Risk Management Project.

Introduction During your Planning Using Institutional Risk (i.e. enterprise risk management–ERM) and Loan Portfolio Management classes at GSBC, you were exposed to different methodologies to identify and manage interest rate risk and credit risk in a bank and plan for contingency funding. This intersession assignment provides you with an opportunity to apply these concepts to your organization. After you complete the assignment, you will have a better understanding of the general value of a risk profile, the specific profile of your bank, and what your bank does to manage overall balance sheet risk and the credit risk in the bank’s loan portfolio. The intent is for you to combine the ERM activities with specific Credit Risk Management activities within your bank to help you make strategic decisions. Importantly, the final part of the assignment is to make recommendations along these lines.

Project Resources and Information Needed

To complete this project, you are expected to generate portions of an internal risk assessment of your institution. In particular, you are asked to assess risk associated with capital adequacy (C), asset quality (A), liquidity (L) and sensitivity to interest rate risk (S).

A. To assess your institution’s capital and liquidity risk profile, you may use your UBPR for the most recent quarter (plus trends) or other information generated by your ALCO or Risk Committee. To assess interest rate risk, you should use one or more of the bank’s internally-generated, or third-party provided, shock reports, such as the earnings sensitivity analysis (earnings at risk analysis) and economic value of equity analysis. If your organization does not have either of these, use available relevant information (GAP, etc.). You covered most of these analytical tools in your first year asset & liability management class.
B. Templates are available at the GSBC website to facilitate completing the credit risk (asset quality) assessment. To access the template, go to the GSBC Learning Environment (LE). On the Risk Management Project course page, an instruction sheet is provided on the site to facilitate entering data into the template. Within your bank, you should obtain Loan Quality information with supporting information available from the UBPR. (www.ffiec.gov/ubpr.htm)

If you are a regulator or do not work for a financial institution, attempt to gather the information from a bank you have examined, or from regulatory reports, e.g. examination reports, and the Uniform Bank Performance Report (UBPR). Alternatively, you might ask one of your fellow students to share information on his/her bank. To protect the confidentiality of the information, it is not necessary that regulators disclose the name of the bank.

I. Executive Summary [5%]

Briefly, describe the current situation in your institution regarding ALCO and Credit Risk. Using GSBC experience, comment on the quality and completeness of these activities. Briefly summarize your current job responsibilities. For additional project context, summarize your financial institution’s asset size; age of the institution; ownership structure (e.g. family owned, closely held, sub chapter S, publicly traded); markets served; and principal loan products offered.

II. ERM: Construct a Profile for the institution’s Capital adequacy, Liquidity and Interest Rate Risk [35%]

Obtain a recent copy of your bank’s ALCO report or Risk Management report. Supplement this information with UPBR data as appropriate. For Parts A, B and C, refer to the most comprehensive method of measuring interest rate risk (static GAP, earning/income sensitivity and/or simulation, economic value of equity (EVE) or net present value sensitivity, model simulations, etc.) that your bank uses to analyze the bank’s current exposure to interest rate changes.

NOTE: As additional information related to this ERM section, please refer to Dr. Koch’s “Interest Rate Risk Basics: Enterprise Risk Management Project” exhibit found on the GSBC website in the section related to this project.

A. What are the bank’s interest rate risk policy targets? Cite specific policies related to the allowable size of GAP, the sensitivity of earnings, and/or the sensitivity of EVE. Interpret what the figures mean.

B. Describe your bank’s current interest rate risk profile. Attach a copy of all relevant data. This information will be shared only with the grader.

a) Explain what the figures indicate regarding the bank’s interest rate risk exposure. Specifically, is the bank asset or liability sensitive and is the bank positioned to profit if rates increase or decrease? If your bank does earnings sensitivity analysis or EVE sensitivity analysis, what is the estimated impact on earnings and/or the economic value of equity across different rising and falling rate environments? Cite specific figures for the earnings impact by comparing the change in earnings compared to some base case or most likely case.

b) Is the bank’s aggregate interest rate risk exposure large or small? Describe how you arrive at this conclusion.

For Parts C and D, identify the financial ratios and related metrics that your institution uses to identify, measure, and manage its capital and liquidity position. Use the information to address the issues referenced in each part.

C. Funding the Bank:

1. Describe the amount and nature of your organization’s funding that comes from core deposits. If interest rates rise by 1% – 1.5% over the next year, describe (in general) what will happen to the amount and mix of your organization’s core deposits.
2. To what extent does your bank rely on purchased, non-core liabilities? Cite specific data for federal funds purchased and repurchase agreements (RPs), Federal Home Loan Bank advances, jumbo CDs, internet and rate board deposits, etc. and compare key ratios to peers. Describe the collateral that your organization posts in support of these liabilities. Discuss the bank’s holdings of liquid assets that are not pledged as collateral. Explain, in general, whether and why your institution’s liquidity risk is low, moderate or high.

D. Examine and cite data for your institution’s leverage ratio relative to peers. What is the five year trend to the present? If your institution raised external capital, describe the strategic purpose of the capital raise. Explain, in general, whether and why the risk profile of your institution’s capital position is low, moderate or high.
E. At this point in the analysis of ERM, several of the components of the CAMELS rating have been explored—specifically Capital (C); Liquidity (L); and Interest Rate Sensitivity (S). Asset Quality will be considered in the next major project section. Based on the components reviewed, provide a summary with explanation regarding your overall assessment of the Enterprise Risk Management effectiveness, taking into account the capital, liquidity, and interest rate sensitivity positions of the institution analyzed.

III. Construct and Assess an Aggregate Credit Risk Profile [50%]
A: Construct a Quantity of Risk Profile for your bank The Quantity of Risk Profile utilizes summary loan portfolio information which should be available from the senior credit officer or senior lender in your bank as well as from the UBPR. (NOTE: If the information requested is not readily available, do the best you can. However, be sure to describe any shortcomings to the complete analysis, how you used the available information to draw conclusions, whether you believe it might be beneficial for your bank to develop more comprehensive portfolio information, and what information additions you believe will be helpful).

1. Transaction Risk: Transaction Risk is determined by an assessment of a combination of activities related to individual credit transactions. Loan Selection, Underwriting, and Monitoring are the three primary components of Transaction Risk.

As an initial assessment approach, interpretation of parts of the UBPR will be used. As discussed in class, several different ratios will be observed to provide insight into the level of Transaction
Risk for the Loan Portfolio. NOTE: These observations are only part of the overall assessment which also must include assessment of Loan Selection, Underwriting, and Monitoring.

The initial assessment for Transaction Risk begins with observations on Page 1: Summary Ratios of the UBPR (see Day 5; Slide 4 from class). The first observation involves comparing the bank against itself and against peer group across time for Loan & Lease Analysis: Total Loans & Leases 90+ Days Past Due plus Nonaccrual Loans as a % of Total Loans and Leases.

Next, refer to Page 7: Analysis of Credit Allocation and Loan Mix from the UBPR (see Day 5; Slide 5 from class). Of interest on this page are three ratios—again comparing the bank against itself and against peer across time. The ratios are: a) Net Loss to Average Total Loans b) Loans and Leases Allowance to Total Loans and Leases, and c) Loans and Leases Allowance to Nonaccrual Loans and Leases Third, refer further to Page 7 (see Day 5; Slide 6 from class) to review details of Net Losses by Type of Loans and Leases of the bank against itself and against peer across time.

The last part of the UBPR Transaction Risk assessment relates to Pages 8 and 8A: Analysis of Past Due, Non-accrual, and Restructured (see Day 5; Slide 7)

NOTE: Finalize an overall Transaction Risk assessment. Remember that the goal for assessing Transaction Risk is to combine the inferences determined by reviewing the above components of the UBPR with your understanding of the Selection, Underwriting, and Monitoring processes into an overall conclusion. Describe your thought process for determining an overall Transaction Risk level. For all parts of the Quantity of Risk, the overall risk for each component will be categorized as Low, Moderately Low, Moderate, Moderately High, or High.

2. Lines of Business: Include a table in the paper of your bank’s major lines of business expressed in as a percentage (%) of Total Risk Based Capital. a) NOTE: This may be found in the UBPR: a. Major loan categories as a % of Total Capital may be found on page 7B of the UBPR (Analysis of Concentrations of Credit). b) REMEMBER: If an industry within a Line of Business is => 20% of Capital, that industry should be identified separately to be used with the Intrinsic Risk Scoring Worksheet. a. NOTE: Owner Occupied Commercial Real Estate should be included in C&I and broken down by respective industries if possible. b. Examples of Industries within Lines of Business (See 3c below for sample Lines of Business): i. Within Agriculture: 1. Dairy 2. Row Crop

ii. Within CRE (Permanent): 1. Multi-family 2. Strip Retail Centers 3. Office 4. Warehouse c. As with Transaction Risk, if all data are not available, do the best you can. Comment on what is available, how you used that information, and whether you believe additional bank-wide tracking might or might not be beneficial. Provide reasons for your assessment.

3. Intrinsic Risk: Use the information contained in the Line of Business/Industry table to determine how many Intrinsic Risk Scoring Worksheets should be completed, and complete the Worksheets. NOTE: Refer to the UBPR page 7B: Analysis of Concentrations of Credit: Loans and Leases as % of Total Capital. a) One Intrinsic Risk Scoring Worksheet will be completed for each Line of Business (after subtracting Industries within that Line of Business that =>20% of Total Risk Based Capital from the UBPR— NOTE: TRBC found on page 11C, Analysis of Capital, of the UBPR). b) One Intrinsic Risk Scoring Worksheet will be completed for each Industry that =>20% of Capital. c) If a line of business has nominal outstandings (i.e. <5% of the loan portfolio) combine the outstanding for all similar lines of business and intuitively assign an Intrinsic Risk Score.
NOTE: Examples of lines of business include: :Consumer Direct Indirect Home Equity Credit Card :Commercial and Industrial (C&I) :Real Estate Commercial Construction Commercial Permanent Residential Construction Residential Permanent :International :Municipalities :Agriculture :Factoring/Commercial Finance/Asset Based Lending :Not for Profit

NOTE: After completing the required number of Intrinsic Risk Worksheets, form an overall conclusion for the total Intrinsic Risk for your bank. Provide narrative in the paper explaining how you came to the final Intrinsic Risk determination.
4. Concentration Risk: Include a table in the paper highlighting major Concentrations expressed as follows: (NOTE: Information determined from the Concentration Risk Template found on the GSBC Website) a) Borrower: 10 largest borrowers as % of Capital (do not use actual names. A total, or list, by “Borrower 1”, “Borrower 2”, etc. is sufficient) b) Largest Line of Business or Industry as % of Capital c) Second largest Line of Business or Industry as % of Capital d) Geographic Concentration: Use the Geographic Concentration Matrix found on the Loan Portfolio Management Template at the GSBC Website to assess the level of Geographic Concentration.
Based on your assessment of the categories of Concentration Risk, form a final determination of the Overall Concentration Risk Level. As with the other components of the Quantity of Risk, rate the overall Concentration Risk as: Low, Moderately Low, Moderate, Moderately High, or High.
B. Finalize a Quantity of Risk Assessment: Use the Quantity of Risk information and templates prepared as instructed above to construct a Quantity of Risk Assessment for your bank.

STEP 1: Once you have completed assessments for Transaction Risk, Intrinsic Risk, and Concentration Risk, provide a summary graphic (such as below) to indicate the relative risk in each category:

T = Transaction Risk I = Intrinsic Risk C = Concentration Risk

STEP 2: Summarize your conclusions regarding the Quantity of Risk for your bank. a) What does the Quantity of Risk profile suggest about the potential for volatility in portfolio credit quality, earnings, and risk to capital? b) If you believe that any of the components of Quantity of Risk should be addressed in your bank, describe those components and provide potential solutions that you would deploy if you were in charge of the risk profile for the institution.

C. Construct a Quality of Risk Management Assessment:
STEP 1: Describe your institution’s Priorities and Culture. Discuss how you formed your determination of the Priorities/Culture.
STEP 2: Discuss Implemented Risk Controls in your bank focusing on describing the components of Behavior Influencing, Behavior Directing, or Behavior Controlling Controls utilized.
Describe your assessment (and reasons for that assessment) of the appropriateness of the Implemented Risk Controls in combination with Priorities/Culture and Loan Portfolio Management Tools utilized by your bank.
STEP 3: Discuss the Loan Portfolio Management Tools utilized in your bank. What steps would you recommend to better monitor, manage, or reduce the portfolio risk revealed in the profile?
STEP 4: Form an Overall Assessment of the Quality of Risk Management for your institution based on the combination of Priorities/Culture, Risk Controls, and Portfolio Management Tools. Provide a description of how you formed your overall assessment. D. Aggregate Risk Determination and Loan Portfolio Management Conclusions: a. Plot your combined final Quantity of Risk assessment with your final Quality of Risk Management assessment (NOTE: refer to the quadrant combination used in class—Day 5 Deck). Remember, there should be one point plotted. State the conclusions for each category. For example: Quantity of Risk– Moderately High: Quality of Risk Management—Moderately Weak) b. Based on this combination, provide a conclusion (and your reasons for that conclusion) of the overall efficiency and effectiveness of the Loan Portfolio Management system in your bank i. If the LPM system is appropriate, what makes it so? ii. If your LPM system has identified weaknesses, what are they, and what solutions would you recommend?

IV. Project Summary (10%) This project is designed to engage the project author in an in-depth analysis of an overall risk analysis of a financial institution. The first major section of the project focused on components of Enterprise Risk Management such as Capital, Liquidity, and Sensitivity to Interest Rates. The second major section of the project focused on Asset Quality, utilizing a methodical approach to analyzing the Quantity of Risk and the Quality of Risk Management of the institution, and then combining those components into an overall Aggregate Risk Determination.

The final 10% of this project requires a fully developed summary of how all of the components analyzed work together to form an overall risk assessment for the organization. The purpose of this section is to assess and explain your observations and conclusions related to the current risk position of the subject organization.

Finally, you are asked to provide an assessment of whether the overall risk assessment for the subject organization is decreasing (i.e. becoming less risky), increasing, or stable. You must provide reasons for your final conclusion as well.

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