Now Is The Time to Use Data The Right Way

data-6-29-18.pngMost bankers are aware of the changes that are forthcoming in accounting standards and financial reporting for institutions of all sizes, but few are fully prepared for the complete implementation of all of the details in the new current expected credit loss (CECL) models that will take effect over the next few years.

Banks that act now to effectively and strategically collect, manage and utilize data for the benefit of the institution will be better positioned to handle the new accounting requirements under CECL and evolving regulations with state and federal agencies.

Here are three articles that cover key areas where your board should focus its attention before the rules take effect.

credit-data-6-29-18.pngCredit Data Management
Under Dodd-Frank, the law passed in the wake of the financial crisis, banks of all sizes and those especially in the midsize range of $10 billion to $50 billion in assets were required to do additional reporting and stress testing. Those laws have recently been changed, but many institutions in that asset category are opting to continue some form of stress testing as a measure of sound governance. Managing credit data is a key component of those processes.

management-6-29-18.pngCentralizing Your Data
Bank operations are known to be siloed in many cases as a matter of habit, but your data management can be done in a much more centralized manner. Doing so can benefit your institution, and ease its compliance with regulations.

CECL-6-29-18.pngGet Ready for CECL Now
The upcoming implementation of new CECL standards has many banks in a flurry to determine how those calculations will be developed and reported. Few are fully ready, but it is understood that current and historical loan level data attributes will be integral to those calculations.

M&A Readiness: Making Sure Your Bank Can Do Acquisitions

acquisitions-5-10-17.pngWith many financial institutions benefiting from increased stock values and renewed optimism following the November election, merger activity for community banks is on the uptick. Successful acquirers must remain in a state of readiness to take advantage of opportunities as they present themselves.

Whether a prolonged courtship or a pitch book from an investment banker, deals hardly, if ever, show up when it is most convenient for a buyer to execute on them. As a result, buyers need to develop a plan as to what they want, where they want it and what they are willing to pay for it, long before the “it” becomes available. M&A readiness equates to the board of directors working with management to have a well-defined M&A process that includes the internal and external resources ready to jump in to conduct due diligence, structure a transaction and map out integration. Also, M&A readiness requires that buyers have their house in order, meaning that their technology is scalable, they have no compliance issues and the capital is on hand or readily available to support an acquisition.

Technology. In assessing the scalability of an institution’s technology for acquisitions, a buyer should review its existing technology contracts to see if it has the ability to mitigate or even eliminate termination fees for targets that utilize the same core provider. Without this feature, some deals cannot happen due to the costs of terminating the target’s data processing contracts. Cybersecurity is another key element of readiness. As an institution grows, its cybersecurity needs to advance in accordance with its size. Buyers need to understand targets’ cybersecurity procedures and providers in order to ensure that their own systems overlap and don’t create gaps of coverage, increasing risk. Additionally, buyers should understand existing cybersecurity insurance coverage and the impact of a transaction on such policies.

Compliance. Compliance readiness, or lack thereof, are the rocks against which even the best acquisition plans can crash and sink. Ensure that your Bank Secrecy Act/anti-money laundering programs are above reproach and operating effectively, and that your fair lending and Community Reinvestment Act policies, procedures and practices are effective. Running into compliance issues will cause missed opportunities as the regulators prohibit any expansion activities until any issues are resolved.

Conducting a thorough review of compliance programs of a target is critical to an efficient regulatory and integration process. A challenge to overcome is the regulators’ prohibition on buyers reviewing confidential supervisory information (CSI), including exam reports as part of due diligence. While the sharing of this information has always been prohibited, the regulatory agencies have become more diligent on enforcement of this prohibition. Although it is possible to request permission from the applicable regulatory agency to review CSI, the presumption is that the regulators will reject the request or it will not be answered until the request is stale. As such, buyers should enhance their discussions with target’s management to elicit the same type of information without causing the target to disclose CSI. A simple starting point is for the buyer to ask how many pages were in the last exam report.

While stress testing may officially apply to banks with $10 billion or more in assets, regulators are expecting smaller banks to prevent concentrations of risk from building up in their portfolios. The expectation is for banks to conduct annual stress tests, particularly among their commercial real estate (CRE) loans. Because of these expectations, buyers need to know the interagency guidance governing CRE concentrations and how they will be viewed on a combined basis. Reviewing different stress-test approaches can help banks better understand the alternatives that are available to meet their unique requirements.

Capital. An effective capital plan includes triggers to notify the institution’s board when additional capital will be needed and contemplates how it will obtain that capital. Ideally, the buyer’s capital plan works in tandem with its strategic plan as it relates to growth through acquisitions. Recently the public capital markets have become much more receptive to sales of community bank stock, but this has not always been the case. In evaluating an acquisition, the regulators will expect to see significant capital to absorb the target as well as continue to implement the buyer’s strategic plan.

The increase in financial institution stock prices has increased acquisition opportunities and M&A activity since the election. Opportunistic financial institutions have plans in place and solid understandings of their own technology needs and agreements, regulatory compliance issues and capital sources. Although it sounds simple, a developed acquisition strategy will aid buyers in taking advantage of opportunities and minimizing risk in the current environment.

To Better Understand Bank Real Estate Credit Concentrations, Give Your Portfolio a Workout

stress-test-4-19-17.pngBy now, the vast majority of banks with credit concentrations in excess of the 2006 Interagency Regulatory Guidance have discussed this with regulators during periodic reviews. To underscore the importance of this to the regulators, a reminder was sent by the Federal Reserve in December of 2015 about commercial real estate (CRE) concentrations. The guidance calls for further supervisory analysis if:

  1. loans for construction, land, and land development (CLD) represent 100 percent or more of the institution’s total risk-based capital, or
  2. total non-owner-occupied CRE loans (including CLD loans), as defined, represent 300 percent or more of the institution’s total risk-based capital, and further, that the institution’s non-owner occupied CRE loan portfolio has increased by 50 percent or more during the previous 36 months.

While the immediate consequence of exceeding these levels is for “further supervisory analysis,’’ what the regulators are really saying is that financial institutions “should have risk-management practices commensurate with the level and nature of their CRE concentration risk.” And it’s hard to argue with that considering that, of the banks that met or exceeded both concentration levels in 2007, 22.9 percent failed during the credit crisis and only .5 percent of the banks that were below both levels failed.

So the big question is: How to mitigate the risk? Just like the idea of having to fit into a bathing suit this summer can be motivation to exercise, the answer is to give your loan portfolio a workout.

And in this context, that workout should consist of stress testing designed to inform and complement your concentration limits. In other words, the limits you set for your bank should not exist in a vacuum or be made up from scratch, they need to be connected to your risk management approach and more specifically, your risk-based capital under stress. What’s necessary is to take your portfolio, simulate a credit crisis, and look at the impact on risk-based capital. How do your concentration limits impact the results?

For our larger customers, we find that a migration-based approach works best because the probability of default and loss given default calculations can come from their own portfolio and they can be used to project forward in a stress scenario (1 in 10 or 1 in 25-year event, for example). For our smaller banks or banks that do not have the historical data available, we use risk proxies and our own index data to help supplement the inevitable holes in data. Remember, the goal is to understand how the combination of concentrations and stress impacts your capital in a data-driven and defensible way.

Additionally, the data repository created from the collection of the regulatory flat files (the only standardized output from bank core systems) can be used for a variety of purposes. This data store can also be used to create tools for ongoing monitoring and management of concentrations that can include drill down capabilities for analysis of concentrations by industry, FFIEC Code, product/purpose/type codes, loan officer, industry and geography (including mapping), and many others. The results of loan review can even be tied in. The net result is a tool that provides significant insight into your portfolio and is a data-driven road map to your conversation with your regulators. It also demonstrates a bank’s commitment to developing and using objective analytics, which is precisely the goal of the regulators. They want banks to move past the days of reliance on “gut feel” and embrace a more regimented risk management process.

When the segmentation and data gathering is done well, you are well positioned to drive your portfolio through all sorts of different workouts. The data can be used for current allowance for loan and lease losses, stress testing, portfolio segmentation, merger scenarios and current expected credit loss (CECL) calculations, as well as providing rational, objective reasons why concentration limits should be altered.

And just like exercise, this work can be done with a personal trainer, or on your own. All you need is a well thought out plan and the discipline to work on it every day as part of an overall program designed for credit risk health.

Why a Compliance Mindset Is Hurting Community Banks

risk-management-1-20-17.pngCommunity banks are wasting money on compliance. They are spending more than ever, hiring additional risk officers, internal auditors, compliance officers, vendors and consultants. They are checking every box and fulfilling every mandate. And they are doing it all wrong.

A recent study by the supervision division at the Federal Reserve Bank of St. Louis found that spending more on compliance isn’t leading to higher regulatory ratings for the smallest community banks. It isn’t elevating the bank’s regulatory management scores, or positioning banks for success.

That’s because having a compliance mindset is a recipe for mediocrity, no matter the size of the bank. The banks that will earn the most leeway with regulators—and maximize value for shareholders—will naturally implement and utilize the tools and processes that are a prerequisite for compliance as a critical function of their strategic and capital planning processes.

When that happens, compliance becomes a mere afterthought; something that is more icing on a cake that doesn’t need icing to begin with. This type of approach is actually easy to execute. You don’t need expensive, overrated and highly misleading black-box models and software. You don’t need an entire department dedicated toward enterprise risk management.

What you do need is a cultural mindset, which starts with the CEO and the board of directors. They must change the outlook in the bank so that risk management tools are used to play offense, not defense. These proactive and forward-looking tools enable the team to see problems before they materialize. The CEO can then position the bank to gain a competitive edge, while its competitors (from both an operational and capital markets perspective) get blindsided.

I participated in a recent regulatory panel with the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp. The topic was how best to manage commercial real estate concentrations. Part of the discussion revolved around the role of stress testing, which can be critical to showing examiners that a bank has enough capital to handle a risky portfolio.

Stress testing is a great tool for the job, but it’s a tool, not the job. Banks that simply submit stress tests to regulators as evidence that they can manage a loan portfolio aren’t going to get what they want.

Instead of viewing stress tests as an end game, bank CEOs need to think of them as tools to provide insights. Reports must be discussed at the board level and understood by the highest levels of management. And then the bank must adjust its strategy if the tests show a potential problem. This lesson applies to much more than concentrations. The results of adequate stress testing offer a strategic guide to capital planning, M&A and more.

The trick to compliance is to not treat it as a compliance exercise. It must be an integral part of strategic planning. A CEO cannot give a stress test to the chief risk officer and say, “Make the problem go away.” CEOs must look at the results, understand them and use them to adjust their strategic thinking. If organic growth is not working, the proper analytics can guide the executive team’s strategic course toward a merger or acquisition.

A funny thing happened when I began talking about this compliance mindset on the recent regulatory panel. The regulators nodded their heads in agreement.

Why Growth Matters for CRE Concentration Risk

Community banks are contending with the increasing risk profile of and regulatory scrutiny around commercial real estate (CRE) concentrations. Indeed, the regulatory community telegraphed in December 2015 their intentions of focusing bank examinations on concentration management, and since then, the FDIC has noted an increase in matters requiring board attention (MRBAs) associated with concentrated loan exposures. Additionally, the Office of the Comptroller of the Currency raised its regulatory stance on CRE lending from “monitoring status” to “an area of additional emphasis.” To explain their renewed attention, the regulators cited intense loan growth, sharp rent-rate and valuation increases, competitive pressures and an easing in underwriting standards eerily similar to the lead-up to the Great Recession—during which many community bank failures were driven by construction & development (C&D) and CRE concentrations.

While there is evidence that this renewed attention has shifted many banks’ CRE underwriting stance to a net tightening position, this has yet to have a material impact on C&D and CRE loan outstandings. A trend analysis across all commercial and savings banks shows intense increases in both C&D and non-C&D regulatory CRE.

Growth Rates By Type of Asset for All Commercial and Savings InstitutionsCRE-loans-small.png

Note the sharp difference between C&D (red) and non-C&D Regulatory CRE (orange): the Great Recession saw a precipitous drop in C&D balances, but multifamily and other property (i.e., non-owner-occupied CRE) increased in total outstandings during and after the Great Recession with growth since the recession of 142.5 percent and 49.3 percent respectively.

It is constructive to highlight that growth rates—while sometimes overlooked—are explicitly part of the 2006 CRE regulatory guidelines. Those guidelines stipulate that an institution is only in excess of the CRE guideline if CRE as a percent of capital is greater than or equal to 300 percent and the institution’s CRE portfolio has increased by 50 percent or more during the prior three years.

The regulators have repeatedly pointed out that—unlike many other regulatory prescriptions and proscriptions—the CRE guidelines are not limits. The FDIC has noted that because “community banks typically serve a relatively small market area and generally specialize in a limited number of loan types, concentration risks are a part of doing business” and the OCC specifically caveated that the “guidance does not establish specific limits on CRE lending; rather, it describes sound risk management practices that will enable institutions to pursue CRE lending in a safe and sound manner.”

In this context, growth may be the most important element of the CRE guidelines because it quantifies the potential that portfolio size may outstrip the risk management infrastructure (spanning credit, capital, strategic, compliance and operational components) to support that lending. In cases of aggressive growth (whether you are above or below the other regulatory CRE criteria), it is that much more important to establish proactive and robust credit risk monitoring and management.

Luckily, as the CRE guidance is now quite mature, industry-wide best practices exist to aid in this exercise:

  1. Monitor the risk for all of your bank’s credit concentrations—not just CRE and C&D.
  2. Analyze and segment your entire portfolio by at least the “regulatory big three” of product, geography and industry. It is also constructive to slice-and-dice by vintage, underwriting bands, branch, etc.
  3. For each segment, calculate and monitor growth rates along with percent of risk-based capital and asset quality (and consider establishing management triggers and thresholds on these key risk indicators).
  4. Analyze your portfolio hierarchically so high-level trends are digestible for boards of directors while the detail can be drilled through so the results are tactically relevant to management and even individual loan officers. Banking is a relationship business, and risk analytics should lead to action that may start with a borrower conversation.
  5. Especially in the current relatively benign credit environment and in situations where loan growth may obfuscate asset quality deterioration, monitor leading indicators of risk like underwriting policy exceptions, loan review downgrades, covenant violations, valuation trends and average underwriting attributes.
  6. Perform portfolio and firm-wide loss stress testing to quantify the loss potential under hypothetical and severe conditions. Roll such stress test results through your balance sheet and income statement to assess the impact on earnings and capital adequacy.
  7. Where your portfolio analytics or portfolio-wide stress tests identify sensitive concentrations, perform loan-level stress testing.
  8. Incorporate credit concentration risk within your allowance for loan losses (ALLL)—remember that concentration risk is one of the nine subjective qualitative and environmental risk factors laid out by the 2006 Interagency Guidance on the ALLL and reaffirmed by FASB’s CECL standards update.

Bank Boards Should Focus on Commercial Real Estate Concentrations

risk-management-10-10-16.pngBank boards should make sure they are reviewing their policies and practices related to commercial real estate (CRE) lending. Regulators have made clear that CRE concentration risk management will be a focus at exam time.
While many banks are approaching the CRE limits that trigger regulatory scrutiny, they are often not following best practices for managing concentration risk, particularly in stress testing, Comptroller of the Currency Thomas J. Curry warned recently in a speech.

As a result, the Office of the Comptroller of the Currency elevated CRE concentration risk management to “an area of emphasis” in its latest Semi-Annual Risk Perspective. The Federal Deposit Insurance Corp. also reports that CRE-related informal enforcement actions known as Matters Requiring Board Attention are increasing.

The OCC says that CRE portfolios have seen rapid growth, “particularly among small banks.” The decision to emphasize CRE concentration risk management follows a statement from all three prudential regulators late last year that they would “pay special attention to potential risks associated with CRE lending” in 2016. Regulators said they could ask banks to raise additional capital or curtail lending to mitigate the risks associated with CRE strategies or exposures.

At the same time we are seeing this high growth, our exams found looser underwriting standards with less-restrictive covenants, extended maturities, longer interest-only periods, limited guarantor requirements, and deficient-stress testing practices,” Curry said in announcing the new emphasis.

Proper stress testing is crucial to managing CRE concentrations—but stress testing is the right tool for the job, it’s not the job itself. Too many banks think they can solve the CRE problem with stress testing alone. Here’s how they are doing it wrong:

  1. Only the CRE loan portfolio is being stress tested, which does a disservice to parts of the bank that are strong.
  2. Data gathering for stress testing each loan is a nightmare. Most banks don’t have it centralized. This will be an issue for banks when the Financial Accounting Standard Board’s new Current Expected Credit Loss standard (CECL) is implemented as well.
  3. Banks are treating the stress tests as a check-the-box exercise, without including top management to guide the process or use the results to position the bank for success.
  4. Management doesn’t understand the results, so they are not in a position to have effective conversations with examiners about why the tests are important.
  5. Most banks are not applying the stress test results toward strategic and capital planning.

Banks should use a combination of top-down and bottom-up stress testing to demonstrate to examiners that they can be trusted with elevated levels of CRE concentration. Key to that analysis is using loan-level data to analyze performance of the portfolio by vintage—e.g. the risk factors affecting loans change depending on the economic and market conditions on the date of origination—another lesson that will be important for banks when they implement CECL.

CRE concentration risk management best practices also include global cash flow analyses, an understanding of lifetime repayment capacities, proper appraisal reviews and ongoing monitoring of supply and demand. Banks must ensure that they have the right policies, underwriting standards and risk management policies to allow the board to monitor the concentration risk and understand the CRE limits. Appropriate lending, capital and allowance for loan and lease losses (ALLL) strategies are crucial.

Many banks are making the same mistakes when it comes to CRE concentration risk management, the FDIC reported in a recent teleconference. Besides insufficient stress testing, common weaknesses include:

  • Outdated market analyses that conflict with the bank’s strategic plans, either because the market data is wrong or not unique to the bank
  • Excessive limits
  • Poor concentration reporting and board documentation
  • Lax underwriting and insufficient loan policy exception programs
  • Appraisal review programs without sufficient expertise or independence
  • No CRE contingency plans
  • ALLL analyses that fail to consider CRE risks
  • No CRE internal loan review
  • Limited construction loan oversight

M&A can be an attractive solution to CRE issues for some community banks. Acquisitive banks, however, need to take special notice of the CRE concentration regulatory warning. Many potential acquisitions will result in concentrations that trigger special regulatory scrutiny, especially if they are cash-heavy transactions and are dilutive to tangible book value. Acquiring banks must be prepared to demonstrate that they have the capital management infrastructure to manage concentration risk.

Does Your Bank Have the Stress Testing Data You Need?

stress-testing-8-26-16.pngThe next several years will increase the need for better data management at banks. Banks that have experienced the Dodd-Frank Act’s required stress tests (DFAST) already have encountered that need. With the Basel III international accord phasing in and the new current expected credit loss impairment standard (CECL) eventually taking effect, all U.S. financial institutions are facing ever more demanding regulatory requirements driving the need for enhanced data and analytics capabilities.

Credit data is becoming increasingly integral to stress tests, as well as capital planning and management and credit loss forecasts. To meet regulatory expectations in these areas, though, some banks need to improve the quality of their data and the control they have over it. Effective data management can bring valuable support and efficiencies to a range of compliance activities.

Expanding Data Requirements
DFAST, which is required of banks above $10 billion in assets, is highly dependent on data quality. The DFAST process—including scenarios, analytics, and reporting—requires banks to maintain a vast array of reliable and detailed portfolio data, including data related to assets and liabilities; to customers, creditors and counterparties; to collateral; and to customer defaults.

Under Basel III, banks will need to gather even more data. The requirements call for consistent data sourcing and reconciliation, liquidity management and the capture of data for historical purposes, among other things.

The Financial Accounting Standards Board’s new CECL model for GAAP reporting applies to all banks and will bring implications for data management. Banks and financial services companies will need borrower and economic data, exposure level data, historical balances, risk ratings and data on charge-offs and recoveries. Failure to capture quality data in these and other areas could result in tougher examinations, reliance on peer or industry data, questions about safety and soundness and drops in capital and profits.

Data Management Challenges
Small banks generally have a handful of credit data sources, while large banks can have 15 or more—and the number of sources is expected to grow in coming years as new products are released. In addition, the data often is stored in different formats and might not be subject to any governance or control. It’s no wonder that banks can find it difficult to get a handle on their data, let alone produce a “single source of truth” that can withstand examiner scrutiny.

One solution to this dilemma is a credit data warehouse. A data warehouse can provide a vehicle for controlling and governing an immense amount of data. It allows a bank to easily show an examiner the data that was used for its models, the data sources and how the data reconciles with the bank’s financial statements.

Banks might encounter some obstacles on their way to effective warehousing, though, including the sheer volume of data to be stored. Quality assurance is another common issue. For example, information might be missing or not in a standardized format. Data availability also can pose problems. A bank might have the required information but not in an accessible format.

Best Practices
Overcoming these problems comes down to data governance—how a bank manages its data over time to establish and maintain the data’s trustworthiness. Data management without active governance that is targeted toward achieving a single source of truth isn’t sustainable.

In the case of DFAST, it’s important to resist the temptation to take a short-term perspective that considers only the data required for stress testing. Banks that take a more global view, bearing in mind that the data is used throughout the organization, will fare much better. Such banks build a framework that can handle the new data requirements (including those related to historical data) that will surely continue to come in the future.

Banks also should remember that data management is not a one-off task. A bank might have clean data today, but that data will degrade over time if not managed on an ongoing basis.

Finally, banks should not overlook the human factor. Success isn’t brought about by a database but by the people who are stewards for the data and the processes put in place to audit, balance, and control the data. The people and processes will, of course, be enabled with technology, but the people and processes will make or break a data management program.

Time to Take Control
Effective data management is an essential component of any stress testing endeavor, but data management also has implications that extend to CECL and Basel III compliance and likely will aid banks in coping with many forthcoming regulations and requirements. Banks that don’t yet have control of their data should take steps now to establish the governance, framework and people and processes necessary to ensure the completeness, accuracy, availability and auditability of a single source of truth for both the short- and long-term.

Taking Portfolio Risk Management from Reactive to Proactive


One of the most significant changes banks have made since the financial crisis is their assessment of portfolio risk. Generally, an older reactive approach has give way to more effective proactive measures. However, some banks still struggle to identify and address symptoms of negative issues before a problem arises, necessitating yet another shift in thinking. As lending competition rises and portfolio growth assumes a greater priority, banks should evaluate their ability to quickly and successfully recognize trends, both positive and negative. Here are four key questions that banks should ask to determine whether their current processes effectively mitigate risk and uncover opportunities for growth:

Are we effectively identifying negative trends?
If identifying downward trends relies on manually sorting through reports, the answer to this question is most likely “no.” Even if done on a daily basis, it is nearly impossible to manually review deposit accounts and changes in line-of-credit balances, or notice declining credit scores with the precision needed to anticipate problems. Without automation, banks remain in reactive mode. Proactive risk management has become synonymous with technology, enabling banks to spot potential problems at the onset and then shore up with additional collateral or guarantors, modify the loan or take other necessary measures.

How many places are portfolio managers going in order to access data?
Data integration is one of the most significant hurdles associated with portfolio risk management. Often, key data remains housed in separate Excel spreadsheets and reports. Together, integration and automation enable banks to constantly collect third-party data along with core data, organized within a single database. In addition to easier access, this gives portfolio managers a holistic view of their portfolios to better manage behavior and more quickly catch potential problem credits.

Are we accounting for the positive side of the risk management spectrum?
Think about risk management as a spectrum; on one end, there’s the risk we typically consider–credit risk. On the other side, there is the opportunity risk of potentially losing a good customer. Banks notoriously expose themselves to opportunity risk by being poor miners of their own data. Since the best prospects are existing customers, growth requires banks to better harness their data, making it actionable to improve cross selling.

Are we conducting regular stress tests?
Increasing the frequency of portfolio reviews and stress testing is also reliant on technology. Annual portfolio reviews are simply not enough. Likewise, stress testing should not be an annual event, but instead a dynamic component of banks’ risk management strategies. With processes for continuous, technology-driven portfolio risk management, evaluating both vulnerabilities and opportunities can shift from an annual practice to an ongoing one.

The final question banks should ask is whether excess resources dedicated to portfolio monitoring are coming at the expense of generating new business. Reactive strategies can be distracting because they typically require client facing, revenue-producing resources to be actively involved in the portfolio management process. Portfolio risk management is about weighing all costs; those incurred from delays in recognizing credit risks as well as those associated with missed opportunities. Technology today makes it possible to lessen those costs and instead, support growth objectives and above all else, your bottom line.

Lessons Learned From the Stress Tests

Stress-testing-9-24-15.pngIn the wake of the implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act stress test (DFAST) regulations, the term “stress test” has become a familiar part of the banking lexicon. The DFAST regulations require midsize banks—those with assets between $10 billion and $50 billion—to project the expected impact of three economic scenarios—baseline, adverse, and severely adverse—on their financial statements and capital ratios. Midsize financial institutions were required to report this year’s stress test results to their regulators by March 31, 2015, the second round of stress tests required for these banks.

Although the submission that was due in March was round two, most banks felt that it demanded just as much effort as the first round of stress tests.  Regulators focused more on process than results in round one and clearly stated that what was acceptable in the first submission would be insufficient for subsequent examinations. Little formal feedback is in so far, but what we have heard indicates that continuous improvement was definitely expected.

Model Mechanics
In the first round, most banks either used simplistic models or projections that did not capture their risks fully. Banks now are expected to develop enhanced models, and more significant portfolios are being modeled using bottom-up rather than top-down approaches. In assessing models, regulators are questioning assumptions and methodologies and looking for well documented, sound conceptual bases for the modeling choices made. Overly manual modeling processes also are being flagged as impractical for ad hoc use. The message is loud and clear: stress testing models are expected to be integrated into risk management practices.

One common area for continued attention appears to be documentation. Whether it’s better organizing information to make it easier to follow the bank’s processes, improving validation documentation, writing user procedures, or better documenting the effective challenge process, the feedback received thus far reinforces that DFAST truly is a formal process. The documentation has to be sufficient for banks to manage, monitor and maintain the overall stress testing program. It also needs to be detailed enough to allow other users, including validators and regulators, to clearly understand the process.

Validation continues to be a big area of focus, and attention is being paid to both the timing and extent of validation activities. Timing is a critical review point, as the models are expected to be validated prior to the final stress test exercise. Validations have been criticized for having incomplete documentation, for failing to assess data lineage and quality, and for not being comprehensive. As modeling systems become more sophisticated, validations need to provide broader coverage. Validators—whether internal or third-party resources—must be experienced and competent, and they must deliver a sound validation in accordance with the agreed scope.

Banks have been encouraged to shore up organizational structures and procedures to keep their stress testing programs up-to-date and intact. With competition for quantitative resources at an all-time high, many are making choices about hiring statistical specialists and using contractors to keep on track. Banks are focusing on more automated processes, broader business participation, and more detailed user procedures to make sure the loss of one or two employees does not cause a program to fall apart completely.

Life in the DFAST Lane
As with most important business processes, effective DFAST risk management requires significant input from business management, risk management, and internal audit. A collaborative relationship among these three lines of defense results in the strongest DFAST processes. With reporting deadlines for the next cycle in 2016 being delayed from March 31 to July 31, banks have a bit of breathing room to assess the effectiveness and efficiency of their DFAST programs. Banks should use this extra time to further develop documentation, address highest priority issues, and continue to integrate stress testing into routine risk management practices.

Six Steps for Creating the Ultimate 2016 Producer Incentive Plan

compensation-plan-06-23-15.pngThere will always be strong demand for high performing producers. Incentive plans, when designed correctly, can help attract, motivate and reward the employees who are key to driving the bank’s success.

It may seem straightforward, but if this were an easy and predictable process, banks would spend much less time and energy reviewing and modifying their plans each year. In reality, it’s not easy, but it is critical to create an incentive program that aligns with current business priorities while also considering the factors that motivate your top sales staff.

Keep this list handy because while summer is just beginning, the fact is, it won’t be long before it’s time to recalibrate your plans for 2016.

  1. Know Where You’re Going.  Establishing guiding principles for the incentive plan is often an underappreciated step, but it aligns design decisions with the important operating goals of the bank. Be clear about exactly what you are trying to accomplish. Enhance revenue growth? Sell to new customers or deepen current relationships, or both? Perhaps you simply want to push your best performers to operate at an even higher level than in the past, or for strategic business reasons, you want this same group to shift focus toward a new market. Revisiting these principles will help establish and reinforce the underlying basis for the incentive plan.
  2. Determine the Plan Type. There is often considerable deliberation about the type of plan to deploy. Will a goal-based team plan provide your sales staff with a collaborative environment to motivate them to meet their sales objectives or will an individual production plan work better? How about a hybrid of the two? Identifying the approach that fits your culture and operating unit best will drive the right behavior.
  3. Simplify the Measures. Performance metrics will directly influence behavior. Should a commercial relationship manager be compensated for gathering deposits, increasing loan growth, referring mortgage customers, cross-selling wealth services, and doing so with the highest level of customer service? Well, yes. But should they be compensated for each of those measures or will individual measures for each slice unwittingly shift focus from the top priority goal? It is important to identify the most direct drivers of business success, while recognizing the potential impact of trying to cover too much ground.
  4. Calibrate Payout with Production. Understand the historical levels of production for your sales staff and the required output for the coming year, and align these expectations with appropriate payout opportunities. Are you willing to pay for breakthrough performance and if so, how much? What level of production are you not willing to pay for? And do these hurdles align with the revenue required to meet the business unit’s financial goals?
  5. Test for Risk. Do your own stress-testing to ensure the design will generally meet risk review tolerances before the plan is evaluated for risk. Ask the following questions: How much leverage is in the plan? Are the measures balanced and not placing too much emphasis in one area? Is there proper administrative and governance rigor? Does payout frequency align with the product life horizon? Are holdbacks or deferrals necessary in order to provide a means to adjust awards based on quality?
  6. Ensure Differentiation. The conservative nature of the industry often leads to final plan decisions that simply don’t provide for differentiated incentives, meaning there is not enough “pay daylight” between top and average performers. Providing meaningful differentiation is one of the principles behind well designed incentive plans—it will ensure your producers who lead the pack will be well compensated and highly motivated.

The potential impact to the bank if incentive plans underperform can be the difference between meeting and missing targets. Running through this checklist may help to identify enhancements that can optimize your plans and create a path to success.