Farm Credit System Economic Capital Project Update

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Farm Credit SystemEconomic Capital Project Update

• Greg Reno, Vice President
• U.S. AgBank, FCB
• RAAW Conference
• August 28, 2006

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Why Economic Capital?
Moodys System Financial Reporting Assessment
-2004
Category 2003 2004 Risk Management .... U
U Asset/Liability Management .. L U Asset
Quality . L U Adequacy of
Capitalization L L Liquidity and
Funding . U U Profitability ...............
.............................. M Overall
.. L U
U Useful M More Useful L Less Useful
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Why Economic Capital?
Moodys System Financial Reporting Assessment

• Reporting Weaknesses Adequacy of
  Capitalization
• The FCS provides useful information regarding
  regulatory capital requirements and compliance
  with these requirements. However, Moodys
  believes that a separate risk-based economic
  capital calculation to benchmark required equity
  capital relative to all the risks faced by the
  System would be more useful.
• Less Useful designation due to lack of
  information surrounding the Banks use of other
  capital models (e.g., economic capital).

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Why Economic Capital?
Moodys System Financial Reporting Assessment

• What information would Moodys like to see?
• Details of the use of other capital adequacy
  models in addition to the regulatory requirements
  (i.e., economic capital)
• Moodys believes that disclosing separate
  risk-based economic calculations of required
  capital as compared to all other System risks
  would support existing disclosures

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Economic CapitalWhat Does it Mean?

• Economic Capital
• Provides a consistent measure of risk across
  business lines within and among entities
• Amount of capital needed to withstand a
  worst-case loss, without going insolvent
• Capital for Unexpected Losses

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Economic CapitalWhat Does it Mean?

• The amount of Economic Capital needed is based
  upon an institutions risk profile and the
  solvency standard (AA, A, BBB, etc.) targeted by
  the institution

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Credit risk measurement

• Economic Capital additional inputs
• 4 Correlations
• 5 Maturity

• Expected Loss inputs
• 1 Probability of Default (PD)
• 2 Loss Given Default (LGD)
• 3 Exposure At Default (EAD)

Economic Capital
Loss Rate
Expected Loss
Time
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Economic Capital-A Consistent Approach

• PPC Established System workgroup for Economic
  Capital.
• Develop disclosure template
• Develop common Economic Capital model
• Develop standardized assumptions
• Evaluate system-wide PD/LGD Database.
• Provide communication to FCA on the Systems
  Economic Capital Efforts

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The initial System disclosure will be combined
Bank-only information.

• System-level information may be expected in the
  future model structure should consider this
  possibility.
• Disclosure of economic capital for retail credit
  risk may be desired in the future.
• Models should incorporate credit risk within the
  investment portfolios.
• Initial disclosures will not attempt to model
  structural, political, or liquidity risk.

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JPMorgan Chase Disclosure
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Citigroup Disclosure
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Managements Discussion and Analysis (MDA)

• Economic capital disclosure will be presented in
  MDA
• MDA - a qualitative discussion of the financial
  statements
• Purpose assist reader to better understand
  System financial position
• Disclosure must be consistent with financial
  statements
• Economic capital disclosure must have consistent
  application with common, defined assumptions

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FCB Economic Capital Table Example

• (in billions)
• Credit risk XX.X
• Interest rate risk XX.X
• Operational risk XX.X
• Economic risk capital XX.X
• Restricted capital (Insurance Fund) XX.X
• Other (excess capital) XX.X
• Combined Bank capital and
• Insurance Fund XX.X

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Basel II Preliminary Review

• In addition to current disclosures, additional
  Basel II disclosures to consider may include
• Amount of Tier 1, 2, and 3 capital
• Economic capital requirements for credit risk
  portfolios defined under the risk-based approach
• Analysis of PDs (expected versus actual)
• Exposure covered by collateral by credit risk
  portfolio
• Exposure covered by guarantees/credit derivatives
  by credit risk portfolio
• Total gross credit risk exposures plus average
  gross exposures over the period broken down by
  major types of credit exposure

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All System Banks will utilize a common economic
capital model.

• All 5 Banks have chosen BancWare E-Risk as their
  economic capital solution.
• Brannan Johnston has been the project manager for
  all System installations and serves on the
  Economic Capital Workgroup.
• Maintaining consistency among institutions in
  order to create a meaningful disclosure is a key
  focus of the workgroup activity.

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Multiple data sources populate the credit model
Exposure
Balances Commitments
ExpectedLoss
Exposure at Default
Portfolio historical data
Probability of Default
Default Risk Unexpected Loss
Credit Risk Capital
ERisk calibration analysis
Loss Given Default
Default correlations
Market data
Maturity-Risk Unexpected Loss
Portfolio concentrations
Portfolio snapshot data
Effective Maturity
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Other key credit risk parameters
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Operating risk is based on non-financial analogs
with similar business risks
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All Bank economic capital models will target a
AA solvency standard.

• Consistent with market expectations of a GSE
  issuer.
• Individual Associations may choose to operate at
  a lower solvency standard, but their funding bank
  must have sufficient capital to support a AA
  standard overall.

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Economic Capital is calculated from the total
risk distribution
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Economic CapitalWhat Does it Mean?
Financial Institution

• Economic Capital at a targeted AA Solvency
  Standard
• Means the likelihood of the institution incurring
  losses in excess of the Economic Capital amount
  is similar to the likelihood of a AA rated bond
  defaulting (3 in 10,000)
• The targeted Solvency Standard is not a Credit
  Rating for the Institution

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Financial institutions need capital to absorb the
risks undertaken
Unexpected Loss
Need capital to withstand this level of losses
without going insolvent
Loss Rate
Expected Loss
Time
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Each Bank model will aggregate individual
Association results into a Bank model.

• Impact of each individual borrower risk is
  aggregated by using this model structure.
• Consistent structure across all five banks.

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To determine Economic Capital needs, risks are
aggregated
Asset/Liability Management Risk
Market Risk
Risk Correlation
Operating Risk
Credit Risk
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The first disclosure is tentatively planned for
2008, based on 12/31/07 information.

• Each Bank is at a different stage of the
  installation process.
• Initial adjustment/analysis may take at least one
  year per Bank/District.
• Ultimately, Bank CFOs and System Audit Committee
  must sign off on disclosure.
• Efforts should continue to target 12/31/07.
• Plan for an internal trial based on 12/31/06.

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The System should develop market-based standard
PD/LGD benchmarks.

• Benchmarks should be consistent with investor
  expectations, and System lenders should work to
  adjust standards to achieve results consistent
  with the benchmark.
• Benchmarks should be based on all domestic
  borrower defaults, not just ag-related.
• System has reviewed proposals from Moodys and
  SP to provide benchmark data. Moodys was
  selected.

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Moodys Benchmark PD Rates
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The System should develop a system-wide PD/LGD
database.

• Merits outweigh any potential cost.
• There will be considerable economic value to
  outsiders for this data in the future.
• Recommend housing at a System technology
  provider.
• Access, as approved by PPC, via secure website.

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The System needs to continue to coordinate
communicate with FCA on economic capital issues.

• FCA will not consider economic capital regulation
  development in 2006.
• FCA is evaluating Basel 1a-type regulation
  development in 2007.
• System must coordinate communications with FCA on
  this topic through PPC.

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Top 5 reasons you should care about Economic
Capital

• Price loans to earn appropriate risk adjusted
  spreads.
• Meet future regulatory risk-based capital
  adequacy modeling requirements
• Measure Return on Equity by Line of Business,
  Product, or Customer
• If you dont understand Economic Capital, your
  replacement will.
• If you dig RAROC, you rock!!