Addressing Concentrations of Risk

1. Addressing Concentrations of Risk Twenty Twenty Analytics is a joint venture between Goldstein Schechter Koch and Kirkland, Russ, Murphy & Tapp www.gskcpas.com & www.krmtcpa.com

2. Current Guidance • Supervisor Letter – Concentration Risk, 10-CU-03 issued by the NCUA March 2010 • Non-Authoritative Guidance, released by the NCUA during 2008, Multi-Dimensional Portfolio Analysis (MDPA)

3. Concentration Risk • What is concentration risk? • A risk concentration is any single exposure or group of exposures with the potential to produce losses large enough (relative to capital, total assets, or overall risk level) to threaten a financial institution’s health or ability to maintain its core operations.10-CU-03

4. Types of concentration risk • Asset classes (e.g. residential real estate loans, member business loans, automobile loans, loan participations or investments). • Concentrations within a class of assets. Examples include, but are not limited to: • Loans to one borrower or associated group of borrowers (may include several different types of loans – residential real estate, MBLs, consumer loans, etc).

5. Types of concentration risk - continued • Residential Real Estate Loans – collateral type, lien position, geographic area, non-traditional terms (such as interest-only, payment option, or balloon payment), fixed or variable interest rate, low or reduced underwriting documentation, and loan-to-value (LTV). • Member Business Loans (MBLs) – types of loans (e.g. real estate, working capital, and credit cards), collateral type, payment feature (such as interest-only, balloon payments), loan term, geographic area, and LTV.

6. Types of concentration risk - continued • Loan Participations – types of loans (e.g. residential real estate, MBL, and automobile) and the sub-classes associated with the types, originating lender, and geographic area.

7. Highlights 10-CU-03 • Management is to perform a risk assessment which demonstrates their understanding of the risk of the product or service, quantifies the potential loss exposure and documents a rational business decision on the acceptable concentration level based on the analysis. • Create data processing systems capable of warehousing data on various lines of business, commensurate with its size and complexity, to properly identify and measure concentration risk.

8. Highlights 10-CU-03 - continued • Develop effective, accurate and timely risk rating systems for managing concentration of risk in the loan portfolio. These risk ratings should be objective, sensitive to changes in the borrower and/of loan characteristics – which are validated via an independent review function.

9. Highlights 10-CU-03 - continued • Management to provide timely and periodic reports, in a format that clearly indicates changes in concentration risk – commensurate with size, complexity and risk exposure. These reports should not only measure concentration of risk against board approved parameters but should measure how the risks change over time.

10. Highlights 10-CU-03 - continued • Establish a policy which addresses its philosophy on concentration risk, limits commensurate with net worth levels and the rationale as to how the limits fit into the overall strategic plan of the credit union. • Perform routine portfolio-level scenario and sensitivity tests to quantify the impact of changing economic conditions on asset quality, earnings and net worth. The analysis should predict possible future outcomes given an event or series of events.

11. Highlights 10-CU-03 - continued • The analysis should additionally be multi-faceted to explore the effects of a single event or multiple negative events on the portfolio. • Provides new guidance for examiners conducting audits of credit unions to ensure that all of the guidance included in the letter have been considered

12. Highlights 10-CU-03 - continued • The board of directors must establish a policy which addresses its philosophy on concentration risk, limits commensurate with net worth levels, and the rationale as to how the limits fit into the overall strategic plan of the credit union. • Once the appropriate risk management systems and policies are in place, it is essential monitoring and oversight become routine functions at the senior management level within the credit union.

13. Multi-Dimensional Portfolio Analysis • MDPA is a forward looking process for conducting a global analysis of credit portfolios; it includes the identification and analysis of risk factors, both at the point of loan origination and periodically afterward. By moving from a single point of risk analysis (origination) to a method that incorporates ongoing review of the changing credit quality within a portfolio, credit unions are able to establish a proactive system of risk identification and mitigation.

14. Multi-Dimensional Portfolio Analysis • MDPA is expected to reduce the aggregate number and amount of non-performing credits as ongoing monitoring helps management to identify and mitigate changes in risk profile.

15. Multi-Dimensional Portfolio Analysis • Step 1: Identify risk factors, such as credit scores, market collateral values, or levels of unsecured debt, that are indicative of changes in credit quality since origination. • Step 2: Establish risk thresholds and risk categories for the purpose of ongoing monitoring. These thresholds may be different than initial underwriting standards, and the thresholds should be specific to various product types.

16. Multi-Dimensional Portfolio Analysis • Step 3: Develop reporting system to track current risk category of individual credits and summarize key information in aggregate reports. • Step 4: Identify trigger points when action will be taken to mitigate risk associated with a particular credit. For example, if current loan-to-value rises above 120 percent, access to unused portions of a home equity line may be restricted.

17. Multi-Dimensional Portfolio Analysis • Step 5: Define risk mitigation strategies for risk categories. Strategies should be customized to consider the product type, risk factors, and level of exposure (potential loss amount). • Step 6: Take action to implement risk mitigation strategies.

18. Multi-Dimensional Portfolio Analysis • Step 7: Continue periodic monitoring of portfolios. Identify changes in risk factors that move individual credits to different risk categories. Measure individual credit and portfolio risk levels against defined thresholds for action. Frequency of risk identification efforts should be linked to exposure (portfolio impact to net worth) and risk levels (higher risk portfolios would warrant more frequent monitoring).

19. Multi-Dimensional Portfolio Analysis • Step 8: Report on changes in portfolio, identify high risk credits, and continue cycle by taking action to implement appropriate risk mitigation strategies. • Step 9: Periodically test results of MDPA by adding new risk factors and/or eliminating factors that do not generate reliable results. Credit unions should expect to see changes in predictive risk factors over time, as conditions change within the field of membership and economy.

20. Who We Are • Twenty Twenty Analytics is a company that specializes in the review and homogeneous analysis of loan portfolios for credit unions. • We have developed a series of models that can be instrumental to your management team in identifying, analyzing and monitoring concentrations of risk within your loan portfolio. • Each of our models is customizable to your specific needs and we have a proven record of validating and identifying economic risks and uncertainties that expose your portfolio to risk.

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