1. ASSET/LIABILITY MANAGEMENT 1

2. Equity Valuation Focus Basic fixed rate asset valuation rule: – Rates rise  value falls – Rates fall  value rises Management’s task: Maximize market value of equity – MVEQ is the market value of assets (MVA) minus the market value of liabilities (MVL) – Rate changes result in changes in MVA and MVL – Changes in MVEQ caused by interest rate changes reflect interest rate risk 2

3. Duration GAP Duration GAP Analysis – Price sensitivity of bank’s assets and liabilities – Impact of rate changes on stockholders’ equity value Duration measures effective maturity of an asset or liability – Time-weighted average of present value of expected cash flows relative to its price – Measures price sensitivity to rate changes The larger the duration, the larger the price sensitivity The smaller the duration, the smaller the price sensitivity

4. Duration Example What is the duration of a bond with a $1,000 face value, 10% annual coupon payments, 4 years to maturity and a 12% YTM?

5. Duration GAP Duration GAP Model – Focus on managing market value of equity – Compares duration of assets with duration of liabilities – The larger the duration GAP, the larger the change in the economic value of stockholders’ equity when interest rates change – A duration GAP of zero implies that changes in rates would not affect the value of equity 5

6. Positive and Negative Duration GAPs Positive DGAP – assets are more price sensitive than liabilities Rates rise: assets fall proportionately more in value than liabilities, so EVE falls Rates fall: assets rise proportionately more in value than liabilities, so EVE rises Negative DGAP - liabilities are more price sensitive than assets Rates rise: assets fall proportionately less in value than liabilities, so EVE rises Rates fall: assets rise proportionately less in value than liabilities, so EVE falls 6

7. EVE Sensitivity Analysis Similar steps as earnings sensitivity analysis However, in EVE analysis the focus is on: – The relative durations of assets and liabilities – How much the durations change in different interest rate environments – What happens to the economic value of equity across different rate environments 7

8. EVE Sensitivity Analysis Rate ShocksDOWN200STATICUP200 UP300UP400 FFS and Other10,98410,85210,72010,65510,589 Net Loans151,608147,286142,412139,863137,458 Securities135,789124,577114,611109,628104,645 Non-earning Assets23,186 Assets (Market Value)321,567305,901291,029283,332278,878 MMDA/NOW/Savings104,523 96,40992,20690,10488,003 CD’s93,015 91,54490,07389,33888,603 Checking51,52647,52644,63543,18941,744 FFP & Other Borrowings32,32430,72829,07728,25227,427 Other3,279 Liabilities (Market Value)284,667269,486259,270254,162249,055 Economic Value of Equity36,90036,41531,75929,17026,823 Percentage Change1.3% 0-12.8%-19.9%-26.3% Equity Ratio11.48% 11.90%10.91%10.30%9.72% 8

9. Assumptions Prepayments on loans Does the model account for loan floors and caps? Call options on investment securities Non-Maturity Deposits – Betas – Decay Rates 9

10. Assumptions-Deposit Betas Core Deposit accounts typically have administered rates, meaning the rates change when management at the bank say they change. We do know however that there is often some response to market rate changes. To model this sensitivity we use a Beta factor. This is the percentage of rate change each account will move with a 100 basis point movement in Fed Funds. 10

11. Assumptions-Deposit Betas Betas vary from bank to bank. Betas can vary from time to time depending on the liquidity needs of the bank and changes in competition. While it is useful to look at how the bank has historical changes interest rates, the assumptions used in the model are a prediction (guess) of how much the bank will change the rates in the future.

12. Assumptions-Deposit Betas Per 100 basis point change in fed funds, betas for the following types of accounts typically range as: Savings: 5 to 30 basis points MMDA: 10 to 50 basis points NOW: 10 to 50 basis points Some banks may be outside of these ranges. Most models allow the bank to have different betas for upward or downward rate shocks.

13. Assumptions-Decay Rates Decay rates essentially are an assumption about the average life of your non-maturity deposits. They will have the most impact on your bank's EVE measurement. The longer you model these deposits to be, the more base EVE for the bank. Calculating the value of all assets and liabilities is a reasonably straightforward exercise except when it comes to core deposits. They have a beginning balance and a rate, but they are missing the term structure (i.e. they're "non- maturity" deposits). The decay assumptions you provide give them an assumed term structure. 13

14. Assumptions-Decay Rates Decay Rates are the most powerful assumptions in the measurement of EVE. They are also the most difficult to determine. FDICIA Decay Rates Industry Studies Bank Deposit Study Stress Testing 14

15. Assumptions-Decay Rates FDICIA Decay Rates – Developed in 1980’s. Many models use these as default assumptions. May not be an accurate picture of your bank’s decay rates. Industry Studies – Several models have recently adopted these as they indicate significantly longer decay rates than FDICIA rates. May not relate to what is going to happen when rates rise.

16. Assumptions-Decay Rates Bank Deposit Study – Very expensive and likely will not show how your deposits will react when rates start to rise from these low levels. Stress Testing – Whatever assumption is being used for decay rates, they should be stress tested to see what speed will cause excess risk to the bank.

17. Assumptions-Decay Rates The following slide is an example from a real bank of what can happen to the projected EVE from quarter to quarter with a change to the decay rate assumptions. The model’s vendor lengthened the decay rate assumptions when they purchased an industry deposit study from a third party.

18. Assumptions-Decay Rates CheckingNOWMMDA/Savings Quarter 172 Months60 Months48 Months Quarter 2100 Months Change in EVE+200 Basis Points+300 Basis Points+400 Basis Points Quarter 1-12.8%-19.9%-26.3% Quarter 2+4.6%+4.1%+6.0%

19. Assumptions-Decay Rates Why did EVE increase on the previous slide? By lengthening the decay rates, the bank shifted from a positive duration GAP to a negative duration gap.

20. Surge Deposits Bank on previous slide had experienced growth in NMD’s from 56% to 63% of total deposits over past two years. ( Approximately $15 million) Most banks have experienced sharp growth in NMD’s over the past two to five years. Customers are parking money until rates start up. How should this effect decay rates?

21. Regulatory Requirements Must be measured for changes in interest rates up to 400 basis points. Realistic Policy Guidelines 21

22. Policy Example Change in EVE +/- 100 Basis Points-10% +/- 200 Basis Points-15% +/- 300 Basis Points-20% +/- 400 Basis Points-30% 22

23. Conclusion/Takeaways Duration GAP analysis is the basis for modeling risks to EVE from interest rate changes. In most banks decay rate assumptions have the biggest effect on the models projections.