With 2009 wrapped up and financial institutions finalizing budgets and plans for 2010, one worry is consistent throughout the industry: increased regulatory scrutiny. Every banker would agree that regulators will have a single-minded focus on community bank risk. While this is indeed a necessary step and one everyone expects, the real worry stems from how far the regulation will go, and how the potential “overreaction” will constrict growth moving forward.
New Capital Minimums
The new capital minimums that are sure to cause continual stress on the balance sheet and income statement have been a main driver of discussion in boardrooms across the country. The point of contention should be that the minimum capital regulations did not guard against bank failures over the past 24 months. One could argue that they actually contributed to allowing too high of risk, which promoted failures.
There should not be minimum capital requirements; there should be capital requirements based on what level of risk a bank actually takes. The risk-based capital ratio is a naïve way of gauging credit risk in a community bank. We have seen time and time again that the regulatory mandated liquidity ratios do not reveal true liquidity risk in most cases.
Your Own Risk Assessment
So, what can be done to provide your own risk assessment that will aid you in identifying and balancing your risk profile going forward? Step one is moving your risk assessment from an intuitive process to a dynamic simulation. Community bank boards must provide their management team with the tools needed to dynamically model current risk and project risk into the future.
These models should be able to simulate the bank’s balance sheet and income statement over time.
Further, the modeling tools should not only simulate interest rate risk, but also simulate credit risk. Risk management should not be considered a forced expense. Risk management should be considered the method of gaining the most profitability while optimizing risk.
Many community banks have uncovered risk imbalances that led to many issues during this period. Whereas the imbalance was not realized prior, it is now front and center and being addressed through the development of risk management systems to correct their imbalances.
If this is not done, the regulatory requirement to do so may be extensive and costly.
The vast majority of institutions in the top 15th percentile of m.rae’s risk reward ranking have remained in the top 15th percentile during this credit cycle.
How did they do it? They have taken and continue to take a low-to-moderate level of overall risk.
The components of this are lower levels of credit risk, a management of liquidity and earnings at risk through maintaining a high level of cash-type deposits (60% – 75% in checking accounts, savings accounts, and MMDAs), a low level of capital risk, and a high level of net overhead performance.
Community banks should have these risk management models in place to achieve their desired balance of risk and reward:
- Long-term capital model. This model should project out the bank’s strategic plan at least annually over the next 10 years. The model should have a balance sheet and income statement with all pertinent ratios. The model should also have a dividend plan.
- Credit risk models. Credit risk models should look at the bank’s credit risk from multiple angles using the bank’s actual loan mix and loan trends. Directors and senior management need to be proactive in assessing all risk, and based on this assessment, the board should set strategy on how risk will look in the future. Management will then develop the tactics needed to stay within the set risk parameters.
- Dynamic interest rate risk model. This tool should model each loan, investment, deposit, and borrowing. Besides interest rate shocks, the model should have the ability to simulate interest rate yield curve shifts. The model should also allow management to run “what-if” scenarios of balance sheet changes. This dynamic modeling will assess and project the bank’s earnings at risk, liquidity risk, and capital risk under real-life simulations.
To maximize these models, the best practice is:
- Education where needed. With the rising complexity of the industry and issues coming out of this recent financial crisis, filling knowledge gaps is crucial. Devote time at each board meeting to raising risk awareness and economic understanding and how it affects your balance sheet and income statement.
- Pay attention to your committees. We have found that special training sessions for the ALCO and Credit Committees have been very successful in setting best practices for financial institutions going forward. They help map out meeting agendas, identify necessary changes to policy, and foster comfort among committee members with the issues at hand.
- Rewrite policies to reflect the models and how they interpret and project risk for the bank.
The reality is that community banking was, and still is, the strongest part of our nation’s financial system. Traditional, conservative community banking still works!
The regulators and the accounting industry should look at what worked and apply these standards to the overall industry. Community bankers and directors should be proactive in adopting these standards in their own banks and leading the industry to these higher standards.