1. Bank Liquidity and Wholesale Funding II Examination Guidance and Procedures

2. 2  Overview  UBPR ratios  Borrowings and Pledging  Interest Rate Risk  Capital and Earnings  Examples

3. 3 RD Memo, Transmittal #2000-046  Issued August 22, 2000  In response to: – Increase in FHLB membership – Increased complexity and short-term nature of advances  Discusses: – Asset/liability management strategies that banks employ with the use of advances – Framework for examining the effects of these strategies.

4. 4 Section 6.1 of the Manual of Examination Policies  Additional funding sources, such as: – Borrowings – Trust preferred securities – Asset securitization  Core versus non-core deposits  Brokered and rate sensitive deposits  Warning indicators for liquidity and contingency planning  Funding diversification versus cost  Changes in UBPR ratio analysis

5. 5 RD Memo, Transmittal #2002-039  Issued August 28, 2002  FDIC does not discourage use of wholesale funding sources when incorporated into well-managed funding program  Examiner comments/criticisms related to: – Degree of risk faced – Quality of bank management

6. 6 Supervisory Perspective  Risks associated with FHLB advance usage  Impact when managing: – Liquidity – IRR – Earnings – Capital

7. 7 Liquidity Implications  Historically - liquidity ratings were driven by balance sheet ratios  Now - possible for banks to operate with fewer liquid assets  Examiners – consider bank's access to wholesale funding sources

8. 8 Examination Guidance and Procedures  Overview  UBPR ratios  Borrowings and Pledging  Interest Rate Risk  Capital and Earnings  Examples

9. 9 Advance Usage and UBPR Liquidity Ratios  Advances categorized as non-core funding  Use can increase non-core funding dependence ratios

10. 10 Caution Be careful when determining institution's core funding sources. – Classified as core – may not be – Not classified as core – may be – Advances can increase the loans/deposits ratio

11. 11 When Assessing Liquidity…  Traditional liquidity ratios may not present accurate picture  Follow existing exam guidance – consider: – UBPR ratios – Stability of FHLB advances – Institutions unused borrowing capacity

12. 12 Examination Guidance and Procedures  Overview  UBPR ratios  Borrowings and Pledging  Interest Rate Risk  Capital and Earnings  Examples

13. 13 Secured Borrowings – Disadvantages  Require collateral to be pledged  Removes these assets as possible liquid sources  Concern is partially mitigated – FHLB accepts assets not normally considered liquid

14. 14 Ramifications of FHLB Advances  Banks should understand ramifications  FHLB can curtail advances if collateral quality deteriorates below standards  Banks should have backup plan  Banks should understand risks associated with Option-Advance Programs

15. 15 Funds Management Policies  Should discuss use of non-core funding sources  Limits and types should be outlined  Discuss how these funds should be used  Consistent with bank's strategic plan  Board should understand risks/rewards

16. 16 Red Flag  Rapid growth funded by advances  Strategy driven by consultant's recommendation more than board/management strategic plan

17. 17 Examination Guidance and Procedures  Overview  UBPR ratios  Borrowings and Pledging  Interest Rate Risk  Capital and Earnings  Examples

18. 18 FHLB Advances and IRR  Second area where FHLB advances should be evaluated  Advances can reduce or increase a bank's IRR exposure

19. 19 IRR Measurement System  Management measurement system  Capture effect advances and assets funded by advance has on the bank's IRR exposure

20. 20 Advance Containing Options  Pay special attention to these  Rise in interest rates – FHLB probably would exercise its option  Examiners – determine if bank's IRR measurement system accounts for terms of FHLB advances

21. 21 Examination Guidance and Procedures  Overview  UBPR ratios  Borrowings and Pledging  Interest Rate Risk  Capital and Earnings  Examples

22. 22 Purchasing Earning Assets  Some banks use advances to purchase earning assets  May cause increased IRR and credit risk  May cause a decline in the NIM and ROA  Monitor this risk/reward tradeoff

23. 23 Advances and Growth Strategy  Advances used as part of growth strategy require controls  Examiners – determine if institution has controls in place

24. 24 Projections  Projections should be made for: – Cash flows – Profits – Balance sheet composition – Resulting increase in risk  Examiners – review this activity

25. 25 Examination Guidance and Procedures  Overview  UBPR ratios  Borrowings and Pledging  Interest Rate Risk  Capital and Earnings  Examples

26. 26 Wholesale Funding Transaction Jan. 15, 2004 – Bank obtained FHLB advance and purchased FNMA note

27. 27 Wholesale Funding Transaction (continued)  Funding – $10 Million FHLB advance at 2.95% 121 bp less than a traditional 5-year, fixed-rate advance 31 bp less than a traditional 1-year, fixed-rate advance – 5-year /1-year option  Investment – $10 Million FNMA note at 4.11%  Matures on 1/15/2009

28. 28 Transaction Performance How did this strategy work? DateNoteAdvanceSpread 1/20044.11%2.95%116 bp On 2/15/2005 advance was called and replaced with a fixed rate, non-callable advance at 4.20% for a 3.75 year term. 2/2005 - Present 4.11%4.20%(9 bp)

29. 29 Replacement Funding  New advance  Spread on transaction changes dramatically – is negative  Initial low advance rate - attractive  Many institutions do not consider repercussions

30. 30 Risk Associated with Callable Advances  Option will be exercised to benefit FHLB  Detriment to the borrowing institution  Examiners may see this scenario

31. 31 Examiners – Consider These Questions  Does management understand characteristics/risks?  Is transaction consistent with bank's strategic plan?  Does transaction comply with bank's policy requirements?

32. 32 Also Consider…  Was management’s selection process of components carefully considered?  Prior to executing transaction – did management evaluate risk/reward tradeoffs?

33. 33 Finally, consider these questions…  Is the bank’s IRR measurement system capable of accurately modeling both the asset and liability components of the transaction?  What is the transaction’s effect on the bank’s overall IRR exposure?  What is the impact on the bank’s liquidity?

34. 34 Wholesale Funding Transaction  Proposed Transaction  Investment – $10 Million FNMA 5:0% CMO (Accretion Directed, TAC) – Average Life: 5 years – Yield: 4:98%  Funding – $10 Million FHLB Amortizing Advance – Maturity: 5 years – Rate: 3.09%

35. 35 Wholesale Funding Transaction Bank Balance Sheet:Before Transaction Total Assets $100 MillionLiabilities $90 Million Capital $10 Million Tier 1 Capital Ratio: 10% Bank Balance Sheet:Before Transaction Total Assets $110 MillionLiabilities $100 Million Capital $10 Million Tier 1 Capital Ratio: 9.1% Projected Spread: 1.89%

36. 36 Funds Management Policies  Leveraging with FHLB advances easily attained in large quantities allows for rapid growth  Banks need sound funds management policies  Growth should be planned and well- managed

37. 37 Questions Examiners Might Ask  Asset quality  Economic conditions  Overall risk profile With the decline in the bank's capital ratio, is the bank's capital position expected to remain satisfactory when considering trends in:

38. 38 A Growing Source of Funding  Growth in traditional core deposit products lag increases in non-core funding  Wholesale funding – secondary source of support for community banks  Yet, this funding source is growing

39. 39 Depositor Behavior  Influenced by several factors  Depositors more inclined to invest in shorter-term, highly liquid deposit products  Bank customers do not want to tie up dollars for extended periods of time

40. 40 We Might Ask:  Are these funds actually 'core' deposits?  How 'sticky' are these 'core' deposits?

41. 41 Higher Yields Depositors investing funds longer-term utilizing higher yielding deposit products (i.e. brokered, jumbo CDs)

42. 42 Wholesale Funding Trend  Due to various factors – wholesale funding plays prominent role in banking strategies  Trend likely to continue

43. 43 In the next section… Select the next section, Presentation Review, to continue.