Risk Management After the Financial Crisis

by Jay Brew and Michelle Gula | January 2010

With 2009 wrapped up and financial institutions finalizing budgets and plans for 2010, one
worry is consistent throughout the industry: increased regulatory scrutiny. Every banker would
agree that regulators will have a single-minded focus on community bank risk. While this is
indeed a necessary step and one everyone expects, the real worry stems from how far the
regulation will go, and how the potential “overreaction” will constrict growth moving forward.

New Capital Minimums

The new capital minimums that are sure to cause continual stress on the balance sheet and
income statement have been a main driver of discussion in boardrooms across the country. The
point of contention should be that the minimum capital regulations did not guard against bank
failures over the past 24 months. One could argue that they actually contributed to allowing
too high of risk, which promoted failures.

There should not be minimum capital requirements; there should be capital requirements
based on what level of risk a bank actually takes. The risk-based capital ratio is a naïve way of
gauging credit risk in a community bank. We have seen time and time again that the regulatory
mandated liquidity ratios do not reveal true liquidity risk in most cases.

Your Own Risk Assessment

So, what can be done to provide your own risk assessment that will aid you in identifying and
balancing your risk profile going forward? Step one is moving your risk assessment from an
intuitive process to a dynamic simulation. Community bank boards must provide their
management team with the tools needed to dynamically model current risk and project risk
into the future.

These models should be able to simulate the bank’s balance sheet and income statement over
time.

Further, the modeling tools should not only simulate interest rate risk, but also simulate credit
risk. Risk management should not be considered a forced expense. Risk management should be
considered the method of gaining the most profitability while optimizing risk.

Many community banks have uncovered risk imbalances that led to many issues during this
period. Whereas the imbalance was not realized prior, it is now front and center and being
addressed through the development of risk management systems to correct their imbalances.

If this is not done, the regulatory requirement to do so may be extensive and costly.

The vast majority of institutions in the top 15th percentile of Seifried & Brew’s risk reward

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 ranking have remained in the top 15th percentile during this credit cycle.

How did they do it? They have taken and continue to take a low-to-moderate level of overall
risk.

The components of this are lower levels of credit risk, a management of liquidity and earnings
at risk through maintaining a high level of cash-type deposits (60% – 75% in checking accounts,
savings accounts, and MMDAs), a low level of capital risk, and a high level of net overhead
performance.

Community banks should have these risk management models in place to achieve their desired
balance of risk and reward:

• Long-term capital model. This model should project out the bank’s strategic plan at least
annually over the next 10 years. The model should have a balance sheet and income
statement with all pertinent ratios. The model should also have a dividend plan.

• Credit risk models. Credit risk models should look at the bank’s credit risk from multiple
angles using the bank’s actual loan mix and loan trends. Directors and senior
management need to be proactive in assessing all risk, and based on this assessment,
the board should set strategy on how risk will look in the future. Management will then
develop the tactics needed to stay within the set risk parameters.

• Dynamic interest rate risk model. This tool should model each loan, investment, deposit,
and borrowing. Besides interest rate shocks, the model should have the ability to
simulate interest rate yield curve shifts. The model should also allow management to
run “what-if” scenarios of balance sheet changes. This dynamic modeling will assess and
project the bank’s earnings at risk, liquidity risk, and capital risk under real-life
simulations.

• To maximize these models, the best practice is:

• Education where needed. With the rising complexity of the industry and issues coming
out of this recent financial crisis, filling knowledge gaps is crucial. Devote time at each
board meeting to raising risk awareness and economic understanding and how it affects
your balance sheet and income statement.

• Pay attention to your committees. We have found that special training sessions for the
ALCO and Credit Committees have been very successful in setting best practices for
financial institutions going forward. They help map out meeting agendas, identify
necessary changes to policy, and foster comfort among committee members with the
issues at hand.

• Rewrite policies to reflect the models and how they interpret and project risk for the
bank.

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 The reality is that community banking was, and still is, the strongest part of our nation’s
financial system. Traditional, conservative community banking still works!

The regulators and the accounting industry should look at what worked and apply these
standards to the overall industry. Community bankers and directors should be proactive in
adopting these standards in their own banks and leading the industry to these higher standards.

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