- Stress Testing: Understanding Your Loan Portfolio
- Welcome David Munn to the B&V Team
- Basel III – Are regulatory capital increases coming soon?
- Upcoming Liquidity & Interest Rate Disclosure
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By: David Munn
Business Advisory Services Director
The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) is considered by many analysts to be the most comprehensive financial regulatory reform measure taken since the great depression. That is a considerable statement if you consider that the Garn-St. Germain Act of 1982 deregulated the mortgage industry which may have precipitated the crisis that Dodd-Frank is trying to prevent from recurring.
By most measures, Dodd-Frank is a complicated piece of legislation. While pundits will argue that it targets only the largest financial institutions, many community bankers are not readily convinced. Whether it is the rules affecting mortgages, the “agenda” being offered by the newly established Consumer Financial Protection Bureau or that the rules being drafted to accompany the law will eventually trickle down to community banks – community bankers feel that there is much about Dodd-Frank to be concerned about.
The FDIC is responsible for implementing a number of initiatives under the Dodd-Frank Act. Within the Act are the parameters dealing with stress testing. Dodd-Frank provides that banks over $10 billion will be required to conduct annual stress tests. Since adoption, the various Federal regulators have been working to adopt consistent “stress test” parameters including a uniform definition. That definition was finalized when the FDIC released its Summer 2012 edition of Supervisory Insights. By definition, “Stress testing is a forward-looking quantitative evaluation of stress scenarios that could impact a banking institution’s financial condition and
capital adequacy”. The publication goes on to say that stress testing expectations for the institutions in excess of $10 billion are not required for community banks. So what do the regulators expect of banks less than $10 billion?
In a statement released jointly by three Federal regulators on May 14, 2012 , the statement reiterated that community banks are not required to conduct the types of stress testing directed at larger institutions.
However, “the agencies continue to emphasize that all banking organizations, regardless of size, should have the capacity to analyze the potential impact of adverse outcomes…”. Read – all banks should incorporate stress testing.
Stress testing is not new and does not have to be complicated. However, it does require a more familiar understanding of your loan portfolio. The Department of Banking has been stress testing loan portfolios for over ten years as part of the examination process. Essentially there are two methods for stress testing loan portfolios. I refer to them as Macroeconomic and Microeconomic methods.
Stress testing on a Macroeconomic scale occurs when risk assessments are based upon assumptions about potential adverse external events that could adversely affect entire portfolios. Examples include changing market conditions or a sudden and dramatic increase in interest rates. Free markets change continually, so for testing purposes the key word is “stress”. What would severe and extended drought conditions mean to farmers & ranchers? What would $40 oil for an extended time frame mean to the numerous oil field support service firms? What would happen to the East Texas poultry industry if a natural disaster wreaked havoc over an extended time frame? These are examples of market changes that can devastate select loan portfolios.
Stress testing a credit portfolio on a microeconomic basis means subjecting individual credits to extreme conditions. The risk factors employed can be unique to the borrower or they can be unique to the area. Factors again can include changes in interest rate and changes in market conditions. An extended drought will have a direct impact on a bank’s farming customers, but it will also have an indirect effect on other businesses in the community. But on a microeconomic level we are in a better position to understand customers and their ability to adapt. Do they have the capital, liquidity, experience and customer diversification to withstand calamity and, if so, for how long?
Stress testing, if done properly and adequately, is nothing more than information or an informative tool. Texas bankers went through stressful times from the mid-1980’s to the early 1990’s. Texas bankers, those that survived, emerged stronger and wiser and now the Texas economy is the envy of most states. If some of the banks that didn’t survive would have had a better understanding of their loan portfolios would they be around today? I don’t know, but it’s safe to say if they had known what was coming they would have reacted differently.
David Munn is Briggs & Veselka Co.’s Business Advisory Services Director. We would like to welcome David to the team and provide you with information on his expansive professional background.
David had over 28 years of continuing service with the Texas Department of Banking. During his career, David assumed an escalating degree of responsibility in the examination of state chartered or licensed financial institutions including commercial banks, trust companies, foreign bank agencies and money service businesses. As a result, David has an excellent understanding of bank operations, credit administration and the unique rules and regulations made applicable to these institutions.
Throughout his career with the Banking Department, David served as a Senior Bank Examiner and was responsible for directing the examination of state chartered financial institutions. He has a thorough background in evaluating the condition of institutions
through assessing capital, asset quality, earnings, liquidity, sensitivity to market risk and all aspects of management.
David’s professional career includes:
• Participating in over 550 examinations of institutions ranging in size from small community banks to regional banks with assets in excess of $60 billion.
• Serving as Examiner In Charge of over 125 examinations of smaller community banks to larger regional institutions with assets in excess of $10 billion.
• Working independently, or with federal law enforcement officers, in performing approximately 100 bank fraud investigations resulting in numerous convictions or Prohibition Orders issued by the Banking Commissioner.
David graduated from Texas State University in San Marcos with a Bachelor’s Degree in Business Administration. He also graduated from the Colorado School of Banking in Boulder, Colorado. He is a member of the Association of Certified Fraud Examiners.
If you would like to contact David Munn, you can reach him at DMunn@bvccpa.com or by calling 713.667.9147.
By: Dan St. Clair, CPA
Over the past few months the most frequently asked questions at Board and Audit Committee meetings have been about Basil III. There appears to be a great deal of uncertainty related to this new guidance and how it will affect Community Banking. What appears clear is, whether through Basil III or other means, there has been steady pressure to increase the level of regulatory capital required for financial institutions. The underlying goals of Basel III include strengthening the quality of regulatory capital, improving loss-absorbance safeguards and enhancing banks’ ability to continue functioning as financial intermediaries, especially during periods of financial stress.
Key changes noted in the new guidance include an increase in Tier 1 capital ratio from the current 4.0% level
up to 6.0%, with a new “Common equity Tier 1 capital ratio.” This new ratio, proposed at 4.5%, would exclude non-cumulative perpetual preferred stock which currently qualifies as tier 1 capital. Also new are Capital Conservation Buffers that would need to be maintained to avoid restrictions on capital distributions and certain discretionary bonus payments.
Perhaps the most significant changes relate to risk-weighted assets, as the guidance will introduce more sensitive treatment on multiple credit exposures. There are new or increased risk weights proposed related to exposure to foreign sectors, residential mortgages, volatile commercial real estate such as development or construction, past due exposures and several other areas.
For example, 1-4 Residential Mortgages are currently set as a 50% risk weighting. Under Basil III, the risk weighting can range from 35% to 200% depending on several factors. The new guidance provides for two categories of 1-4 family loans. Characteristics for a category 1 loan would include terms not to exceed 30 years, fully amortizing loans with no balloon payment and not more than 90 days past due, with all loans not meeting these criteria being classified as category 2 loans. Within both categories, the risk weighting will range based on initial loan-to-value (LTV) with category 1 from 35% to 100% and category 2 from 100% to 200%. It is important to note that these risk percentages are based on initial LTV, which means the banks must now store information on the original loan-to-value and that the risk weightings will not decrease as the risk of loss decreases with improved LTV.
The Basel Committee on Baking Supervision published the Basel III proposal in December 2009 and noted that banking organizations “will need to hold more capital to meet the new minimum requirements.” The Federal Reserve has proposed applying this regulation to all U.S. banks and would phase in beginning January 2013. This proposal was open for comments until September 7, 2012, which was extended until October 22, 2012, and we now wait for any updates related to consideration of those comments. Due to the significant response from the public and industry sectors during the comment period, it is expected that the Federal Reserve will take another look at the situation to make any changes in the rules less complicated. Look for additional information on the effects of Basil III coming soon. Whether adopted or not it appears very clear that regulatory capital increases are coming soon.
By: Travis Williams
The Financial Accounting Standards Board (FASB) has proposed the Accounting Standard Update (ASU), Disclosures about Liquidity Risk and Interest Rate Risk, as there is a strong demand by users of financial statements for improved disclosures in the liquidity risk and interest rate risk disclosure. This is follow-up to the ASU No. 2010-20 issued in July 2010 which addressed the credit risk disclosures. The ASU was issued in June 2012 with a focus on improving disclosures around liquidity and interest rate risk. This ASU is open for comments and all comments for this proposed ASU are due by September 25, 2012. The following is a brief overview of the ASU:
The liquidity disclosures, which will apply to all entities, will provide information about the risks that the reporting entity will encounter difficulty when meeting its financial obligations. For this disclosure the following is required:
1. Liquidity Gap Maturity Analysis – This will disclose the expected maturities of financials assets and liabilities.
2. Available Liquid Funds – This will disclose all available liquid funds.
3. Issuance of time deposits (for depositary institution) – This will disclose the cost of funding from the issuance of time deposits and acquisition of brokered deposits.
Interest Rate Risk Disclosures
The interest rate risk disclosures, which will apply to only financial institutions, will provide information about the reporting entity’s exposure to fluctuations in market interest rates on its financial assets and liabilities. For this disclosure the following is required:
1. Repricing Gap Analysis – This will disclose disaggregated classes of assets and liabilities based on the repricing dates of classes of financial instruments.
2. Sensitivity Analysis – This will disclose the interest rate sensitivity that presents the effects of hypothetical, instantaneous interest rate changes on earnings and equity.
The proposed ASU brings the convergence of US GAAP closer to International Financial Reporting Standards (IFRS). The proposed ASU does not have an effective date; it will however be effective as of the beginning of the period of adoption. The ASU also has illustrative disclosures and tables for the required information. We suggest discussing the update with your third party vendors in order to have these disclosures ready as of the financial statement date. A copy of the exposure draft can be found on the FASB’s website.
For more information on how Briggs & Veselka Co. can be of assistance, please contact us directly. For accounting assistance, contact Dan St. Clair or Travis Williams. For internal controls, compliance and regulatory assistance, contact David Phelps or Terry Sherrill. For loan review and portfolio stress testing, contact David Munn. All can be reached at 713.667.9147.