Risk Management

Allowance for Loan and Lease Losses (ALLL)

Firms are failing to maintain an adequate allowance for loan and lease losses (ALLL) and/or are not updating methodologies to reflect the current adverse economic environment. Some Seventh District banks are using long look-back periods for the calculation, which may not be appropriate in the current environment. Some have required significant special provisions to restore ALLL adequacy.

Inadequate maintenance of ALLL impacts earnings and capital. Firms may need to incur substantial ALLL expenses. Provisions may result in firms falling below the PCA "Well Capitalized" threshold.

Credit

Commercial Real Estate (CRE) Valuations

Firms continue to delay in obtaining updated appraisals on property that serves as collateral for loans. Some Seventh District banks have significant CRE exposure.

Outdated or inaccurate appraisals may make it difficult to assess the health of the credit and/or the adequacy of the ALLL.

Credit

CRE Rollover

Since most CRE construction and land development (CLD) loans are made with short maturities, the average Seventh 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 acquire 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

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 significantly increased in previous 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. Firms may be tempted to finance the sale of OREO property to remove it from the balance sheet.

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. Sales financed by the bank may trigger adverse accounting consequences if not structured properly.

Credit

Automaker/ Auto Dealer Exposure

Many banks in the Seventh 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

Mortgage Products

Delinquency rates on home equity portfolios and first lien mortgages have increased over the past year. These pressures are most acute for loan types and property geographies found less often in Seventh District banks.

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

Credit

Syndicated Credits

Shared National Credit (SNC) exposures at community banks have recently increased. Some firms have used participations to build C&I loan portfolios, but have not kept up with agent banks on credit performance.

Deterioration in the asset quality of syndicated loans can have an outsized impact on banks with significant SNC concentrations. Community banks may not have appropriate CRM and reporting to properly monitor the SNC portfolio.

Credit

Sunset of Government Support Programs

Firms are preparing for the sunset dates, reduced availability, or more stringent conditions attached to the Federal programs that were designed to address liquidity and capital needs. Some firms are seeking to prove financial independence by extricating themselves from various government commitments such as TARP.

Banks are assessing the potential reputation risk associated with participating in and exiting the Federal 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

Constricted Liquidity at Problem Banks

Firms which experience declines in ratings on other aspects of their operations will experience restrictions on access to certain liquidity sources.

The FDIC limits access to brokered deposits for firms not in good standing, and secured lenders (including the Discount Window) may require additional collateral. Additionally, poor financial performance (weak earnings, stressed capital) can have a negative effect on counterparty risk tolerance.

Market/
Liquidity

Investment portfolio—classification of securities Other Than Temporary Impairment (OTTI) and Risk-Weighted Capital Treatment

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 and/or an increase in risk-weighted assets. These can have a negative impact on bank capital.

Market/
Liquidity

Collateral Valuation Changes at the FRB Discount Window

The Federal Reserve Bank (FRB) Chicago Discount Window is adjusting advance rates on certain collateral types.

Firms with significant levels of outstanding borrowings and/or deteriorating financial condition may have reduced borrowing capacity with current collateral pledged.

Market/
Liquidity

Municipal Finance

Threatened by budget and economic constraints, the debt ratings of some local governments have come under pressure. Some states may have strained or underfunded public deposit insurance schemes. Furthermore, as bank conditions deteriorate, local municipalities may have less money to deposit at local banks.

Holdings of municipal bonds may experience some declines in value. Banks that rely on public deposits may find that they need to provide additional collateral to pledge against these deposits as state insurance support becomes increasingly uncertain. Public deposit insurance funds may raise premiums or may discontinue insurance coverage.

Market/
Liquidity

Access to Brokered Deposits and Rates Paid on All Deposits

The FDIC continues to focus on the level of brokered deposits within banks' balance sheets. The FDIC's adopted final rule on brokered deposits goes into effect January 1, 2010. Interest paid on all deposits of banks with less than a PCA designation of "Well Capitalized," will be limited to rate caps unless supporting evidence indicates that regional rate caps are higher.

Banks may find reduced access to brokered deposits if certain financial ratios or metrics change, thus providing further strain on liquidity sources. If less than PCA Well Capitalized, banks are expected to limit rates paid on deposits to national rate caps published weekly by the FDIC. Banks have the option to use regional rate data to support a higher rate cap but must provide support for such variances from national data.

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

Making Homes Affordable (MHA) Refinance and Modification Programs

Federal programs for home loan modifications and refinancing could impact institutions in a number of areas, including reducing the value of mortgage backed securities (MBS), and Mortgage Servicing Rights (MSRs) and reducing net interest margins (NIM).

Firms with significant refinancing or modification activity could see reduced NIM and changes in the fair value of MBS holdings and MSRs. Additionally, firms will need to review impacts on IRR modeling assumptions.

Market/
Liquidity

FDIC Prepayment Assessment

The FDIC will require that all institutions prepay their assessments through the year 2012 by 12/30/09.

Firms with tight short-term liquidity may have a difficult time meeting this request without additional borrowings.

Market/
Liquidity

Asset Securitization Market Hurdles

The market for new asset-backed securities (ABS) issues is frozen. Factors attributing to this include disputes on which party claims securitized assets in the event of a bank failure.

Lower ratings will raise the cost of securitization as a source of funding.

Market/
Liquidity

Prepayment Modeling Challenges

Given the long-term mortgage rate environment and inferred divergence between interest rates and prepayment speed relationships realized in 2008 and 2009, prepayment models have not been accurate predictors of prepayment behavior.

Current models based on historical data may not reflect appropriate prepayment speeds going forward. Banks may be overstating or understating their interest rate exposure depending upon prepayment assumptions.

Market/
Liquidity

FAS 166/167 Potential Consolidation of Off-balance-sheet Assets

Implementation of FAS 166/167 rulings may require consolidation of formerly off-balance-sheet assets such as SIV/conduits, securitized assets and asset management funds. The stricter rulings recognize the extent to which formerly off balance sheet activities were supported by banking organizations during the financial crisis.

Stricter interpretative guidance based on factors of control and economic benefit poses on-balance-sheet consolidation of formerly off-balance-sheet assets. Once consolidated on balance sheet, firms will be required to hold risk-based capital in support of these assets. These formerly off-balance-sheet assets must be reported on balance sheet and earnings statements effective November 15, 2009.

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

Equity markets' volatility continues to impact funding ratios for those banking institutions still sponsoring defined benefit pension plans. Declines in funding ratios exacerbate claims on bank capital and earnings, which are already under pressure.

Market deterioration and fraud have resulted in numerous state/ municipal pension plans being re-categorized as underfunded. The impact on states' bond ratings for underfunding is dependent, in part, on statutory funding requirements.

Underfunded plans could require additional funding and may trigger legal and reputational risk. State and/or municipalities with underfunded plans may have difficulty accessing capital markets at favorable terms. Banks with exposure to those municipalities may see declines in the value of existing municipal securities.

Plan sponsors are re-assessing risks with concerns for exposure to securities lending, alternative investments, large-cap vs. mid and small cap equity and liability driven investments.

Operations

Break-the-Buck (BTB) Money Market Funds (MMF)/Stable Value Funds (SVFs)

Broken buck concerns exist for SVFs that feature a guarantee of both return and principal to investors, To the extent that SVFs have depressed market to book Net Asset Values (NAVs), third party "guarantors are obliged to make investors whole on their guaranteed portions of the portfolio. SVFs' third party guarantors seek to renegotiate and/or void their contractual guarantees.

Fiduciary banks could experience systemic runs on these funds due to depressed NAVs, fueled by an actual or perceived risk of wrappers/ guarantors voiding their guarantees. To the extent wrappers/guarantors are successful in voiding their obligations, fiduciary banks face heightened legal and reputational risk exposure.

Legal/
Operations

2-a7 Money Market Fund (MMF)Rule Changes

As early as 2010:Q1, the SEC may finalize MMF rule changes designed to reduce the risk of future investor panic and the resulting commercial paper (CP) market freeze, as experienced in 2008. The proposed changes include tightening MMF quality and liquidity restrictions, eliminating MMFs' stable $1 NAV and mandating stress testing of MMFs' access to liquidity.

MMFs hold 40% of all CP issuances. The proposal to limit the funds' weighted average maturity (WAM) to 60 days could impact CP term issuers' funding costs via both higher rates and increased rollover risk. Investor demand may shift to "safer" bank CDs if MMFs' eliminate stable $1 NAVs.

Legal/
Reputational/Liquidity

Increased Risk of Fraud

Current market conditions exacerbate the risk of both internal and external fraud. Examples include financial reporting fraud, Ponzi schemes, mortgage fraud, foreclosure and loan modification fraud, payment system fraud, identity theft, insider and external exploitations of problem banks and malicious penetration of information technology (IT) systems.

Financial institutions may face increased financial and reputational risk. They must monitor internal controls to verify that deficiencies are addressed in a timely fashion.

Reputational/
IT/BSA

Payment Card Industry (PCI)

The PCI uses personal information to conduct financial transactions. Misuse or uncontrolled dissemination of the data may negatively impact the "trust" relationship.

Fraud perpetrated through illegal access to information presents financial, reputational and legal risk.

IT

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

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

Fraudulent Electronic Funds Transfers (EFTs)

Banks offering commercial internet banking products have been reporting an increase in fraudulent EFTs. Hackers use authentic log-in credentials from corporate clients to “impersonate� them and initiate transactions.

Risks include legal, regulatory, credit, operational and fraud. Commercial internet banking products often lack true two-factor authentication, and customers are often lax regarding security diligence/patching.

IT

Pandemic Virus Outbreak (e.g. H1N1 Flu)

As of Oct 5, 2009, twenty-seven states reported widespread influenza activity (almost all viruses reported are H1N1) Confirmed cases and deaths continue to rise..

The adverse economic effects of a pandemic event could be significant, both nationally and internationally. Due to their crucial financial and economic role, financial institutions should have plans in place that describe how they will manage through a pandemic event.

IT

BSA: Tax Evasion Disclosure

An increase in the number of high net-worth individuals secreting away money may mean greater government scrutiny of foreign bank accounts and complicit financial institutions.

Financial institutions that actively create and market off-shore investment programs for clients need to ensure that due diligence is conducted and a legitimate business reason for the structure exists.

BSA