Commercial Banking - Balance Sheet Management PDF

Commerci al Banking Module 2 Balance Sheet Management The Balance Sheet - Loans The primary earning asset of any bank is its loan portfolio Lending is an essential function of commercial banking Credit is the lifeblood of our economy with banks being the primary provider A bank safeguards cli...

Commerci al Banking Module 2 Balance Sheet Management The Balance Sheet - Loans The primary earning asset of any bank is its loan portfolio Lending is an essential function of commercial banking Credit is the lifeblood of our economy with banks being the primary provider A bank safeguards client deposits and uses these deposits to lend. Through lending, bank management satisfies the legitimate credit needs of the community and credit market it serves Bankers are an integral part of the community in which they serve and banking as a career allows those with the desire to help and serve experience a career that is meaningful and rewarding Bankers play a vital role by seeking out and assisting individuals and companies which in turn plays an important part in overall economic growth. Without bankers that are committed to the mission of sourcing and decisioning appropriate opportunities, resources would be wasted. Bank loans contribute materially to the bank’s profitability by providing higher returns than most of bank assets such as investments. Serving the credit needs of its service area is a fundamental obligation of a commercial  As goes higher return, loans carry a higher level of risk. There is The always a need for risk- reward balance approach. Balance Good bankers are good listeners and are consultive and trusted advisors. They take the time to understand the needs of a client and offer solutions which in turn enables the bank to generate fees and interest income for the value they add Sheet- Due to the nominal spreads due to interest rate environment today, a bank has to get its money back Loans If a bank charges off $1M loan, this eats up capital. A $1M reduction in capital prevents the bank from making $10M of loans to customers assuming a 10% capital ratio. Another way to look at it from the income perspective is a $1M loan loss at today’s spreads, the bank needs $33M in new loans to cover that loss. There are three primary risks involved with the loan portfolio, credit risk, pricing risk and liquidity risk. The credit risk isn’t always just likelihood of loss each year. Risk can be masked by favorable economic conditions for several years until an event driven event causes losses. When making a loan, the bank must engage in the 5 CS of credit when gauging creditworthiness. Character, capacity, capital, collateral and conditions.  Types of loans include Commercial loans which include revolving lines of credit, asset based revolving loans and term loans. In addition, a commercial bank makes The consumer loans which includes personal lines of credit, automobile loans and mortgage Other loans types of commercial lending include Balance Standby and Commercial letters of credit, leases, factoring and Asset Backed loans. Sheet- Loans Commercial loans are made for a variety of purposes. Working capital needs, the purchase of fixed assets such as fleets or equipment, loans for acquisition of companies and nonproductive uses such as dividend recap and repayment of shareholder loans  In majority of cases, a commercial bank is secured by the assets The of the company although there are larger companies that might qualify for unsecured loans. Generally, banks tie the collateral to the purpose of the loan proceeds. Balance However, in the case of acquisition of a company, many times the borrower is paying the seller for intangible value of the company based upon an earnings multiple so there is not always collateral coverage. This is referred to as airballs. In many cases, these Sheet- loans are more challenging due to lack of asset coverage as well as integration risks. Loans In the acquisition space, many times the companies will have a leverage debt profile that denotes it as leveraged lending and/or enterprise value from a regulatory perspective which carries higher risk. The regulatory definitions and regulations are complex and require tracking and reporting and many banks avoid this space all together. Be definition leverage lending would include debt profiles that are leveraged greater than 3x senior debt/EBITDA or 4x total debt/EBITDA. Enterprise Value then comes into play when there isn’t sufficient collateral coverage in addition to a leverage profile. Many community banks do not offer this type of lending as it is if not structured properly it carries a higher risk profile in some cases. It is good though to have a general understanding of the terminology  Critical to any bank is the formulation and implementation of a sound credit policy that is designed to address the risk framework that has been set out the Bank’s Board of Director and Executive Management. The loan policy is part of the overall risk management strategy that the Bank develops that appropriately defines the risk appetite for not only loans but other areas of risk management. Most people think of the loan policy first when The discussing risk because the loan portfolio is considered the most critical risk element that the bank manages. Other types of risk will be discussed within the course, but we will focus on risk management as we discuss loans. An appropriate Balance policy should align desirable structures that meet the risk appetite. In addition, the policy should be fluid to respond to the changing economic pressure within an economy while aligning with the acceptable risk tolerance of the Bank. Sheet- In addition, Banks not only formulate and implement a sound loan policy but also concentration policies that outline the risk to certain asset classes the bank is willing to take. Most limits are set as a percentage of risk-based capital but that can vary bank to bank. Loans Most banks have triggers and limits in order to ensure the bank’s strategic objectives are being maintained in alignment with this risk appetite. Two critical ingredients of sound risk management are (KRIS) or (KPIS) Key performance indicators or key risk indicators. KRIS are predictive in nature while KPIS are trailing or lagging indicators meaning you are looking at something that has already occurred. These are monitored monthly and or quarterly. Triggers identify when a tolerance level is being approached that could be a potential limit violation if not addressed.  Credit Dashboard/ Triggers (KPIs) 6 Qtr. 6RAF 6Qtr. Qtr. RAF RAFStatusStatus Status CCredit Credit redit AsAs As ofof Currentvs. of Current vs. Current vs. TriggerTrigger Trigger and and and Appetite Appetite Appetite 66 6 Qtr. Qtr. Qtr. Trend Trend Trend CurrentCurrentTrigger Current TriggerAppetite Trigger Appetite Appetite Cla Classified Cla ssified ssified Assets Assets Assets / //(T(Tier (T ier ier 11CaCa 1 pita pita l ACL +ACL Capital l+ ) ) + ACL) Mar-18 ##.#% MMM-YY Mar-18 16.1% 16.1% ##.0% 35.0%35.0%##.0%50.0%50.0% 11Yea 1 YearYea rVinta Vinta rVintage ge geDD elinquency Delinquency elinquency (Consumer) (Consumer) (Consumer) MMM-YY Mar-18 0.7% 0.7% Mar-18 0.#% #.0%2.0%2.0% #.0% 3.0%3.0% 2.32667 2.32667 CreditConcentra Credit Credit Concentra Concentrations tions tions (%(% (%ofofRBC) ofRBC) RBC) CRE CRE CRE (excl.Owner (excl. (excl. OwnerOccupied) Owner Occupied) Occupied) Mar-18 MMM-YY 184.5% 184.5% Mar-18 ###.#% - - - ###.0% 225.0% 225.0% Construction Constructionand Construction and and AA&& ADD& D Mar-18 MMM-YY 60.6% 60.6% Mar-18 ##.#.% - - 70.0% - ##.0% 70.0% Oil Oiland andGas Mar-18 52.8% Mar-18 ##.#%52.8% Oil and Gas Gas MMM-YY - - 70.0% - ##.0% 70.0% 1.14286 1.14286Loa n Growth LoanGrowth Loan Growth (YOY (YOY (YOY Commitments) Commitments) Commitments) C&I 6.3%6.3% C&ITotal C&I Total Total Mar-18 Mar-18 #.#% MMM-YY 10.0% ##.0% 10.0% - - - C&I 8.7%8.7% C&IOwner C&I OwnerOccupied Owner Occupied Occupied - gr - gr Mar-18 Mar-18 #.#% MMM-YY 10.0% ##.% 10.0% - - - CRE 3.3%3.3% CRETotal CRE Total - -grgr Total Mar-18 Mar-18 ##.#% MMM-YY 10.0% ##.0% 10.0% - - - CRE Commercial 0.8%0.8% CRE CommercialMini CRECommercial Mini / Term Mini/ Term / Term Mar-18 Mar-18 ##.#% MMM-YY 10.0% ##.0%10.0% - - - CRE Commercial Construction - gr Mar-18 12.7% 12.7% 10.0% - CRECRE Commercial Construction Commercial Construction - gr Mar-18 ##.#% MMM-YY ##.0%10.0% - - CRE Land A&D - gr Mar-18 -6.0% -6.0% 10.0% - CRE Land CRE LandA&D A&D - gr Mar-18 -#.#% MMM-YY ##.0%10.0% - - Consumer 8.5% ConsumerTotal Consumer Total Total Mar-18 Mar-18 #.#% MMM-YY 8.5% 10.0% ##.0% 10.0% - - - Gross Cha rg e-Off Ra 0.3% GrossCharge-Off Gross Charge-Off Rtio atioRatio Mar-18 Mar-18 #.#% MMM-YY 0.3% 1.0% 2.5% #.0% 1.0% #.#% 2.5% PD D owng ra de R atio (6mm onths) new Mar-18 5.0%5.0% 7.0%7.0% ##.0% 12.0% PDDowngrade RRatio PD Downgrade atio (6 onths) (6 new months) Mar-18 #.0% MMM-YY #.0% 12.0% 6Qtr. RAF RAF 6 Qtr. Status Status Interest InterestRate Rate&&Market Market As of As of Current Current vs. Trigger and Appetite 6Qtr. Trend vs. Trigger and Appetite 6 Qtr. Trend Current Current Trigger Trigger Appetite Appetite  A key factor that is indicative of a bank’s performance is its credit quality. The bank uses a grading system unique to its policy that identified the quality of each loan. This grading of loans factors in the bank’s Allowance for Loan Losses. Most banks have a grading system within pass and non pass loans. Non pass loans should be fairly consistent within banks as the regulatory agencies have specific The definitions for a special mention, substandard or doubtful loan. However, the risk grade systems at most bank have a subjective component that relies on the first line of defense to adequately grade loans. balance The Second line of defense which is generally a credit risk management role will normally validate or participate in the final grading discussion. The third line of defense would be a loan review, auditor or regulator that generally has authority to overturn a grade. Sheet- The regulatory agencies use consistent terminology around Special Mention, Substandard, Doubtful and Loss Loan as it relates to risk grading. These terms are used with analyzing a bank’s qualitative and quantitative reserve for loan losses. When reviewing a bank’s performance, you will see one of the first areas of interest to bank Loans analysts would be the trend in their credit quality either positively or negatively. The loan grading and credit quality is the area that has the most impact to the Bank’s income statement because it is used in order to set an adequate loan loss reserve. The bank uses various methodology to establish the reserve which can impact earnings positively or negatively. When the economy hits difficult conditions some borrowers default and the banks are forced to charge off non- performing loans. These charge-offs are charged against the reserve.  The Balance Sheet-Loans In managing loan risk as mentioned, the governance is set out by its policies. Loan Policy-Lending Bible Concentration Policy-Used to manage your risk profile of the bank Allowance of Loan and Lease Policy- sets out the reserve methodology the bank will use to set the appropriate reserve as it relates to its’ credit quality  As discussed earlier, loans have the ability to impact the income statement of the bank and are the primary source of interest income in most cases. Another source of interest income is investment income. Loan interest + investment income = interest income Interest income less interest expense is considered net interest The income and is the primary source of income for commercial banks. You will also hear it referred to as Net Interest margin when discussing the percentage. (Interest Income-Interest Expense/Total Earning Assets) This is different than the interest Balance Rate Spread which is the average rate earned on earnings assets (Tax Eq) and the average rate paid on deposits) Pricing of loans and managing the interest rate risk is critical in Sheet- managing a commercial bank. This is where the pricing risk comes into play. A bank must manage the pricing risk by offering variable and fixed rates loans. Loans Because the bank loans out its deposits it has to balance the cost of the deposits (cost of funds) with the pricing structure the bank enjoys. If a bank is borrowing money to fund loans this would impact the cost of funds. This is managed through asset liability management and will be discussed more in detail. In summary, cost of funds is deposit cost plus any borrowed funds. One other ratio you will hear in banking terminology, Is loan to deposit ratio. This means what percentage of deposits has the bank deployed in loans.  Another way loans have the ability to impact the income statement is provision expense in order to build the loan loss reserve or the Allowance for Credit Losses or sometimes referred to as (ACL) or loan loss reserve. The ACL is a valuation allowance that is used to absorb probable credit losses. The The ACL is increased in a period of declining credit quality by a provision expense that flows through the income statement. When there a need to release reserves, that Balance release flows back into the income statement increasing income. Generally, the need for increases is driven when the grading Sheet- deteriorates, or true losses (charge-offs) have been recognized by the bank. Bank management has only indirect control over the reserves. They are affected by Loans credit quality and the economy. Management must set reserves with repeatable methodology and justifiable to its board, auditors and regulators In comparison to charge-offs, the bank can recover a loss at a later date and that is referred to as a recovery. You will see a bank discuss the net charge-offs which is Gross Charge-Offs net of all recoveries. The Balance Sheet- Loans The attached reconciliation shows the period changes to the Allowance for Loan Losses period to period. Provision will add to the allowance and a (provision/release) subtracts from the Allowance. Net Charge offs decrease the allowance/reserve while net recoveries increase the allowance/reserve Provision expense is an expense to the bank while a reserve/allowance release shows up in the income statement as revenue.  The second largest earning asset on a banks balance sheet is their investment portfolio. As a general rule, investment securities are part of a bank’s asset liability and liquidity management strategies. The Balance When the loan demand slows, investments are normally purchased in order to continue to earn interest income although in most instances it is a lower return. However, the investments are normally employed Sheet- within a strategy to maintain liquidity that allows the bank to access them and convert them to loans in a period of increasing loan demand. Investme The bank manages to an investment policy for both safety as well as nts interest rate risk (duration and volatility). While considering the asset liability mix, the bank must also invest with liquidity in mind. This includes duration and quality of the investments that will allow them the ability to utilize them to create liquidity if need be. Any example of this would be using a securities portfolio to pledge with the Federal Reserve or Federal Home Loan Bank to borrower for liquidity or to access fixed rate money. In this latter example, the bank might borrow long term to arbitrage portion of its cost of funds in order to offer longer term fixed rate loans.  Most Banks investment policy is heavily weighted to investment grade securities such as treasuries and agency securities. These would include primarily Ginnie Mae, Federal The Home Loan Bank, Freddie Mac, Farmer Mac Fannie Mae other mortgage-backed Securities. Balance Other investments types would include municipal bonds. Sheet- Other factors that play into an investment policy would be regulatory requirements, risk appetite, lending needs, tax laws, liquidity Investme needs and investment yields. The policy should be fluid and allow for changes nts in the economic environment as the demand for loans rise. If you don’t manage the liquidity while balancing loans and investment mix, the bank will sacrifice profitability. However, during economic downturns, volatility of stocks and bonds can result in losses to a bank. The Balance Sheet-Investments The primary goal of the bank's investment portfolio is to obtain the maximum income with the minimum exposure to risk. Banks are in the risk business, and all must have to assume some level. That level of risk is set out by the Bank’s Board of Directors along and Executive Management with approved risk appetite framework. Maximum income does not simply mean purchasing investment with the highest yields but take into consideration, default risk, the interest rate risk, duration and the liquidity in a secondary market. Lastly, the tax considerations and any pledging ability of the investments should be considered. The Balance Sheet-Investments Investment risk must be considered when purchasing investments and evaluated in conjunction with the overall risk-based capital impact. Inflation effects must also be considered. Banks can classify investments as held for trading, available for sale or hold to maturity. For Held for trading portfolios, unrealized gains and losses impact the income statement. Available for sale, unrealized losses hit accumulated other comprehensive income in the equity section of the balance sheet. Hold to maturity unrealized losses are only footnoted but have no financial impact unless sold. However, there is default risk on investments like it is with loans and this was the reason for many problems in the Great Recession. The bank invested in credit default swaps that were not the quality they assumed when purchasing as they relied heavily on the rating agencies and did not fully understand the underlying risk they were assuming in their investment decisions. The Balance Sheet- Investments The primary impacts of the investment portfolio on the income statement is the realization of interest income or capital gains. From an expense standpoint, the investment portfolio could result in expense if an investment is sold at a market loss, or the investment is held for trading account and has to be marked to market. If a sound investment strategy is not utilized in conjunction with the bank’s liquidity or pricing needs, the investment portfolio can have negative impact to the performance of the bank. Investments can incur default risk The Balance Sheet –Cash and Other Assets BANKS ARE AT THE CORE OF THE CASH IS A NON- PAYMENT SYSTEM EARNING ASSET, SO AND PROVIDE BANKS HOLD THIS AT INDIVIDUALS AND A MINIMUM. BUSINESSES WITH CURRENCY AND COINS. OTHER ASSETS WOULD INCLUDE BRANCHES AND EQUIPMENT AND OTHER MISCELLANEOUS ASSETS. The Balance Sheet-Deposits Deposits as mentioned are the Banks work in tandem with bank’s primary funding Deposit accounts offered by With the two primary earnings other banks for the clearing sources and the relationships commercial banks are vitally assets discussed, deposits are and processing of checks and deposits share with these necessary to facilitate the the largest form of liabilities other financial intermediaries earnings assets is critical to payment system for goods for a bank. to facilitate financials the asset liability and services in our economy. transactions. management of the bank. An advantage of commercial banks is they offer FDIC Deposits carry a myriad of Attracting deposits as a low- insurance for the safety and risks including pricing, cost funding vehicle and the soundness of clients up to duration, liquidity as well as growth and changing defined limits of $250,000 per the operational risk from composition of deposits is depositor. There are ways to fraudulent deposits or critical to management of any increase this limit by the type negotiating of checks and wire commercial bank. of account but in general this transfers. $250,000 applies. The Balance Sheet-Deposits The risk of loss with deposits is primarily in the areas of fraud. You can have fraud on the funds being deposited as well as negotiating items for payment in the form of checks or wire transfers. In today’s cyber world these risks have been exasperated. In regard to funds deposited, the risk falls into primarily the risk around our deposits or having good funds. Many times, a client will deposit an item that is not good funds knowingly or unknowingly to the client. The client that gave them the items to be deposited can have done so with insufficient funds so the deposit can be returned to the bank as insufficient. (Hot check). In this instance our client might be unaware and, in the meantime, issue a check to a third party. This is referred to as a return item (to the client). Most banks have internal procedures to issue immediate credit or place a hold based upon knowing he client. Consideration would be made to the length of time this time has banked there as well as performance of their account including average deposits balances. Is the deposit typical of this client? Do they have funds on cover the deposits of funds were not collected ? What is the safety of the deposit? Today, there are a number of ways fraud could factor into the negotiating of items outgoing. There is check fraud and wire fraud The Balance Sheet-Deposits Check Fraud is when a check or the account information is stolen or altered. The Banking client did not write the Check that was presented for payment. There are time limits which will determine who bears the risk of loss, the bank or the client Electronic (wire or ACH) Fraud is even more prevalent with the access to technology. Fraudsters can intercept emails and present themselves as a client and wire the money out fraudulently. It is imperative a bank establish wire procedures that involve verification and authentication of transactions and clients are responsible for due control before initiation of electronic transaction Losses a bank absorbs through these types of losses would appear in the in statement as operational losses which is a direct expense and could be impactful. This is a big focus of banks and regulators in the ever evolving cyber world. The Balance Sheet –Deposits There are different types of Checking- may be withdrawn Savings No maturity but not deposits that a bank will have by check or transferred negotiable to a third-party on their balance sheet. without notice to the bank. payee. Earn interest but no Checking, Savings as well as They may or may not receive stated maturity. Certificate of Deposits interest Deposits are also considered unsecured or secured. Majority of deposits are Banks also accept a wide unsecured however for the range of deposit products and Certificate of Deposits Non- purpose of public funds, these investment products that are negotiable with a stated funds are required to be off balance sheet such as maturity and earns interest secured by collateral over and investment sweeps which above the FDIC limits. produce fee income Acceptable collateral is generally US Government Securities. The Balance Sheet- Equity Capital Capital is going to be discussed briefly as most important aspect of the balance sheet. Capital determines the ultimate strength of a bank. It is not necessarily a question of the more capital the better, vs how much capital is needed based upon the bank’s risk-based capital profile Simply put the balance sheet is assets-liabilities = equity Capital represented stockholder equity or ownership interest in the firm. Common Stock and preferred stock are carried at par. Retained earnings is a cumulative net income since inception minus any dividends. Banks capital requirements defined by regulators has a primary objective of ensuring the safety and soundness of a financial institution. In the 1990s risk-based capital concepts were introduced with the concept of capital requirements are to be commensurate with the bank’s asset quality, liquidity risk, operational risk and other risks. Capital Management will be discussed later at length, but we will discuss it briefly as a component of the bank’s balance sheet. Balance Sheet Manageme nt  Exhibit of Allowance for loan and lease lossesand Balance Sheet Allowance for loan and lease losses is a reserve (bucket we discussed) for future problem loan losses that is carried on the balance sheet as an offset to total loans. Total Loans-Reserve=Total Loans net of reserve Net Charge offs=Charge offsgreater than recoveriesfor the period Balance  Net Charge offs reduces the allowance/reserve (Balance Sheet) for loan losses Net Recoveries=Recoveriesgreater than charge offsfor the period Sheet  Net Recoveries increases the allowance/reserve (Balance Sheet) for loan losses. Manageme Net Charge Offsand/or net Recoveries by themselves only hit the Allowance/ reserve on the balance sheet and do not hit the income statement The impact of these however determinesif you need to add to your allowance nt to remain adequately reserved by takingprovision expense or you can release reserves into income dependingthe direction of your overall credit quality. Provision Expense/Release of reservesand Impact to Balance Sheet (Allowance/Reserve) and Income Statement Provision Expense Increases (addsto) the Allowance/Reserve (Balance Sheet) for loan losses but decreases revenue (Income Statement ) Release of reserves Reduces (takesfrom) the Allowance/Reserve (Balance Sheet) for loan losses but increases revenue (Income Statement ) A Bank can also do neither take expense or release reserves for the period if they believe their reserve to be adequate.