Fundamentals of Sound Risk Management in Community Banks

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Fundamentals of Sound Risk Management in
Community Banks
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Agenda

• Key Elements of Sound Risk Management Programs
• Examples of Key Elements in Liquidity Risk
  Management
• Tools and References

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Why Are We Talking About This?
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Risk Management Key Elements

• Board and Senior Management Oversight
• Policies, Procedures, and Risk Limits
• Risk Measurement, Monitoring, and MIS
• Internal Controls

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Board And Senior Management Oversight

• Primary Board Responsibilities
• Possess working knowledge and remain informed of
  risks inherent in institutions activities
• Review and approve appropriate policies to limit
  key risks
• Periodically evaluate and approve risk exposure
  limits

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Board And Senior Management Oversight

• Primary Management Responsibilities
• Ensure business lines are adequately staffed with
  employees having sufficient expertise
• Provide adequate supervision of daily business
  activities
• Respond appropriately to risks arising from
  changes in competitive environment and/or market
  innovations
• Ensure that the proper infrastructure and
  internal controls are in place prior to embarking
  on new activities or products

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Board And Senior Management Oversight

• Key Issues Regarding Liquidity Risk Oversight
  Include
• Cashier/CFO and ALCO expertise
• Appropriate risk limits in liquidity risk
  management policies
• Consideration of liquidity crisis events in
  contingency funding plan and process
• Planning processes, MIS, and measurement tools to
  effectively carry out board guidance

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Policies, Procedures, and Risk Limits

• Generally, Policies Should
• Provide for proper identification, measurement,
  monitoring, and control of key risks
• Delineate accountability and authority
• Address new activities prior to implementation

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Policies, Procedures, and Risk Limits

• Example Key Asset/Liability Management Policy
  Components
• Delegation of clear lines of authority (ALCO/CFO)
• Quantifiable liquidity risk limits
• Specifications for measuring and reporting
  liquidity risks
• Guidance for completion and review of contingency
  funding plans

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Risk Measurement, Monitoring, and MIS

• Adequate Measurement and Monitoring Require
  Reporting Mechanisms That
• Sufficiently address all material risk areas
• Contain appropriate and reasonable inputs
• Communicate consistency with established limits,
  goals, and expected performance
• Provide accurate, timely, and sufficiently
  detailed information to identify adverse trends
  and current risk exposures

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Risk Measurement, Monitoring, and MIS

• Liquidity Risk Measurement Traditionally Focused
  on Analyzing Several Common Ratios
• Loans to deposits
• Noncore funding dependence
• Liquidity ratio
• Unpledged investments to total assets

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Risk Measurement, Monitoring, and MIS

• Limitations of Traditional Ratios
• Definition differs from reality
• noncore core and core noncore
• illiquid securities and liquid loans
• Static, point-in-time, not forward looking
• Based upon contractual maturities and do not
  incorporate behavioral expectations
• Does not measure anticipated funding needs or
  access to funds

Weak Risk Measurement Tools Lead to Weak Risk
Management
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Risk Measurement, Monitoring, and MIS

• Alternatives to Traditional Ratios
• Trended ratios adjusted for
• large deposits considered core
• small deposits demonstrating noncore features
• Liquidity gap reports
• Sources and uses reports and projections

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Risk Measurement, Monitoring, and MIS
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Risk Measurement, Monitoring, and MIS
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Internal Controls

• Preventative Controls
• Segregation of duties
• Approvals
• Dual controls
• Access limitations
• Contingency plans
• Detective Controls
• Audits
• Management reporting
• Activity logs

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Scenario Analysis and Contingency Funding Plan

• Types of Adverse Scenarios
• Institution specific
• asset quality concerns/capital loss
• unavailable borrowing lines
• operational risk/fraud
• reputation risk event
• Systemic
• uncertainty in market
• FFP and borrowing lines (market disruption)
• breakdown of brokered deposit markets
• systemic credit crisis

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Scenario Analysis and Contingency Funding Plan
Business As Usual
Less Likely
Unexpected
Each scenario requires the liquidity manager to
assess and plan for potential funding shortfalls
Adverse Scenarios
Bank Specific
Systemic
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Scenario Analysis and Contingency Funding Plan

• Contingency Funding Plan Components
• Quantitative
• based on adverse scenario analysis significant
  enough to cause problems
• estimates need to be reasonable
• is there over-reliance upon any one source?

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Scenario Analysis and Contingency Funding Plan

• Contingency Funding Plan Components
• Qualitative
• description of stress scenarios
• steps to declare a crisis, trigger events
• contact information for critical team members
• responsible parties to initiate external
  communication
• reporting requirements what, when, how

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Summary

• Key Elements of Risk Management
• Must be specific to each institutions risk
  profile
• Needs to be in place prior to commencing activity
• Sound Liquidity Risk Management Practices
• Appropriate risk limits
• Scenario analysis and contingency plan

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References

• Risk Management References
• Reserve Banks Web site
• SR Letter 95-51
• Commercial Bank Examination Manual
• Trading/Capital Markets Examination Manual

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Fundamentals of Sound Risk Management in
Community Banks
Questions?