Читать книгу A Risk Professional's Survival Guide - Rossi Clifford - Страница 11

SifiHolding Company is a publicly traded company that was headed by the CEO who also held the title of Chairman of the Board of Directors in the years leading up to the financial crisis. This consolidated power of having both the CEO and chairman titles along with this individual’s unique personal stature in the industry afforded him an ability to run SifiBank in a fashion that met with little opposition to the direction he sought for the company.

The board was composed of 10 members, all handpicked by the CEO and all well-known friends or associates. Two members had some related background in financial services – specifically, having been CEOs of an insurance company and investment company – and no one on the board had any direct risk management experience. The board met quarterly for one day each time and in addition to holding a meeting of the full board to review important issues it also broke up into several committee sessions. Among the committees it had were audit, operations and human capital, legal, and finance.

The CEO believed in having a small management team reporting to him and this meant that only the presidents of SifiBank, SifiThrift, SifiFinancial, SifiInvestment Bank, SifiAsset Management, the CFO, General Counsel, General Auditor, and Head of Human Resources had direct access to the CEO. The CEO had handpicked the presidents as well and all had track records for achieving aggressive product objectives.

At this time the bank had only created the role of Chief Risk Officer two years before the crisis and this was largely a corporate oversight role. In fact at times, the role of the CRO and General Auditor seemed to overlap, creating significant confusion and concern by management that the bank was carrying too many risk oversight staff at a time when margins were thin. The CRO reported into the CFO, leaving an additional layer of management between the senior risk officer of the company and the board. The board did not hold executive sessions with the CRO separate from the CFO or CEO.

Furthermore, risk management activities were spread across the business, operations and audit functions in a decentralized model. As a result, the SifiBank board would pick up risk management issues in piecemeal fashion and only as management decided what was important to elevate to the board. A decentralized risk management function has its own merits over a risk management structure within the corporate center; however, it can lead to a number of governance issues that the firm must understand. In the case of SifiBank, the board of directors delegates development of credit and other major risk policies to the CRO. But since the CRO does not have any responsibility over managing the risk exposure of an individual line of business, a delegation of authority policy would need to be established by the CRO to allow business staff designated to manage risk at the unit level to operate within stated risk objectives. Such a policy would outline the size of deals, loans, and transactions that could be approved by employees, which is oftentimes based on seniority and expertise. By having a small corporate risk office and a large business risk function, it allows an independent review of risk management activities to be conducted by the corporate risk office while allowing the business risk units to be responsible for day-to-day implementation of risk management within each line of business. SifiBank had set up such a structure where each business unit had a CRO who reported directly to each division’s president and indirectly to the CRO. The presidents each created their own performance plans for their CROs with input from the corporate CRO (sometimes also referred to as the enterprise CRO). In the years preceding the crisis, SifiBank’s CEO gave clear direction to the heads of each business that they had to grow their businesses each year by at least 10 percent. As a result, these objectives were handed down to each executive in the operating units, including the business line CROs. For the business CROs, 85 percent of their performance was based on supporting product and sales within the division and only 15 percent was placed on managing the risk exposure of the unit. This executive compensation structure fueled significant risk-taking by SifiBank in the years leading up to the financial crisis.

Lines of Business

SifiBank operates along a complicated product and institutional structure as depicted in Table 1.1. Due largely to historical arrangements, several business lines cross corporate segments. While SifiBank remains the flagship entity with respect to consumer and commercial banking activities, its thrift and finance company divisions provide specialized consumer and commercial banking oriented in some measure to their unique charters.

Table 1.1 SifiBank Business Lines by Corporate Entity

Thrifts, or savings and loans (S&Ls) as they are sometimes known, are depository institutions like commercial banks and are granted operating charters from the state or federal government that allow them to access cheaper (federally subsidized) deposits. But a major differentiator between commercial banks and thrifts is that a thrift institution must maintain 65 percent of its assets in certain qualifying assets, much of which are mortgage-related. This specialization makes thrifts particularly vulnerable to mortgage market conditions. Moreover, thrifts are especially sensitive to interest rate risk, where losses can be realized due to mismatches between typically shorter-dated funding sources and mortgage loans that have long maturities. This will be examined in more detail in later chapters. SifiThrift Company is regulated by the Office of the Comptroller of the Currency (OCC).

SifiFinance Company had been an independent company prior to its purchase by SifiBank in 1999. As a finance company it did not hold a bank charter, which meant that it had to derive its funding via capital market debt issuance. The lack of subsidized deposits puts finance companies at a competitive disadvantage to commercial banks and thrifts. Balanced against that is the fact that unlike banks and thrifts, finance companies are not subject to safety and soundness regulations. They are subject to various state and federal consumer regulations such as those overseen by the Consumer Financial Protection Bureau (CFPB). However, by focusing on subprime borrowers, SifiFinance Company was able to earn substantial income by charging interest rates and fees significantly above that for prime borrowers. The company traditionally offered small ($500–$1,000) short-term (<1 year) unsecured (i.e., requiring no collateralization) personal loans realizing that the average loss rate on this business was between 12 and 18 percent. Borrowers could be graduated to larger loans, eventually after demonstrated payment ability over time, allowing them to obtain a mortgage loan from SifiFinance Company.

SifiBank, as mentioned earlier, is comprised of several commercial bank subsidiaries. SifiBank, having a federal charter, is technically a national bank, overseen from a safety and soundness perspective by the OCC. The Federal Reserve oversees banks that have state charters and are members of the Federal Reserve System (FRS) as well as bank holding companies. The Federal Deposit Insurance Corporation (FDIC) oversees state-chartered banks that are nonmembers of the FRS.

SifiBank’s lines of business are focused on consumer and commercial customers. The bank offers a full array of consumer loan products as shown in Table 1.1 with credit cards representing one of the larger consumer asset classes. SifiCards is one of the most recognized credit cards in the market, however, a rise in cyberattacks on large retailers and banks has placed the company on guard against this risk. But one of SifiBank’s greatest strengths is in its extensive branch network. It operates more than 10,000 retail branch offices across the country, although 75 percent of its network is on the East Coast. The cost of operating branches in an increasingly e-commerce environment has pressured the bank to find ways to reduce its operating efficiency ratio defined as the dollar amount of noninterest expense as a percent of operating revenues. To be more competitive with peer institutions, the bank has waged a cost-cutting campaign for three years and senior management has considered increasing its Internet banking model in an effort to combat higher costs.

Notwithstanding such costs, the branch network represents a significant source of revenue generated from cross-selling of bank products to its customers. On average SifiBank has found that its retail bank customers have about seven products that it obtained from branch operations. That means that when a customer opens up a retail checking or savings account they are marketed for loan and investment products. This compound effect of cross-selling products has boosted revenues even as operating expenses have risen with branch growth.

SifiInvestment Bank was formed to handle all of SifiBank’s vast trading and investment activities for its clients and for proprietary trading. The bank trades in virtually all investment types including equities, fixed income, derivatives such as options, futures and swaps, foreign exchange and commodities. When trading for clients it acts as a market maker, bringing buyers and sellers together without taking a position itself.7 The capital markets group has developed a robust structured finance offering, which features creating, underwriting and investing in various financial instruments with complex cash flow features. Examples of structured financial instruments include mortgage-backed securities and associated resecuritizations, collateralized debt obligations (CDOs), and credit default swaps (CDSs), among others. These types of transactions have a variety of purposes including transfer of different risks such as credit and interest rate risk, tax optimization strategies and obtaining legal and accounting advantages. These often require the establishment of separate legal vehicles apart from the bank to meet certain requirements. Over the years, SifiInvestment Bank has created hundreds of special purpose vehicles (SPVs) for its structured finance activity. The scale and complexity of the business poses significant exposure to SifiBank in terms of counterparty, credit, market, and operational risks.

Five years earlier the capital markets group had established a proprietary trading group that was charged with taking positions in capital markets for profit-making. This type of activity made it a hedge fund within SifiBank and over the years it had performed well for the company, enjoying an annual average return of 18 percent since its inception. The trading group can invest in a wide range of instruments and has focused largely on economic bets since the financial crisis. The company made $1 billion, for example, following the Greek crisis. In the months leading up to the crisis, it took short positions in various sovereign debt instruments of countries that had similar underlying fiscal and monetary problems as Greece. It also was active in shorting various financial stocks during the banking crisis. With the implementation of the Volcker Rule banning proprietary trading at federally insured depository institutions, SifiBank faces a decision whether to spin off the hedge fund unit, shrink it to a regulatory allowable size, or change its direction and merge it with other permissible hedging activities.

SifiAsset Management Company had operated as a well-known retail investment company, founded in 1900 until it was bought out by SifiBank as part of the strategic initiative to build a universal bank franchise. SifiAsset Management is focused on advising private retail clients with wealth management services, investments and brokerage activities.

The other unit within SifiBank is the Corporate Division. This group comprises the nonbusiness-oriented activities of the entire company such as finance, accounting, treasury management services, corporate risk management, legal, IT and operations, and human resources. The company over the years adopted a center of excellence model where these activities would emanate from the corporate center for purposes of maintaining consistency and adherence with applicable laws, regulations and accounting rules as well as promoting best practices across the company. Each operating division of SifiBank maintains a cadre of staff performing these functions for its specific business, but these resources have a direct reporting line to their respective corporate offices.

An important function within the Corporate Division is the Treasury Office. This group is responsible for ensuring that SifiBank and its operating subsidiaries have the right mix and level of funding required to meet its activities, on a day-to-day as well as longer term basis. Each day the Corporate Treasurer and her staff face a complex and well-choreographed exercise of determining how much funding is available from its retail deposit network, wholesale deposits, and short-term funding markets, including asset-backed commercial paper (ABCP), and overnight repurchases (repos), which amount to interbank borrowings. It balances its needs for short-term funds with an ability to issue debt and equity at regular intervals in order to best match its asset and liability structure while maintaining a safe cushion of liquidity on hand to meet uncertain events such as unexpected deposit outflows or other disruptions. Thus, one of the Treasury Office’s major risks is from liquidity risk. In reporting directly to the Chief Financial Officer (CFO), the Treasurer also has responsibilities for asset-liability management within SifiBank. The CFO and Treasurer also work closely with each business unit CFO to maintain the right level of assets in each subsidiary’s portfolio.

For SifiBank and SifiThrift, for example, the bank maintains large held-for-investment (HFI) mortgage positions. These are portfolios that the bank and thrift subsidiaries plan on holding for long periods of time. Some mortgages that are originated, however, are designated as available-for-sale (AFS). These assets, for example, might be formed into a pool to be packaged into a mortgage-backed security (MBS) and sold to investors. Different accounting rules apply for assets held for sale than HFI. Accounting principles, for example, require fair value treatment for assets intended for sale. Depending on a number of factors, including how liquid the market is for an asset, fair value could be assessed based on observable market prices, inferences drawn from closely related assets, or even models if no market pricing is available. During the financial crisis SifiBank saw the fair value of their AFS mortgage securities positions fall 50 percent as investors retreated from the market. Meanwhile, the bank’s HFI portfolios experienced a much smaller decline limited to its expectation of credit losses forming in the portfolio. In originating loans, the bank engages in a “best execution” assessment that determines the highest price it would be able to obtain for a loan whether that is an HFS or AFS disposition. A detailed financial analysis of the value from retaining or selling the asset is performed.

SifiBank Balance Sheet Composition

At an aggregate level, the variety and composition of SifiBank’s balance sheet at the holding company level is illustrated in Tables 1.2 and 1.3. At a glance, Sifibank holds nearly a quarter of its assets in consumer loans, 50 percent of which are in mortgages, with credit cards accounting for another 44 percent. As mentioned before, trends in the economy and housing market will feature prominently in SifiBank’s assessment of the credit and interest rate risk profile of this portfolio. Commercial lending represents about half the size of the consumer business with commercial and industrial loans (C&I) and commercial real estate (CRE) lending evenly split. The consumer and commercial lending businesses couldn’t be more different in many respects. Consumer lending such as the credit card business tends to rely on relatively homogeneous populations to assess risk, which lends itself to intensive data mining analysis. Underwriting for a credit card is more heavily automated than commercial lending which, due to large differences in client, loan size and purpose, among other factors, makes commercial lending a much more manual underwriting process.

Table 1.2 SifiBank Asset Composition

Note: Subcategory percents add up to 100 percent for each category.

Table 1.3 SifiBank Liabilities and Equity

Note: Subcategory percents add up to 100 percent for each category.

The bulk of SifiBank’s remaining assets are distributed across its trading and investment units. More than one-fifth of the bank’s assets are in a variety of derivatives positions. The bank faces significant risk in the fluctuations of prices in these assets known as market risk. In addition, the vast fixed income and MBS holdings are subject to fluctuations in the value of these securities due to interest rate movements, which expose the firm to considerable interest rate risk. Finally, the bank retains 11 percent of its assets in liquid positions such as cash, and a variety of short-term positions. The bank faces the risk that it does not have sufficient assets that could be sold quickly with little or no price effect in the event of an unforeseen problem such as a bank run. Alternatively it must balance that risk against the reduction in income that it realizes for allocating a sizable portion of its assets to no or low earnings investments.

Turning to the other side of the balance sheet, SifiBank shows liabilities totaling $900 billion against $1 trillion in assets. The difference is the amount of equity in SifiBank, or $100 billion. As will be explained in a later section, not all forms of equity (for example, common and preferred stock, loan loss reserves, and subordinated debt instruments) are created equal in the eyes of the regulator. As a result, SifiBank must comply with a variety of different capital requirements as a regulated depository institution.

The liability structure of SifiBank broadly speaking comprises deposits and nondeposits. Just over half of the bank’s liabilities are in deposits and these are evenly split between retail (branch-sourced) and wholesale deposits. Retail deposits are cheapest since federal deposit insurance backs up each account to a significant level which helps hold funding costs down at banks and thrifts. However, as banks grow, their ability to grow deposits from retail branches may not be able to keep pace with asset generation and so bank treasurers may seek out wholesale deposits that can be procured in open markets. Brokered deposits are one such type of wholesale deposit, which allows banks to buy deposits from intermediaries at higher costs than would be the case for retail deposits. Bank regulators for many years have looked at brokered deposits as a source for fueling aggressive risk-taking at some banks that ultimately led to their failure. While such funding sources do need to be carefully evaluated, they can be an important way to augment funding when gaps exist. SifiBank also uses a wide variety of debt instruments of various terms (tenors). As previously mentioned, the bank must manage the composition of both its assets and liabilities in order to reduce exposure to interest rate risk. The weighted average life, or better yet the duration of its assets and liabilities, must be in relative balance for the bank to avoid major declines in the bank’s market value of equity (MVE). Since SifiBank has a large portion of its portfolio in mortgages and other longer-dated investments, it needs to extend the life of its liabilities in an effort to accomplish its asset-liability management (ALM) objectives.

Industry Structure and Competition

Since SifiBank operates in nearly every corner of the traditional banking sector, its competition comes from a variety of different entities. Banking in the United States has undergone significant consolidation for decades as economic forces have driven a large number of banks and thrifts into insolvency or merger precipitated either by economic downturns or weak performance at individual institutions. The nature of bank competition directly influences the risk exposure of SifiBank since its profitability and growth depend on how effectively it can compete in different businesses. To provide some perspective on the overall banking sector, at the end of 2013, there were nearly 7,000 commercial banks and thrift institutions operating in the United States. The industry at that time had a combined asset base of $14.6 trillion. However, 106 firms had assets greater than $10 billion and this group accounted for about 80 percent of the industry’s assets, illustrating a high level of concentration among the largest institutions. More astonishing, 36 banking institutions in the United States had assets at or above $50 billion and these firms accounted for 70 percent of all banking assets in the country.

The performance of the banking sector not surprisingly ebbs and flows with regional and general economic conditions as seen in Figure 1.3. The figure shows how in the period immediately following the financial crisis, net income for the sector was negative, driven to a great extent by mounting credit losses taking place around mortgages. With extraordinary measures taken by the Federal Reserve and Treasury Department to support banking, in time net incomes rose and the industry has stabilized since that time. Another way to look at the relative performance of the industry is to compare net interest margin (NIM) by bank asset size category (Figure 1.4). Net interest margin is defined as the difference between interest income and expense as a percent of average assets. NIM has steadily declined for banks since 2010, reflecting lower income from mortgages as interest rates began rising over time and banks started to see erosion in its fixed income sales as interest rates began coming off very low levels after the crisis.

Figure 1.3 Bank Net Income over Time

Source: FDIC Quarterly Banking Profile, 2013.

Figure 1.4 Bank Net Interest Margins Over Time

Source: FDIC Quarterly Banking Profile, 2013.

Figure 1.5 provides insight into the extent of damage done to the banking sector during the crisis as reflected in nonperforming loans (loans that are 90 days past due or worse). Banks write off (charge-off) bad loans as they become apparent and during the crisis, the noncurrent loan rate was five times that of 2006 levels and the charge-off rate was about six times 2006 levels. Since peaking at the end of 2009, credit performance has significantly improved.

Figure 1.5 Bank Trends in Credit Performance

Source: FDIC Quarterly Banking Profile, 2013.

SifiBank did not escape the financial crisis and in fact in the months following the failure of Lehman Brothers in September 2008 and both mortgage government sponsored enterprises Fannie Mae and Freddie Mac were placed into conservatorship under their regulator, SifiBank saw its stock price nearly evaporate from a price of $50 to just under $2 per share. Bank management realized that it was in trouble both in terms of liquidity and capital. It had not adequately developed its contingency liquidity plan; a framework for maintaining a level of liquidity that would allow the firm to operate under extreme conditions in which funding dried up and/or became prohibitively expensive, for the crisis that unfolded proved to be devastating to capital markets. The bank suffered several downgrades in the months leading up to receiving this special financing. It had been rated by all three credit rating agencies as AA but by October 2008, it was rated C making it more difficult and costly to raise capital. In October of 2008, the U.S. Treasury offered a financial lifeline to SifiBank in the amount of $250 billion to ensure the company would be able to weather further erosion in financial markets.

SifiBank got into this situation through a combination of errors in the way the company was managed that led it to take oversized risks as well as by way of systemic risk to the entire financial system that created a contagion effect throughout the industry. The degree of interconnectedness of capital markets and financial institutions during the year leading up to the crisis led to a sort of financial flu that spread across the sector like a viral pandemic.

In the years leading up to the crisis, senior management ignored repeated warnings from its enterprise CRO regarding an excessive buildup of mortgage loans and securities in its HFI and AFS portfolios. The bank during that period had compounded their problems by originating a set of brand-new mortgage products that had variable payment terms and other features that while flexible for borrowers often meant that they would likely run into payment shock if and when interest rates rose in the future. There had been no prior experience with such products from which to develop an estimate of credit losses and yet the bank accelerated its production of these loans at the request of senior management.

The bank, as stated earlier, had been under pressure to grow earnings and these new nontraditional mortgages enabled SifiBank to originate mortgages at spreads to Treasuries that were significantly above mortgages originated and sold to Fannie Mae and Freddie Mac. The business line CRO for the bank whose bonus was dependent in part on the success of this program acquiesced to a significant amount of risk layering taking place in credit underwriting on these new loans to the point that significant credit risk was embedded in the products for which the bank was not being appropriately compensated. Risk layering occurs when individual risk attributes such as credit score and loan-to-value (LTV) ratio are combined in ways that materially raise the credit risk profile of the loan. For instance, allowing a lower credit score for a low downpayment mortgage raises the likelihood of default for the loan beyond a loan that has both higher FICO and lower LTV (i.e., is less risky). The bank had little historical information on which to base its loan loss reserve or price these new loans and so its models reflected the low level of risk that had been present for the last decade. As a consequence it vastly underestimated the amount of credit risk it was putting on its books.

During this same period, the bank continued to reduce its corporate risk management staff believing that they would be able to save costs by avoiding redundancies with the business risk functions. Moreover, when the products were presented to the board, the CFO and president of the consumer loan division of SifiBank were the corporate officers engaged with the board on this initiative with negligible input from the enterprise CRO. Compounding this problem was the fact that none of the board members had any mortgage or risk background and so little pushback from the board occurred on the potential risks of these products.

Simultaneous to the bank’s origination of these loans, SifiInvestment Bank realized that it could expand its structured finance business by selling CDS that had mortgages as the reference asset. Senior management of the capital markets group convinced the board that these new products would be able to serve a wide range of investor appetites and transform credit risk transfer in the mortgage market by allowing CDS buyers to seek credit protection against mortgage defaults while allowing credit investors to participate in mortgage financing without actually originating or owning the loans on balance sheet. For SifiInvestment Bank it could both be involved in creating the CDS for market as well as take positions (i.e., sell CDSs) and create a stable income stream over time from the premiums paid by CDS buyers. With the bank projecting very low defaults looking into the future, it seemed like a sound business decision in 2004. By 2008 SifiInvestment Bank was reeling from losses that it incurred under its CDS program. As mortgage loans defaulted, the bank as seller of CDS protection was forced to cover losses of its counterparties. These losses, as well as those emanating from the bank’s retained portfolio, were the primary source of capital erosion for the bank. Had the federal government not stepped in when it did, SifiBank was most likely going to fail within a short period of time.

As these losses were being publicized, creditors and other Wall Street counterparties began pulling back from SifiBank. Lines of credit for the bank were at first being renewed at higher rates but over time access for credit dried up. Spreads on ABCP issued by SifiBank widened to such a degree as to be prohibitive for the company in raising short-term financing. Banks no longer wanted to enter into repo agreements with SifiBank and more concerning, the bank began experiencing considerable withdrawal of deposits in the weeks preceding the announcement of financing from the government.8

In order to meet its production targets for its new mortgage program, SifiBank had streamlined a number of its processes and controls in underwriting, closing and servicing loans. Operational efficiencies in mortgage production can mean the difference between becoming a market leader or a follower. SifiBank management pressed hard to place itself as one of the top three mortgage originators in the country before the crisis and to do so meant finding ways to reduce the operational burdens of the loan manufacturing process.

Streamlining bank processes included allowing some loan production staff to bundle closing documents together and sign off with little review of what was being signed. Loan programs allowed many borrowers to avoid having to produce documents verifying their income and employment. Servicing staff was further reduced because, after all, mortgage defaults were expected to remain low. Automation was accelerated in both underwriting and collateral valuation where possible, thus reducing the number of underwriters and property appraisals in the process.

To no one’s surprise, fraud, both internal and external was rampant in these programs and surfaced once loan defaults began rising during the crisis. Counterparties and investors in securities created by SifiBank sued the company for billions of dollars of repurchases based on claims that the loans violated the terms of the contract relating to fraud and misrepresentation. Loan documents went missing during this period and once the deluge of defaults hit the bank, it did not have sufficient servicing resources to handle the caseload. Many borrowers were erroneously foreclosed on as a result, which caught the attention of the media, regulators and litigators. SifiBank faced billions of dollars of legal damages and settlements as state attorneys general and the U.S. Justice Department lodged suits against the bank.

The government’s decision to intervene and prop SifiBank up at the beginning of the financial crisis was very difficult. On the one hand, the government realized that there was a reasonable likelihood that not intervening could lead to SifiBank’s insolvency. If the third-largest U.S. bank were to fail, it would send shock waves through an already weak financial sector potentially resulting in a cascade of bank failures and precipitating an economic depression. But in saving SifiBank, the government risked not only the ire of the U.S. taxpayer but also created a perverse incentive that if a bank was perceived as too-big-to-fail, it could continue to engage in risky behavior knowing that eventually the company would be bailed out.

The government financing for Sifibank came with several strings attached. The government insisted that the CEO and chairman must be replaced as well as several key members of the executive team and board of directors. The bank was also forced into an agreement in which the U.S. Treasury would receive a large number of warrants, effectively allowing the government to exercise options to buy its stock in SifiBank at a favorable price that it held as part of the agreement. The government would also have greater involvement over key decisions for a period of time until the bank was able to repay its obligation to the government. These events ushered in an unprecedented amount of scrutiny for SifiBank and while the morale of company employees took a massive hit, over time it allowed the bank to remake its tarnished image to the public, investors and employees by reinvigorating the principles that had led the company to greatness in its early years.

Within several months of the ouster of the CEO and chairman, the board hired a new CEO, who had formerly been the enterprise CRO of a major competitor and had 20-plus years of banking experience running commercial bank businesses. With this background SifiBank was well on its way to becoming an industry leader in risk management. On the day the new CEO took office he called for the separation of the combined position of CEO and chairman in order to reduce potential conflicts of interest. He further went on to describe his vision for the bank, which was to be built upon a foundation of strong risk management that would allow the bank to operate prudently in all economic environments while positioning itself to grow its businesses profitably and creating significant value for shareholders, customers and employees. SifiBank was to become a risk-centric organization and one that would be admired by its peers and customers over time. But even with that vision, the bank faced regulatory headwinds that posed a number of challenges for the new management team.