01 Jan How Forward-Looking Risk Analytics Became an Essential Community Bank Tool
How Forward-Looking Risk Analytics Became an Essential Community Bank Tool
Actions by regulators in the waning months of 2015 should serve as notice to community banks that ignoring forward-looking analytics will lead to lower CAMELS scores, more examiner scrutiny and higher regulatory capital requirements. The new current expected credit loss model (CECL), which is expected early this year, is also a forward-looking tool.
Amid signs that community banks are again accumulating higher concentrations of risky commercial real estate loans, regulators are reminding banks that stress testing is indeed required to manage concentration risk in their portfolios and to develop realistic scenarios for interest rate risk management. (See “Regulators to Banks: CRE Lending May Lead to More Required Capital,” p. 1).
The large banks have already adopted forward-looking risk analytics and are using the results with regulators. Although community banks are not subjected to the same stress testing requirements as the large banks, the regulatory trend is in the same direction. Those community banks that fail to incorporate new analytics into their risk management systems will find it increasingly difficult to communicate effectively with regulators, who are using forward-looking risk analytics themselves.
Regulatory Paper Trail
The Federal Deposit Insurance Corp. quietly began training its examiners for a new “forward-looking supervisory approach” as early as 2009. Examiners were taught to “carefully assess the institution’s overall risks, and base ratings not on current financial condition alone, but rather on consideration of possible future risks.” The FDIC said it would use both on-site and off-site reviews and “accurate metrics” to identify risk in balance sheets.
The FDIC’s 2015 annual performance plan discussed the need “to implement more forward-looking supervision techniques” for well-rated banks, including those with CAMELS composites of 2, so it could spot deficiencies before they require formal action.
The FDIC has also proposed changing the way it assesses deposit insurance for community banks. The forward-looking proposal counts construction and development loans as higher risk under a new loan mix index, which could lead to higher assessments.
The Federal Reserve hinted early in 2015 that it was using forward-looking risk analytics to ferret out weaker community banks. The Fed ended the year by announcing it had made its supervision framework “more forward-looking and data-driven.” The new program includes the use of forward-looking metrics to target high-risk banks “for enhanced supervision,” while identifying “low-risk” banks that would merit more of a “streamlined supervisory approach.”
The Fed program will include an outlier list and a watch list that would identify banks “with expanded or new areas of risk-taking” and flags those in the early phases of financial trouble. The algorithms used in the data modeling were first tested on community banks, the Fed wrote, but they are now being expanded and customized for all banks. Some metrics are still being developed and full implementation is not expected until 2017.
OCC Embraces Forward-Looking Analytics
The OCC issued a memo to examiners in 2011, noting that one of the tenets of good forward-looking supervision is assigning an adverse rating to the management component of a CAMELS composite before a bank had deteriorated financially, a 2013 OCC audit revealed. The memo noted that the M score should focus on actions and results, not commitments.
Of all the regulators, the OCC has been the most vocal in advocating for forward-looking community bank analytical tools. It issued guidance for community bank stress testing in 2012, reiterating that “some form of stress testing or sensitivity analysis of loan portfolios on at least an annual basis” was a key part of sound risk management for community banks. In June 2012, the OCC also issued revised guidance on capital planning. The document said capital planning must be “forward-looking in incorporating changes in a bank’s strategic focus, risk tolerance levels, business plans, operating environment, or other factors that materially affect capital adequacy.”
Then, in December of 2015, the OCC announced that it had updated its guidance for its Risk Assessment System to clarify the “forward-looking elements” of both the system and CAMELS. The guidance “broadens the concept of risk” to include its impact on a bank’s projections. It also expands the definition of strategic and reputation risk assessments to include both the quantity and quality of risk management. The guidance notes that under the new definitions, “financial condition includes impacts from diminished capital and liquidity,” and that capital includes potential impacts from losses, reduced earnings and market value of equity.
Community banks need to be proactive to ensure they are ready for examiners armed with forward-looking risk analytics. Even if your bank doesn’t have CRE concentrations, use forward-looking risk analytics to stress test your capital, your strategic plans and any potential acquisition you might be considering. Present the results to regulators. Invictus’ clients that have used stress testing results with examiners have seen their capital requirements decrease and their management piece of their CAMELS composite increase.
Forward-looking risk analytics are here, and their use will only expand. Embrace them to smooth the regulatory path, and give your bank a competitive edge in the marketplace.
Editor’s Note: This Bank Insights article is adapted from a forthcoming Invictus Consulting Group white paper. For more information on Invictus’ forward-looking risk analytics and how they can help your bank, please contact George Dean Callas at email@example.com.