Credit Risk Management Wisconsin Bankers Directors Education Series 1

Why Is This So Important Today?  This banking crisis began in late 2007 and continues to be an issue for banks throughout the country …  One of the main criticisms leveled at the banking industry has been the lack of diversification in loan portfolios coupled with a concentration of real estate loans.  In fact, most, if not all, Consent Orders include this as a main issue for troubled institutions.  There are certain kinds of real estate loans that are higher risk and very much on the regulators radar.

REGULATORY DEFINITION LOAN MIX & LEVEL AS A % OF RISK BASED CAPITAL LIMITLOAN DEFINITION BY CALL REPORT 50%1-4 FAMILY CONSTRUCTION LOANS 50%COMMERCIAL CONSTRUCTION LOANS 30%ACQUISITION & DEVELOPMENT LOANS 30%VACANT LAND LOANS 150%SUB-TOTAL (REGULATORY TRIGGER – 100%) 150%NON-FARM NON-RESIDENTIAL (NON OWNER OCCUPIED) 50%MULTI-FAMILY (5+) RESIDENTIAL PROPERTY 350%TOTAL (REGULATORY TRIGGER – 300%) 175%NON-FARM NON-RESIDENTIAL (OWNER OCCUPIED) 500%TOTAL BANK CONFIDENTIAL I Copyright 2012, KPN Consulting, LLC I All Rights Reserved

LOAN PORTFOLIO HISTORICAL PERFORMANCE NET CHARGE-OFF RATE : Q42011: Q32011: Q22011: Q12010: Q42010: Q32010: Q22010: Q1 TOTAL RE LOANS 1.24%1.27%1.42%1.47%2.00%1.89%1.99%2.11% C & D LOANS 3.23%3.40%3.33%3.75%6.28%5.73%5.30%5.34% 1-4 FAMILY RESIDENTIAL CONSTRUCTION LOANS 4.16%4.99%3.88%4.31%8.10%6.66%6.80%7.08% HELOCS 1.82%2.02%2.16%2.20%2.29%2.50%2.65%3.12% C & I LOANS 0.78%0.83%0.88%1.14%1.54%1.79%1.83%2.01% CREDIT CARDS 4.38%5.43%5.42%6.69%7.41%8.47% % % CONFIDENTIAL I Copyright 2012, KPN Consulting, LLC I All Rights Reserved

LOAN PORTFOLIO HISTORICAL PERFORMANCE NET CHARGE-OFF RATE : Q42009: Q32009: Q22009: Q12008: Q42008: Q32008: Q22008: Q1 TOTAL RE LOANS 2.67%2.22%2.06%1.44%1.69%1.20%1.16%0.73% C & D LOANS 8.00%6.09%5.75%3.28%5.22%2.94%2.28%1.12% 1-4 FAMILY RESIDENTIAL CONSTRUCTION LOANS 9.43%7.96%7.61%4.47%6.58%4.37%3.53%1.81% HELOCS 3.13%3.05%3.04%2.37%1.99%1.84%2.03%1.54% C & I LOANS 2.72%2.64%2.44%1.82%1.62%1.06%0.87%0.68% CREDIT CARDS 9.80% % 9.95%7.79%6.17%5.61%5.52%4.83% CONFIDENTIAL I Copyright 2012, KPN Consulting, LLC I All Rights Reserved

BASIC PROBLEM  Boards are biased toward collateral lending and real estate Is often the collateral of choice.  Younger lenders have not been provided cash flow lending training and have become accustomed to the use of collateral as the basic support for the loan.  “If You Got The Dirt, You Can’t Get Hurt” became a common theme during the 1992 – 2006 era for many commercial banks. CONFIDENTIAL I Copyright 2012, KPN Consulting, LLC I All Rights Reserved

REALITY CHECK  During the 1992 – 2006 era, higher risk-higher return lending became a very popular growth strategy …  A&D and Construction loans had the best fees and rates and hence became the loans of choice …  With ever-increasing real estate values, banks that adopted this strategy were rewarded with higher profits and …  In geographies where people were desirous of living, these real estate values grew at an unsustainable pace …  But, this environment also bred a certain laziness in underwriting … CONFIDENTIAL I Copyright 2012, KPN Consulting, LLC I All Rights Reserved

REALITY CHECK  And these issues led to significant losses to our industry that were on display in 2008 –  To be clear, there is nothing wrong with real estate as collateral – rather, it is the lack of attention to repayment through cash flow as opposed to collateral liquidation that is the problem.  And that leads us to diversifying our loan portfolio by addressing the C&I lending opportunity today. CONFIDENTIAL I Copyright 2012, KPN Consulting, LLC I All Rights Reserved

C&I LENDING Key Differences Between Collateral Lending and C&I Lending:  Collateral lending tends to focus on the value of the collateral as the key to the decision …  C&I lending tends to focus on trend analysis as the key to the decision …  And trend analysis tends to be more strenuous as it is focused on at least three time periods. CONFIDENTIAL I Copyright 2012, KPN Consulting, LLC I All Rights Reserved

C&I LENDING  C&I Lending is about observing trends in both the balance sheet and income statements of the borrower then using those trends to aid in making the credit decision.  With this trend analysis, lenders have a much better basis for making the credit decision.  This kind of lending also focuses on factors that provide a much better basis for credit decisions.  And, these factors take away much of the risk that goes with typical real estate transactions… CONFIDENTIAL I Copyright 2012, KPN Consulting, LLC I All Rights Reserved

C&I LENDING  These factors include:  Understanding how successful the potential borrower has been over time  Understanding how the business converts inventory into cash and how successful they have been over time  How much leverage is present in the balance sheet  How consistent has the cash flow been over time  How much asset deterioration will have to occur before your loan is at risk, etc.  C&I lending also involves much less leverage than real estate lending and provides more asset protection. CONFIDENTIAL I Copyright 2012, KPN Consulting, LLC I All Rights Reserved

C&I LENDING  This kind of lending is also more attuned to relationship management as opposed to transaction management…  As opposed to the real estate borrower shopping for the best rate, C & I borrowers tend to shop for the best service and those institutions with the most experienced lenders will have the most success …  C & I lending also provides the bank with more opportunities for other services and income… CONFIDENTIAL I Copyright 2012, KPN Consulting, LLC I All Rights Reserved

KEY CONCEPTS FOCUS ON TRENDS CONSISTENCY IS KEY CORE BUSINESS KNOW BUSINESS OF BUSINESS UNDERSTAND OPERATING ENVIRONMENT UNDERSTAND MANAGEMENT OF BUSINESS ANTICIPATE THE FUTURE MANAGE TO REPAYMENT INSPECT WHAT YOU EXPECT Also, C&I lending focuses the bank on credit ! CONFIDENTIAL I Copyright 2012, KPN Consulting, LLC I All Rights Reserved

CREDIT DECISION APPROACH MANAGE INFORMATION MONITOR / LOAN MANAGEMENT TIMELY RECOGNITION OF DETERIORATION ASSESS INFORMATION STRENGTHS / WEAKNESSES / UNCERTAINTIES GATHER INFORMATION ENVIRONMENT = MARKETPLACE FACTORS IMPACT BUSINESS MANAGEMENT = BORROWER’S RESPONSE TO ENVIRONMENT FINANCIAL STATEMENTS = SUMMARY OF BORROWER’S RESPONSES CONFIDENTIAL I Copyright 2012, KPN Consulting, LLC I All Rights Reserved

C&I OPPORTUNITIES C&I LENDING COMES FROM BUSINESSES THAT ARE: SERVICE PROVIDERS RETAILERSWHOLESALERSMANUFACTURERS Generally speaking, the more financial information available, the lower the risk! CONFIDENTIAL I Copyright 2012, KPN Consulting, LLC I All Rights Reserved

WHERE SOME WENT WRONG “Hunter” – “Skinner” Approach – Inexperienced lenders – Experienced businesses – Single transaction as opposed to creating relationship – Managing deal without managing relationship C & I lending is about developing more and more business with the borrower through trust based on performance. In particular, developing deposit and employee relationships that enhance the credit decision. It should also lead to … CONFIDENTIAL I Copyright 2012, KPN Consulting, LLC I All Rights Reserved

CREDIT PROCESS COMPONENTS PORTFOLIO MANAGEMENT PORTFOLIO ACQUISITION PORTFOLIO MAINTENANCE And this will lead to a better credit experience! CONFIDENTIAL I Copyright 2012, KPN Consulting, LLC I All Rights Reserved

KEYS FOR SUCCESS  Each portfolio must be manageable and lender must have time to develop relationship.  Developing the relationship represents the best new business opportunity.  Maintaining contact with the borrower is key not only for risk mitigation but also for expanding profitability.  Following the financial progress on a quarterly basis assures greatest opportunity for success.  Creating the right structure for the borrower is crucial. CONFIDENTIAL I Copyright 2012, KPN Consulting, LLC I All Rights Reserved

WHY NOW?  Regulators want diversification  Borrowers want choice  Community bankers are best positioned to execute  Diversification will create a more consistent and profitable performance over time CONFIDENTIAL I Copyright 2012, KPN Consulting, LLC I All Rights Reserved