SAMPLE BANK
Capital Plan for 2014-2019
Contents
Management Summary
Overview
Strategic Financial Goals
Compliance Analysis
SWOT Analysis
Capital Failure Definition
Linkage to Business Plan
Capital Plan
Earnings, Growth and Capital Targets
Risk Factors
Credit Risk:
Asset Concentration
Allowance for Loan Loss
Interest Rate Risk
Liquidity
Future Capital Needs and Capital Compliance
Detailed Report
Capital Failure Definition
Compliance Analysis
Static Unstressed
Static Stressed
Financial SWOT Analysis
Strengths
Weaknesses
Opportunities
Threats
Dynamic
Business Plan Assumptions
Unstressed and Stressed Business Plan Results
Contingency Capital Plan
Triggers
Key Actions
Contingency Capital Plan Scenario 1 Assumptions
Contingency Capital Plan Scenario 1 Results
Contingency Capital Plan Scenario 2 Assumptions
Contingency Capital Plan Scenario 2 Results
Capital Goals
Summary
Management Summary
In the Fall of 2013 we engaged FARIN & Associates to assist us with the development of a formalized capital planning approach that helps determine the appropriate levels of capital given the higher requirements imposed by the regulators under BASEL III and the risks associated with the institutional balance sheet. This capital plan is the result of our collaborative efforts. The goal of the capital planning process is to align the work done on strategic planning with the financial risk management process to “right size” the capital for known and potential risks in order to maintain a well-capitalized rating under the CAMEL rating system. In this process we will identify those risks that have the most significant impact on the plan, develop a process for building “scenarios” for testing the plan, and discuss the use and implementation of sensitivity testing within the plan.
Overview
The continuing downturn in the economy and resulting challenges posed to financial instructions has highlighted the importance to all financial institutions to strengthen their capital planning process. A robust planning process is needed in order to enable financial institutions to maintain sufficient levels of capital to meet known, and unknown potential risks from stressed conditions or unforeseen events that may constrain the ability to maintain safe and sound operations. Such capital planning is and has always been a key concern of the Board and management of this institution in order to meet market needs and ownership concerns.
In order to ensure proper controls, it is the belief of our Board of Directors and management team that an effective internal capital planning process be managed at a minimum of annually to assess current risks in operations, financial conditions, and market concerns to prioritize the inevitable tradeoffs between capital levels, growth expectations earnings required to satisfy these divergent goals as well as dividend expectations for shareholders. This capital planning process must be realistic in its undertakings when considering the overall risk levels of the institution, the market conditions in which we are operating, and the regulatory environment that governs our safety and soundness parameters.
Strategic Financial Goals
As part of the capital plan, we developed long range financial goals relating to earnings, growth, dividends and other capital actions needed to meet our capital goals. These goals were set annually for a time frame beginning 1/1/2014 and ending 1/1/2019.
Compliance Analysis
As part of the capital planning process, we tested our capital compliance relative to Basel III capital standards. We performed that analysis on both a static and dynamic balance sheet. In the static analysis the balance sheet is held constant as the regulations phase in. In the dynamic analysis the balance sheet changes are based on our business and strategic plan.
SWOT Analysis
We conducted a financial SWOT with particular emphasis on financial strengths and weaknesses. It is our goal to capitalize on the financial strengths and execute strategies to address the financial weaknesses where appropriate. Many of the opportunities will be acted on in developing our business plan. The threats are a major input into the stress tests performed as part of this capital plan. The stress tests are designed to evaluate the effect of these threats on our viability should the threats materialize.
Capital Failure Definition
The Basel III capital requirements set a variety of standards that institutions must meet or exceed including well capitalized minimums, adequately capitalized minimums, and adequately capitalized minimums plus the new Capital Conservation Buffer. I t was our goal to establish a definition of failure that was specific to our risks, business plan and ownership structure. From this discussion we set ourdefinition of capital failure as falling below well capitalized minimums under the Basel III Capital Regulations at the bank level. In addition, we would also consider capital failure to be falling below adequately capitalized minimums plus the capital conservation buffer at the holding company level.
These definitions of failure set capital minimums after applying stress tests. It is our objective to accumulate and sustain sufficient capital that when stress tests are applied we remain above our definition of failure after executing on a contingency capital plan.
Linkage to Business Plan
The assumptions contained in this capital plan draw upon assumptions in our business plan in 2014 and 2015. Assumptions beginning in 2016 are based on assumptions spelled out in our strategic plan.
Capital Plan
The following sets forth the capital plan goals of Sample. The plan includes detailed steps that the bank will follow to maintain the desired capital levels, growth expectations, and necessary earnings to meet these objectives.
Earnings, Growth and Capital Targets
The following schedule outlines the agreed upon goals for regulatory capital, anticipated asset growth and required earnings & dividend payments to achieve these capital goals. Note that the goals reflect our institutional expectations for potential buffer needs, risk levels and overall market opportunities. This combination of growth, earnings, and dividend targets is based on our business plan and strategic plan.
Incorporated in the capital plan is an assumption that during 2015 we will retire off the $10 million in small business capital we currently carry at the holding company level leaving us with $5.155 million in Trust Preferred Stock as qualifying Additional Tier 1 Capital as of 1/1/2016.
This set of business plan assumptions and actions results in the following capital ratios under the four Basel III regulatory capital requirements. All are well above regulatory capital minimums.
As part of the annual planning process our Board has reviewed these goals and the requisite tradeoffs should either the earnings or growth levels exceed or fall short of these targets by foreseeable amounts. As part of that review the Board has directed management to follow a priority for goals (high to low) as follows.
- Capital – regulatory compliance
- Dividends – meet the cash flow requirements of our different forms of capital.
- Earnings – produce the earnings needed to compensate stockholders and accumulate capital to support growth.
- Capital actions – Retire forms of capital that are expensive. Raise new capital if needed to support growth.
- Growth – grow the bank over time that allows it to take advantage of opportunities while meeting capital goals
In the event of a capital stress, the lowest priority items will be modified first when taking actions to maintain adequate levels of capital.
Risk Factors
With respect to the capital plan, the key risk factors that the bank is exposed to include credit quality, asset concentrations, earnings and liquidity. Earnings can be affected by credit risk, interest rate risk and liquidity risk. The capital plan considers these risks, as well as other factors, that could potentially impact the capital goals as follows:
Credit Risk:
Credit risk can have a significant effect on the bank’s ability to maintain sufficient levels of capital to stay above the bank’s definition of failure. The potential effect of credit risk on this plan was taken into consideration by running credit risk stress tests in determining whether sufficient capital buffers were in place to stay above the our definition of failure.
Asset Concentration
The nature and level of the bank’s asset concentrations can have a major impact on capital levels that need to be maintained due to changes in underlying factors that impact the assets beyond control of the bank. Our bank’s highest level of asset concentrations are in commercial real estate loans, residential real estate loans and C&I loans.
This table assumes no major changes in loan concentrations from the current mix based on call report data.
In our favor is the fact the Fox Valley market has a fairly diversified economic base, becoming less and less dependent on the one major industry (paper) that characterized this market in the past. Today the Fox Valley has major components in insurance, health care and education in addition to a relatively stable industrial base. For that reason a stress to a particular industry is far less likely to damage our portfolio than occurs in many other markets. A recent example is in the recent financial crisis, the Fox Valley felt less stress than was felt at the state and national levels.
Credit concentrations by loan type and by industry were taken into consideration in designing the magnitude of the stress tests performed in the credit risk area.
Note that the bank has historically targeted lending on properties secured by real estate as a core business practice. The historical loss rates experienced with respect to the overall exposure to this segment of the market does not warrant a strategy to reduce these loan levels, but rather better plan for potential losses and hold capital cushions for reasonable risk events. A change in strategy to focus on other lending products would require the bank to acquire talent, systems and knowledge that is costly, and may not prove to provide required returns on the diversification to sufficiently add to or maintain overall capital levels, commensurate with the risks associated with the new loans.
Allowance for Loan Loss
The regulatory capital levels require us to maintain a fully funded allowance for loan loss. Our calculation methodology for the allowance for loan loss is based upon the loan classifications and loss rate experience, internal loan review results, trends in loan performance including delinquency, non-accrual and charge off by loan class. We feel our current ALLL is more than adequate to cover the credit risk in our loan portfolio.
Interest Rate Risk
Our interest rate risk stress tests show the effect of a variety of changes in rates on both net interest income and economic value of equity. At the time this capital plan was developed, our most recent tests effective 10/31/2013 show Sample to be moderately liability sensitive. Results of our October 31, 2013 stress tests were incorporated in the stress tests run as part of this capital plan.
Liquidity
SAMPLE BANK has developed a contingency funding plan that lays out the actions we will take in a liquidity stress situation should a liquidity stress event occur. Because liquidity stress tests are run as part of our contingency funding plan analysis, the potential effects of a liquidity stress were not explicitly considered in developing this capital plan.
Future Capital Needs and Capital Compliance
We ran a variety of scenarios in evaluating our compliance with the Basel III capital requirements. All were based on our holding company capital structure which includes $10 million in SBLF capital and $5.155 million in Trust Preferred Stock, both Additional Tier 1 Capital items under the Basel III standards. The holding company test is the more severe of the two tests in that its balance sheet includes $15.115 million of Additional Tier 1 Capital in the form of Trust Preferred Stock and SBLF Capital. Those two capital items show as Common Equity Tier 1 Capital at the bank level.
The first scenario was a static balance sheet test where our balance sheet was held constant through the full phase-in of the Basel III standards. Our capital position remained well above PCA Well Capitalized capital standards and above the Adequately Capitalized Standards plus the Capital Conservation Buffer through the entire phase-in under all for regulatory capital measures.
In the second scenario we ran a stress test on the static balance sheet plan that considered both credit risk and interest rate risk. Details on stress tests are spelled out in the detailed section of this report. For three of the four ratios, we remained well capitalized through the entire phase-in and met or exceeded Adequately Capitalized Standards plus the Capital Conservation Buffer. The stress tests took the fourth ratio, the Common Equity Risk Based Capital ratio just below the Adequately Capitalized minimums. The fact that in this ratio we do not pass our definition of failure is dealt with in the Contingency Capital Plan that is touched upon in this management summary and elaborated on in detail in the Detailed Report.
In the third scenario we based projections for future periods in the business plan assumptions for growth, earnings and dividends listed in the first table in the management summary. In addition we assumed repayment of the $10 million of SBLF capital during 2015. The balance sheet mix was modified in 2015-2017 to reflect the fact we expect loans to grow 1% faster than assets during that period. Unstressed, the dynamic business plan has Sample in Compliance with Basel III well capitalized requirements as well as Adequately Capitalized plus the Capital Conservation Buffer under all four measures.
In the fourth scenario, we ran the same credit risk and interest rate risk stress tests to the business plan that we had run on the static balance sheet. In this fourth stressed scenario, SAMPLE BANKremains above well capitalized as well as adequately capitalized plus the CCB for the Tier 1 Leverage requirement. On the other three ratios, stressed results fell below failure definitions, the worse two being the Tier 1 Risk Based Capital ratio, and the Total Risk Based Capital ratios that fell well below Well Capitalized minimums and below Adequately Capitalized Minimums throughout the bulk of the forecast through 2019. Those failures indicate that SAMPLE cannot continue to execute under business plan assumptions in a capital stress scenario of the magnitude modeled. So the remaining two scenarios looked at the actions that would be required to maintain a spread over the failure definitions by taking actions not anticipated in the current business plan.
The fifth scenario, Contingency Capital Plan Scenario 1, incorporates modifications to the assumptions in the business plan we would take if we found ourselves in the capital stress scenario like that used in this capital plan. The actions considered the prioritization of our goals discussed earlier in this management summary. In this scenario we made two major changes to business plan assumptions. During the two stress years we shrunk 8.25% per year rather than growing at the speeds indicated in the business plan. We also incorporated changes in balance sheet mix assumptions that would reflect a decline in loans as a percentage of assets and an increase in non-performing loans. We felt these changes were appropriate in that our loan officers would be focused on dealing with asset quality issues rather than originating new loans. Also during the two year stress period, the availability of quality loans would diminish.
The results of this scenario showSAMPLE maintaining capital ratios that met or exceeded Well Capitalized minimums and above Adequately Capitalized minimums plus the CCB all through the forecast.
In the sixth scenario, we evaluated a decision to defer the repayment of the SBLF Capital. While this scenario improved performance under the Tier 1 Leverage, the Tier 1 Risk Based, and Total Risk Based ratios, it slightly worsened performance on the Common Equity Risk Based Ratio because of the increased dividend payout requirements for the SBLF funding. We still needed to shrink at least 8.25% per year to remain in compliance with the Common Equity Risk Based Well Capitalized and the Adequately Capitalized plus CCB requirements.
Detailed Report
Capital Failure Definition
Our definition of capital failure is to have the bank’s regulatory capital ratios fall below well capitalized minimums under the Basel III Capital Regulations at the bank level. Doing so would jeopardize our ability to raise funds through brokered CDs and CDARS. At the holding company level, our definition of failure would be to fall below adequately capitalized minimums plus the Capital Conservation Buffer (CCB) as it is phased in between 2016 and 2019. Doing so would cause restrictions to be placed on payment of dividends, discretionary management bonuses and on retiring capital.
While these definitions of failure may be different than those used by regulators or by other institutions, it is our objective to develop a capital plan that keeps our capital ratios above the failure definition after applying a stress test that combines a credit risk stress with an interest rate risk stress. Should execution of our business plan take capital ratios below the failure definition, we will develop a Contingency Capital Plan that spells out the actions we anticipate taking in a real world stress scenario to keep us above failure ratios defined in this capital plan.