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Risk Perspectives
Highlights of Risk Monitoring in the Seventh District – 4th 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
Making Heads or Tails of Capital Stress Testing
Since the enactment of the Dodd-Frank Act in mid-2010, there has been a tremendous amount of
attention paid to capital stress testing. Although the concept behind capital stress testing is relatively
simple, its formal implementation can range from basic to very complex, leading to confusion among
industry observers and participants about what stress testing means and how it may affect them. At its
core, capital stress testing attempts to quantify the impact on a financial institution given adverse
conditions. Those conditions could include macroeconomic factors such as changes in GDP or the
national unemployment rate, or a sharp decline in the stock market. They could also include more
regional events, such as the loss of a major local business. Stress elements can be even more specific to
an individual institution, such as changes in the company’s net interest margin or the impact on loan
growth of the departure of a key lending team.
The exercise of stress testing
involves converting assumptions
circumstances mentioned above
into a quantifiable estimated
impact on a banking institution.
The advantage of analyzing
capital through stress testing
versus traditional capital ratio
analyses is its prospective nature.
Stress testing looks into the
future in an attempt to capture
outcomes that are difficult to
envision with a static capital
calculation. The thought process
behind stress testing can be just



Capital Analysis
and Review


Largest banks



Dodd-Frank Act
Stress Testing

Non-CCAR banks
with more than
$50B in assets

Internal Capital

Ongoing supervision
and review of banks’
capital plans

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All banks and thrifts
with more than $10B
in assets

Bank Stress

Not part of CCAR,

as important as the outcome, since a robust process will better identify emerging risks.
There are a multitude of stress testing methods being used by banks, both within and outside of the
regulatory framework. The ones displayed on the preceding page are supervisory processes that are
reviewed by the Federal Reserve. The Comprehensive Capital Analysis and Review (CCAR) applies to
nineteen of the nation’s largest banks, and is a formalized process requiring a detailed capital plan and
the submission of data. These firms were asked to submit their plans by January 9, 2012, and evaluation
by the Federal Reserve will be the basis for approving or rejecting certain requested capital actions. The
Capital Plan Review (CapPR) is very similar to CCAR, but applies to a group of twelve banks with more
than $50 billion in assets that are not part of the CCAR exercise. The timetable for CapPR coincides with
that of CCAR, and as with CCAR, capital plans submitted by participant banks will be used to determine
whether requested capital actions will be approved.
Perhaps the highest profile method, Dodd-Frank Act Stress Testing (DFAST), has yet to fully take shape
and is not currently being implemented. The rules under DFAST are still being written; with the current
expectation initial stress tests under the DFAST mandate will take place using data as of September 30,
2012. DFAST applies to banks with more than $10 billion in assets, thus a larger group than the CCAR
and CapPR exercises.
It is important to note that there is no expectation for community banks to implement CCAR- or CapPRlike programs, and DFAST requirements do not apply to small community banks less than $10 billion in
assets. These programs all apply only to larger institutions. There are, however, elements of stress
testing in the Federal Reserve’s guidance applicable to all banks in certain areas, such as commercial real
estate concentrations, liquidity, and interest rate risk. Stress testing can be a useful way for any bank to
identify and quantify the effects of emerging risks.
The field of stress testing is a constantly evolving one. For large banks, the Supervisory Capital
Assessment Program (SCAP) in 2009 laid the foundation CCAR and CapPR. In the case of DFAST, our final
rules will reflect the latest thinking by regulators on the discipline of stress testing.
Commercial Real Estate Trends
Bifurcation of the CRE market remains constant. High quality assets are trading at pre-recession levels
while other assets are finding limited liquidity, with stress in the CMBS market and at regional and
community banks. Select portions of the CRE market have seen sizeable reductions in capitalization
rates. However, the number of such quality CRE projects remains limited and highly competitive. The
majority of Commercial Real Estate (CRE) spreads are widening with respect to the 10 year Treasury
rate. Capitalization rates may be elevated due to investor caution, as industry analysts contend limited
Net Operating Income (NOI) growth in the first few years command higher rates today to compensate
for this risk. Prudent risk management practices are needed to ensure rent, price, and vacancy
assumptions remain in line with the quality of the CRE asset as this bifurcation persists.

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Other Real Estate Owned Trends
Other Real Estate Owned (OREO) portfolios at
institutions under $10B in total assets have been
steadily increasing in the 7th District, as shown on
the graph to the right. Further, 7th District OREO
levels exceed national levels in this sector of the
banking industry. Unlike larger institutions, the
data suggests community banks may not have
the ability to utilize alternative strategies such as
bulk sales to manage problem portfolios. The
recently released SR 11-15 on the Disposal of
Problem Assets through Exchanges is applicable
to all sized institutions. Banks considering
alternatives for disposing these assets are
encouraged to read this guidance, which is
available on the Federal Reserve Board’s web site.
Servicemembers Civil Relief Act – An Escalating Consumer Compliance Risk
Formerly known as the Soldiers’ and Sailors’ Civil Relief Act of 1940, the Servicemembers Civil Relief Act
(SCRA) was formally signed into law in 2003. Recent legal cases and increased attention from regulatory
agencies has heightened consumer awareness of SCRA. As a result, compliance, legal, and reputational
risk can elevate for firms lacking the risk management to properly monitor adherence with this law.
SCRA provides certain benefits to covered military members, including but not limited to protection
from eviction, foreclosure, and default judgment. SCRA also increases the limit of guaranteed life
insurance by the federal government and reduces the interest rate on covered transactions. A number
of large financial institutions recently acknowledged SCRA violations which resulted in multi-million
dollar settlements and/or civil monetary penalties. These findings and overall awareness ultimately led
to the creation of the Office of Servicemember Affairs within the recently formed Consumer Financial
Protection Bureau. Given the potential compliance concerns associated with SCRA, financial institutions
should ensure consumer compliance risk management programs are capable of identifying and abiding
by the SCRA for its servicemember customers.
Step Up Bonds
Today’s persistently low rate environment has caused many banks to search for additional yield in their
investment purchases. One higher-yielding investment that is increasingly held by many banks is stepup bonds. Step-up bonds are a type of structured note where the coupon increases or “steps up”
according to a predetermined schedule. Step-up bonds also often contain a simultaneous call option
whereby the issuer is allowed to redeem the security at each coupon step-up date at no cost. This call
feature creates potential uncertainty in the timing of principal payments and amount of interest
received, and as a result, additional market price volatility and reinvestment risk. While community
banks often invest in Agency step-up bonds, large institutions have increased their issuance of this
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product type. Risk management practices should consider the market risk these products can exhibit
prior to purchase. A thorough review of the call risk and the market value implications from market rate
increases exceeding determined step up increases are key elements to consider. Risk management
systems and pricing tools should capture the cash flow volatility of these products if purchased.
FASB's Financial Instruments Project and Trends in the Allowance for Loan & Lease Losses (ALLL)
The May 2010 proposed Accounting Standards Update, Accounting for Financial Instruments and
Revisions to the Accounting for Derivative Instruments and Hedging Activities, is expected to be reexposed in 2012. Since the initial proposal, extensive discussions have ensued surrounding classification
and measurement of financial instruments, impairment of financial instruments, and hedge accounting.
The FASB has distributed discussion papers on various aspects of the project and has communicated
changes that are likely to appear in the re-exposed standard. Examples of changes to existing standards
include the elimination of the Held-to-Maturity investment category and the addition of fair value
information to be shown parenthetically on the face of the balance sheet. The recognition principle for
measuring impairment is also anticipated to be impacted, moving towards a more forward looking loss
recognition principle based on expected losses. As re-exposure of the standard gets closer, financial
institutions need to be proactive in understanding how significantly the potential changes might impact
their institution, and be poised to analyze the actual impact of the re-exposed standard once it is issued
in 2012. Many good high level summaries exist today explaining the proposed changes and it is assured
that those will be quickly updated once the proposal is re-exposed.
Regarding the ALLL, regulators are reporting a significant number of banks released reserves in 2011, as
measured by the overall change in the ALLL. It is understood that as the credit quality of portfolios
improves and delinquency and charge-off rates start to decline, changes to the ALLL will occur. Support
for changes in the ALLL methodology should be well documented and should reflect the credit quality of
the portfolio.
Financial Institution Fraud Outlook
With the continuing global financial crisis and lack of improvement in the real estate market, financial
institution fraud will continue to be a high risk for banks. As evidenced by the increase in mortgage loan
fraud Suspicious Activity Report filings, mortgage fraud continues to be a problem and the sluggish
housing market will likely remain an appealing climate for fraud perpetrators. Often targeting distressed
homeowners, some prevalent mortgage fraud schemes are foreclosure rescue scams, mortgage
modification scams and short sale fraud. Commercial loans are also at high risk for fraud due to the
slow recovery of the real estate market. Borrowers, who encounter refinancing difficulties due to
outstanding loan balances higher than collateral values, may misrepresent their assets or property value
to qualify for loans. Financial institutions should also be alert to insider fraud. According to the
Association of Certified Fraud Examiners, employees pose the greatest fraud threat in this current
economy. Budget cuts at many banks have resulted in a reduction of compliance and risk management
functions creating more opportunities for fraud, as well as longer periods of time between when the
fraud starts and when it is detected. Financial pressure, both personally and professionally, has also
increased and can weigh into the rationalization of committing such acts.
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