A Risk Professional's Survival Guide - Rossi Clifford

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by the CRO to allow business staff designated to manage risk at the unit level to operate within stated risk objectives. Such a policy would outline the size of deals, loans, and transactions that could be approved by employees, which is oftentimes based on seniority and expertise. By having a small corporate risk office and a large business risk function, it allows an independent review of risk management activities to be conducted by the corporate risk office while allowing the business risk units to be responsible for day-to-day implementation of risk management within each line of business. SifiBank had set up such a structure where each business unit had a CRO who reported directly to each division’s president and indirectly to the CRO. The presidents each created their own performance plans for their CROs with input from the corporate CRO (sometimes also referred to as the enterprise CRO). In the years preceding the crisis, SifiBank’s CEO gave clear direction to the heads of each business that they had to grow their businesses each year by at least 10 percent. As a result, these objectives were handed down to each executive in the operating units, including the business line CROs. For the business CROs, 85 percent of their performance was based on supporting product and sales within the division and only 15 percent was placed on managing the risk exposure of the unit. This executive compensation structure fueled significant risk-taking by SifiBank in the years leading up to the financial crisis.

       Lines of Business

SifiBank operates along a complicated product and institutional structure as depicted in Table 1.1. Due largely to historical arrangements, several business lines cross corporate segments. While SifiBank remains the flagship entity with respect to consumer and commercial banking activities, its thrift and finance company divisions provide specialized consumer and commercial banking oriented in some measure to their unique charters.

Table 1.1 SifiBank Business Lines by Corporate Entity

      Thrifts, or savings and loans (S&Ls) as they are sometimes known, are depository institutions like commercial banks and are granted operating charters from the state or federal government that allow them to access cheaper (federally subsidized) deposits. But a major differentiator between commercial banks and thrifts is that a thrift institution must maintain 65 percent of its assets in certain qualifying assets, much of which are mortgage-related. This specialization makes thrifts particularly vulnerable to mortgage market conditions. Moreover, thrifts are especially sensitive to interest rate risk, where losses can be realized due to mismatches between typically shorter-dated funding sources and mortgage loans that have long maturities. This will be examined in more detail in later chapters. SifiThrift Company is regulated by the Office of the Comptroller of the Currency (OCC).

      SifiFinance Company had been an independent company prior to its purchase by SifiBank in 1999. As a finance company it did not hold a bank charter, which meant that it had to derive its funding via capital market debt issuance. The lack of subsidized deposits puts finance companies at a competitive disadvantage to commercial banks and thrifts. Balanced against that is the fact that unlike banks and thrifts, finance companies are not subject to safety and soundness regulations. They are subject to various state and federal consumer regulations such as those overseen by the Consumer Financial Protection Bureau (CFPB). However, by focusing on subprime borrowers, SifiFinance Company was able to earn substantial income by charging interest rates and fees significantly above that for prime borrowers. The company traditionally offered small ($500–$1,000) short-term (<1 year) unsecured (i.e., requiring no collateralization) personal loans realizing that the average loss rate on this business was between 12 and 18 percent. Borrowers could be graduated to larger loans, eventually after demonstrated payment ability over time, allowing them to obtain a mortgage loan from SifiFinance Company.

      SifiBank, as mentioned earlier, is comprised of several commercial bank subsidiaries. SifiBank, having a federal charter, is technically a national bank, overseen from a safety and soundness perspective by the OCC. The Federal Reserve oversees banks that have state charters and are members of the Federal Reserve System (FRS) as well as bank holding companies. The Federal Deposit Insurance Corporation (FDIC) oversees state-chartered banks that are nonmembers of the FRS.

      SifiBank’s lines of business are focused on consumer and commercial customers. The bank offers a full array of consumer loan products as shown in Table 1.1 with credit cards representing one of the larger consumer asset classes. SifiCards is one of the most recognized credit cards in the market, however, a rise in cyberattacks on large retailers and banks has placed the company on guard against this risk. But one of SifiBank’s greatest strengths is in its extensive branch network. It operates more than 10,000 retail branch offices across the country, although 75 percent of its network is on the East Coast. The cost of operating branches in an increasingly e-commerce environment has pressured the bank to find ways to reduce its operating efficiency ratio defined as the dollar amount of noninterest expense as a percent of operating revenues. To be more competitive with peer institutions, the bank has waged a cost-cutting campaign for three years and senior management has considered increasing its Internet banking model in an effort to combat higher costs.

      Notwithstanding such costs, the branch network represents a significant source of revenue generated from cross-selling of bank products to its customers. On average SifiBank has found that its retail bank customers have about seven products that it obtained from branch operations. That means that when a customer opens up a retail checking or savings account they are marketed for loan and investment products. This compound effect of cross-selling products has boosted revenues even as operating expenses have risen with branch growth.

      SifiInvestment Bank was formed to handle all of SifiBank’s vast trading and investment activities for its clients and for proprietary trading. The bank trades in virtually all investment types including equities, fixed income, derivatives such as options, futures and swaps, foreign exchange and commodities. When trading for clients it acts as a market maker, bringing buyers and sellers together without taking a position itself.7 The capital markets group has developed a robust structured finance offering, which features creating, underwriting and investing in various financial instruments with complex cash flow features. Examples of structured financial instruments include mortgage-backed securities and associated resecuritizations, collateralized debt obligations (CDOs), and credit default swaps (CDSs), among others. These types of transactions have a variety of purposes including transfer of different risks such as credit and interest rate risk, tax optimization strategies and obtaining legal and accounting advantages. These often require the establishment of separate legal vehicles apart from the bank to meet certain requirements. Over the years, SifiInvestment Bank has created hundreds of special purpose vehicles (SPVs) for its structured finance activity. The scale and complexity of the business poses significant exposure to SifiBank in terms of counterparty, credit, market, and operational risks.

      Five years earlier the capital markets group had established a proprietary trading group that was charged with taking positions in capital markets for profit-making. This type of activity made it a hedge fund within SifiBank and over the years it had performed well for the company, enjoying an annual average return of 18 percent since its inception. The trading group can invest in a wide range of instruments and has focused largely on economic bets since the financial crisis. The company made $1 billion, for example, following the Greek crisis. In the months leading up to the crisis, it took short positions in various sovereign debt instruments of countries that had similar underlying fiscal and monetary problems as Greece. It also was active in shorting various financial stocks during the banking crisis. With the implementation of the Volcker Rule banning proprietary trading at federally insured depository institutions, SifiBank faces a decision whether to spin off the hedge fund unit, shrink it to a regulatory allowable size, or change its direction and merge it with other permissible hedging activities.

      SifiAsset Management Company had operated as a well-known retail investment company, founded in 1900 until it was bought out by SifiBank as part of the strategic initiative to build a universal bank franchise. SifiAsset Management is focused on advising private retail clients with wealth management services, investments and brokerage activities.

      The

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