what measure is acceptable, but we must appear to be doing something…

Forward Looking Liquidity: Since the dawn of the FDIC Liquidity Ratio (which the FDIC has since disavowed), liquidity has been a point-in-time, slightly historical ratio. By the May board meeting, you would present and discuss the April 30 liquidity calculations and (perhaps) a historical liquidity trend. For most community banks, this was and still is sufficient, as most institutions don’t change rapidly and have plenty of time to detect liquidity trends and adjust funding plans accordingly. With the recent liquidity crisis, regulators have (correctly) observed that some banks have rapidly moving balance sheets that require additional forward-looking liquidity modeling. As with most regulatory thoughts, this one will now trickle down to all institutions, whether you need it or not.

Traditional accountants and CFOs like real (actual historical or current) numbers. Real numbers are accurate, can be balanced and don’t change. Many accountants get a bit squeamish when the annual planning process comes along, as it requires projections, estimations and significant uncertainty. Compared to the minor discomfort of annual budgeting or forecasting, forward liquidity calculations are downright gut wrenching. They require us to make assumptions about the most irrational and erratic of all creatures – humans. What will our loan originations and paydowns look like over the next 90 days? Will deposits increase or shrink? What will our competitors do to impact our market? Which securities will be called?

We have been developing a couple of forward liquidity models and have beta tested with a few clients. If you are scheduled for an exam soon, please let me know and we will help you get ready by deploying one of our models along with an updated Liquidity Policy.

Contingent Funding Planning (CFP) Policy: For those of you who don’t have enough policies to keep up with, here is another one that you will be expected to have in place for your next exam. Is liquidity during market disruptions important? Definitely. Can we identify, in general, the sources of liquidity that we have and which ones could go away at the worst possible time? Probably. Can we create a model that will address all possible events AND show that the bank will survive those events? No, because we can’t describe the next failure event any more accurately that we could have predicted the events of the last 18 months.

In the contingent funding modeling we have done thus far, the amount of data necessary to model reasonably and the assumptions required to come up with an answer make me question whether the output is worth (a) the effort and (b) the paper on which it is printed. We’ll keep working to come up with a simple model that provides reasonable outputs, but there is nothing simple about the combination of forward looking liquidity and hypothetical stress events. Like with #2 above, we intend to roll out our current CFP and model based on risk and exam schedules.

As Louisiana Office of Financial Institutions Chief Examiner Sid Seymour wrote recently, “We understand that some of our institutions are finding it somewhat difficult to perform comprehensive liquidity analysis and contingency planning as outlined in the expanded liquidity risk management guidance contained in Financial Institution Letter (FIL) 84-2008…” We have found that almost all banks are finding it hard to comply with FIL 84-2008, because it addresses complex issues that are changing rapidly. My best advice: read FIL 84-2008 (several times) and begin thinking about your exposures. Rest assured that we are working on a reasonable solution. I don’t want to rush anything, but I also don’t want you to go into your next exam without something in hand. Please let us know as soon as your next exam is scheduled so that we can help you prepare.

The Regulatory Mindset: The FDIC is scared. The deposit insurance fund is depleted, banks are failing faster than in previous economic contractions and Congress wants to know why the problems couldn’t have been averted. Where the FDIC once gave broad latitude to the OCC, OTS and state chartering agencies, now everyone else is expected to take a back seat to the almighty insurer. In the eyes of some field examiners (FDIC and others), anything abnormal is bad. If your bank is funded from nontraditional sources or invested in nontraditional assets, the presumption is that you have taken on excessive risk. Don’t let examiners make sweeping assumptions and penalize you for the way your bank is structured. Choose which battles are worth fighting, then stand up and defend your position. If the worst case is a 2 or 3 rating in liquidity and a composite 1 or 2, consider swallowing your medicine with a smile. If the concern might result in a composite 3 rating (and/or regulatory order) that you feel is undeserved, fight to the last man. You should know your bank better than someone who comes in for two weeks every 18 months. A disagreement, handled professionally, is an opportunity to show just how well you know how your bank behaves. We will be glad to join in your fight as appropriate, either on the front lines or behind the scenes.

US vs. THEM

In case you haven’t noticed, the financial markets don’t care much for our current administration’s handling of the economy. Now, it appears that the government may have a larger role in running the ‘too big to fail’ banks.

While a few in the media have noticed that there is a wide gulf between the events occurring in the money center banks and the community banking world, the average American has no concept of how different WE are from THEM. Most media articles talk about “banks” without differentiating between mortgage banks, investment banks, large commercial banks and community banks.

For years, community bankers have operated under the radar -- invisible to Washington, invisible to Wall Street and invisible to many consumers. Let me repeat for emphasis: invisible to many consumers. While small town America knows their local banker (he’s the only game in town), the typical man on the street in most metropolitan areas knows only Chase, Capital One, Regions or the other megabank with branches on every corner.

This environment provides a once-in-a-banking-lifetime opportunity to change that. As a champion of community banking, I challenge each community banker within reach of this post to step up and introduce yourself to your community in one or more of the following ways:

1. Help them to understand how we got in this mess. Generally, the media is doing a terrible job of communicating the whole story; instead, stories lurch from one lurid headline to another without any attempt to gain perspective or understanding.

2. Tell them your bank’s story (how you aren’t like Citi, who controls the decisions in your bank, who your board members are). Help people see the difference between US and THEM.

3. Offer assistance. Some of your neighbors are feeling direct or indirect economic pain. Others fear that they are next. As community bankers, we should help those who are financially wounded but not unsalvageable. Keep in mind that some of your own shareholders and employees may be in need of help.

4. Don’t stay in the foxhole too long. While lending to anyone who walks in the door isn’t usually a good idea (that’s why you aren’t in the trouble some banks are in), you should not draw back in fear and exacerbate the problem. Most of you have money to lend and no other attractive investment options. Find people who meet the 5 C’s of Credit and then do what you do best: lend money.

5. Make your customers, old and new, your marketing force. Tell them your story (see #1 & 2 above) and ask them to repeat it. Take such good care of them (see #3 and 4) that they can’t help but repeat what has become THEIR story about YOU.

Another thought: If your employees aren’t already your biggest fans and best marketing force, address that problem immediately.

If you would like help presenting your story to your board, your employees or your community, we can help. Send me an email and I’ll share some thoughts on how it can be done.