Risk Management
Types of Banking Risks
The Federal Reserve System has established a banking risk framework that consists of six risk factors: credit, market, operational, liquidity, legal and reputational risks. During examinations, institutions' risk management structures are reviewed using these risk categories.
Financial Institution Risk Management Programs
The Fed has also identified four key infrastructure components of effective risk management programs:
- active board and senior management oversight
- adequate policies, procedures and limits
- adequate risk-measurement, monitoring and management information systems
- comprehensive internal controls
Each type of risk, in turn, has its own specific types of risk controls.
Federal Reserve Bank of Chicago Risk Committee Findings
Every quarter, the Chicago Fed's Risk Committee meets to determine the top banking risks facing Seventh District banks in the upcoming months, and to develop appropriate supervisory responses. The following list of top banking risks incorporates the September 2008 results. Since banking conditions rarely change dramatically from quarter to quarter, the list of top risks tends to change only gradually over time.
We hope you find the Risk Committee's list useful, providing you with some insight on current concerns of bank supervisors.
Issue |
Background |
Impact |
Type |
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Outdated or inaccurate appraisals may make it difficult to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 |
Issue |
Background |
Impact |
Type |
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 |
Issue |
Background |
Impact |
Type |
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 |
Issue |
Background |
Impact |
Type |
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 |
|