Risk Management

Commercial Real Estate (CRE) Valuations

Firms may be falling behind in obtaining appraisals on property that serves as collateral for loans. Some District banks have significant CRE exposure.

Outdated or inaccurate appraisals may make it difficult to assess the health of the credit or the adequacy of the allowance for loan andlease losses (ALLL).

Credit

CRE Rollover

Since most CRE construction and land development (CLD) loans are made with short maturities, the average District bank with CRE concentrations will have significant rollover of CRE portfolios in 2009 and 2010.

Credit availability may be in question as many banks are trying to exit troubled relationships. As a result, banks may encounter significant levels of other real estate owned (OREO) as borrowers are unable to find loans to support projects. Also, banks may see a significant increase in troubled debt restructurings (TDRs) as they are unable or unwilling to take losses on loans and work with borrowers to wait out the recession.

Credit

Retail CRE Exposure

Stress in the retail CRE market is starting to show through increases in vacancy rates, slowing absorption and softening in rents.

Banks may have relied on income from traditional income-producing CRE loans to offset stress in CLD portfolios. Problems in the other areas of CRE could significantly impact bank earnings.

Credit

Automaker/ Auto Dealer Exposure

Many banks in the District have indirect exposure to the auto industry via dealer financing, supplier financing, and loans to employees of the industry.

Failure or significant cutback in one of the domestic manufacturers could adversely impact the loan portfolios of institutions in areas with significant auto concentrations.

Credit

Troubled Debt Restructuring ( TDR)

Many banks have been modifying terms of loans (particularly CRE-related loans) in attempts to work with borrowers. However, neither levels of TDRs reported nor the number of banks reporting them in the Call Report has increased over the past two quarters.

Failure to report assets as TDRs could misstate the credit risk position of a bank and distorts required disclosures about TDRs. TDRs must be evaluated for impairment under FAS 114, even if the loan type is outside the initial scope of the standard (e.g. residential mortgages).

Credit

Other Real Estate Owned (OREO)

OREO levels are increasing at institutions across the District, particularly CRE OREO.

Banks haven’t had to deal with such a volume of OREO in more than 20 years and may not have the experience to handle it. Also, saturation of markets with inventory and lack of buyers may result in significant holding periods for OREO, which may adversely impact bank earnings and liquidity.

Credit

Commodities Decline

Declines in commodity prices have occurred in conjunction with overall declines in the market.

Declines may result in a positive impact for livestock farmers as inputs are cheaper; and a negative impact for crop farmers going into 2009 as presale prices for delivery may be lower. In addition, in late 2008, some corn farmers were unable to deliver crops at pre-sold prices because certain ethanol plants went bankrupt due to high input prices.

Credit

Home equity lines of credit

Delinquency rates on home equity portfolios at District banks have increased over the past year.

Traditionally a lower risk asset, delinquencies in this portfolio could lead to further pressure on earnings and liquidity.

Credit

New Treasury/ Fed/ FDIC Programs

Firms are sorting through the implications of new Federal programs aimed at addressing liquidity and capital.

Banks are assessing the potential reputation risk impacts of participating in the programs, as well as the operational risks associated with monitoring and tracking the use of the funds received. Banks should also consider the risk of over-reliance on these programs as a funding source, as the programs will eventually be phased out.

Market/

Liquidity

Spillover impacts from other risks

Liquidity is a consequential risk and most other bank risks are already on elevated status.

Increases in credit, legal, and reputation risks can negatively impact liquidity risk. Additionally, poor financial performance (weak earnings, stressed capital) can have a negative effect on counterparty risk tolerance.

Market/
Liquidity

Investment portfolio - classification of securities and Other Than Temporary Impairment (OTTI)

A number of private label mortgage backed securities, collateralized debt obligations, and other investment securities are experiencing notable declines in market value and/or credit rating.

Banks with investments in these categories may face OTTI, classification of securities or an increase in risk-weighted assets. These can have a negative impact on bank capital.

Market/

Liquidity

Financial health of municipalities (local and national)

Threatened by budget and economic constraints, and reliant on monoline insurers, municipalities may have seen the ratings and values on their securities decline.

Banks with investments in municipal securities may face OTTI and loss of collateral value. Banks that provide financial services to municipalities may experience reduced public deposits and draws on lines of credit (financial or standby).

Market/
Liquidity

Interest rate environment

Fed Funds, LIBOR and other key market rates are at historic lows and their relationship to one another continues to evolve.

The basis risk between balance sheet items continues to increase; net interest margins may compress; and there may be incentives for yield chasing in the investment portfolio.

Market/
Liquidity

Financial health of Federal Home Loan Banks

According to ratings agency reports, the Federal Home Loan Banks (FHLBs) are currently facing the potential for accounting impairments on their private label MBS portfolio.

If investor demand for FHLB debt declines, the funding provided by the FHLBs to their member banks may be constrained, causing higher prices or limitations on advances.

Reductions in dividends and limitations placed on the ability to redeem FHLB stock may impact a bank’s modeling assumptions, investment values, and income projections.

Market/
Liquidity

Access to brokered deposits

Apart from FDIC restrictions on issuance, anecdotal information indicates that some brokers are opting not to sell certificates of deposit (CDs) issued by banks with poor standing on certain industry metrics.

Companies that rely on brokered CDs may face additional liquidity stress especially if certain financial ratios or metrics change.

Market/
Liquidity

Investments in trust preferred securities

Some banks have significant investments in trust preferred securities issued by other banks; dividends on many of these issues have been suspended.

Firms with significant holdings of trust preferred securities may face a heightened risk of reduced cash flows as economic conditions could result in more institutions deferring interest on these cumulative instruments.

Market/
Liquidity

Break-the-buck (BTB)

The Federal Reserve's policy decision to reduce its target rate to near zero has caused numerous registered money market funds to break the buck.

BTB situations could accelerate fund redemptions and result in further net asset value ( NAV) declines. Many funds have responded by reducing or waiving fees in order to reduce operating expenses that would normally be offset against assets, keeping NAVs stable.

Operations

Alterations to SFAS 140/

FIN 46

Accounting rules governing the housing of assets in special purpose entities (SPEs) are under review. A preliminary outline is due in the spring, with compliance required by January 2010.

Securitizing banks could see the qualified status of their SPEs revoked, moving assets back on the balance sheet and straining liquidity and capital. Participations that are not "plain vanilla" may also be affected.

Operations

Lookback periods for calculating the ALLL

Firms have traditionally used a reasonably long historical interval of loss rates to estimate loan provisions.

With loan quality deteriorating quickly due to market stress, a shorter historical horizon of loss rates or a prospective analysis may be more reflective of the current market conditions and may represent a more appropriate loan loss methodology.

Operations

Bank-Owned Life Insurance (BOLI) and

Corporate- Owned Life Insurance (COLI)

Several potential issues exist as the use of bank-owned and corporate-owned insurance has flourished over the past decade. Issues include proliferation of separate accounts at community banks, deterioration of wrappers' financial condition, and increased concentrations at banks with capital erosion.

Market downturns may increase the risk of losses in insurance holdings in separate account products. Community banks may not possess the expertise necessary to manage these products, particularly given recognized deficiencies in insurance risk management practices.

Operations

Pension plans

Depreciation in bank defined benefit plan assets increases the likelihood of an underfunded plan at an already stressful time for bank earnings and capital. Secondarily, market deterioration and fraud have resulted in numerous state/municipal plans being re-categorized as underfunded.

Underfunded plans could require additional funding and may trigger legal and reputational risk. State and/or municipalities with under-funded plans may have difficulty accessing markets without penalties. If realized, banks with exposure to those entities may see declines in values of existing securities.

Operations

Remote Deposit Capture (RDC)

RDC is one of the fastest growing products introduced by financial institutions with approximately 7,000 adopters. It allows bank customers, consumers or branches to make deposits by scanning the document electronically, transmitting for posting, and clearing.

Risks include legal, regulatory, credit, operational and fraud. The evolution includes a web-based application that may increase information security issues.

IT/BSA

Mobile banking

Mobile banking refers to the facilitation of financial transactions via mobile means (e.g. cell phones). The adoption rate is predicted to increase sharply in the years ahead.

Risks include legal, regulatory, credit, operational and fraud. Mobile banking has a higher exposure to IT risk due to browser-based applications.

IT/BSA