Second Proficiency test prep Flashcards
What is the key characteristic of a Special Mention loan?
Has potential weakness (vs. actual/well-defined) weakness; generally relates to the structure of a loan
Characteristics of a Special Mention Item
- Inadequate supervision of credit
- Questions on condition or control of collateral
- Economic/market conditions may unfavorably affect obligor in future
- A declining trend in financial condition
- Structure
What is the key characteristic of a Substandard loan?
Has well-defined weakness
What are the loan classifications?
Pass
Criticized - Special Mention
Classified – Substandard, Doubtful, Loss
Classification on Investment Security
CCC+ rated bond w/ impairment = SS – amort. cost
SS – inadequately protected, well-defined weakness, institution will sustain some loss if not corrected
Doubtful – same as above plus collection or liquidity in full is questionable
Loss – uncollectible; should be promptly charged off
Consumer Retail Classification Matrix
Open Closed 1-4 family
End End Home Eq
LTV>60%
—————————————————————————
90 days Past Due Subs Subs Subs
120 days None Loss None
180 days Loss None Loss (loan in
excess of
collateral val
What is required for a retail loan that secured by residential real estate?
Loans that are secured by residential real estate require a current assessment of value at 180 days past due (not the original value!)
Weighted-Classification Ratio For CAMELS-rated banks
Weightings of classification ratios:
- Substandard @ 20%
- Doubtful @ 50%
- Loss @ 100%
- Value Impaired @ Variable % Allocated transfer risk reserve (ATRR)
Take weighted total and divide by Tier 1 Capital and the ALLL
Asset Quality
CAMELS Rating Guidelines
Rating WCR
1 0 – 5% Strong
2 5 – 15% Satisfactory
3 15 – 30% Fair/Less than satisfactory
4 30 – 50% Deficient
5 > 50% Critically Deficient
Asset Quality
ROCA Rating Guidelines
Rating WCR
1 0 – 0.5% Strong
2 0.5 – 1.5% Satisfactory
3 1.5 – 3.0% Fair/Less than satisfactory
4 3.0 – 5.0% Deficient
5 > 5.0% Critically Deficient
If ALLL methodology is sound, but implementation is faulty, is the reserve adequate?
Yes, the reserve is adequate
FAS 114 / ASC 310
Standards for specific reserve; loan-by-loan review of impairment
Remember “I” for Individual or “1” one in three-one-zero
What should the FAS 114 (ASC 310) reserve methodology include?
Three measurement techniques:
* PV of expected CFs
* Observable market rate
* Estimated fair value of underlying collateral
Reserve allowance is difference btw the book value and the result from above valuation
Methodology Reasonableness Test
Tests adequacy of reserves – results should be compared to bank’s internal methodology Formula: * Deduct identified losses * 50% of doubtful * 15% of substandard
Where are Credit Losses booked?
B/S I/S
______________________________________
Loans ALLL Provision
Undrawn Commit
& Letters of Cr Liab Expense
Derivatives Liab Income
Accounting for Provision to the ALLL
Dr. Provision (expense) $10,000
Cr. Reserve (contra asset) $10,000
Loans $1,000,000
Reserve (10,000)
________________
Net Loans 990,000
Accounting for a Loan Charge-off
Dr. Reserve $5,000
Cr. Loans $5,000
Loans $995,000
Reserve (5,000)
______________
Net Loans 990,000
Accounting for a Loan Recovery
Dr. Cash $1,000
Cr. Reserves $1,000
Loans $995,000
Reserves (6,000)
______________
Net Loans 989,000
Why is a loan designated as Nonaccrual?
The purpose of designating a loan nonaccrual is to distinguish between:
* Loans that are of sound quality and performing as agreed
Versus
* Loans that are weak and unable to perform, or will be unable to perform as agreed
When should a loan be placed on Nonaccrual?
When full payment of principal and interest is no expected; the loan can be < 90 days if feel loan collection is in doubt
Accrual/nonaccrual decision tree – when can a loan be put on accrual when the principal
or interest are 90 days or more past due?
When the loan is both well-secured and in process of collection
Calculating Troubled Debt Restructuring Original bal. = $500,000 Paid down = $350,000 Recorded/accrued interest = $20,000 Modified note = $350,000 Due in 1 yr., interest rate = 4% Effective rate implicit, PV = $354,000 ($340,000 Principal + $14,000 Interest)
- Calculate the recorded amt. of the loan
Principal bal. at restructuring $350,000
Accrued interest (to maturity) 20,000
Less any unamort. principal 0
Add any unaccreted discount 0
Deduct any charge-off netted 0
________________________________
Recorded amt. of Loan $370,000
- Calc. PV of expected future cash flows
- Impairment = $370k-$354k= $16k
If ALLL – impairment is neg., then ALLL not adequate
DR. Provision (expense) $16k
CR. ALLL (contra asset) $16k
What credit score is considered subprime?
660
When is an appraisal not required?
- In which value is $250,000 or less
- A business loan with value of $1M or less and not dependent on the sale of, or rental income from, real estate as the primary repayment source
- Subsequent transactions resulting from an existing extension of credit
What are the supervisory Loan-to-Value limits?
Loan Category LTV limit
Raw land……………………………………………….. 65%
Land development……………………..…………..75%
Construction Commercial,
multifamily, & other nonresidential……….80%
What is Other Real Estate?
- Real property other than premises owned or controlled by the bank
- Usually acquired in satisfaction of a debt previously contracted
- Can also be:
o Property formerly used for bank business
o Originally acquired for expansion
What is required for ORE accounting?
- Should be booked at ORE upon physical possession
- Amount booked should be lesser of
o Fair value less estimated costs of sale
o Recorded amt. of loan plus any senior debt on the property - Loss on loan, including costs, must be charged to ALLL at time of foreclosure
How is a lien perfected?
SAPS
- Search: UCC-11, search country records for previous ownership of collateral
- Attach: security agreement in coordination with promissory note
- Perfect: UCC-1 (Financing Stmt) filing
- Search: perform another UCC-11 search to ensure
What are the bankruptcy code chapters?
Chapter 7 – liquidation of debtor’s assets and distribution among creditors
Chapter 11, 12, 13 – Reorganization
- Chap. 11 – Bus/ Indivs. that do not have steady income stream
- Chap. 12 – Farmers and farm family
- Chap. 13 – Wage earners & their proprietorships
Who determines Legal Lending limits?
- Established by laws of the state where bank’s headquarters is located
- National banks are subject to lending limits set forth in 12 USC 84
What is the Cash Coverage Ratio?
NetCashfromOperatingActivities
Financing Costs* + Current portion of Long Term Debt (CPLTD)**
- Including interest expense, dividends
- *Current portion of LTD @ the end of the prior year
Should be greater than 1
How do you calculate Cash After Debt Amortization?
Net Cash from Operating Activities - FinancingCosts
= Net Cash Income
- Current portion of long term debt (CPLTD)
= Cash After Debt Amortization
Define Interest Rate Risk
The exposure of current and future earnings and capital arising from adverse movements in interest rates
What are the four forms of IRR?
Mismatch/Repricing risk
Yield curve risk
Options risk
Basis risk
Mind your own Business
Who manages IRR?
Asset-Liability Committee (ALCO)
Treasury Department
Risk Manager
Internal Audit
What are the most common IRR models?
Re-pricing Gap
Income simulation/Earnings-at-Risk (EAR)
Economic Value of Equity (EVE)
What does the Re-pricing Gap model capture?
Mismatch/Repricing risk
What are the key assumptions of the Repricing Gap model?
- All repricing within a specific time bucket occurs simultaneously
- Slotting assets, liabilities and OBS items based on the first repricing interval
- All maturing assets and liabilities are reinvested at overnight rates
What are the positives and negatives of the Repricing Gap model?
* Positives o Easy to produce and understand o Inexpensive o Clearly illustrates repricing gaps * Negatives o Static, ST perspective
Asset Sensitive v. Liability Sensitive
Rates Asset Sensitive Liability Sensitive
____________________________________________
Increase + -
Decrease - +
What does the Income Simulation/EAR model simulate?
A bank’s exposure to loss of earnings over a period of time
What are the key assumptions of the Income Simulation/EAR model?
- The BS is used to project earning is accurate
- Selected interest rate scenarios are robust
- New business will product expected results
- Runoff schedules and prepayment speeds are accurate
- Core deposit behavior is realistic
What is the key negative of the Income Simulation/EAR model?
Not a reliable estimate of LT risk exposure
What does EVE calculate?
- PV of CFs from assets, liabilities, and OBS items based on a forecasted change in interest rates
- EVE = PV of assets – PV of liabs. +/- OBS
IRR Models: Strengths and Weaknesses
Criteria Gap Simulation EVE
_________________________________________
ST Exposure Yes Yes NA
LT Exposure Yes No Yes
Repricing Yes Yes Yes
Basis No Can Can
Yield Curve No Can Can
What are three types of rate scenarios?
- Shocks – Take base curve +/- 100 bps, 200 bps, and 300 bps
- Historical – analyze real life stress periods, adjust base case curve to mimic actual rate changes
- Hypothetical – macro-economically plausible ‘what if’ scenarios
At a minimum, what rate scenario must the bank look at?
At a minimum, the bank must look at instantaneous +/- 200 bps parallel shift in market rates
What does the ‘S’ component consider?
- Quality of Risk Mgmt – The ability of management to identify, measure, monitor, and control risk
- Market Risk Exposure – Give the bank’s size, complexity, and the adequacy of capital and earnings
Describe the 5 levels of rating for the ‘S’ component
1 – IRR sensitivity well controlled, min. potential that earnings/ capital will be adversely affected. RM is strong. Earnings /capital provide substantial support.
2 – IRR sensitivity is adequately controlled, moderate potential earnings/capital will be adversely affected. RM is satisfactory. Earnings/ capital provide adequate support
3 – IRR needs improvement or that there is significant potential earnings/capital will be adversely affected. RM need to be
What can be determined from the Balance Sheet?
Whether the bank has enough liquidity to handle a crisis
Net non-core funding dependence
= Netnon-corefunding–STinv
________________________
Loans, ORE, and Securities > 1 yr.
Negative ratio is favorable
Positive ratio means bank is relying too much on volatile liabilities
The Parent Company must …
Serve as the Source of Strength!
Double Leverage Ratio
= EquityInvestedinSubs
__________________
Parent Co Equity Capital
If > 120%, too big
What is expected from the Board of Directors in managing Market Risk?
- Approving policies, procedures, and strategies
- Liquidity risk profile
- Identifying executive level lines of authority
- Monitoring performance periodically
- Reviewing contingency funding plans
What is required in a contingency funding plan?
- Triggers
- Roles and responsibilities
- Scenario analysis
- Alternate funding sources
What are early signs of a liquidity problem?
- Deterioration in asset quality
- Changes in fund providers
- Decreased size of individual transactions
- Difficulty accessing longer-term maturities
- Increased pricing costs, increased Loan/Deposit
- Changing markets
Who is an insider?
- Directors
- Principal Shareholders
- Executive Officers
- Policymakers
- Related interests (business owners and immediate family that resides in house)
When is a shareholder a “principal” shareholder?
Must own >= 10% of stock for control
Which of these is a principal shareholder –
(a) Bob owns 7% of the bank and his ex-wife Rachel who remarried and moved away owns 7%
(b) Rachel owns 7% of the bank. Her daughter Sarah who owns 4% is staying with her while she looks for a job
(c) Paul owns 6% of the bank. He is the 10% owner and managing partner of a law firm which owns 5% of the bank
a) No
b) Yes
c) Yes
What are the two categories of related interests?
1) Business which they control (25% is automatically control of business)
2) Immediate family living in house
When is an individual considered to have a controlling interest in a bank? In a company?
10%, 25%
What loan credit criteria apply to all loans made to insiders?
Must be same terms as loan to independent 3rd party
What loan pricing criteria apply to most loans make to insiders?
Same as the general public
What loan pricing exception is permitted?
Insider can receive the same discounts as all insiders
Who is an executive officer?
Treasurer President
Corporate Secretary
VP (unless Board Resolution to not included VPs)
How much can a bank lend to its executive officers?
Up to $100,000
What two types of loans to executive officers don’t count against the lending limit?
Loans for a home (1st Mortgage) or education
When is an overdraft a violation of Regulation O?
When there is no preliminary agreement and it is over $1000
What is a BHC?
A company (bank, corporation, or business trust) that has control (>= 25% of voting shares) of a bank
What is the largest asset on a BHC’s balance sheet?
Investment in bank subsidiary
What is the main expense on a BHC’s income statement?
Interest on debt
Originally, what activities were BHC’s allowed to engage in?
Activities closely related to banking (i.e. loans, securities, mortgage lending)
What is a chain banking organization?
2 or more banks controlled by the same individual or related interests
Which FR regulation implemented the BHC Act and Change in Bank Control Act of 1978?
Regulation Y
What is the primary advantage of a BHC?
Provides financial flexibility
- Consolidated tax returns
- Tax advantage to bank subs
- Treasury stock (repurchase)
Wider investment powers
Centralization of operations
What is a BHC allowed to charge for operations?
No more than a 3rd party – used to determine that method for allocating costs is appropriate
What is the primary “doctrine” for BHCs?
To serve as a source of strength to is subsidiaries
What is the Gramm-Leach Bliley Act of 1999?
- Allowed banks to be affiliated with securities firms and insurance companies
- Preserve separation of banking & commerce – allows activities “financial in nature”
- Held to higher standard (well-cap., well-managed, satisfactory CRA rating)
What are disadvantages of a BHC?
- Additional FR regulations and inspections
- Additional filings (FR-Y)
- Possible securities law regulations
- Possible dealings with minority shareholders
What are the four subcomponents of the “R” in the BHC rating system?
- Board and Sr. Mgmt. oversight
- Policies, procedures, and limits
- Risk monitoring and MIS
- Internal controls
(this rating is “forward looking”)
What are the four subcomponents of the “F” in the BHC rating system?
- Capital
- Asset quality
- Earnings
- Liquidity
(this rating is “point in time”)
What does the “I” for the BHC rating system capture?
Assesses the impact of non depository entities on the depository subs (includes Parent and all nondep. subs)
What is the rating scale for “I” of the BHC Rating System?
- Low likelihood of significant negative impact
- Limited likelihood
- Moderate likelihood
- Considerable likelihood
- High likelihood
How can a BHC have an adverse effect on bank subs?
- Excessive risk and fail
* Adverse intercompany transactions and excessive dividends
What should be considered for “I” of the BHC Rating System?
- Is capital adequately distributed across all subs?
- Do intra-group exposures undermine condition of banks?
- Is parent cash flow dependent on excessive dividends?
- Impact of strategic growth plan, op losses or poor control environment of parent/nonbanks
- Legal/Rep risk of parent and non-banks
- Contagion! A situation in which a faltering economy in one country causes otherwise healthy economies in other countries to have problems.
What is included in the “C” component of the BHC Rating System?
- Overall assessment
- Forward-looking and static assessment of consolidated BHC
- Not a numeric average
What is included in the “D” component of the BHC Rating System?
- “D” stands outside of composite rating
- Use primary/functional regulator’s rating
- For multi-bank holding company, weighted average of composite ratings
What is the definition of “Control”?
When a person or persons acting in concert acquire ownership, control, or the power to vote (directly or indirectly) 25% or more of any close of voting security - Outright Control
What is the definition of “Rebuttable Presumption of Control”?
When a person or persons acting in concert acquire ownership, control or the power to vote (directly or indirectly) 10% or more of any class of voting security, and if:
- the institution is registered with the SEC, or
- no other person will own, control, or hold the power to vote a greater percentage
Who has control and presumption in the following scenario:
Jones Mr.A Mrs.A Mr.B Mrs.B Mr.S Mrs.S
22 21 6 20 6 13 10
No individual control
Jones – Presumption (alone)
A & B – Outright control (in concert)
S – Presumption (in concert)
Regulation DD
Truth in Savings Act
- Account disclosures
- Calculation of interest
- Advertising
Regulation CC
Expedited Funds Availability Act
- Availability schedules
- Deposit holds
- Payment of interest on deposits
Regulation E
Electronic Fund Transfer Act
- Disclosures
- Liability limits for unauthorized transfers
- Error resolution procedures
- Preauthorized transfer rules
Regulation P
Privacy of Consumer Financial Information
- Governs treatment of consumers’ nonpublic, personal financial information
- Initial and annual notices
Regulation B
Equal Credit Opportunity Act
* Prohibits discrimination in any aspect of the credit transaction
Consequences for not complying
* Civil liability
o Indiv - $10,000FHA
Fair Housing Act
Prohibits discrimination based on a prohibited basis –
* in the sale or rent of a dwelling
* To otherwise make unavailable or deny a dwelling
* In making available a residential RE-related transaction
* In the terms or conditions of such a transaction
FCRA
Fair Credit Reporting Act
Regulation C
HMDA – Home Mortgage Disclosure Act Data reported by banks and FIs is used for:
- Fair lending exams
- CRA exams
- Public disclosure
If a banks not comply, may result in CMPs
Regulation BB
CRA – Community Reinvestment Act (CRA)
Requires that banks do not arbitrarily exclude low and moderate income areas in area where the bank does business
- Bank should help meet credit needs of community
Regulation Z
Truth in Lending Act Primary disclosures are:
- APR
- Finance charges
- Variable-rate terms
- Closed-end prepayment penalty provisions
Regulation H
Flood Disaster Protection Act
Regulation X
Real Estate Settlement Procedures Act (RESPA)
Covers federally related mortgages – loans secured by a first or subordinate lien on residential property
What are the three forms of discrimination?
Overt – apparent
Disparate treatment – evident that criteria is discriminating
Disparate impact – discovered when testing policies and procedures
What is an assessment area?
- Area where the bank does business
- One or more metropolitan statistical area (MSAs) or political subdivisions
- Does not arbitrarily exclude low and moderate income areas
What are the Compliance Ratings?
1 – Strong
2 – Generally strong
3 – Less than satisfactory
4 – Unsatisfactory (requires close supervision)
5 – Substantial noncompliance (in need of strong supervisory attention)
What are the CRA small bank ratings?
Outstanding – Excellent performance
Satisfactory – Reasonable performance
Needs to improve – poor performance
Substantial noncompliance – very poor performance
What risks related to compliance?
Legal
Reputational
Operational
Credit
Credit Risk
Arises from the potential that a borrower or obligor will fail to perform on an obligation
Market Risk
Risk to a financial institution’s condition resulting from adverse movements in market interest rates or prices
Liquidity Risk
Potential that an institution will be unable to meet its obligations as they come due because of an inability to liquidate assets or obtain adequate funding
Operational Risk
Arises from the potential that inadequate information systems, operational problems, breaches in internal controls, fraud, or unforeseen catastrophes will result in unexpected losses
Legal Risk
Arises from the potential that unenforceable contracts, lawsuits, or adverse judgments can disrupt or otherwise negatively affect the operations or condition of a banking organization
Reputational Risk
The potential that negative publicity regarding an institution’s business practices, whether true or not, will cause a decline in the customer base, costly litigation, or revenue reductions
OREO
- usually RE used to secure debt
- Must write off difference between loan amount and the property’s fair value
o Excess charged against the ALLL - Capital expenditures can be added to the OREO acct to extent of the value added
OBS Items
L/C
SBLC – not directly linked to shipment of goods
Unfunded loan commitment
Lines of credit
Past Due Loans
Loan that is 30-89 days delinquent – a banker can accrue interest
Noncurrent Loans
Loans that are past due 90 days or more or placed on nonaccrual status
What should be reviewed to determine Asset Quality?
WCR 0 – 5% = 1 5 – 15% = 2 15 – 30% = 3 30 – 50% = 4 50% + = 5
Total Classified Asset Ratio
Total Classified Assets
___________________
Tier 1 Capital + ALLL
Weighted Classified Asset Ratio
Substandard 20% + Doubtful 50% + Loss 100%
____________________________________
Tier 1 Capital + ALLL
ALLL
Contra-asset to absorb estimated credit losses associated with the loan portfolio
- Increase ALLL - debit the provision account (expense) and credit the ALLL
- Charged off loan - debit the ALLL and credit loans
- Recovery of charged-off loan – debit cash and credit ALLL
Adequacy of ALLL
50% of doubtful loans
15% of substandard loans
+estimatedcreditlossesover12months
Recommended ALLL (A)
Bank’s ALLL
What should be reviewed to determine Earnings?
ROAA = Annualize Net Income/Average Assets
Rating < $100M $100 $300 $1-$5B >$5B
-300M $1000M
________________________________________
1 1.15% 1.05% .95% .85% .75%
2 .95% .85% .75% .65% .55%
3 .75% .65% .55% .45% .35%
4 <.35%
Net Interest Margin
NII/Ave. Earning Assets
The difference between interest income and interest expense as a percent of average earning assets
Non-Interest Income
NII/ Adjusted Operating Income
Fees and charges for services, such as checking, safety deposit and trust, that are on a non-interest basis
Overhead Expense (Efficiency Ratio)
Non-interest expense / Interest income + non-interest income
Total of operating expense for the bank, primarily salaries, occupancy, technology, and professional fees
Provision Expense
- Periodic changes to income determined by mgmt. and the board based on their estimate of loan quality and the adequacy of the reserve
- Where a bank’s credit quality has the most discernible impact
- Has the potential for distorting a bank’s earnings
Adjusted ROAA
- Shows if earnings are understated or overstated
* Adjusted ROAA should be within 10% of ROAA
What should be reviewed to determine Capital?
Tier 1 RBC Ratio 4%
Total RBC Ratio 8%
Tier 1 Leverage Ratio 3%
- Asset quality – not rated more than 1 number above AQ because AQ is prime driver
- Earnings
Tier 1 Capital
+Stockholders equity (CS, Surplus, Undiv. Profits)
+/- Unrealized loss/gain on AFS securities
+ Non-cumulative Perpetual preferred stock
+Minority interest in consolidate subs
Less:Goodwill and all intangible assets (except some mortgageandcreditcardservicingrights)
Tier 2 Capital
+ ALLL
+ Perpetual preferred stock
+ Hybrid capital instruments
+Termsubordinateddebtandpreferredstock
= Tier 2 Capital Elements (dedicated to specific risks or repayment)
Tier 1 RBC
Tier 1 Capital / Risk-Weighted Assets
RWA – BS
o 20% - Cash items in process of collection, Claims on depository institutions, US gov’t sponsored agency obligations, municipal securities
o 50% - Loans secured by first liens on residence, municipal securities – revenue bonds
Total RBC
Risk based capital addresses the credit risk that is inherent in different assets and takes into account off balance sheet items when addressing capital
Total Capital = T1+T2+T3
______________________
Risk-Weighted Assets
Prompt Corrective Action (PCA)
Well Adeq. Under Sig Crit
Cap Cap Cap Under Under
Cap Cap
_______________________________________
Total RBC >=10% >=8 =6% >=4 =5% >=4 <=2
Section 5199(b)
Restricts dividend payments to the current year’s earnings plus the prior two years’ retained net income, after allowing for transfers to surplus
Section 5204
Restricts bank dividends to undivided profits, less any amount of statutory bad debts that the bank has on its books in excess of ALLL
Reg I
Investment in FR stock – 6% of the member bank’s paid-up capital (CS) and surplus; half must be subscribed;
Restricts the purchase of FR stock, up to 3% of bank’s capital
Sources of capital
Earnings retention (internal) Raising capital via capital markets (ext) Through shareholders and directors (ext) Sale or redistribution of assets
What is reviewed for liquidity?
Assets – mix, maturity, and marketability
- Loans – low liq. (earnings/liq. trade-off)
- Securities – med liq. (HTM, AFS)
- FFS – high liq.
- Cash – most liq.
Liabilities – core versus noncore
Two major types of liquidity
Asset liquidity – conversion of assets
Liability liquidity – borrowings
Net non-core funding dependence
Non-corefunding–STinvestments
____________________________
LT Assets (loans, OREO, Secs > 1yr.)
is negative if reliance on non-core funds is low; the bigger the negative #, the less the bank relies on non-core funds
Price v. yield
Yield = Coupon rate, PAR
Yield > Coupon rate, Discount
Yield < Coupon rate, Premium
BOD v. Sr. management
BOD - Strategic direction, competent mgmt. is in place, appropriate plans and policies, monitor ops and fin. performance, ensure CRA performance
Sr. Management – day-to-day operations, implementation of P&P, ethical standards, compliance with laws and regs.
5 COSO elements
Control environment
Risk assessment Control activities
Information and communication
Monitoring
Non-Accrual Loans
A banker can accrue interest on loans until (1) it is 90 days past due (unless well secured and in process of collection) or (2) collection of P&I is in doubt. Interest is classified as a loss.
Impaired Loans
Creditor will be unable to collect all amounts due including P&I as scheduled according to loan agreement based on current information. If PV of expected future cash payments is less than recorded amount of loan then difference is amount of impairment.
Restructured debt
Loans and leases whose terms have been modified because of deterioration in the financial condition of the borrower. Two methods for restructuring: (1) transfer of assets – recording the lower of fair market value or book value of asset transferred and charging-off any deficiency; (2) modification of terms
How do banks absorb losses?
Through earnings, ALLL and capital
Inventory DOH
Inventory/COGS * 365 days
Should be low or declining
AR DOH
Net AR/Net Sales * 365 days
Indicates mgmt.’s collection abilities
Lows or declining DOH means greater operating efficiency
AP DOH
AP/Purchases or COGS * 365 days
Measures creditor financing of inventory
Increasing DOH may indicate CF problems
Working Capital
Current assets – current liabilities
LT financing of Current assets
When is an appraisal required?
Non-residential txns. Over $250M
When is an evaluation required?
- Transactions $250M or less
- Business loans $1M or less & repayment not from sale or rental income of real estate
- Existing loan with no big change in market value
What constitutes a loan concentration?
Loans in a particular segment equal 25% or more of capital
What are the four types of borrowing entities?
Sole proprietorship – business owned by one person who is liable for all debts
General partnership – 2 or more people who operate business; all partners are liable jointly for debts
Limited partnership – several partners have limited liability as long as 1 partner has unlimited liability
Corporations – legal entity exists independently from people who own. C-Corp – company pays taxes on its profits. S-Corp – profit/losses flow through shareholders for tax purposes.
Current Ratio
Current assets/ current liabilities
Current dollars available to pay current obligations
If CR<100% means adverse funding situation
Quick Ratio
Cash+marketablesecurities+AR Current liabilities
More accurate measurement of liquid assets available to pay current liabilities
Held to Maturity (HTM)
On BS at book value or historical cost; reflects management’s intent to hold the securities until they mature; cannot typically be sold without incurring an unfavorable accounting treatment for the remainder of the portfolio
Available for Sale (AFS)
On BS at market value according to FASB115 – unrealized gains/losses are reported directly as a separate component of equity capital; A large % of a bank’s investment portfolio should be designated as AFS b/c investment securities provide a secondary source of liquidity
Trading securities
On BS at market value; reported on GL at market value with unrealized gains/losses in value reported directly in income statement as part of earnings
Mortgage-backed Securities (MBS)
Mortgage loans are secured; convert loans to securities and then sell them to investors. Benefits: (1) improves credit and liquidity risk, (2) reduction in RWA decreases capital requirements, (3) generates additional fee income.
Collateralized Mortgage Obligations (CMO)
Represent ownership in specified cash flows from underlying pools of mortgages; CMOs take money and direct it to tranches; P&I payments are made to tranches according to specifications.
GAP Model
RSA and RSL are slotted according to repricing date. EAR = Rate Change x GAP.
Assumptions: time bucket slotting, static balance sheet, parallel change in yield curve
Weaknesses: ST focus, does not capture option, basis, or yield curve risk and inappropriate for complex BS
NII Simulation model
Advantages: Projects NII, addresses assumptions, can capture mismatch, basis, and option risk
Weaknesses: ST focus, only captures option risk when options are in the money, difficult to project far into the future, results can be shaded by mgmt.
Duration of Equity analysis
D = D ( A) less D (L) + D
E A L OBS
_________________________
Equity
Used to forecast the sensitivity of the EVE to a change of rates less
Change in EVE = -D
E x (% change in rates)
Weaknesses: (1) only accurate for small rate changes, (2) duration of diff. instruments will change at diff. rates over time,(3) does not capture basis or option risk
Strengths: One number result & captures IR risk from all time
PV Scenario Analysis
PVE = PVA – PVL + PVO
Calculates NPV of assets, liabs, and OBS & recalculates NPV for each instrument for a given rate.
Strengths: LT measure of IR risk, captures all IRR and accurate even for larger rate change scenarios
Weaknesses: Difficult to estimate appropriate interest
BHC Advantages
1) geographic expansion
2) greater financial advantage
3) economies of scale
4) can redeem own stock which increases EPS
5) financial flexibility
6) strengthening of sub bank capital
BHC Disadvantages
1) Additional FRB regulations and report filings
2) Audited financial stmts. For BHS >$500M in assets
3) Y-6A – changes in investments
4) FRY-8 – intercompany txns
5) FRY-9C – consolidated financial stmts. For BHCs >$150m in assets; FR Y-9SP (small BHC every 9 mos.); FR Y-9LP (lg BHC quarterly)
Intercompany Transactions
- Dividends paid by subs to parent
- Fees paid by subs
- Tax allocation
- Competing balances
BHC Min. Capital Ratios
- Total RBC/RWA = 8%
- Tier 1 Capital/RWA = 4%
- Tier 1 Leverage = 3%
Single Leverage Ratio
Parent Co. Debt/ Parent Co. Equity
If >$150M in assets, >30% means highly leveraged
If 100% means highly leveraged
Double Leverage Ratio
Equity investment in subs/parent co equity capital
>100% means double leverage – not good!
Double Leverage Payback Ratio
(Equity Inv. In Subs) – (Parent Co. equity capital)
_____________________________________
(Annual Parent Co. NI)
Measures times in years BHC is expected to repay its double leverage based on current earnings
Formation of Small BHCs (Reg Y)
A BHC must finance at a minimum 25% of the purchase price of small bank acquisition with equity
BHCs Transactions not requiring prior notice
- Has controlled 25% of more of voting stock of a bank or BHC since March 1979
- Is presumed to have controlled the organization since March 1979 if the aggregate amount of voting securities held does not exceed 25%
- Future acquisitions of voting securities as long as such person remains the largest shareholder under 25%
Exemptions from Board Approval
- Bank trust depts. may assume control over shares of another bank or BHC in a fiduciary capacity unless…
- Acquisition of securities in satisfaction of DPC; bank must divest securities within 2 years of the acquisition
- Passive acquisition of shares through stock split of stock dividend, acquisition through inheritance, gifts, or DPC
Section 23A
To prevent misuse of bank’s resources stemming from transactions with affiliates:
- Limits aggregate amt of covered txns between bank and any one affiliate to 10% of bank’s capital
- Aggregate amt of covered txns of all affiliates shall not exceed 20% of bank’s capital
- Prohibits transfer of low quality assets between
Exemptions to 23A
- Sister bank relationships, except low quality assets
* Loans to affiliates secured by US Treasuries or agencies
Section 23B
Protects bank subs by mandating that any transaction with affiliates is made under similar terms and conditions as made to non-affiliated co.
Regulation O
Prevents insiders (executive officers, directors, principal shareholders) form using their positions in bank to get loans or more preferential terms
Executive officers – chairman, president, VP, cashier, secretary, treasurer
Principal shareholders – power to vote 10% or more of voting securities
¼% not regarded as preferential
Limit on loans to insiders
In excess of $25,000 or 5% of bank’s capital and surplus unless:
(1) credit has been approved by majority of BOD and (2) interested party has abstained from voting in this manner.
Overdrafts
No member bank may pay an overdraft of an executive officer or director unless made in accordance with (1) written pre- authorized interest bearing extension of credit plan, (2) written pre-authorized transfer of funds. Does not apply to aggregate of
$1000 or less provided that (1) acct. is no overdrawn > 5 days and (2) bank charges same fee
Regulation T
- Regulates extension of credit by and to brokers & dealers
- Provides for special purpose accts to record txns between a customer and a creditor
- Limits margin lending by requiring initial equity must be at or equal to 50% of stock’s market value
Regulation U
- Governs the amount of money a bank may lend for a stock purchase where the loan is secured by margin stock
- Restricts loans made for the purpose of purchasing or carrying margin stock
- Credit granted must not be more than 50% of the value of the pledged stock
Regulation X
Applies Regs. T & U to US people when they obtain credit outside the US to purchase or carry US securities
Regulation Y
- Applies to acquisition of control of banks and BHCs by company and by individuals
- Defines the scope of permissible activities for BHCs
- Defines the administrative procedures for securing approval for the acquisition of banks and the conduct of non-banking activities
Regulation Z
Fed rules that requires disclosure of credit terms, sets procedures for resolving billing errors, and implements the Truth in Lending Act
Large Bank CRA Test
For banks with assets of $250M or more
Lending test - # and amt. of loans
Investment test – meet credit needs of assessment area Service test – Delivering retail banking services
Fedwire
Provides for the electronic transfer of immediate and irrevocable pmts. between participating institutions.
Both a clearing and settlement facility
Daylight Overdraft
Banks exceeds the balance on its reserve account throughout the day
CHIPS
Funds transfer network owned and operated by the NYCH delivering and receiving USD pmts. between domestic and foreign banks that have offices in NYC
Txn can be reversed (unlike Fedwire)
SWIFT and Telex
Two most common message systems
Does not result in immediate transfer of funds from the issuing bank
FBO Rating System
R – Risk Mgmt
O – Operations
C – Compliance
A – Asset Quality
Transfer Risk (ICERC)
Risk that an obligation cannot be paid in the currency it was denominated because of lack of restrictions on the availability of the currency
Also stems from economic, social, or political problems
Asset Maintenance
Used to protect depositors and creditors by ensuring that the office maintains liquid US assets in excess of 3rd party liabilities
Reg K
Outlines office approval procedures and standards, powers, permissible activities, and disclosure of supervisory info. to home country
Informal Enforcement Actions
Commitment Letter – least severe
Board Resolutions
MOU
Formal Enforcement Actions
Written Agreements
Cease & Desist – violation of law
Prohibition & Removal
Termination of Fed Membership & FDIC insurance – a conservator is appointed
IT – Management Processes
Encompasses planning, investment, development, execution, & staffing of IT from a business perspective; includes strategic planning, reporting hierarchy, management succession and indep. review
IT Architecture
Underlying design of automated IT system & components; encompasses physical & logical architecture; allows users to easily enter data at normal & peak times; risk is that components will not meet LT company objectives
IT Integrity
Reliability, accuracy, & completeness of information delivered to user; risk is not being able to satisfy end-user requirements
IT Security
Safety afforded to information assets & their data processing environments using physical and logical controls; prevents unauthorized access, destruction of information assets, maintenance or storage
IT Availability
Delivery of info to end users; effective when information is consistently delivered on a timely basis in support of business & decision-making process
SDLC
Process of developing, acquiring, implementing & maintained computerized systems; should define requirements, assess current systems, consider options, determine design, acquire components, conduct testing, implement changes
Fiduciary Principles
Duty to administer assets in agreement with terms and conditions
Duty to invest prudently
Duty to act in the best interest of the client
Prudent investor
Manage risk, diversify investments, exercise appropriate care, skill, and caution.
Mismatch Risk
Where the repricing periods of assets and liabilities are not matches, causing one or the other to reprice at difference times. The time lag between the two instruments creates a mismatched exposure.
Option Risk
Refers to both explicit and implicit put or call options embedded in financial instruments. The risk is that the proceeds or disbursements from exercising the option could be reinvested at a lower yield or purchase at a higher yield.
Basis Risk
The risk that spread between instruments of similar maturities will change.
Yield Curve Risk
The risk of unequal changes in the spread between two rates for the same instrument of different maturities, i.e. treasuries.
Duration
- Weighted average time to receipt of the PV of cashflows.
- Coupon and maturity determine cashflows
- Yield and maturity determine the effect of the discount rate
Hedging activities
- Forward contracts
- Future contracts
- Interest rates swap
- Put and call options
4 Elements of Risk Management
- Board and Senior Mgmt. oversight
- Policies, procedures, and limits
- Risk measurement, monitoring and MIS
- Internal control
Control Activities
- Segregation of duties
- Approval
- Verification
- Reconciliation
- Review operating performance
- Absences
BHC Control Structure
Each of the following conditions constitute direct or indirect control of a bank:
- Ownership, controls or power to vote 25% or more of the outstanding shares of a bank.
- Control election of a majority of directors
- Power to exercise controlling influence over management or policies
Section 24A
Covers credit transaction between a bank and its parent or other affiliates.
Sister banks are exempt Covered credit txns have limits
* 10% per affiliate
* 20% in aggregate for all affiliates
Section 24B
Covers service related transaction between a bank and its parent or other affiliates
- Txns should be based on fair market value
- Made at arms length
- Made on terms similar to those offered to outsiders
ROCA Asset Quality Ratio
20%SS+50%Doubt+100%ofLoss
__________________________________
Total non-related assets + Total class. Conting.
FBO Due From and Due To accts
Due From – an asset account for an FBO if money is lent to HO
Due To – a liability acct in which money is injected into FBO from HO
Trust Ratings System
M - Management O – Operations, Control, Audit E – Earning C – Compliance A – Asset Mgmt.
Capital Prompt Corrective Action
T1 RBC Total RBC Tier 1 Lev
_________________________________________
Well Cap 6% 10% 5%
Adeq Cap 6% 8% 4%
Undercap <3%
Critically Undercap Less than 2% tangible eq to tot assets
Leverage Ratio
Tier 1 Capital
______________
Avg total assets
What is adequately capitalized?
4% Leverage T1C / ATA
6% T1RBC T1C / RWA
8% Total RBC T1+T2+T3 / RWA
What is BHC minimum regulatory standards
BHC
4% Leverage T1C / ATA (3% if one rated)
4% for all others
4% T1RBC T1C / RWA
8% Total RBC T1+T2+T3 / RWA
Regulatory minimum for bank \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_ 3% Leverage T1C / ATA 4% T1RBC T1C / RWA 8% Total RBC T1+T2+T3 / RWA
