Kelly Coughlin talks to Kevin Chiappetta, CFA, Financial Institution Management Associates Corporation about bank portfolio stress testing tools that are being utilized to help banks get prepared for the new FASB rule and CECL
Kelly Coughlin is CEO of BankBosun, a management consulting firm helping bank C-Level Officers navigate risk and discover reward. He is the host of the syndicated audio podcast, BankBosun.com. Kelly brings over 25 years of experience with companies like PWC, Lloyds Bank, and Merrill Lynch. On the podcast Kelly interviews key executives in the banking ecosystem to provide bank C-Suite officers, risk management, technology, and investment ideas and solutions to help them navigate risks and discover rewards. And now your host, Kelly Coughlin.
Kelly: Kevin, I came across FIMAC I think, at a conference in Wichita, where I met your CEO, Greg Donner. I think Greg made a presentation there that I thought was really interesting. Let’s just start out with a little bit of just brief background, Kevin, of who you are. Then we can do a deeper dive into what FIMAC does, and what you see going on in the market today.
Kevin: I appreciate the opportunity. Living in the Milwaukee area, my wife and I are the parents of two recently grown children. We’ve got one out of college, living overseas. We’ve got one who’s in college not too far from you, up in the St. Paul area.
Kelly: You came over from your executive director from a company called Balance Sheet Solutions.
Kevin: That’s correct.
Kelly: You guys are in the space of helping banks manage their balance sheet … Both their assets and liabilities. Correct?
Kevin: That is correct. We actually are two different approaches on that. We consider ourselves a technology company. We do provide the tools to do that. There are a number of them in the market place available at different price points. Different models which accomplish the tasks with slightly different variations, but we also are the consulting side of it. We use those tools to help the financial institution understand the risk that’s inherit in that, and use that risk information to make different decisions. We also want to be able to lend the expertise that we’ve been able to accumulate over the years. Both from bank CFO positions and other consulting firms to help them understand that information. Help them build that information better.
Having the technology is fantastic. It’s helpful, but understanding how to use that technology is really where we’re kind of moving forward with our firm, helping those institutions understand what all goes into using technology to make better decisions.
Kelly: The first point of entry is technology. Give them some tools. They start to use it, and they think that it probably triggers more questions than answers, so they need help implementing it. You’ve got a consulting area that helps the bank from that point.
Kelly: What are some of the different business models out there to help the bank with their ALM?
Kevin: The most basic approach that we’ve seen is the technology side.
Here’s our model. Here’s what it cost to run it. We can help you move data in and out. Here are the results. We provide that series of results in a report, and you’re off on your own.
There is some benefit to that. Obviously, it tends to be more of a low-cost entry. For those who are well-versed in that type of thing, it might be advantageous. We can see all the way up to the full consulting as we’ve described it before.
We know that there are a number of competitors in the market space that provide that as well. We see some of this provided by firms who offer other product lines. Perhaps a broker dealer could offer something like that under a different feed-based arrangement, so we see a number of different ways to pay for that service. Whether you’re paying through a soft-dollar transaction type of thing that doesn’t show up on the income statement, or more on the straight feed base.
There are probably three or four different ways, I think, that we see financial institutions using this information. Where is it coming from? Who’s running it? When we start to compare the models themselves, we get into what type of random number generator is being used to create rate paths and some of the more geeky stuff that comes along with the rate models. We can start to split hairs as to one model comparison to the next.
I think the business side of it really breaks down into a model-only on the left-hand side, and on the right-hand side, the full-in consulting. Either you are or you’re not a full service on the consulting side. You’re just merely providing the service that brings the data in and pushes the reports out.
Kelly: You certainly have plenty of brokers that are trying to jam municipals and securities into the asset side. Right? That’s one component that is somewhat of a unique approach that you guys have.
Kevin: Without a doubt. We’ve run across some of those models. I don’t want to be overly disparaging. It really cuts back to something. We want to make sure as an organization that we separate duties. We do that in a lot of different areas. Those who are responsible for money coming in versus money coming out.
To the big duties, we try to make sure that we split the risk-taking and risk-measuring. When you start to combine those two duties you open up the opportunity for one to kind of crowd out the other. When you have advice that’s given on an overall risk-management standpoint for somebody who’s being compensated for selling you risk, it doesn’t take long to see that the opportunity to create more risk than you wanted to was there.
I’m sure there are very good people doing that modeling, but when it comes down to it at the end of the day. Whether I eat or not is dependent on you buying risk and adding it to your balance sheet.
The opportunity to create an environment that looks like you can absorb more risk is clearly there. Personally, I just don’t think that you’ve done enough effort to separate those two duties to make sure that conflict of interest is removed if you’re getting the information on your risk-management and acting on that from the same place. It creates too much room to create errors either willfully or otherwise.
Kelly: In other words, if you’re going to accept the business model where brokers drive the decisions, then you better have done your preparation and homework beforehand so that you know exactly what you need. Don’t let them decide which assets sit inside the bank’s portfolio at the inherit conflict. Is that a fair statement?
Kevin: Yeah. I think that’s a spot-on statement. Clearly, to create these risk reports it requires a certain amount of judgement to go into some of the assumptions. I don’t want to get overly technical but if you look at the liability side, it requires a certain amount of assumption. You need to understand the impact of that assumption has on the result. If my main motivation is to sell risk asset, I can make an organization look more or less risky depending on what is necessary. The opportunities exist for that to happen. Any time the opportunity for that conflict of interest opens itself up, it has risk managers and organizations who are responsible for managing that risk.
I think it’s imperative that we try to close off those opportunities. Whether or not you believe they’re there. The opportunity for it to be there and anybody with a suspecting eye is going to be drawn right to that, taking that opportunity for that risk-management problem off the table. It just goes a long way in proper governing.
Kelly: All right. Another approach, that I’ve seen in the marketing out there, might be to outsource it completely to another investment management firm where they will take on the entire function. They’ll take care of finding and executing the trade. Presumably, not with their own broker, I would imagine, but in theory they could. They could be a broker dealer, they could be an investment adviser, and run the trade. Do you see much of that going on?
Kevin: Yeah. We do see some of that. Some of my background comes from that particular business model, whether with or without the dealer side. It’s not too dissimilar from the role I described earlier on our consulting side, where we spend a great deal of time getting to know the organization and working along with them.
In essence, being an outsourced CFO, or finance division if you will, we create that role and play that role within the organization. Along the lines with that business line, however, it’s imperative that you don’t simply take it off their table and say, “Go focus on lending,” or “File your table reports and everything will be fine.” It’s imperative that you become part of the organization, provide the information, the education, and help them understand what’s going on with that decision-making process.
It might seem easy, say, in February now to come up with the reports from the year end, then tell them where they are and what they can do, but along about April, May when they need to answer for an exam a process , “ Where did those numbers come from? How did you make that decision process?” I can’t think of something that would go worse in that exam process than not being able to answer a question because you just don’t know what’s going on behind the numbers that created that decision. However, we approach that.
If you don’t include management in the decision-making process, I think later on there’s going to be some difficult conversations you’re going to be having.
Kelly: Why don’t we talk about what’s going on with this new FASB ruling, the current expected credit loss that is coming out here? I believe it’s going to come out this year. Correct? What are you guys doing? What should banks be doing? What are your thoughts around that issue? It seems to be a fairly big one.
Kevin: It clearly is. It’s kind of been hovering out there for a while now. This sort of looming storm coming our way. As we look and see the discussion of the proposal, I think the proposal become more finite this year, so we get a lot better feel for how it comes out. It’s a slight shifting from the current allowance calculation where our allowances sort of reflect previous history on loan credit performance. It gets more into a projection.
From our standpoint it really works very well with the mathematics that we’ve been doing in the forecasting for interest rate risk. It may be an eyebrow-curler but I think there some really definite, clear parallel there. We’re expected to put a present value on the projected losses for a particular loan, loan portfolio, or loan type. However we want to look at that. That really kind of goes along with the same type of mathematics we run now for expected cash flow.
From our standpoint, this is more of a pivoting of how we’re going to create that projection of loan losses from a look-back historically to a forward-looking calculation. The technology that we have isn’t going to require us to make any major changes in the mathematics of it. We’re just applying it a slightly different focus. To be projecting a current value of a future cash flow, that’s kind of what our whole business is about.
While it is somewhat scary, because we still don’t know exactly what it is, and it’s going to change to focus of what we’re doing. We feel very strongly that we have the tools, and the expertise in place to help management get their arms around this forecasting process. Then, sort of tweak the way put the input into a loan-stressing calculation or a forward-looking calculation.
It’s so similar to what we’re doing now that we’re trying to take a sort-of … Let’s relax, focus on it, and apply that same thought process into the loan loss process. We think we’re going to be able to come up with a solution that’s going to be fairly well understood, fairly well put into place, and maybe less stress than we we’re thinking at the beginning, simply, because of the unknown.
Kelly: You guys aren’t currently doing that now for loan portfolios. You’re doing it for assets. You’re doing it for investments. Correct?
Kevin: Yeah. Absolutely. We’re applying that same concept to losses. What is the value of that loss? Is it the currently value of those future losses? The same discounting process that we’re going to go through. We’re just using that into a different piece of the balance sheet than we’ve had in the past. We’ll do a study so we can build an assumption built on some sort of a historic look-back as to how the depositors behave. We’ll help them understand the pre-payment speed. All the different assumptions that have to go into that technology in order to understand the behavior of the cash flows under different rate environment. We help them with that point.
I mentioned earlier that I think one of the biggest assists we’ve had right now is just bringing people up to speed into what it is we’re doing. The board can handle those responsibilities that have been squarely put into their lap, but they just don’t have the day-to-day expertise to deal with making sure that they can deal with what’s going on. When they see what comes out of that technology, they get a better feel for what went into it and what it’s telling them once they see the results.
Kelly: Okay. You guys are well-positioned, I’m thinking or at least from what I’m hearing, for this CECL ruling. Correct?
Kevin: Yeah. We’re very confident that we have the tools in place now to tackle CECL. There’s still a lot of detail that needs to be brought out and put into place, but we understand the mathematics of it very well. That’s the business we’ve been in for decades.
Just merely applying that concept here isn’t overly frightening. Again, there are detail that need to be brought out. There are certain things that we need to make sure we’re comfortable with so that we’re applying it properly to comply with the CECL guidelines. Without a doubt, we’re very confident that we have the knowledge, expertise, and the tools in place to tackle this once we get around what all the specifics are.
Consciously optimistic is the right way, I think, to put that.
Kelly: Okay. That’s great. Do you have any take-aways that you’d like to go away with?
Kevin: Sure. Let’s start with CECL because that’s what we we’re most recently discussing, and again, it’s going to bare a repeating.
We have the knowledge and the expertise in place already as banks, and institutions. We’ve been working with these concepts. We’re now applying it to a different area of the balance sheet and the balance sheet reporting. I think it’s important to know what the guidelines are, but by the same respect we want to make sure that we don’t get overly concerned with the concept of moving from a backward-looking to a forward-looking projection of losses. It’s merely applying the concepts we know into a different area.
The biggest concern that we have on CECL is more making sure we understand the guidelines behind the assumption building process and get that done. We want to make sure that we don’t step into a panic state because it’s something new.
From an interest rate standpoint, one of the things that we’re trying very, very hard is to get people to conceptualize as they get into the balance sheet management process. Not merely the interest rate reporting process.
What do we mean by that? As I’ve mentioned before, we have the technology side of our business. We do a great job of getting the information, and reporting that information. What we do with that information becomes the big next step. From the consulting side, what we’re trying to get organizations to understand is more the movement up the scale towards this modern portfolio theory.
We want to look at the balance sheet as an entire entity rather than component, as most things are done now. For instance, organizations that run an investment portfolio with a certain set of guidelines, because we don’t want risk here. We take risk elsewhere. That isn’t necessarily beneficial to the overall organization, or to the balance sheet.
We want to look at how a decision is made in a loan portfolio. It has an impact on the balance sheet. We want to understand that. A decision made in the investment portfolio has an impact on the balance sheet, and we want to understand what that is.
Understanding how things interact with each other when we’re going through the risk management process is one of our biggest challenges. Trying to evolve organizations out of the component style management into a more holistic balance sheet style management.
In order to do that, you really need how the balance sheets react to each other. In order to do that, you need to be able to break down interest rate risk reports that we’ve provided. In order to get to position, we have to take three steps backwards. We need to make sure the policies are written correctly, that the management understands what we’re doing, that the process of doing testing, stress testing, movement rates, and seeing how different decision’s reactions appear on the balance sheet.
All of those things become critical in order to look at the balance sheet management as opposed to component management. When we start using this information to make management decisions as to merely reporting what our risk profile is, that is a huge step forward in getting everybody aligned.
We’ve got Board alignment through line management alignment. Everybody understands what we’re trying to accomplish. Everybody understands how things impact, and we know that before those decisions are made. We just feel that’s a much better approach. One that if we embrace the holistic approach, the decision making process becomes more a matter at looking at the menu and picking which we want to have as opposed to hoping that things work out our way.
Kelly: Great. Very helpful. Do you have a favorite quote?
Kevin: There’s one from a business standpoint that I was told a long, long time ago. I try to remind people of the same thing. When you find yourself in a hole, the best exit strategy is to stop digging. You see how people try to manage their way out of that hole. It sounds kind of basic. Maybe a little too folksy, but it makes a whole lot of sense. Whatever put you in that spot, you need to stop doing it first. That’s our first strategy. Stop doing what put you in that world of hurt, and start trying to come up with ways to get out of it.
Kelly: That’s great.
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Kelly is licensed with the Minnesota State Board of Accountancy as a Certified Public Accountant. Kelly provides bank owned life insurance portfolio and nonqualified benefit services to banks across the United States. The views expressed here are solely those of Kelly Coughlin and his guests in their private capacity and do not in any other way represent the views of any other agent, principal, employer, employee, vendor or supplier of Kelly Coughlin.