THE ROLE OF DIRECTORS THE ROLE OF DIRECTORS IN RISK MANAGEMENTIN RISK MANAGEMENT

Directors’ ForumDirectors’ ForumMaine Association of Maine Association of

Community BanksCommunity Banks

November 28, 2007November 28, 2007

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Jim Clarke, Ph.D.610-688-9466

jjclarke2@aol.com Jim teaches asset/liability management in the Graduate School of

Banking sponsored by America’s Community Bankers. He is responsible for much of Americas’ Community Bankers ALM education. He also conducts ALM seminars for the Financial Management Society, [FMS], Risk Management Association (RMA), and other national associations.

Jim conducts seminars on ALM for both state banking associations and individual banks. He annually conducts a “Current Issues in ALM” seminar for state bankers associations throughout the Midwest, central Atlantic states & New England.

Dr. Clarke is a frequent speaker at banking conventions on both ALM and strategic issues. Jim has written extensively in the area of ALM and bank strategies.

Jim has a B.A. in Economics from LaSalle College and a Ph.D. in Economics from the University of Notre Dame. He is a former faculty member in the Finance Department at Villanova University. He sits on the board of two community banks and an investment company.

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The Board’s Role should start with a strong ALCO tradition!

ALCO Process – The Role of the Board ALCO Process – Stay Disciplined ALCO Process – Liquidity & Interest Rate

Risk ALCO Process – The Agenda Critical Information for Decision Making Apply Techniques to Current Environment It has been a tough year – be patient!

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ALCO Process – Start with the Role of Board

Senior Management’s Role

Daily decision making managing assets & liabilities

Managing risk on an ongoing basis

Board’s Role Establishing policy – we review a new one every

meeting.

setting risk limits Monitoring risk

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Good ALCO Tradition Lay out a meeting agenda – this forces

discipline into the meeting! Stay with the agenda each meeting –

this will re-enforce the important issues! The chair must maintain enforcement of

agenda and a sensible time frame for the meeting!

Make sure the meeting addresses the critical issues – asset funding or cash allocation!

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Making ALM Decisions Based on Critical Data

1. What is the interest rate forecast? There is plenty of free information.

2. What is the bank’s liquidity position? Requires a cash

flow pro forma! Do you need cash, if not why play the aggressive deposit pricing game – there are times when you should consider shrinking the bank [2007].

3. What is the bank’s interest rate risk exposure? Is the bank asset or liability sensitive?

Now we are ready to make decisions- Deploying cash – Now we are ready to make decisions- Deploying cash – 2002 to 2004, and funding assets – 2005 & 2006! 2002 to 2004, and funding assets – 2005 & 2006!

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ALCO Meeting Agenda Interest rate forecast! National & local business conditions-you

make loans! Cash flow pro forma – what is my liquidity? Interest rate risk report – know your

sensitivity! Decision making – What Theory tells us? Managing Assets through the 1st quarter

2007 Managing Liabilities through the 1st quarter

2007

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The May 2007 Yield Curve Exemplifies the Toughest Environment:

The worst of all possible worlds for Banks[Almost – 1979 to 1981 was the worst]

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Market Interest Rates – The Current Yield Curve

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Current Versus Recent High

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Yield Curve Versus Recent Low

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The last eight years have been a clinic for the ALCO!

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

Highest (3/13/00) Today (11/01/07) Lowest (6/13/03) Mean

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This is the August futures market forecast before sub prime crisis was understood!

Fed Funds Futures

4.75

4.88

5.00

5.13

5.25

5.38

AUG 07 SEP 07 OCT07

NOV 07 DEC 07 JAN 08 FEB 08 MAR08

Contract

Rat

eRate Target Prev Close

8/9/07 10:34 AM

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Critical Data: November ViewString of rate cuts ahead - 4.00% by

May

Fed Fund Futures

4.000

4.250

4.500

4.750

5.000N

ov-

07

Dec

-07

Jan

-08

Feb

-08

Mar

-08

Ap

r-08

Source: Bloomberg L.P.

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Interest Rate Summary Interest rates are a critical variable in bank

asset/liability management! We need to establish a forecast for rates at

the ALCO meeting._________________________________If you expect rates to rise: shorten assets and lengthen liabilitiesIf you expect rates to fall: Lengthen assets and shorten liabilities

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Financial Risk and CAMELS Ratings

Credit Risk – A in CAMELS Interest Rate Risk – S in CAMELS Embedded Option Risk – S in CAMELS Market Risk – S in CAMELS Marketability Risk – L in CAMELS Liquidity Risk – L in CAMELS Currency Risk - S in CAMELS

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Capital Risk – “C” in CAMELS

MetricRegulatio

nWell

Capitalized Your Bank[Optimal]

Tier 1 Risk Based

Capital (RBC)4.00% 6.00%

Total RBC8.00% 10.00%

Tier 1 Leverage Ratio 4.00% 5.00%

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Why do we see capital ratios erode?

Loan problems Non performing become write offs!

Rapid balance sheet growth Typical for large mortgage originators

A leverage transaction gone bad – usually occurs because interest rate environment changes!

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Asset Quality – “A” in CAMELS

Diversifying risk – increase portfolio size and risk will decrease.

Bank Loan Portfolio is the primary source of credit risk.

How feasible to diversify: Residential Mortgage Portfolio HELOC Commercial Real Estate

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Monitoring Credit Risk – Note that Thrifts and Commercial Banks will have different

standards!

Metric Comment

Losses/Loans [0.3% to 0.10%]

Non Current/Loans [0.40% to 0.70%]

Allowances/Loans [0.70% to 1.25%]

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Asset Quality-Loan Portfolio is the Key

Loan Category % of Bank’s Loan Portfolio

Comment

Construction Loans

5% to 25% Portfolio concentration Geographic concentration% of equity

1-4 Family RML 25% to 85% Loan to valueGeographic concentration New Products – IO & negative amortizing ARMs

HELOC 5% to 15% % of equity Sub Prime

Commercial Real Estate Loans

15% to 45% Diversification Underwriting

Commercial & Industrial Loans

2% to 18% Non real estate collateral Monitoring is critical

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Liquidity Risk – the “L” in CAMELS

Metric Comment[Mature Bank]

Loan/Asset or Loan/Deposit

50% to 85%75% to 110%

Net Non Core Dependence

Depends on bank size – but increasing across all peer

groups!

Short-Term Non Core

Dependence

Good correlation to interest rate risk

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Interest Rate Risk – “S” in CAMELS

Define: The impact on the Bank’s financial statements from a change in market interest rates:

Income Statement Impact on Net Interest Margin

Balance Sheet Impact on Market Value Capital

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Types of Interest Rate Risk Re-pricing Risk (Gap Analysis) Basis Risk (Different between indexes) Yield Curve Risk (How does the yield

curve shift?) Market or Price Risk (Market value

capital) Option Risk (Call, Prepayment, Caps)

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Impact on Financial Statements

Income Statement

NIM = II/AA – IE/AA

Balance Sheet

Asset – Liabilities = Capital

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Income Statement ImpactRates

IncreaseRates

Decrease

AssetSensitiv

e

Margin increases

Margin decreases

LiabilitySensitiv

e

Margin decreases

Margin increases

Asset Sensitivity – Assets respond more to a change in rates than liabilities.

Liability Sensitivity – Liabilities respond more to a change in rates than assets.

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How do we measure interest rate risk? Gap Analysis – Gap is determined from the

balance sheet and measures the impact on the income statement. This is a traditional measure many banks use to measure IRR.

Simulation Analysis – Models each asset & liability as to the impact from a change in interest rates. Allows for a simulation of both the balance and income statement from a rise and fall in rates.

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Regulator expects Board to set limits on IRR.

Change in Rates Change in NII or Margin

Change in MV Capital

+200 bps

+100 bps

base case

-100 bps

-200 bps

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Board’s Role in Monitoring Risk

Monitor periodically – Quarter is routine, but more often if problems arise!

Review similar data when monitoring!

Don’t wait for an elephant to walk by – at that point it is too late!

Look for recurring variation – ask for explanation!