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RIsk Perspectives
Highlights of Risk Monitoring in the Seventh District – 2nd Quarter 2013

The Federal Reserve Bank of Chicago’s (Seventh District) Supervision & Regulation Department tracks
current and emerging risk trends on an ongoing basis. This Risk Perspectives newsletter is designed to
highlight a few of the timeliest themes for the Seventh District’s supervised financial institutions. This
newsletter is not intended to be an exhaustive list of the current or potential risks and should not be
relied upon as such. We encourage each of our supervised financial institutions to keep abreast of risk
trends most relevant to their individual operations and business models.

Regulatory Capital Rules Finalized
The Federal Reserve Board on July 2 approved a final rule regarding capital standards at banking
organizations in the United States. The rule addressed capital requirements set forth in the Dodd-Frank Wall
Street Reform and Consumer Protection Act, as well as implemented Basel III regulatory capital standards in
the United States. The Federal Reserve Board noted in its press release the following summary of the rule:
The final rule minimizes burden on smaller, less complex financial institutions; It establishes an
integrated regulatory capital framework that addresses shortcomings in capital requirements,
particularly for larger, internationally active banking organizations, that became apparent during
the recent financial crisis.
A link to the entire press release can be found here. The final rule was coordinated with the Federal Deposit
Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC).

Supervisory Guidance
The Federal Reserve Board of Governors periodically releases Supervision and Regulation Letters,
commonly known as SR Letters, to address significant policy and procedural matters related to the Federal
Reserve System's supervisory responsibilities. The following SR Letters were released in the second
quarter 2013. A complete listing of SR Letters is available on the Federal Reserve Board’s website.
SR 13-13 / CA 13-10

Supervisory Considerations for the Communication of Supervisory

SR 13-12

Commodity Futures Trading Commission (CFTC) Swap Clearing Rules

SR 13-11

Filing Procedures for Annual Independent Audits and Reports Required
Under Federal Deposit Insurance Corporation (FDIC) Rules

SR 13-10

Format for Safety-and-Soundness Reports of Examination and
Inspection for Community State Member Banks and Holding
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Companies Rated Composite "4" or "5"
SR 13-9 / CA 13-6

Minimum Standards for Prioritization and Handling Borrower Files
with Imminent Scheduled Foreclosure Sale

Current Risk Topics
District Bank Performance
The banking industry nationwide posted record profits for the first quarter of 2013. However, profitability
was in part driven by one-time gains reflected in non-interest income, provision expense declines and gains
in the investment bank subsidiaries at some of the country’s largest banks. In the Seventh District, Return
on Average Assets (ROAA) for Q1 2013 fell from 0.82% to 0.75%, due primarily to net interest income
compression, but this was partially offset by provision expense decreases. Over the past few years,
aggregate provision expense in the District has steadily dropped from around 1.3% of average assets in
2010 to 26 basis points in the first quarter of 2013. Although financial results from the second quarter are
still preliminary, earnings press releases and disclosures to date suggest first quarter trends continued in the
second quarter. Headline profits continue to appear quite healthy, but may mask some of the same
important underlying trends – falling provisions and one-time benefits, rather than profits from margin
Net interest margins (NIM) in this low
Interest Income and Interest Expense to Total Earning Assets
interest rate environment have been
Seventh District – All Banks
compressed as loans and securities
Interest Income
re-price at lower rates, while 7.00% 6.59% 5.98%
deposits, already near the lower 6.00%
Interest Expense
bound of 0% interest expense, remain 5.00%
and have been growing, thus
compressing NIM. To put this into
3.00% 3.24%
context, NIM in the late 90s peaked
around 4.0% compared to Q1 2013 2.00%
7G results of 3.0%. While there has 1.00%
been some increase in non-interest 0.00%
Mar-07 Mar-08 Mar-09 Mar-10 Mar-11 Mar-12 Mar-13
income from last year, this has not
been enough to offset the drop in interest income in most institutions.

Modeling Complex Products
As banks struggle to maintain or expand net interest margin (NIM) in today’s low rate environment,
financial institutions may be tempted to implement non-traditional strategies to increase profitability. In
addition, some of these non-traditional strategies may involve complex products, which may not only
increase inherent and legal risk, but are also prone to model risk. The marketplace contains certain complex
products that require data which is difficult to obtain. In addition, some complex products rely on risk
measurements that use highly subjective assumptions. A few examples of common complex products
include asset backed securities and mortgage servicing rights (MSRs). Asset backed securities and other
securitized instruments can be complex to model for economic valuation because they require underlying
collateral data and are largely impacted by the structure of repayment of cash flows. MSRs can be difficult
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for banks to model for interest rate risk, as interest sensitive fee income needs to be measured in net
interest income interest rate risk modeling.
Many banks engage in third party relationships to measure interest rate risk. Third party models can be
proprietary and therefore may lack transparency. It is important for bank management to understand
model capabilities, applicability, limitations and assumptions. The Federal Reserve SR Letter 11-7 provides
Guidance on Model Risk Management and speaks specifically to validation of vendor and other third-party
products banks of all sizes should follow for model governance.

Student Loans
Nationally, student loan delinquencies have drawn attention from policy makers to household consumers.
Both student loan debt and delinquencies have risen significantly in the past seven years, with the latter
outpacing the former. In addition, approximately one third of the total U.S. student debt outstanding
resides on financial institutions’ balance sheets. Included in this total is roughly $238 billion government
guaranteed loans originated by financial institutions prior to the termination of the Federal Family
Education Program in June 2010. However, the overall risk to financial institutions appears to be limited.
The historical loss rate among financial institutions from government guaranteed loans is low because
lenders are generally reimbursed a minimum of 97% of uncollected principal and interest if a borrower
becomes delinquent (provided the lender complies with the servicer requirements). The delinquency rates
for private student loans have been improving post-crisis. Since 2009, private lenders have tightened
underwriting polices and required cosigners for an increasing portion of loans.
While the current inherent risk of student loans may be limited, ancillary impacts of student loan
delinquencies on a banks borrowing population should be considered. Prudent risk management calls for
banks to incorporate borrower student loan obligations when assessing repayment risk of consumer
portfolios. Inadequately high student loan debt may inhibit access to credit, which could negatively impact
bank growth objectives. Private student loans are largely variable rate products subject to payment shocks
upon re-pricing. Lastly, a deficit reduction policy may result in a pullback in government guaranteed student
loans and, by extension, a growth opportunity for lenders. Entry into this business requires an appropriate
review of new products as well as controls for approval and underwriting processes.
The Expansion of Vendor Management Risk
Traditionally, vendor management has been a focus of both banks and supervisors as an information
technology (IT) risk management perspective. Information technology is a critical factor needed to support
the organization’s strategic goals and business objectives, and therefore vendor management of IT services
is embedded within firms’ risk management practices. While vendor management within IT remains an
important risk management element, recent trends indicate the scope of outsourced services is expanding
beyond core processing and information technology to areas such as anti-money laundering transaction
monitoring, loan portfolio analysis, interest rate risk modeling, compliance functions, risk management
services, customer service centers, consumer credit information, etc. Consequently, the risks posed by
outsourcing, both in the traditional and non-traditional sense, have increased in accordance with the
volume, scope, and pressure -driven decisions associated with these arrangements. Potential increased risks
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include data security risk as external vendors are increasingly given access to sensitive corporate and
confidential information; concentration risk due to utilization of vendor services to perform multiple
activities; reputational risk resulting from customer dissatisfaction or vendor failure and compliance risk
due to vendors’ non- compliance with various laws and regulations and supervisory guidance. The risks
associated with these arrangements should be regularly communicated to the board since the overall
responsibility lies with the bank’s board of directors and senior management.
While financial institutions can delegate a wide range of activities to a third party, the risk and responsibility
for compliance and oversight cannot be delegated. As such, the decision to outsource should be carefully
evaluated and aligned with the bank’s strategic goals and include the following controls: preparing a risk
assessment, developing a robust vendor due diligence, creating a well-defined vendor contract and
providing a structure for ongoing monitoring and oversight. To this end, financial institutions should
establish a vendor management program that provides a framework for management to identify, measure,
monitor, and control the risk associated with outsourcing activities.

CFPB Issues Final Rules Impacting Mortgage Servicing
On January 17, 2013 the Consumer Financial Protection Bureau (CFPB) issued several new mortgage rules
regarding mortgage loan servicing, which amend the Real Estate Settlement Procedures Act (Regulation X)
and Truth in Lending Act (Regulation Z). These new rules will significantly impact financial institutions’
mortgage loan servicing and loss mitigation practices.
Nine major topics are addressed in the amendments to Regulations X and Z. For Regulation X, these
amendments include prohibiting servicers from charging a borrower for forced-placed insurance coverage
unless the servicer has a reasonable basis to believe the borrower failed to maintain hazardous insurance.
In addition, servicers are required to comply with certain error resolution procedures, including providing
the borrower written notification of the results of an investigation within 30 to 45 days. Other amendments
to Regulation X include requiring servicers to establish certain policies and procedures. A full list of the
amendments to Regulation X can be found here.
Regulation Z amendments also pertain to mortgage servicers. The amendments require servicers to provide
a periodic statement for each billing cycle for most instances and provide notification to consumers with
adjustable rate mortgage between 210 and 240 days prior to the first payment of the newly adjusted rate.
A complete outline of the rule can be found on the CFPB’s website.

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