C
Policy 603
Concentration Risk Policy
Original Approval Date: 8/2011
Purpose
The purpose of this document is to establish a policy, which addresses our philosophy
on concentration risk, summarizes concentration risk limits, and provides the rationale
as to how the limits fit into the overall strategic plan of ECCU.
The board acknowledges the primary threat to ECCU, as it pertains to concentration
risk, is in our real estate loan portfolio. Real estate lending has long been the
cornerstone of our strategic plan. By aggressively managing concentration risk, we can
continue to focus on real estate lending without adversely affecting net worth. The
benefits obtained with a high concentration in real estate loans have historically far
outweighed the risks of significantly adversely affecting net worth.
Introduction
The term “concentration risk” generally denotes the risk arising from an uneven
distribution of business relationships or from a concentration in business sectors or
geographical regions, which is capable of generating losses large enough to jeopardize
an institution’s solvency. The Basel II Framework further defines concentration in
respect to collateral as an additional risk category. It constitutes an indirect
concentration risk as it has an impact only in the event of default.
Identification and Reporting of Concentration Risk
Each product or service carries some risk of financial exposure or loss for the credit
union. Management will 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.
The larger the concentration level, the more robust and advanced the analysis and risk
management techniques should be.
Management will perform a risk assessment that quantifies the potential loss exposure
at least semiannually. While all major product types will be included, the primary focus
will be on the real estate portfolio. The results of the risk assessment will be reported to
the board, along with a rational business recommendation on acceptable changes to
concentration levels. The reports should be in a format that clearly indicates changes in
concentration risk and is commensurate with the size, complexity, and risk exposure of
the credit union. The reports should measure concentration risk against board
approved parameters, comment on macro economic factors that could influence
concentration risk (unemployment, foreclosure rate, property values, etc.), and also
measure how the risks change over time.
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Comprehensive and Accurate Data
Credit union management will maintain comprehensive and accurate data for each risk
area. This includes a quality control function to ensure that data entry and changes are
accurate and timely. The credit union should have a data processing system capable of
warehousing data on various lines of business to properly identify and measure
concentration risk.
Risk Rating System
Developing an effective, accurate, and timely risk rating system is an important tool for
managing concentration risk in the loan portfolio. Risk ratings methodology should be
objective, sensitive to changes in borrower and/or loan characteristics, documented,
and validated via an independent review function once development is finalized.
The Board of Directors recognizes that risk measurement is a complicated process and
will likely be a “work in process” for the foreseeable future. However, failure to take
actions now and conquer the “learning curve” will likely inhibit ECCU’s potential for
growth.
The concentration risk for deposits, interest rate risk, liquidity risk, investments, and
critical vendors will be derived from the processes and metrics outlined in the applicable
board approved policy that govern each of those areas.
All the exposures, including credit exposure, will be summarized in the Enterprise Risk
Capital Planning Matrix (ERCP). The ERCP aggregates quantifiable risk exposure and
the resulting potential effect on net worth. It allows management to react quickly to
changes in net worth and mitigate risks before credit union capital is negatively
impacted. The ERCP is:
• A tool for prioritizing and managing potential risk and not a forecast of future
•
•
losses.
Static in nature and a snapshot at a given moment in time.
A first step in attempting to quantify enterprise risk exposure. Risk measurement
and forecasting will evolve and become increasingly more sophisticated over
time.
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An illustration of the Enterprise Risk Capital Planning Matrix follows:
Educational Community Credit Union
Enterprise Risk Capital Planning Matrix ($'s in 000's)
as of June 30, 2011
Total Assets as of
6/30/2011
$
346,973
% of Total
Assets
9.22%
Description
Regulatory Net Worth
Amounts
$
32,007
Interest Rate Risk + 300 (1)
$
2,324
0.67%
Credit Risk
Real Estate
Auto
Unsecured
EZ Access Line of Credit
Credit Card
Total
$
$
$
$
$
$
(785)
(285)
(121)
(56)
(198)
(1,445)
-0.23%
-0.08%
-0.03%
-0.02%
-0.06%
-0.42%
Liquidity Risk (3)
$
(29)
-0.01%
Adjusted Capital
$
32,857
Credit Risk Coverage (4)
Adjusted Capital Position plus
Allowance for Loan Loss
$
1,140
$
33,997
9.80%
$
$
20,818
13,178
6.00%
3.80%
(2)
Minimum capital position
Capital Cushion
(5)
Notes:
(1)
Change in Net Interest Income +300 bps rate shock (12 months)
Estimated loan value at risk = % loans outstanding * DQ ratio > 2
months
(3) Total Unused LOC + High deposit Members - investment portfolio liquidation borrowing capability
(2)
(4)
Allowance for Loan Loss as of
(5)
Adequately capitalized per NCUA
6/30/2011
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9.47%
The direct impact on net worth from concentration risk is difficult (if not impossible) to
quantify. However, concentration risk may produce credit risk, liquidity risk, and interest
rate risk, which (while still difficult) are all quantifiable. The ERCP aggregates
quantifiable risk exposure and the resulting potential effect on net worth. When the
Adjusted Capital Position plus the Allowance for Loan and Lease Losses falls below the
adequately capitalized limit of 6%, the ALM Committee will report to the Board the steps
to be taken to restore the Adjusted Capital Position plus ALLL to 6% or greater over a
reasonable period of time. Steps to be considered may include but not be limited to:
• Increasing net worth with normal operating earnings
• Increase loan rates
• Lower share rates
• Increase non-interest income
• Decrease operating expenses
• Decreasing assets
• Reducing shares by lowering rates
• Prepaying borrowings
• Not obtaining new borrowings as existing borrowings mature
• Eliminating loan product offerings contributing high amounts of credit risk
• Commit to reducing concentrations in loan products/categories
contributing the highest amounts of credit risk
• Selling blocks of loans to reduce risk and/or produce a premium on sale to
increase net worth
• Reducing liquidity risk– see Liquidity policy for steps to be considered to
reduce liquidity risk
• Reducing interest rate risk – see Asset Liability Management policy for
steps to be considered to reduce interest rate risk
Concentration Philosophy and Strategic Linkages
Strategy is as much about what you choose not to do as it is in choosing what to do.
ECCU will continue to abstain from indirect auto financing and on what we do best, real
estate lending.
Our strategy and value proposition are grounded on providing an extraordinary member
experience, while simultaneously working together, doing the right thing, and having
fun. Those values take the form of providing members with high rates on shares, low
loan rates, and low fees. While our lending focus has resulted in a concentration of real
estate loans, the efficiencies gained from high average balances and processing
expertise are the funding mechanisms of that strategy and our value proposition.
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Our real estate focus has allowed us to engage in a managed growth strategy that has
resulted in the economies of scale and profitability necessary for survival in the new
post-recession world. Our ongoing profitability analysis confirms real estate loans to be
by far our most profitable loan product. Credit losses on real estate loans have
historically been significantly lower than any other loan type and continue to be - in spite
of the worst correction/devaluation in real estate values in recent times AND the “Great
Recession.”
Like mortgage banks, our real estate concentration has not been an accident, but preplanned and part of our business strategy and philosophy. ECCU is a specialized
lender, who deliberately incurred credit concentrations to benefit specifically from
knowledge advantages gained from focusing on selected products and targeted
categories of member borrowers. We have constantly outperformed our industry and
peers in asset quality as measured by loan losses despite credit concentrations. In fact,
we have outperformed our peers precisely due to our relatively high concentration in
real estate loans and our underwriting. We fully expect that trend to continue.
Our real estate portfolio represents significantly less exposure to net worth than any
other loan products. Our concentration risk analysis reveals that real estate loans make
up 63% of our total loan portfolio, but represent significantly less capital exposure. Our
financial performance during the 2008 - 2010 economic downturn would have been
significantly worse had we had a higher concentration of consumer loans.
To remain vibrant ECCU must continue to grow, albeit at a slower pace than in our past.
Absent our current real estate business model, we will be forced into other areas to fuel
our moderate growth (i.e. Indirect Auto Lending). Upfront investment will negatively
affect earnings and the quality of the asset on our books could diminish as we gain a
working knowledge of any new product or service we choose to offer. Unintended
consequences would likely be less concentration, but increased risk.
Concentration Limits
See Attachment
Third Party Vendor Oversight
Vendor concentration risk(s) will be managed in accordance with the Outsourcing
and Vendor Management Policy.
When working with third parties, due diligence is essential to ensure the risks are
properly identified and managed. Examples of third party services include purchase of
participations in loans; underwriting, processing and safekeeping member loans; and
purchase or safekeeping investments. Due diligence reviews need to take into account
the nature of the service, length and depth of expertise exhibited by the vendor, staffing
changes, economic and regulatory changes, and risk mitigation strategies associated
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with vendor oversight. Also important to note is that due diligence is an ongoing
process. It encompasses the original review at the outset of product or service
implementation and should be updated periodically to monitor changes in the vendor’s
ability to deliver products or services which meet the credit union’s expectations.
Scenario and Sensitivity Analysis
Management should routinely perform portfolio-level scenario and sensitivity tests to
quantify the impact of changing economic conditions on asset quality, earnings, and net
worth. In general, scenario analysis uses the model to predict a possible future
outcome given an event or a series of events, while sensitivity analysis tests a model’s
parameters without relating those changes to an underlying event or real world
outcome. The outcome of sensitivity analysis is to determine which assumptions have
the most impact on the model’s results. Management should consider the susceptibility
of portfolio segments with common risk characteristics to changing market conditions.
Examples of common risk characteristics can be by loan type, investment type,
collateral type, geographic area, individual or associational groups of borrowers,
business lines, etc.
The analyses should be multi-faceted to explore the effect of single and multiple
simultaneous negative events on the portfolio. The sophistication of scenario and
sensitivity analyses should be consistent with the size, complexity, and risk
characteristics of the portfolio as a whole.
Compliance Statement:
This policy is intended to comply with all NCUA regulations and guidelines, as well as
federal and state laws that are applicable. The Concentration Risk Policy for ECCU is
effective upon the adoption by the Board of Directors. Future revisions to this policy can
only occur with Board approval.
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