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Risk Perspectives
Highlights of Risk Monitoring in the Seventh District – 1st Q 2011

The Federal Reserve Bank of Chicago (Seventh District) Supervision group follows current and emerging
risk trends on an on-going basis. This Risk Perspectives newsletter is designed to highlight a few current
risk topics and some potential risk topics on the horizon for the Seventh District and its supervised
financial institutions. The newsletter is not intended as an exhaustive list of the current or potential risk
topics and should not be relied upon as such. We encourage each of our supervised financial institutions
to remain informed about current and potential risks to its institution.

Current Risk Topics
Municipal Finances

Seventh District State Budget Shortfalls

State finances are making headline news, and the $2.8
2010
Proj. 2011 Proj. 2012
trillion Muni Fund industry experienced volatile markets
Illinois
$14.3 B
$13.5 B
$15 B
with fourth quarter market price declines, higher yields
Indiana
$1.4 B
$270 M
$1.3 B
and record outflows going into 2011. Industry analysts
Iowa
$1.3 B
$1.1 B
$294 M
are mixed in their forecasts of the performance of
Michigan
$3.3 B
$1.8 B
$2 B
municipal debt. Financial institutions should ensure that
Wisconsin $3.2 B
$3.4 B
$1.8 B
they are aware of their exposure and are employing
appropriate risk management practices, including pre-purchase analysis and on-going monitoring for
credit, market, liquidity and other risks. Institutions can be exposed to the municipal market in a variety
of ways, including ownership of investment securities, municipal deposits, variable rate demand notes
sponsorship and support, sponsored mutual funds, asset management products, and lines of credit or
direct loans to municipalities. Institutions can also be indirectly exposed to municipalities if their loan
customers rely heavily upon a state or local municipality for a large portion of their revenue stream.
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Credit Risk – Financial institutions may be exposed to credit risk through their holding of
investment securities, support of variable rate demand notes, and lines of credit or loans to
municipalities.
Market/ Liquidity Risk – Deterioration in credit quality (real or perceived) may impact the
marketability and liquidity value of municipal investment securities. Further, bankers need to
be aware of contingent liabilities associated with support of Variable Rate Demand Notes
(VRDN) or other lines of credit.
Fiduciary Risk - Firms holding managed municipal mutual funds (MMF) that are 2a-7 MMF funds
may face potential break-the-buck risk to a firms’ capital.

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Residential Real Estate
The residential real estate market continues to show considerable strain. Housing markets remain
weak, prices continue to ease, and Other Real Estate Owned (OREO) levels and shadow inventories are
expected to dampen housing markets through 2011. In addition, strategic defaults and a substantial
volume of delinquent first mortgages coupled with performing second mortgages place additional strain
on residential portfolios and may result in elevated losses on poorly monitored residential mortgage
portfolios. Lastly, a significant portion of both the district’s as well as the nation’s borrowers are
underwater.
Asset Management and OREO Practices
Banks’ exposure to elevated volumes of OREO remains a concern here in the Seventh District as well as
system-wide. Despite continual marketing efforts, price reductions and even available financing, OREO
volumes remain elevated. Foreclosed construction properties remain the single largest contributor to
OREO levels in the Seventh District, representing 50% of the total. OREO presents several risks to
banks, including: 1) elevated levels of nonearning assets, 2) upfront and ongoing maintenance costs, 3)
extended marketing times and potential for fraud from nominee purchases, and 4)subsequent flipping
of properties. Strong OREO management and disposition strategies include, among others, formal
written policies and strategies that govern the investment, management, maintenance, leasing,
marketing, and ultimately sale of OREO assets, as well as OREO aging reports, periodic refreshing of
asset valuations to ensure appropriate market pricing, and monitoring of property conditions through an
OREO condition report.

Agricultural Real Estate
The recent, and in some cases, large
increases in agricultural real estate
prices, especially in traditional
agriculturally reliant areas of the
Seventh District, have supervisors,
bankers, and even Reserve Bank
presidents increasingly cognizant of
the potential for inflated valuations.
Kansas City Reserve Bank President
Thomas Hoenig noted, in an interview
with Bloomberg on 17 February 2011,
that the farmland boom may be an
“unsustainable bubble.” A confluence of factors are impacting land prices, including large increases in
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agricultural commodity prices, an influx of new non-agrarian investors (including hedge funds), and
historically low borrower interest rates. Institutions are exposed to a potential decline in agricultural
land values in a number of ways, including increased leverage when purchasing agricultural land tracts
and cash flow difficulties arising from excessive leverage brought on by increased borrowing availability.
ALLL Trends and Proposal by the FASB and IASB
Coverage ratios are one indication of adequacy of reserve levels. Supervisors in the Seventh District
noticed a moderate increasing trend in the median ALLL coverage of total loans as well as coverage of
nonperforming loans. As loan portfolios stabilize for some Seventh District institutions, these institutions
may feel they can release some reserves. Examiners will be monitoring the release of reserves, broadly
defined as a reduction in provision levels, for appropriateness.
The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board
(IASB) issued a loan impairment proposal for comment on January 31. The proposal moves U.S.
generally accepted accounting principles (GAAP) and international financial reporting standards (IFRS)
from an incurred loss to an expected loss model that would utilize more forward-looking data to
estimate credit losses. The impact of the proposed standard would be to recognize loan losses earlier
than under the current model based on management’s estimate of expected future credit losses. A
revised expected loss approach for estimating credit loss would require institutions to revise ALLL
estimation processes and increase ALLL levels.
Managing Data Integrity through the use of Spreadsheets
Financial institutions utilize user developed applications (UDAs) such as spreadsheets to support critical
decision making processes, and financial and regulatory reporting requirements. Some examples of
critical spreadsheets may be those used for board reporting, to calculate allowance for loan loss
reserves, income and condition statements, yield analysis and stress testing and other modeling tools
that project potential conditions based on changing assumptions and variables. Activities for critical
spreadsheets such as data input, development of formulas, creating data linkages, changes, testing and
backup may rely on and be controlled by the local administrator of the spreadsheet and may not be
subject to formal access, integrity and availability policies, procedures and controls.
The potential business risk of possible financial condition misstatements or erroneous assumptions in
decision making models warrants a closer look at the controls in place to mitigate those risks. As with
many information systems risk management processes, the first step in managing the population is to
identify the current inventory and risk rank that population according to its criticality. Next, based on
risk, the population should be subject to testing/validation and controls should be in place to secure and
maintain the integrity of the spreadsheets. Lastly, a formal framework and repeatable process should
be implemented to ensure ongoing integrity and control.

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Potential Risk Topics On the Horizon….
Risk Retention - The Agencies (OCC, FRB, FDIC, SEC, FHFA, and HUD) issued on March 29 a notice of
proposed rules (comment period until June 10) to implement the credit risk retention requirement set
forth in the Dodd-Frank Act. The proposed rule requires securitizers of residential mortgages to retain at
least five percent of the credit risk of the collateralized assets. The Agencies believe that the new credit
risk retention requirements will help address the weaknesses and failures of the mortgage securitzation
process and markets, by providing incentives for firms to monitor and ensure the quality of mortgage
assets. The requirements will also help align the interests of the financial institutions with investors.
Supervisory Guidance on Model Risk Management – SR 11-7
On April 4, 2011 the Federal Reserve Board released SR Letter 11-7, which provides supervisory
guidance on model risk management. SR 11-7 discusses model risk management with respect to model
development, implementation, use, governance, policies, and controls. It also provides guidance on
model validation, including expectations for vendor or third-party models and guidance relating to back
testing and sensitivity testing.
A complete listing of SR Letters released is available on Federal Reserve Board’s website.

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