1. THE ROLE OF DIRECTORS IN RISK MANAGEMENT THE ROLE OF DIRECTORS IN RISK MANAGEMENT Directors Forum Maine Association of Community Banks November 28, 2007

2. 2 Jim Clarke, Ph.D. 610-688-9466 jjclarke2@aol.com Jim teaches asset/liability management in the Graduate School of Banking sponsored by Americas Community Bankers. He is responsible for much of Americas Community Bankers ALM education. He also conducts ALM seminars for the Financial Management Society, [FMS], Risk Management Association (RMA), and other national associations. Jim conducts seminars on ALM for both state banking associations and individual banks. He annually conducts a Current Issues in ALM seminar for state bankers associations throughout the Midwest, central Atlantic states & New England. Dr. Clarke is a frequent speaker at banking conventions on both ALM and strategic issues. Jim has written extensively in the area of ALM and bank strategies. Jim has a B.A. in Economics from LaSalle College and a Ph.D. in Economics from the University of Notre Dame. He is a former faculty member in the Finance Department at Villanova University. He sits on the board of two community banks and an investment company.

3. 3 The Boards Role should start with a strong ALCO tradition! ALCO Process – The Role of the Board ALCO Process – Stay Disciplined ALCO Process – Liquidity & Interest Rate Risk ALCO Process – The Agenda Critical Information for Decision Making Apply Techniques to Current Environment It has been a tough year – be patient!

4. 4 ALCO Process – Start with the Role of Board Senior Managements Role Daily decision making managing assets & liabilities Managing risk on an ongoing basis Boards Role Establishing policy – we review a new one every meeting. setting risk limits Monitoring risk

5. 5 Good ALCO Tradition Lay out a meeting agenda – this forces discipline into the meeting! Stay with the agenda each meeting – this will re-enforce the important issues! The chair must maintain enforcement of agenda and a sensible time frame for the meeting! Make sure the meeting addresses the critical issues – asset funding or cash allocation!

6. 6 Making ALM Decisions Based on Critical Data 1. What is the interest rate forecast? There is plenty of free information. 2. What is the banks liquidity position? Requires a cash flow pro forma! Do you need cash, if not why play the aggressive deposit pricing game – there are times when you should consider shrinking the bank [2007]. 3. What is the banks interest rate risk exposure? Is the bank asset or liability sensitive? Now we are ready to make decisions- Deploying cash – 2002 to 2004, and funding assets – 2005 & 2006! Now we are ready to make decisions- Deploying cash – 2002 to 2004, and funding assets – 2005 & 2006!

7. 7 ALCO Meeting Agenda Interest rate forecast! National & local business conditions-you make loans! Cash flow pro forma – what is my liquidity? Interest rate risk report – know your sensitivity! Decision making – What Theory tells us? Managing Assets through the 1 st quarter 2007 Managing Liabilities through the 1 st quarter 2007

8. 8 The May 2007 Yield Curve Exemplifies the Toughest Environment: The worst of all possible worlds for Banks [Almost – 1979 to 1981 was the worst]

9. 9 Market Interest Rates – The Current Yield Curve

10. 10 Current Versus Recent High

11. 11 Yield Curve Versus Recent Low

12. 12 The last eight years have been a clinic for the ALCO!

13. 13 This is the August futures market forecast before sub prime crisis was understood!

14. 14 Critical Data: November View String of rate cuts ahead - 4.00% by May

15. 15 Interest Rate Summary Interest rates are a critical variable in bank asset/liability management! We need to establish a forecast for rates at the ALCO meeting. _________________________________ If you expect rates to rise: shorten assets and lengthen liabilities If you expect rates to fall: Lengthen assets and shorten liabilities

16. 16 Financial Risk and CAMELS Ratings Credit Risk – A in CAMELS Interest Rate Risk – S in CAMELS Embedded Option Risk – S in CAMELS Market Risk – S in CAMELS Marketability Risk – L in CAMELS Liquidity Risk – L in CAMELS Currency Risk - S in CAMELS

17. 17 Capital Risk – C in CAMELS Metric RegulationWell Capitalized Your Bank [Optimal] Tier 1 Risk Based Capital (RBC) 4.00%6.00% Total RBC 8.00%10.00% Tier 1 Leverage Ratio 4.00%5.00%

18. 18 Why do we see capital ratios erode? Loan problems Non performing become write offs! Rapid balance sheet growth Typical for large mortgage originators A leverage transaction gone bad – usually occurs because interest rate environment changes!

19. 19 Asset Quality – A in CAMELS Diversifying risk – increase portfolio size and risk will decrease. Bank Loan Portfolio is the primary source of credit risk. How feasible to diversify: Residential Mortgage Portfolio HELOC Commercial Real Estate

20. 20 Monitoring Credit Risk – Note that Thrifts and Commercial Banks will have different standards! MetricComment Losses/Loans[0.3% to 0.10%] Non Current/Loans [0.40% to 0.70%] Allowances/ Loans[0.70% to 1.25%]

21. 21 Asset Quality-Loan Portfolio is the Key Loan Category% of Banks Loan Portfolio Comment Construction Loans5% to 25% Portfolio concentration Geographic concentration % of equity 1-4 Family RML25% to 85% Loan to value Geographic concentration New Products – IO & negative amortizing ARMs HELOC5% to 15% % of equity Sub Prime Commercial Real Estate Loans 15% to 45% Diversification Underwriting Commercial & Industrial Loans 2% to 18% Non real estate collateral Monitoring is critical

22. 22 Liquidity Risk – the L in CAMELS MetricComment [Mature Bank] Loan/Asset or Loan/Deposit 50% to 85% 75% to 110% Net Non Core Dependence Depends on bank size – but increasing across all peer groups! Short-Term Non Core Dependence Good correlation to interest rate risk

23. 23 Interest Rate Risk – S in CAMELS Define: The impact on the Banks financial statements from a change in market interest rates: Income Statement Impact on Net Interest Margin Balance Sheet Impact on Market Value Capital

24. 24 Types of Interest Rate Risk Re-pricing Risk (Gap Analysis) Basis Risk (Different between indexes) Yield Curve Risk (How does the yield curve shift?) Market or Price Risk (Market value capital) Option Risk (Call, Prepayment, Caps)

25. 25 Impact on Financial Statements Income Statement NIM = II/AA – IE/AA Balance Sheet Asset – Liabilities = Capital

26. 26 Income Statement Impact Rates Increase Rates Decrease Asset Sensitive Margin increases Margin decreases Liability Sensitive Margin decreases Margin increases Asset Sensitivity – Assets respond more to a change in rates than liabilities. Liability Sensitivity – Liabilities respond more to a change in rates than assets.

27. 27 How do we measure interest rate risk? Gap Analysis – Gap is determined from the balance sheet and measures the impact on the income statement. This is a traditional measure many banks use to measure IRR. Simulation Analysis – Models each asset & liability as to the impact from a change in interest rates. Allows for a simulation of both the balance and income statement from a rise and fall in rates.

28. 28 Regulator expects Board to set limits on IRR. Change in RatesChange in NII or Margin Change in MV Capital +200 bps +100 bps base case -100 bps -200 bps

29. 29 Boards Role in Monitoring Risk Monitor periodically – Quarter is routine, but more often if problems arise! Review similar data when monitoring! Dont wait for an elephant to walk by – at that point it is too late! Look for recurring variation – ask for explanation!