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PROFITstar® Model Validation

Sample Bank

December 2011

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Table of Contents

Executive Summary .............................................................. 2

Regulatory Guidance on Model Risk Management ............... 4

The Scope of ProfitStars’ ALM Model Validation .................. 8

Review of Account Setup .................................................... 10

Review of the Monthly Update Process .............................. 26

Historical Review ............................................................... 43

Maturity & Repricing Review.............................................. 48

Review of PROFITstar Portfolio .......................................... 49

Historical Loan & Deposit Rate Correlation Analysis ........... 52

Review of Assumptions ...................................................... 66

Review of General Model Setup ......................................... 80

Additional Regulatory Guidance on ALM Modeling ............ 84

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Executive Summary

ProfitStars deems the bank’s ALM model setup and assumptions to be reasonable subject to making the recommended changes discussed in the model validation report. Prior to making the changes, it is recommended that the proposed changes be thoroughly discussed with ALCO to understand both the rationale for the changes, as well as how the new assumptions impact the overall model results.

The following recommendations are listed in order of their relevance and effect on accuracy of the model projections / calculations:

High Significance Recommendations 1. Non-Accrual loan setup should be reviewed to ensure their unique characteristics

are being handled correctly (page 12). 2. Shock constraint settings should be reviewed in two separate sections of the model

(pages 24-25). 3. The FHLB yield curve setup needs to be reviewed for several spot rate plot points

(page 26). 4. The bank should look into adding the recommended fields that are currently missing

from the loan file and investment files. The addition of these fields will provide more precision in interest rate risk calculations (pages 29-42).

5. Portfolio components for agencies and CMOs should be reviewed and modified to ensure proper cash flow modeling (pages 51-53).

6. Pricing assumptions for loans and deposits should be reviewed and compared to the results of the rate correlation and regressional analysis performed (pages 54-66).

7. Decay assumptions for non-maturity deposits should be reviewed and updated as appropriate (pages 68-70).

8. The bank should review prepayment assumptions on loan products and modify as discussed (pages 70-74).

9. The current use of key rates should be reviewed to ensure accurate pricing strategies (betas) and repricing characteristics (pages 74-76).

Moderate Significance Recommendations 1. The recommended breakout within the balance sheet and income statement should

be considered. These recommendations will enhance the bank’s ability to model accurate cash flow and enhance projected income/expense calculations (pages 11 and 21).

2. Rate information and Maturity/Repricing/Balloon timing should be reviewed for accuracy (pages 14-16).

3. Fair value assumptions should be reviewed to ensure the bank is accurately valuing each product (pages 16-18).

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4. Download exceptions for three of the loan files should be reviewed and addressed (pages 43-44).

5. Current offering rates should be reviewed for accuracy on numerous accounts (pages 48-49).

6. The projected cash flow schedule for one specific investment category should be reviewed for accuracy (page 50).

7. Instrument level detail should be added for mortgage accounts in order for the BondEdge mortgage loan prepayments to be most effectively used (pages 79-80).

Low Significance Recommendations 1. Auto update actions should be reviewed and modified as recommended (page 19). 2. One balance sheet special account code should be changed (page 19). 3. Risk-based percentages on asset accounts should be reviewed (page 20). 4. The setup of federal and state income tax calculations should be reviewed (pages 22-

23 and 84).

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Regulatory Guidance on Model Risk Management

Overview The validation of an Asset and Liability Management (ALM) model is a key part of the overall model risk management process. Since 2010, there have been three primary regulatory guidance letters that relate to overall model risk management and to model validations:

2010 Interagency Advisory on Interest Rate Risk (IRR) Management

2011 Supervisory Guidance on Model Risk Management

2012 Interagency IRR Management FAQ

The above letters provide a solid foundation for the current regulatory framework for the overall assessment of model risk. These letters supplement the “2000 OCC bulletin on Risk Modeling” (OCC 2000-16) and expand the scope of the requirements.

The “2011 Supervisory Guidance on Model Risk Management” (aka the “Guidance Letter”) was published by the Board of Governors of the Federal Reserve System and the Office of the Comptroller of the Currency (OCC). While not all financial institutions are regulated by the Federal Reserve Board or the OCC, it is reasonable to expect that the other regulatory agencies adopt a similar stance with regards to the managing of model risk. The Guidance Letter states that a model consists of three elements which should be validated. The elements include:

1. Information input – This element relates to the validity of the assumptions and data provided to any model. Model validations performed by ProfitStars primarily focus on the institution’s assumptions to ensure that they are reasonable for ALM planning and stress testing. Although ProfitStars does not have perfect knowledge of an institution’s specific ALM profile or objectives, we can provide guidance on the reasonableness of the assumptions used within the ALM model based on our experience and knowledge from talking to a variety of regulators and financial institutions.

2. Processing – This element includes the method and equations used to transform the inputs into estimates. ProfitStars uses an independent third party to verify that its model calculates correctly and does not contain any material mathematical discrepancies. The model certification is conducted by McGuire Performance Solutions (MPS) on every other model year’s release. A copy of the latest model certification can be found here.

3. Reporting – This element translates the processed estimates into standardized information. The output results of reports are also verified during the MPS model certification. If an institution creates customized reports, they need to verify the accuracy of the resulting outputs. It’s also important to understand the context of

https://forclients.jackhenry.com/ProductsAndServices/PROFITstarPROFITabilityCUPRO/ReferenceInformation/Pages/ModelCertification.aspx

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any formulas being used, as well as time frames being reported on. This is critical in order to have useful data for making executive decisions.

The Guidance Letter further advises that there are two primary risks associated with any model. The first major risk component is model errors. These types of errors include mathematical issues and design defects. As previously stated ProfitStars uses an independent third party to test and ensure that the ProfitStars ALM model does not have any material issues such as mathematical or design flaws. A third model error relates to assumption quality. A proper model validation will examine the assumptions used and make recommendations for changes.

The other major risk component is tied to incorrectly or inappropriately using a model. The ProfitStars ALM model is meant primarily for ALM and IRR analysis. When management uses the ALM model for other forms of analysis beyond what it is primarily designed for, it runs the risk of not getting meaningful or accurate results. Because of this, management must take care to control how the model is being used.

Minimizing Model Risk In order to minimize model risk, the Guidance Letter recommends that institutions:

1. Establish limits on model use: In other words, models should be relied upon up to some limit. A proper validation can provide guidance on the accuracy of the models results and what other components need to be considered outside of the model. It is important to utilize both qualitative and quantitative data to get the most out of a model.

2. Monitor model performance: A best practice is to measure performance by conducting a back-testing of past model results based on initial estimates. A sensitivity analysis can be performed which isolates the key drivers that factor into the differences between actual and projected results for a given period. As noted in the “2012 Interagency IRR Management FAQ” (aka the “FAQ Letter”): “Management should conduct ongoing monitoring and outcomes analysis of model performance using the institution’s results (Back-testing)”. Back-testing results can take on many different forms. Some of the most common items back-tested in an ALM model include forecasted margin (volume/rate/mix factors), pricing estimates, prepayment estimates and decay estimates. Back-testing of all of these elements is not within the scope of a ProfitStars’ model validation.

3. Adjust or revise model: After a validation is conducted, there should be a number of recommendations that will result in changes to different parts of any ALM model. The ProfitStar validation will show the potential degree of importance for each of the various suggestions.

4. Supplement model results with other analysis: Performing additional analyses that supports the assumptions being used. Examples of this would be conducting

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a regression analysis to support pricing, prepayment or decay assumptions, based on historical customer/member data.

5. Have a periodic Model Validation performed: The recommendation of the FAQ Letter is that financial institutions “should conduct a periodic review – at least annually but more frequently if warranted”. It further states that if there are material changes made to a model, the changes warrant a more frequent validation. The Guidance Letter further states that: a) All model components are subject to validation: There needs to be a complete

and thorough review in the validation. b) Validation work is subject to critical review by independent party(s), not just

the line of business: While internal reviews are one aspect of the validation process, other parties should also be included in the validation process. Using a third party clearly provides an independent group not subject to the control of the model user(s).

c) The group doing the validation must have the requisite knowledge, skills and expertise: It is acceptable to use parties such as an institution’s internal audit area, as long as they have sufficient ALM knowledge. If the institution uses a third party, the party needs to have the skills and knowledge in ALM. An organization such as ProfitStars has employees doing validations with a strong background in ALM.

d) The group doing the validation must have explicit authority to challenge users: Using a third party such as ProfitStars provides this form of objectivity and informed opinion needed. ProfitStars does not have a vested interest in the financial institution following a particular balance sheet strategy. ProfitStars’ goal is to help the financial institution understand their risk-return tradeoff for any strategies that they look to undertake so that the institution can make an informed decision for themselves.

6. Have a validation report which is structured to include: a) That all the model aspects have been reviewed. b) Highlights of potential deficiencies. c) Whether adjustments to the model are warranted. d) A clear executive summary. e) A synopsis of the model that includes major limitations and key

assumptions.

The regulatory letters stress the importance of an independent party being involved in order to provide an unbiased opinion as to the current state of the ALM model and make appropriate recommendations. As summarized in the Guidance Letter, “Independence is not an end in itself but rather helps ensure that incentives are aligned with the goals of the model validation… The quality of the *model validation+ process is

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judged by the manner in which models are subject to critical review.” In this regards, an institution should look for independence in two forms:

1. Independence from the party responsible for the model updating and maintenance processes. ProfitStars does not maintain the models for its clients. An exception to this is our ALM service bureau clients. For these clients, we recommend that another party performs the model validation in order to avoid a potential conflict-of-interests.

2. Independence from providing recommendations that the third party could potentially benefit from. ProfitStars does not recommend (nor do we benefit from) one particular ALM or investment strategy over another.

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The Scope of ProfitStars’ ALM Model Validation

The ProfitStars’ ALM model validation is intended to address the key elements discussed above which pertain specifically to the validation of the ALM model inputs and assumptions.

The following is a list of what is directly covered within the model validation document:

Review chart of accounts setup.

Evaluate chart of accounts to determine if there is appropriate breakout on fixed, variable, tiered and callable instruments.

Review setup of non-accrual and participated loans to ensure best practice assumptions and procedures are observed.

Review fair value discounting methodologies and modeling practices.

Review the utilization and setup of key rates and yield curves.

Examine application files to ensure all required downloadable fields and recommended fields are in use.

Test results of model inputs & outputs based on the monthly update process.

Run correlations & regressions of historical loan and deposit rates compared to market rates to determine possible pricing relationships.

Assess if offering rates and portfolio rates appear reasonable and updated on a regular basis.

Review reasonableness of the maturity and repricing cashflows.

Review the estimated non-maturity deposit life assumptions utilized by the financial institution.

Review the estimated prepayment assumptions utilized by the financial institution.

Examine the use of key rate ties, balance sheet ties and other projection formulas available in the model setup.

Verify use and setup of rate floors and ceilings within the model.

Issue an Executive Summary that indicates the potential impact of key findings and recommendations.

Issue a Report of Engagement which discusses the details of key findings and recommendations.

Conduct a consultative call to review findings included in the written Report of Engagement.

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The following list includes the items NOT addressed in the ProfitStars’ ALM model validation report. These items are still considered a critical but separate part of the overall ALM model risk management process:

Earnings risk analysis

Capital risk analysis

Liquidity risk analysis

Credit risk analysis

Back-testing analysis

ALM strategies analysis

Review of policies and procedures relevant to the ALM/IRR process

Review processes employed for model updates

Review processes employed for ALCO/board/auditor/examiner preparation

Reconcile ALM/IRR data to financial statements

Ensure proposed recommendations are changed within the financial institution’s model or a final review of the changes made (additional charge and follow-up time would apply if requested)

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Review of Account Setup Balance Sheet Setup Account Detail The account levels affect how the accounts total into other accounts and are also used for filtering the data on edit grids and in reports. Our recommendation is for major subtotals on the asset side to correspond with major subtotals on the liability and equity side.

Comments:

The bank has good breakout within the loan section. Loans are broken out between fixed and variable and the variable rate loans are tied to the associated rate index plus a spread. The breakout can be used in conjunction with the rate index and spread to key rate (margin) to enhance the interest income calculations in projections and interest rate risk analysis. If there are several different indices associated with a particular variable rate loan account, I recommend that the variable rate accounts get split out by index in order to give the most model precision. The bank’s investment section has suitable breakout in regards to the types of securities, but I encourage the bank to go further. Agency and municipal securities should be separated into callable and non-callable categories. This allows the ALM model to best capture the embedded call options more accurately. This recommendation is discussed in more detail during the review of the investment file setup. The bank currently has regular certificates broken out into tiers of greater than $100,000 and less than $100,000. Since the insured limit has been raised to $250,000, I suggest adding a third tier to the bank’s certificate and IRA break-out. The bank offers different interest plans on demand deposit accounts (NOW, HiFi, Savings and Club accounts). These accounts are broken out within PROFITstar. Doing this follows our recommendation and will provide a more accurate depiction of projected funding costs.

Non-accrual Loans When ProfitStars recognizes an instrument as a non-accrual loan via the Non-Accrual Flag loan field, it automatically codes the coupon as 0%. If Instrument Level Detail (ILD) is enabled for these accounts, all cash flows are placed in the first monthly time bucket. Not enabling ILD allows the user to manually adjust the non-accrual cash flows. It is recommended to not have ILD enabled for non-accrual loans so that cash flows can be adjusted based on their expected pay down.

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Consequently, projections for performing loans will be inaccurate if non-accruals are not split out from the rest of the portfolio and given their own account. We recommend separate accounts for non-accruals (either a single account for all loan types or multiple non-accrual accounts broken out by loan category).

Comments:

The bank’s ALM model has non-accrual accounts broken out from the performing loan accounts. This follows our recommendations and is particularly relevant now as non-accrual loans have been on the rise across the industry.

Even though the bank has non-accruals separated on the balance sheet, there are additional steps that need to be setup in order for non-accrual loans to be handled accurately in regards to earning asset calculations. Although these loans are not currently earning interest, they are still considered an earning asset and must be set up accordingly for accurate net interest margin calculations. As mentioned above, PROFITstar has a “Non-Accrual Flag” field that helps automatically handle the behavior of non-accrual loans. A key rate tie must be setup to prevent projected income from being calculated during rate shock calculations. I recommend giving myself or our support department a call and we can assist you in this setup.

Another important aspect for non-accrual loans is the expected cash flow of these loans. I would generally expect a WAL of one year or less if the bank is aggressively trying to reduce this portfolio. As a best practice, I recommend overriding the contractual cash flows in the maturity/repricing module with expected pay downs of non-accruals on a loan-by-loan basis. Non-accrual loan cash flows are currently being placed in the last time bucket, which extends the duration of these balances.

For EVE purposes, non-accrual loan accounts should generally be set up to valuate at ‘quote’ value. This allows the bank to key in expected market values based off of the latest expected loan loss calculations. However, if the bank writes these loans down to market on a monthly basis, then book value is an appropriate valuation treatment. The bank is currently treating these balances at book value. If these balances become larger and more material to the loan portfolio, the bank should continue to review them to ensure they are set up in an appropriate manner. Loan Participations When ProfitStars recognizes an instrument as a participated loan, it should be set up to ignore the balances that are parted out and only model the portion of the loan that the bank retains. If the loan file does not contain the necessary fields to recognize participation loans, it is common to see clients create contra asset accounts in order to

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model the net loan balances. Contra accounts come from the general ledger and do not provide cash flow information. Consequently, projected loan cash flows and interest are inaccurate when using this modeling method. We recommend against using contra accounts to model loan participations.

Comments:

The bank currently has several accounts designated to handle participated loans. For participated sold loans, these loans should be netted against the total amount to give the bank a clearer picture of the loans the bank truly owns. This is the recommended method of handling participated sold loans from an ALM perspective. It allows the bank to more accurately value the loan portfolio. The bank is currently breaking out gross loans and then backing off the participated balances. However, the participated cash flows on large accounts such as “FNMA Parts Sold” are not coming in from the loan file. Therefore, their cash flows are being approximated. The ideal way is to have the net balance position reflected via the loan download file, as this will provide the most precision.

Rate Type/Maturity Type/Maturity Interval/Repricing Type/Repricing Intervals The rate type options for rate information are: Fixed, Variable, or N/A for non-rate bearing accounts. These options determine if the account generates income or expense and whether the account is a fixed or variable rate instrument. The Maturity Interval, along with the Maturity Type, determines when new volumes will mature. The Repricing Interval, along with the Repricing Type, determines the frequency that the new volume of a variable account will reprice. The Maturity Interval is intended to reflect the ‘contractual’ term of the instrument. This Maturity Interval is applied to any new volume that you project on the account. You can apply prepayments to that maturity schedule to assist in modeling an ‘average life’ for the instrument. We recommend reviewing the chart of account settings at least annually. There are three fields that make up Maturity Timing. They are Maturity Type, Maturity Interval, and Balloon Interval. The Maturity Type options are:

N/A: There is no maturity for the account. This option should be used for all non-rate-bearing accounts and accounts that do not have maturity associated with them (such as demand deposits).

Number of Months: The maturity length for the account is expressed in number of months.

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Month of the Quarter: The account matures in a specified month in the quarter. The maturity interval value indicates which month (e.g., 2 = second month in the quarter).

Month of the Year: This account matures in a specified month of the year. The maturity interval indicates which month (e.g., 1=Jan, 5 = August). This is used for accounts like Christmas Club accounts that mature once a year.

There are three fields that make up Repricing Timing. They are Repricing Type, Repricing Interval and Initial Interval. The Repricing Type options are:

N/A: There is no repricing for this account. This selection is for Fixed Rate accounts.

Number of Months: The repricing for the account is expressed in number of months.

Month of the Quarter: The account reprices in a specified month in the quarter. The repricing interval indicates which month (e.g., 3 = third month in the quarter).

Month of the Year: This account reprices in a specified month of the year. The repricing interval indicates which month (e.g., 1=Jan, 5 = August).

For fixed-rate certificate accounts, the maturity and repricing intervals would match the term, in number of months, for each line item. Loans and investments require additional thought & analysis. While your current portfolio may be a good indicator of the term of your new volume, a detailed review of products booked in the most recent months is recommended. Comments on Rate Information:

Account settings appear to be appropriate with the following exceptions: Account # Account Title Current Setting Recommendation

105 CDO - AFS Fixed Rate Variable Rate - all CDOs in the current portfolio are floaters.

111 FHLB NYStock Balance Sheet and Income Statement

accounts are linked.

Unlink the income statement account from the balance sheet account in order to forecast quarterly dividend payments.

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Comments on Maturity Type & Intervals:

Account settings appear to be appropriate with one exception listed below:

Comments on Repricing Type & Intervals:

Account settings appear to be appropriate with one exception listed below: Account # Account Title Current Setting Recommendation

105 CDO-AFS 60 months Shorten the interval to more closely reflect the current portfolio. Current CDOs are set to reprice quarterly (every three months).

Although most loan, investment and deposit accounts appear to be set up accurately, I strongly encourage the bank to review the rate information, as well as the maturity and repricing intervals on a regular basis to ensure an accurate cash flow schedule is being calculated for new volume. Balloon intervals are discussed in more detail in the next section but if loans have balloon timing, it is important to make sure both an accurate contractual amortization is input (maturity interval) in addition to an accurate balloon term (balloon interval). Incorrect rate information or maturity and repricing intervals can overstate/understate the amount of interest rate risk on the balance sheet. Balloon Intervals The balloon interval is used to determine the amortization stream for new volumes. There are three options:

If the value in the Balloon Interval is zero, the account does not amortize. The entire balance matures based on the Maturity Interval.

If the balloon term is equal to the Maturity Interval, an amortization schedule is calculated based on the Maturity interval (this account has NO balloon payment).

If the Balloon Term is less than the Maturity Interval, a balloon payment will be made. The instrument will amortize based on the term specified by the Maturity Interval until the balloon interval is reached. At that point the remaining balance matures.

A balloon interval of ‘1’ indicates that the entire balance could mature at once.

Account # Account Title Current Setting Recommendation

105 CDO-AFS 60 months

Extend the interval to more closely reflect

the current portfolio. Current CDOs have

maturity dates between 2038 and 2042.

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General guidelines for Balloon intervals are as follows:

Loans should use the same balloon interval as maturity interval except for true balloon loans. For true balloon loans, use the stated balloon interval.

Interest-only loans should have a balloon interval of ‘0’.

Amortizing investments (such as MBS and CMO) should be treated like loans.

Non-amortizing investments should have a balloon interval of '0'.

Time Deposits should have a balloon interval of '0'.

Demand type accounts should have a balloon interval of '1'.

All other accounts not fitting into one of the above classifications should have a balloon interval of '0'.

Comments: All balloon interval settings are set up per our recommendations with the following exceptions:

Fair Value Codes The correct Fair Value code needs to be selected for each balance sheet account in order for the Fair Value matrix to correctly calculate Fair Value of Portfolio Equity. There are a number of different ways to determine the ‘value’ of the each balance sheet account. Most non rate-bearing accounts are valued at their current balance. For rate-bearing accounts the valuation process involves calculating the present value of all future cash flows. Fair Value Treatment options include:

N/A: These accounts are not included in the Fair Value calculation or the Fair Value reports.

Book: The Historical, Current, and Projected Fair Value of this account are equal to the balance of the account.

Quote: The Historical Fair Value of the account is manually input in the edit screens for the Historical Fair Value data item.

Discount: The Current and Projected Fair Value of the account is calculated using discounting techniques (its Fair Value equals the sum of the discounted cash flows). This option is available only for rate-bearing Balance sheet accounts.


351 Cmas Club Cks 1 month 0 months

542 Deferred Rent 1 month 0 months

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FAS107/Discount: This option can be used to calculate the book value of Demand Deposit Accounts for FAS107 purposes and for Economic Value calculations, the accounts can use decay rates or core/non-core to discount their value.

The general guidelines for setting up these codes are as follows:

All non-rate bearing accounts except capital accounts are set to Book.

All rate bearing accounts are set to Discount.

Rate Bearing Securities, such as – Treasuries, Agencies, Municipals, CMOs, MBSs, Asset Backed Securities and other like accounts where a market value can be obtained are set to Quote – If a market value cannot be obtained – use Discount.

Other accounts that add into Total Investments, such as – Bank CDs, Mutual Funds, FHLB Stock, Federal Reserve Bank Stock, Corporate Bonds, Bankers Bank, Wescorp, BOLI, and other like accounts should use Book or Discount as appropriate.

All capital accounts are set to N/A and are excluded from the calculation.

Any Unrealized Gain/Loss Accounts on Investments are set to N/A and are excluded from the calculation.

Any Valuation accounts such as premiums and discounts are set to N/A and are excluded from the calculation.

Each time you make changes to the Maturity or Repricing Interval in your chart of accounts, you will need to review the Fair Value codes for each account. Refer to the guidelines explained above to determine the code that should be used.

Comments:

Accounts appear to have appropriate settings with regards to the fair value discount treatment with the following exceptions:

Investment valuations are being done on a security-level basis within the Portfolio model and utilizing market values that come from Morgan Keegan. This follows our best

Account

#Account Title

Current

SettingRecommendation

28 Time Deposit

Discount -

Offering

Rate

Discount - Treasury Yield Curve

variousnon-accrual loan

accountsBook

Quote value based on expected loan loss

calculations, unless bank writes these loans down

to market on a monthly basis.

493 Line of Credit BookDiscount - FHLB Yield Curve (unless entire

balance is paid off monthly)

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practice recommendation, as it accounts for the embedded optionality within securities, including call provisions and prepayments.

Fair Value Spreads/Servicing Costs

Loan accounts are set up to discount by the treasury yield curve with a corresponding fair value spread. Applying a spread above the treasury yield curve is important as the treasury curve is a risk free curve so the spread helps account for the risk in pricing loans. Since I do not know the source of the spreads the bank is using, I recommend (if not already done) that the bank document how these assumptions were derived and review these spreads on a regular basis to ensure they reflect current market conditions.

The bank is currently utilizing a curve of FHLB advance rates to value non-maturity and time deposit balances. This follows our recommendations as the FHLB rates are the closest corresponding market rates for deposits. For borrowing accounts that remain on the books for longer than one month, I also recommend that they also be set up to discount to a curve of rates. Similar to loan spreads, deposits should have a cost associated with each product to account for the cost in servicing these products. Currently, the bank is utilizing servicing costs prescribed by the Office of Thrift and Supervision (OTS). The OTS servicing costs can be found in the OTS publication called “Selected Asset and Liability Price Tables”. Although the OTS agency is no longer in existence, this is a common starting point still used by many banks for estimating their deposit servicing costs.

The servicing cost estimates from the former OTS study are: Deposit Type Servicing Cost

Non-Interest DDA 2.57 Savings/Passbook 1.39

Transaction 1.80 Money Market 0.86

Certificate of Deposit 0.20

These OTS servicing costs are often used as a proxy of a financial institutions’ deposit servicing costs when internal data wasn’t available. However, recent regulatory pronouncements suggest that using industry averages is a viable short-term solution only until internal cost estimates can be derived.

If the bank determined their internal servicing costs, these costs would likely have similar characteristics as the estimates above. For instance, CDs (a limited touch product) would generally cost less to service compared to a transactional account (which tends to include the cost of statements, ATM servicing/maintenance, teller

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salaries, etc.). Therefore, the OTS servicing cost estimates noted above can be used as a rough benchmark for validating the internal servicing costs once they are derived.

Auto Update Actions Setting up the Auto Update Options makes the building of the maturity/repricing schedules fast and accurate. Before using the Auto Update option, you must first identify the appropriate action to be taken for each account on your balance sheet. The general guidelines for setting up these codes are as follows:

All non-rate bearing accounts should be set to Balance in > Last

Rate bearing accounts that are downloaded from an application file (Loan, CD, Investment) should be set to None

Demand Accounts should be set to Balance in > Last when using Decay Rates, otherwise set to core/non-core.

Accounts that you are inputting the cash flow should be set to None

Overnight Accounts (Fed Funds) should be set to Balance in First

Amortized Accounts that are not downloaded from an application file (Credit Cards, Student Loans) should be set to Amortize

Comments:

Accounts have appropriate auto update settings with the following exceptions:

Any balance sheet account that downloads from a loan, investment or deposit file should not have an auto update action associated with the account. The download will populate the projected maturity information (payment schedule, interest rate, maturity date, repricing date, etc.). Also, any account that downloads from the general ledger but does have contractual maturity dates should have an auto update action of “none”. This allows the bank to manually input the appropriate maturity schedule.

Account # Account TitleCurrent

SettingRecommendation

Various

premium

amortization &

discount

accretion

investment

accounts

Historical

Balance

in Last

‘Amortize’ and change maturity interval from

‘n/a’ to a number of months based on the

anticipated maturity period of the respective

investment class.

Variousnon-accrual loan

accounts

Historical

Balance

in Last

Manually input expected cash flows based off of

expected loan loss calculations.

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Special Account Codes Special account codes are used to identify specific accounts or types of accounts. They are also used for such things as calculating ratios, cash flow reporting, and some calculations in Projections.

Comments: All balance sheet special account settings appear appropriate with the following exception:

As previously, special account codes are used for certain ratio calculations within PROFITstar. In order for accurate ratio calculations, the bank will need to follow the recommendations above.

Risk Based Percentage/Risk Components The Risk Based Percentage field determines to what extent the account will be included in the Risk Based Capital Calculation. This field is only found in bank and thrift models.

By assigning each asset account to one of the balance sheet risk components, the accounts are included in RBNW Requirement calculation. This field is only found in credit union models.

Comments: The bank does have ‘Risk Based Percentages’ input on the asset portfolio. By assigning each asset account a risk percent, this allows PROFITstar to calculate risk-weighted assets and risk-based capital ratios. I recommend reviewing the model settings periodically to ensure the accuracy of the risk-based capital settings.

For an additional point-of-reference, I also recommend reviewing the guidelines below to ensure the appropriate risk based percentages have been applied to the bank’s asset portfolio.

Risk Category

Rating Account Types

Category 1 0% Cash Claims on OECD*

Claims on central governments & central banks

Category 2 20% Claims on US government agencies

Category 3 50% Loans secured by 1st liens on 1-4 family residential properties

Revenue municipals

Category 4 100% All other assets

*OECD = Organization of Economic Cooperation and Development


153 Other RE Fixed Assets OREO

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Income Statement Setup

Account Levels The account levels affect how the accounts total into other accounts and are also used for filtering the data on edit grids and in reports. Our recommendation is for major subtotals on the income side to correspond with major subtotals on the expense side. Comments:

As with the balance sheet, the bank has good breakout on the income statement. The recommendations made previously for the balance sheet setup will impact the income statement setup in the model’s chart of accounts as well. In addition, I suggest changing the bank’s stock investments. In the review of the rate information previously discussed, I mentioned a recommendation to separate the income account from the balance sheet account on the bank’s stock investments. This is recommended because it allows the bank to more accurately model projected dividends received when the dividends are not received on a monthly basis. A good example of this is the ‘FHLB NYStock’ account, which historically has received dividend payments on a quarterly basis.

Accrual Basis The accrual basis is used to calculate the monthly interest income or expense on an account. The basis is also used in calculating historical portfolio rates and ratios. The options available are:

30/360: Calculation uses a 30-day month and 360 day year. Per industry conventions, MBS, many CMOs, and some agency and municipal bonds use this method.

30/365: Calculation uses a 30-day month and the actual number of days in the year. Leap years use 366 days.

Days/360: Calculation uses the actual number of days in the month and 360 days in the year. Per industry conventions, money market securities, including Treasury bills, typically use this calculation.

Days/365: Calculation uses the actual number of days for each month and for the year. Per industry conventions, the quoted rate on an investment CD may use this calculation.

Comments:

While there are some industry standards, interest annualization conventions are at the discretion of each bank for loans and deposits. The majority of income statement

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accounts are set up on a ‘Days/365’ basis. However, the following accounts are set up on a ‘30/360’ basis:

Account # Account Name

110 Fed Res Stock

111 FHLB NYStock

545 Total Other Liabilities

564 Earnings Credit

565 Cost of Funds

I recommend reviewing the basis settings to ensure that income is calculated correctly for each account and make changes as necessary.

Federal and State Tax % There are three options for calculating federal and state income taxes in projections. The options are:

None – the system performs no tax calculation and makes the projected tax accounts editable.

Effective Rate (the default method) – the sytem multiplies the effective tax rate account found in Databank by the monthly taxable income number.

Tax Table – the sytem calculates income taxes on a year-to-date basis using the tax brackets and rate specified on the customizable tax table.

In addition, this is the percent of a detail account’s income or expense that is subject to State or Federal taxes. Accounts with a State or Federal Tax value less than 100% result in an income statement adjustment when calculating the monthly State or Federal Taxable Income amount.

Comments:

The bank’s current income tax settings for December 2011 are: Federal Tax Rate: 34% (using an effective rate tax calculation) State Tax Rate: 6% (not currently using)

The federal rates are consistent for both historic and projected timeframes. The state tax rate shows 6% for historic timeframes, but is not being used and is being forecast at

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0%. Looking at history, state taxes appear to be paid sporadically and for nominal amounts. Based on this, 0% appears to be a more reasonable tax rate than 6%. I recommend reviewing the income statement to ensure that any account exempt from federal and/or state taxes is modeled correctly. The detail accounts that currently set up to be exempt are:

Account # Account Name Federal Tax % State Tax %

73 Muni Tax Exe FR 20% 0%

74 Muni Taxable FR 20% 0%

80 Gen Oblig HTM 20% 0%

81 Rev Oblig HTM 20% 0%

82 Indust Dev HTM 20% 0%

128 Demand Loan TF 20% 0%

149 Mtg Tax Free 20% 0%

618 BOLI Income 20% 0%

Special Account Codes Special account codes are used to identify specific accounts or types of accounts. They are also used for such things as calculating ratios, cash flow reporting, and some calculations in Projections.

Comments:

Income statement special account settings appear appropriate all accounts.

There are a few rules of thumb when it comes to defining income and expense accounts as “operating”. The Operating Income/Expense special account code should not be included on the following types of accounts:

Accounting adjustments

Write downs or Unrealized Gain/Loss

Subtotal accounts

It special account codes are on both a subtotal account and detailed accounts within the subtotal’s section, it causes a ‘doubling’ effect in certain ratio calculations. The bank has avoided these common pitfalls and all of their income statement special account codes are appropriately set up.

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Databank Setup

Data Type Setup Databank accounts have a data type setting of either Global or Organizational:

Global accounts are those items that are uniform throughout the organization. A global setting indicates that any value you enter at your consolidated level applies to all your sub-organizations. You only need to enter in global data one time. Global accounts often include certain Key Rates and Statistics that are common to all organizations. Examples of this type of account are yield curve Key Rates, number of common stock savings outstanding, or the number of board members. The global setting is typically used for key rate data.

Organization accounts consist of information that relates specifically to a certain organizational unit. All databank accounts with an organizational setting would need to be updated at each organization each month. Examples of Organization statistics include number of employees, number of accounts, or the square footage occupied by that unit. The organizational setting is typically used for statistical types of data. Comments:

All data type settings are appropriate and no changes are recommended.

Shock Constraints Key rate accounts have a setting under “Shock Constraints” that enables the user to allow negative rates to occur in projections or to limit all interest rates shocks to result in positive numbers (or zero). Beginning in the 2010 version of the model, there is also a setting to “Allow negative Discount Rate due to Servicing Cost”. This is found in the Preferences Setup under the Model Setup tab. The default is for this to be checked to mimic prior behavior. Comments: The settings for all key rates are currently set to “Allow negative rates”. It is recommended to change this to “Do not allow negative rates” to follow current best practices, particularly in the present rate environment. Making this change creates an implied floor of 0.00% on the key rate. The recommended Databank Setup setting is shown below:

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Also, the Fair Value setting to allow a negative discount rate due to servicing costs on non-maturity deposits under the Model Setup section is checked by default. However, it is our recommendation to uncheck this option. The recommended (unchecked) setting is shown below and can be found by going to Setup -> Preferences and selecting the Model Setup tab.

Yield Curve Setup In Databank you may have multiple yield curves. For graphing purposes the key rate curve you choose needs to have the number of months until it matures placed in the account setup. Many clients are now discounting to a yield curve rather than discounting to an offering rate when calculating fair value. In order to determine the rate a particular balance

would be discounted to, the PROFITstar Fair Value calculation matches up the balance in each maturity time frame (for each individual account) with its corresponding point on the yield curve. For example, based on the maturity/repricing schedule, the dollars scheduled to mature in the first maturity/repricing time frame are discounted to the one month rate on the yield curve.

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Comments:

The bank is appropriately calculating yield curves based upon treasury and FHLB advance spot rates. The treasury yield curve is utilizing spot prices from one month (30 Day T-Bill) to a 30 year rate (30 Yr T-Bond). Similarly, the FHLB advance curve is utilizing spot rates out to 132 months (11 years). The FHLB yield curve should be reviewed, as it does not appear that all spot rates are tied to the appropriate months on the yield curve.

Below are the Treasury and FHLB Yield Curves set up in the model as of December 2011:

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Review of the Monthly Update Process The purpose of this section is to assist in reviewing the process followed when loading client data into the model. This includes a review of the download files and the processing of the general ledger and application files.

For each of your downloaded files below: A field that is bolded indicates that it is included in the file. A field that is in red indicates that it is missing from the download, but is recommended. A field bolded in red indicates it is missing from the download, but is required. A field that is crossed through indicates that it is not applicable to your model.

Download Setup

Is there a Balance Sheet File being used? Yes No

Balance Sheet (ICPPRGL.TXT)

Are the proper fields and formats set up for the Balance Sheet? Yes No

Account # (Required)

Current Balance (Required)

Average Balance (Recommended)

Branch or RC # (Required for Consolidated clients) Comments: All required fields are present and appropriately set up for all three balance sheet files.

Is there an Income Statement File being used? Yes No

Income Statement (ICPPRGL.TXT)

Are the proper fields and formats set up for the Income Statement? Yes No

Account # (Required)

Monthly Income\Expense (Required if file contains MTD income)

Current Balance (use only if file does not contain MTD income)

Branch or RC # (Required for Consolidated clients)

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Comments: The setup is appropriate. The bank is utilizing all of the required fields and they are properly arranged. For the income/expense amount, the monthly figure is being captured instead of the YTD figure – this is the preferred choice of the two amount fields.

Is there a Time Deposit File being used? Yes No

CD File (icpprdeposittime.txt)

Are the proper fields and formats set up for the CD files? Yes No

Sort Field(s) (Required)

Amount (Required)

Interest Rate (Required) Maturity Date (Required)

Branch or RC # (Required for Consolidated clients) Origination Date (Recommended)

Are there any variable rate CD’s? Yes No

If yes, at least one of the following fields is needed:

Rate Change Freq Code (Recommended)

Repricing Date (Recommended)

Rate Tie Description (Recommended) Comments: The bank is currently bringing in all of the required and recommended fields for time deposit products with the following exceptions:

Missing Field Impact of missing field Rate Change Frequency

This field is used as the 2nd option to calculate the next repricing date. This field is necessary if the Repricing Date field is missing or invalid.

Rate Tie Description This field is used as the 3rd option to calculate the next repricing date. This field is necessary if the Repricing Date and/or the Rate Change Frequency fields are missing or invalid.

Is there a Demand File being used? Yes No

Demand Deposit File #1 (icpprdeposit.txt)

Are the proper fields and formats set up for the DDA file? Yes No


Amount (Required)

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Interest Rate (Required)


Demand Deposit File #2 (icpprdepositdda.txt)

Are the proper fields and formats set up for the DDA file? Yes No


Amount (Required)

Interest Rate (Required)


Comments: The bank is currently bringing in all of the required and recommended fields for demand deposit products. Accounts are also being broken out into interest types, which follows our recommendation.

Is there a Loan File being used? Yes No

Loan File #1 (icpprln.txt)

Are the proper fields and formats set up for the loan file? Yes No

Sort Fields (Required) – could be renamed in setup to make the translation easier.

Amount (Required)

Interest Rate (Required) Maturity Date (Recommended)

Payment Amount (Required) Payment Frequency (Recommended) – frequency code of ‘00330’ needs to be defined.

Next Payment Date (Recommended)

Participation Code (Recommended) – ‘Participation %’ is field set up, but not being used.


Status Code (Recommended if applicable)

Origination Date (Recommended)

Actual Maturity (Recommended)

Non-Accrual Flag (Recommended)

3rd Party Spread (Recommended if applicable) Are there any variable rate loans?

Yes No

If yes, at least one of the following is needed:

Rate Change Frequency (Recommended)

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Rate Tie Description (Recommended) Other options related to variable rate loans:

Lifetime/Periodic Floor-Spread (Recommended)

Lifetime/Periodic Ceiling-Spread (Recommended)

Original Interest Rate (Required if using “Spread”)

Lifetime/Periodic Floor-Absolute (Recommended)

Lifetime/Periodic Ceiling-Absolute (Recommended)

Key Rate Index (Recommended for breaking up the chart of accounts if more than a single index is used per account)

Spread to Key Rate (Recommended) Loan File #2 (lnpart.txt)



Amount (Required)


Payment Amount (Required) Payment Frequency (Recommended) – defaulted to ‘monthly’


Participation Code (Recommended if applicable)






3rd Party Spread (Recommended if applicable)

Are there any variable rate loans? Yes No










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Spread to Key Rate (Recommended) Loan File #3 (mortpay.txt) – being used to populate actual maturity amounts for mortgage products.



Amount (Required)








Actual Maturity (Recommended) – review amounts; actual principal maturity less than contractual principal maturity for accounts such as ‘Mtg Res/Escrow’ for historical timeframes reviewed. Based on this, no prepayment percent is being calculated or used.














Spread to Key Rate (Recommended) Loan File #4 (loanpayments.txt) – being used to populate actual maturity amounts for consumer and construction loan products.

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Amount (Required)






















Spread to Key Rate (Recommended) Loan File #5 (ICPPRLNmort.TXT)



Amount (Required)


Payment Amount (Required) Payment Frequency (Recommended)


Participation Code (Recommended) - ‘Participation %’ is field being used.

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Actual Maturity (Recommended) – coming in with ‘mortpay.txt’ download extract.




If yes, at least one of the following is needed: Note: currently all fixed rate mortgage records, although download file is setup to utilize variable rate fields if they were to become applicable.










Spread to Key Rate (Recommended) Comments: Required and recommended fields are present and set up properly with the following exceptions:

Missing Field Impact of missing field Next Payment Date Payment information is required to calculate the loan amortization

schedule. If the Next Payment Date is not included, the model will use the Payment Amount and Payment Frequency values to estimate when the next payment is to be made.

Origination Date This field is used for Average Age calculations in the maturity/repricing module and to gather statistical date for new accounts during the current month’s download process.

Actual Maturity Since the Actual Maturity represents a principal only amount which includes the contractual maturity amount plus any prepayments received, it is used to calculate the historic prepayment behavior of loan records. Without this field, alternative methods would have to be used to come up with prepayment history to use for future expected prepayment behavior.

Non-Accrual Flag This field is used to identify any loans that are in a non-accrual

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status. This field will allow PROFITstar to automatically change the interest rate on these loans to 0.00% to prevent interest from being calculated. As mentioned earlier in the validation, non-accrual loans should be considered an earning asset and therefore should be rate-bearing. This field will enhance projected income and interest rate risk calculations.

3rd Party Spread If applicable, downloading the 3rd Party Spread field allows the model to calculate a ‘Net Rate’ and replaces the Interest Rate for a record. This is calculated by subtracting a 3rd Party Spread from the Interest Rate. The Net Rate will be used to calculate the maturity schedule and is the rate used to calculate projected income.

Rate Change Frequency

When used in conjunction with Repricing Date, it will determine the repricing frequency of the balance in time frames beyond the initial future reprice date. If not present, the model will look to use the Rate Tie Description to approximate future repricability.

Repricing Date This is a preferred field for variable rate loans, as it tells specifically when a loan record is eligible to reprice. If not present, the model will look to the Rate Change Frequency and Rate Tie Description fields to approximate when a loan record is next eligible to reprice.

Rate Tie Description If the Rate Change Frequency and Repricing Date fields are missing or blank, the Rate Tie Description will be used to denote if a loan record is variable and eligible to reprice in the first future month.

Ceiling/Floor – Spread

(Lifetime/Periodic)

These fields identify how much each variable rate loan record’s interest rate can change each repricing period or over the life of the loan. In order for the Lifetime Spread to work correctly, the Original Interest Rate must be included in the loan file. Modeling how much a rate can change per repricing period or over the life of the loan is critical to ensure accurate pricing of the loan portfolio in both the current and alternative rate environments.

Ceiling/Floor – Absolute

(Lifetime/Periodic)

These fields identify how much each variable rate loan record’s interest rate can change each repricing period or over the life of the loan. Modeling how much a rate can change per repricing period or over the life of the loan is critical to ensure accurate pricing of the loan portfolio in both the current and alternative rate environments.

Key Rate Index If more than one index is being used by a specific loan category, it is recommended to consider breaking out the loan category by index type and using the indices as sort fields. This allows for the most accurate pricing precision on the current loan portfolio.

Original Interest Rate

This field identifies the interest rate at the time the loan was originated. If this field is missing, the use of the Lifetime Spread field will not work properly.

Spread to Key Rate (Margin)

This field identifies the spread or margin above/below the rate index. This information is used to determine what rate each

34

variable rate loan is eligible to reprice to. This field is critical given the low rate environment and the fact that a lot of loans are currently at or below their floor. In some cases, loans will not get above their floor even if market rates climb 100 bps. Not having this field can potentially cause an overstatement in interest income during interest rate risk analysis for earnings risk.

Is there an Investment File being used? Yes No

Is PROFITstar Portfolio being used? Yes No

For Investment Data? Yes No

For Borrowing Data? Yes No

Investment File #1 (profits.csv) Import Format File: Morgan Keegan – FNBN

Are the proper fields and formats set up for the investment file? Yes No

Accrual Basis (Recommended)

Book Value (Required)

Category or Sector Code (Required)

Coupon Frequency (Required)

Coupon Rate (Required)

Coupon Type (Required)

CUSIP (Required)

Description (Recommended)

FAS115 Status (Recommended)

File Date (Recommended)

Interest Reset Frequency (Required)

Last Payment Date (Recommended)

Lifetime Rate Cap (Recommended)

Lifetime Rate Floor (Recommended)

Market Value (Required)

Market Value +100bp (Recommended)



Market Value -100bp (Recommended)



Maturity Date (Required)

Maximum Rate Adjustment (Recommended) – using ‘Margin’ field

Next Coupon Date (Recommended)

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Next Reset Date (Required)

Original Par Value (Recommended)

Par Value (Required)

Premium/Discount (Required)

Purchase Date (Recommended) – using ‘Settlement Date’ field

Purchase Value (Recommended)

Purchase Yield (Recommended)

Quality Rating (Recommended)

Rate Index (Recommended)

Rate Spread (Recommended) – ‘Margin’ field a possible candidate

Safekeeping Location (Recommended)

Security ID - (Required)

Security Update Method (Recommended)

Servicing Fee (Recommended)

Settlement Date (Required)

Spread over Yield Curve (Recommended)

Status (Recommended)

Step-Up Frequency (Recommended)

Structured Note Schedule (Recommended)

Tax Status (Recommended)

Yield Curve (Recommended) – not in file, defaulted to ‘Treasury Yield Curve’

Yield to Call (Recommended)

Are there any amortizing investments (MBS/CMO)? Yes No

If yes, the following fields are needed:

Average Age (Recommended)

Compound Frequency (Recommended)

First Amortization Date (Recommended) – using ‘Settlement Date’ field

Next Payment Source (Recommended) – not in file, defaulted to ‘Supplied’

Next Scheduled Payment (Required)

Payment Includes Prepayment (Recommended) – not in file, defaulted to ‘Yes’

Prepay -400 bp (Recommended)

Prepay -300 bp (Required)



Prepay +100 bp (Required)



Prepay +400 bp (Recommended)

Prepay Type (Recommended) – using both CPR and PSA speeds

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Are there any callable investments? Yes No

If yes, the following is needed:

Call Frequency (Required)

Call Methodology (Required) – no default, but using ‘Yield Curve’ for all callable securities.

Call Price (Recommended)

Callable Flag (Recommended)

Exercise Dates (Recommended if in file)

Next Call Date (Recommended)

Spread Over Yield Curve (Recommended) – manually input, but most are 0.000%.

Yield Curve (Recommended) – defaulted to use Treasury Yield Curve.

Investment File #2 (HC.csv) Import Format File: Morgan Keegan – Main Office

Are the proper fields and formats set up for the investment file? Yes No

Accrual Basis (Recommended)

Book Value (Required)

Category or Sector Code (Required)

Coupon Frequency (Required)

Coupon Rate (Required)

Coupon Type (Required)

CUSIP (Required)

Description (Recommended)

FAS115 Status (Recommended)

File Date (Recommended)

Interest Reset Frequency (Required)

Last Payment Date (Recommended)

Lifetime Rate Cap (Recommended)

Lifetime Rate Floor (Recommended)

Market Value (Required)









Maturity Date (Required)

Maximum Rate Adjustment (Recommended) – using ‘Margin’ field, all securities currently

37

fixed and show margin of zero

Next Coupon Date (Recommended)

Next Reset Date (Required)

Original Par Value (Recommended)

Par Value (Required)

Premium/Discount (Required)

Purchase Date (Recommended) – using ‘Settlement Date’ field

Purchase Value (Recommended)

Purchase Yield (Recommended)

Quality Rating (Recommended)

Rate Index (Recommended)

Rate Spread (Recommended) – ‘Margin’ field a possible candidate

Safekeeping Location (Recommended)

Security ID - (Required)

Security Update Method (Recommended)

Servicing Fee (Recommended)

Settlement Date (Required)

Spread over Yield Curve (Recommended)

Status (Recommended)

Step-Up Frequency (Recommended)

Structured Note Schedule (Recommended)

Tax Status (Recommended)

Yield Curve (Recommended) – not in file, defaulted to ‘Treasury Yield Curve’

Yield to Call (Recommended)

Are there any amortizing investments (MBS/CMO)? Yes No

As of December 2011, there is one floating CMO security at this level. If yes, the following fields are needed:

Average Age (Recommended)

Compound Frequency (Recommended)

First Amortization Date (Recommended) – using ‘Settlement Date’ field

Next Payment Source (Recommended) – recommend defaulting to ‘Supplied’

Next Scheduled Payment (Required)

Payment Includes Prepayment (Recommended) – recommend defaulting to ‘Yes’

Prepay Flat (Required)

Prepay -400 bp (Recommended)

Prepay -300 bp (Required) – field in file, but no values for CMO



Prepay +100 bp (Required) – field in file, but no values for CMO


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Prepay +400 bp (Recommended)

Prepay Type (Recommended) – using both CPR and PSA speeds

Are there any callable investments? Yes No

If yes, the following is needed:

Call Frequency (Required)

Call Methodology (Required) – no default, but using ‘Yield Curve’ for all callable securities.

Call Price (Recommended)

Callable Flag (Recommended)

Exercise Dates (Recommended if in file)

Next Call Date (Recommended)

Spread Over Yield Curve (Recommended) – manually input, but all are 0.000%.

Yield Curve (Recommended) – defaulted to use Treasury Yield Curve.

Comments:

All of the required and recommended fields are present with the following exceptions:

Missing Field Impact of missing field Compound Frequency This field states the frequency of a security’s coupon payments. If

missing, it will default to ‘at maturity’ for discounts and zeroes, ‘monthly’ for MBSs and CMOs and ‘6 months’ for bullets. For securities with atypical compound frequencies, these default values will not provide as great of precision without this field included in the investment download file.

File Date This field reflects the date the file was created and is useful for comparing files, as well as for troubleshooting offages between expected and downloaded results.

Last Payment Date This field is the date of the previously received principal and interest

payment for an amortizing security. It is needed to properly calculate future expected cash flows.

Lifetime Rate Floor This field identifies the minimum rate that each floating security’s interest rate can change to over the life of the security. Modeling the absolute floor is important to ensure accurate interest rate risk analysis by limiting the movement of floating securities to more closely match their contractually allowed rate movement.

Next Payment Source This field determines the source of the next scheduled payment for MBS and CMO securities. It can either be calculated or supplied by the download. If not provided, it defaults to ‘calculate’.

Payment Includes Prepayment

A flagged field that indicates whether a downloaded payment amount is P&I only or if the payment amount includes additional maturing

39

amounts as a result of prepayments. Without specifying this, the prepayment amount runs the risk of being counted twice if the amount is included in the field, but is not identified as such.

Rate Spread This field is the positive or negative spread over the Rate Index to be used to price a floating security. For floating securities, this field is critical to ensure the proper pricing over future time frames.

Security Update Model

A user defined field that allows the user to include/exclude securities from receiving update information from the Bloomberg interface. This is not applicable if you do not use the Bloomberg interface.

Servicing Fee The percentage charged by the issuing body associated with a mortgage-backed investment. The fee is the difference between the stated coupon rate for the mortgages and the weighted average coupon rate of the underlying mortgages. Without this field, the model will use a default of 0.5%.

Spread Over Yield Curve

The positive or negative spread over the Yield Curve that should be used for cash flow calculations and rate shocks. For callable securities, it is also used in conjunction with the Yield Curve to determine when a security would be called.

Status A user-defined field that can be used to exclude rows of information during the import process. This is useful for excluding securities that are no longer part of your investment portfolio.

Step-Up Frequency This field determines when the security will be checked for callability, and how often the coupon rate can be stepped up. The frequency options are Monthly, Quarterly, Semi-Annually, Annually or Scheduled. This is critical for step-up securities to ensure the proper handling of future pricing.

Structured Note Schedule

This field is used to adjust variable-rate securities if they are structured notes that can either be called or have their coupon rate increased on predetermined call/step dates. When this field is set to step-up, the ‘call options’ tab in the security information screen is replaced with a ‘structured note options’ tab. The fields on this tab allow you to specify step rates and call prices for each call/step date.

Yield to Call This is the yield based on the next possible call date. If this field is not downloaded, it will be calculated by the model.

Are there Cash Flow Files being used? Yes No

Is there a Borrowing file being used in the download? Yes No

Borrowings File (n/a)

Are the proper fields and formats set up for the borrowings file? Yes No

• #1 Sort Field (Required)

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• Amount (Required)

• Interest Rate (Required)

• Maturity Date (Required)

• Call Date (Recommended if applicable)

• Branch or RC # (Recommended for Consolidated clients if at more than one org)

• Origination Date (Recommended) Are there any variable rate borrowings? If yes, at least one of the following is needed:

• Rate Change Freq Code (Recommended)

• Repricing Date (Recommended)

• Rate Tie Code (Recommended)

Are there any amortized borrowings? Yes No

If yes the following fields are needed:

• Payment Amount (Required)

• Next Payment Date (Recommended)

• Payment Frequency (Required) Comments: The bank is currently utilizing the GL file to populate the borrowing portfolio on the balance sheet and manually inputting the cash flows for the balances. For December 2011, the only borrowing position was a $300,000 line-of-credit balance. Due to the small position, creating the cash flows in this way is acceptable. Ideally, by creating a file that can be downloaded into PROFITstar will allow the bank to be more efficient in updating the projected cash flows on a monthly basis and reduce the chance of incorrect maturity and rate information due to manual input errors.

Is there a Key Rate File being used? Yes No

Key Rate File (keyrates.prn)

Are the proper fields and formats set up for the Key Rate file? Yes No

#1 Sort Field (Required)

Rate (Required) Comments: The model has the key rate file properly set up. In addition, it is currently utilizing another file titled “ftes.csv” to download in statistical FTE information into databank at the branch level.

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Testing the Download Files

Comments:

As I tested the bank’s monthly update process using the December 2011 download files, the following exceptions were noted:

Loan File #1 – icpprln.txt Exception Impact of Exception

1 record is missing a Lifetime Ceiling.

This exception is typically the result of loan records that don’t have a ceiling. The default for most core systems is to default a value of 0.00 within the loan file. PROFITstar will flag this as an exception if the value is 0.00 or if the value is smaller than the Lifetime Floor. This missing information could possibly impact interest income calculations during a rising rate environment when calculating interest rate risk. Since it is a single record that is missing this rate, it is possibly an encoding error within the loan file.

6 records set up to use a Participation Code that have not been defined.

This warning is due to the fact that the participation code has been redundantly set up on this download file, but sold participations are being accounted for in another loan download file. Therefore, this warning is non-material to the download process.

2 records use Payment Frequency Codes of “00330” and “” that have not been defined.

The payment frequency is used to determine how often principal payments are received and populate the maturity/repricing schedule. By missing frequency codes, the amortizing cash flow will potentially be inaccurate.

1 record is missing a valid Repricing Date.

If variable rate loan records are missing a valid repricing date, PROFITstar will use the rate change frequency to determine the next repricing date. This is not nearly as accurate as the repricing frequency is based on the current month, not necessarily the last time the loan repriced.

To review the records causing these errors/warnings, click the Details… link during the Move/Link process as shown below:

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Loan File #2 – lnpart.txt Exception Impact of Exception

Blank line in the file causing non-material exceptions.

These errors/warnings have no impact on the model. To prevent them from occurring in the future, blank rows should be removed so that only data rows are included in the file.

To review the records causing this warning, click the Details… link during the Move/Link process as shown below:

Loan File #3 – mortpay.txt Exception Impact of Exception

1 record has a Sort Field of “9” which is not yet defined.

The actual maturity for this loan record will not be downloaded into the model until the link is defined.

To review the records causing these warnings, click the Details… link during the Move/Link process as shown below:

Overall, the download process is mostly clean. Once the items above rate, code and date information gets reviewed on the accounts as stated above, the download files will be free from significant exceptions. This could save time on the monthly download process and increase the precision of the modeling results.

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Historical Review Databank Items Updated: The Databank stores a variety of financial and non-financial information that is used throughout the model. There are three major sections of items in Databank: 1) Check figures for balancing that include Total Assets, Net Income, and YTD Income, 2) Off Balance Sheet Statistics including Charge offs, Recoveries, and Delinquencies 3) Key Rates

Comments:

Check figures for total assets, net monthly income and YTD income have been consistently entered in the bank’s model for the last 10 years at not only the consolidated organization but the sub-organizations (branches) as well. These check figures are useful to assist in the monthly balancing process.

Key rates provided by the monthly download via PROFITstar have also been populated consistently for the last 10 years.

The bank is also doing a good job of consistently tracking other off-balance sheet items including loan delinquency dollars, charge off dollars, recovery dollars, # of FTE’s, and rate information that can be used by both PROFITstar and PROFITabiliity. I often see databank as one of the more underutilized areas of the ALM model, so it is good to see it effectively used as intended.

Balance Sheet Month End The month end balances are critical for financial reporting and projections. Out of balance issues may indicate problems with the download or incomplete data. Problems can occur in maturity/repricing and projections when history is out of balance.

Comments:

In reviewing the last 24 months of historical month-end balances, all time periods are in balance at the consolidated level. One month (June 2011) shows a variance of less than one dollar. This is likely due to rounding and is considered non-material for ALM/IRR purposes.

44

Balance Sheet Averages Average balances are used for both ratio and portfolio rate calculations. Comments:

In reviewing the last 24 months of historical average balances, all time periods are perfectly in balance at the consolidated level. Average balances are critical in certain ratio and portfolio rate calculations, I recommend the bank continue to ensure averages are accurate and in balance on a monthly basis.

Income Statement Income statement balances are used when completing many of the ratio calculations. For rate bearing accounts, the income or expense is used when calculating portfolio rates.

Comments:

In reviewing the last 24 months of historical income/expense values, all time periods are perfectly in balance at the consolidated level.

Distribute Income/Expense Option Distribute Income/Expense is a useful way of distributing income/expense when the general ledger places the income or expense from multiple balance sheet accounts into just one income or expense statement account.

Comments:

The bank appears to be utilizing the Distribute Income/Expense option for non-maturity and time deposit accounts. The bank has the ability to automate this process as part of the monthly download/update through the ‘Automated Functions’ feature within the Tools menu. Within this function, the bank can identify which subtotals where the income/expense needs to be distributed. The current expense accounts set up to be distributed are ‘checked’ on the following page:

45

The Distribute Income/Expense tool provides a useful way of distributing income/expense when the general ledger places the income from multiple balance sheet accounts into just one income statement account. The Distribute Income/Expense calculation uses the formula shown below to arrive at the income or expense amounts for each individual account adding into the subtotal. If the sum of these amounts varies from the GL subtotal amount, the difference is then distributed on a pro-rata basis.

The formula used for this calculation is: (((Prior Month End Balance + Current Month End Balance) / 2) * Portfolio Rate) * Basis

Ideally, if rate bearing accounts have a one-to-one relationship with the GL numbers, the bank wouldn’t need to use this action to distribute the income/expense.

46

The bank is currently distributing the interest income and expense appropriately. I have no additional recommendations to make.

Portfolio Rates The current month's portfolio rates are used in updating maturity/repricing. Missing portfolio rates in history could cause missing portfolio rates in maturity/repricing, which in turn can cause incorrect calculations of interest income/expense as you move forward into projections.

Comments:

All rate-bearing accounts with non-zero balances have portfolio rates that appear appropriate. The bank has done a good job of ensuring that a portfolio rate is downloaded, calculated or input on rate-bearing accounts to ensure accurate income and expense calculations. Offering Rates An offering rate is the current rate offered for new volume. The current month’s offering rates are used in projections, Fair Value and Interest Rate Sensitivity Analysis. Fair Value can use the offering rate as the discount rate on each account. If you have missing offering rates in the current month’s history, the discount rate for fair value is 0%. In the Interest Rate Sensitivity Analysis feature, the current month offering rate is used to calculate interest income and expense on rate bearing accounts. When no rate is entered as the current month offering rate, net interest income could be calculated incorrectly.

Comments:

Based on the current month’s input offering rate compared to the actual rates on the current portfolio and to the average rate on new volume, the bank is doing a decent job of maintaining the offering rates. The majority of offering rates mirror rates on the current balance, which appears reasonable. However, for a few accounts there is a noticeable gap between these rates. This is not to say that the offering rates being used are inaccurate, particularly for accounts with limited new volume over the last few years. It is recommended to review these accounts for accuracy. As examples of accounts that stand out, review the offering rates on the next page and update current/projected offering rates as necessary:

47

* Average rate on new volume is the average interest rate for accounts originated in the current month (December 2011). A ‘n/a’ denotes that there were no new originations during the month to use for comparison.

As mentioned earlier, a difference between the portfolio rate and the offering rate on fixed rate products with minimal new volume over the last few years is expected. I have outlined below a couple scenarios where the difference in these rates should be minimal:

1. Loans that can reprice on a regular basis. Due to the different repricing dates, the portfolio rate will not equal the offering rate but the variance is generally minimal unless dramatic pricing policy shifts have occured.

2. Non-maturity deposits that can change rates daily. There should be minimal (if any) variance between the portfolio rate and offering rate.

I also noticed a few instances where the variance between the current month offering rate and the average rate on new volume is significant. The current month offering rate should be consistent with the average rate on new volume. From my experience the common reason why significant variances exist is due to the lack of breakout on the balance sheet. The lack of breakout typically includes deposit tiers with different rates paid that are not being accounted for. This can also include different interest rates on loans based on fixed or variable or even credit score. More detail on the balance sheet within the loan and deposit section provides more accuracy in regards to projected income and interest rate risk calculations. It is also critical to make sure the key rate ties are reviewed, particularly on deposit accounts. If there are spikes up or down from the current month’s offering rate and the first projected month’s offering rate, this is indicative of a key rate tie that needs to be revised. This is discussed in greater detail in the Key Rate Ties section.

Account

#Account

Current

Offering Rate

Current

Portfolio

Rate

Average Rate on New

Volume*

50 Structured Agenc 3.53% 2.09% 2.56%

74 Muni Taxable FR 3.96% 5.08% 5.49%

91 Corp Bond Fixed 5.00% 3.81% 2.87%

123 Demand Loan Fix 3.25% 5.86% 5.30%

132 Construction 3.25% 5.37% 4.54%

133 Construction Var 3.25% 4.15% 6.00%

155 Install Simple 4.25% 7.13% 9.33%

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Maturity & Repricing Review Maturity/Repricing Balancing Although maturity and repricing is static, this information is an integral part of your projections. The maturity and repricing data works in connection with your growth

assumptions. This allows PROFITstar to accurately calculate future purchases as well as when variable rate accounts reprice.

Comments:

There were no material balance or rate errors/warnings.

Balancing maturity/repricing is a critical step in the monthly update process. Loan, investment and deposit cash flows are the backbone of the bank’s projection and interest rate risk results.

Maturity/Repricing Reasonableness The maturity and repricing schedules are used in the calculation of interest income and expense in the Projections module and as the starting point for both Fair Value and the Interest Rate Sensitivity Analysis results. The maturity schedule should represent the timing of the principal payments on the account. The repricing schedule should represent the timing of when the account can reprice for the first time.

Comments:

The majority of accounts with maturity/repricing cash flow schedules appear reasonable based on the current chart of account structure with the following exception: Account # Account Comments

105 CDO – AFS This account has a 60 month term set up in the chart of accounts. However, the current CDOs on the books have durations much longer than this (maturity dates between 2038 and 2042). I recommend that the bank extends the maturity interval set up in the chart of accounts to more closely reflect the current portfolio. Projecting a shorter duration that what is likely to occur will under-state the amount of risk to capital (fair value) on the balance sheet.

It is important the bank address the issues outlined above as inaccurate cash flows can either understate or overstate the risk on the balance sheet. It’s also recommended to review the maturity intervals periodically to ensure they continue to reflect the characteristics of the bank’s current balance sheet composition.

49

Review of PROFITstar Portfolio A big benefit of modeling CUSIP level detail within the PROFITstar Portfolio model is the ability to model the unique option risk that each CUSIP has. This option risk includes prepayment assumptions on amortizing securities, call triggers on callable instruments and step-up characteristics on structured agencies. CUSIP level detail also allows financial institutions the ability to model the unique repricing characteristics for each variable rate CUSIP. The repricing characteristics include Next Reset Date, Rate Index, Rate Spread, Ceiling, Floor, Max Rate Adjustment, etc. If financial institutions are unable to model the option risk and repricing characteristics correctly, forecasted income and interest rate risk results will be inaccurate.

Securities with Variable or Structured Interest Rates

Comments:

Structured Agencies are becoming popular with a lot of financial institutions. These agencies provide future earnings potential for the institution but they are also longer in term than most agency notes. Because of their long durations, examiners tend to scrutinize these securities greater, so modeling the step-up schedule accurately is critical to accurately capture the potential interest rate risk. The bank is identifying structured agencies correctly within PROFITstar Portfolio. As of December 2011, the following CUSIP’s have structured/step-up characteristics:

313370JJ8 313371C46 313371HT6

313371JQ0 313371RH1 313371RP3

313375FM4 3133F4XU0 3134G2H54

3134G3FX3 3136FM2T0 3136FMNP5

3136FMNP5 3136FR7J6 3136FRN82

3136FRR39 3136FRV26

Although the above CUSIPs are categorized as structured, their Coupon Type also needs to be changed to ‘structured’ in order to properly set up the structured note options. Once this is done, the Next Step Date, Step-Up Frequency and Step Rates can be input.

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ARM-backed securities have unique repricing characteristics in regards to when each security can reprice, how often it can reprice and what rate it will reprice to. All of this information is available in the Morgan Keegan files and the bank is properly using all of the fields, including the Next Reset Date, Interest Reset Frequency, Rate Index and Rate Spread. Finally, in order to ensure the the Portfolio components use the same forecasted market rates as the PROFITstar ALM model, the Synchronize function needs to be run. This is found on the Key Rates tab as shown below:

During my testing, the rates refreshed when I ran this function, which indicates that Portfolio had not been recently synchronized with the PROFITstar model.

Securities with Amortizing Cash Flows

As of December 2011, around 9% of the bank’s total investment portfolio was comprised of amortizing CMO and MBS securities. With amortizing securities, modeling the expected cash flow schedule is a critical component in interest rate risk analysis. Given the current rate environment, prepayment trends have been on the rise which is shortening the duration of these cash flows. As I reviewed the bank’s MBS and CMO portfolios, I observed noticed the following:

CUSIP 31397M4Y0 is a floating CMO, but is currently linked to the ‘CMO Fixed Rate’ account in the ALM model. I recommend linking it to the ‘CMO Var Rate’ account in order to properly differentiate between the fixed and floating CMOs.

CUSIP 3133XE5D7 is a floating CMO, but only has prepayment estimates in the Morgan Keegan file for -400 and +400 bps rate environments. I recommend contacting Morgan Keegan to see if prepayment assumptions can be fully supplied for this CUSIP.

Modeling a CMO cash flow accurately is important as most CMOs have lag periods or specific open/close windows that delay when principal payments are received. Currently, the bank isn’t modeling these open/close windows which is resulting in the CMO cash flows to behave like an MBS cash flow.

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In order to model the lag period or the open/close windows, the category for each CMO CUSIP must be identified as “CMO Tranche”. If the category is “CMO”, then the open/close windows are not available. When the “CMO Tranche” category is chosen, PROFITstar Portfolio will calculate the expected payment amount to determine the amortization schedule.

Securities with Call Options

The bank is currently modeling callable securities using the treasury yield curve. However, there should also be a spread associated with the yield curve. A positive or negative adjustment should be made to all spot rates provided by the yield curve forming the basis for comparison with the security’s coupon rate to evaluate the potential exercise of the security’s call option. The spread should be calculated so that each security is ‘at the money’ based on its weighted-average life. In addition, a reissuance cost should also be added to the spread. Typical reissuance costs could be between 15 and 50 basis points (your bond agent may be able to provide additional industry information on current reissuance costs that they are seeing). If the yield curve plus spread plus reissuance cost is ‘in the money’ at a given call date, it would be called.

Additional Comments

The bank is downloading each CUSIP into PROFITstar at ‘Par’ value. Par value does not account for the amortization/accretion of the premium/discount on the balance sheet or income statement. When ‘par’ is used, the bank is responsible for amortizing/accreting this manually. If book value is downloaded, the premium/discount amortization/accretion is determined by Portfolio based upon a constant yield methodology. This is the recommended way to handle the amortization/accretion. The only time ProfitStars recommends the use of Par Value is if the bank would like to amortize/accrete the premium/discount faster or slower than PROFITstar Portfolio.

52

Historical Loan & Deposit Rate Correlation Analysis A key component that financial institutions must address when attempting to effectively model loans and deposits is the rate that will be earned from and paid to customers, both in the current rate environment as well as future rate environments. Understanding how the institution’s loans and deposits have been priced historically provides valuable insight in determining the validity of the pricing assumptions being used in PROFITstar. As most balance sheets are liability sensitive with regards to repricing, modeling deposit accounts for purposes of interest rate risk assessment presents a challenge for most institutions as the sensitivity of the account offering rates to secondary market rates vary at different points in the business cycle. This is also magnified by the fact that most depository institutions maintain a large percentage of their natural deposit base in accounts that lack a specified maturity date.

To properly assess the risk to future earnings or the risk to an institution’s capital position, it is imperative that financial institutions periodically review and assess the validity of the pricing assumptions used to model loans and deposits, as these assumptions are used to calculate the projected change in interest income and expense as well as to calculate the fair market value of the accounts.

This section will provide insight into how the bank has historically priced loans and deposits during the most recent business cycle. This analysis is structured to assess the rate change sensitivity of loan and deposit offering rates in relation to changes in secondary market rates. In addition to assessing the magnitude of change, the analysis will assess the timing of the change by including various lags or delay periods.

As a first step in assessing the bank’s historical pricing decisions for loan and deposit accounts, ProfitStars performed a correlation analysis of each of the selected market rates listed to the right and the offering rates on the bank’s loan and deposit accounts.

In the PROFITstar ALM model supplied by the bank, there were a total of 26 loan and 21 rate-bearing deposit accounts eligible for this analysis. To achieve the most precision with the statistical analysis, each loan and deposit account was examined on an individual basis for the period covering August 2006 to April 2012, or a period of 69 months. For accounts that are newer and didn’t have data going back to

Secondary Market Rates

Fed Funds 1 month Libor 3 month Libor 6 month Libor

3 month Treasury 6 month Treasury

2 year Treasury 5 year Treasury

10 year Treasury WSJ Prime

53

August 2006, these accounts were reviewed from January 2009 through April 2012, or a period of 40 months.

The results of the analysis show the existence of varying degrees of correlation between the offering rates on loans and deposits and selected market rates as evidenced by observed correlation coefficients. Correlation coefficients show directional movement between the historical changes in the offering rates and the historical changes in the selected market rates. In simple terms, a correlation of +95.00% means that the two data series are moving in the same direction 95.00% of the time. Higher correlation results indicate greater directional movement in the same direction. Alternatively, if the correlation observed is -95.00%, it means the two rates are moving in opposite directions 95.00% of the time. If the correlation is observed to be zero, it means that the data series are neither moving directly or inversely: no real pattern is evident. The correlation analysis will indicate the secondary market rate that each loan and deposit has the best correlation to but will not indicate the sensitivity to market rate changes (rising/falling rate environment). In addition to analyzing the correlation coefficients, a regression analysis was performed to determine the sensitivity of each of the bank’s loan and deposit rates to market rate change. A regression is performed using the best fitting market rate and lag period against the banks’ offering rates to come up with the linear equation that characterizes the relationship between the rates. This linear equation produces a slope (“beta”) and y-intercept (“then add”) which can be incorporated into key rate tie (KRT) pricing assumptions directly into the PROFITstar model. Each linear regression produces an R-Square value. The R-Square value is used to measure the level of success of the regression in predicting the value of the bank’s future offering rates. The higher the R-Square value, the better ability of the market rate to predict changes in the bank’s offering rates. An R-Square with a lower value corresponds to a lesser ability of the market rate. Low R-Square values can signify many things, including non-rate factors and the bank setting pricing regardless of current market conditions. Ideally, the information provided in the resulting tables should be compared to the assumptions currently used in the PROFITstar model in the key rate ties section of the chart of accounts to determine the validity of the current assumptions. Where appropriate, the key rate tie assumptions can be updated to use the results of this analysis.

54

First Mortages In reviewing the bank’s first mortgage loan rates, accounts correlated most closely to changes in the 6 month LIBOR rate. The study also showed that the bank has historically reacted relatively fast to changes in market rates as signified by the zero month lag on the most closely correlated market rate. Even though the bank has historically reacted quickly to market changes when rates decline, the bank has not lowered loan rates as far a market rates. This is illustrated with a beta of 24.55%, which signifies that First Mortgages have historically repriced at 24.55 basis points for every 100 basis point change of the 6 month LIBOR rate. Although a single beta has been determined as part of this analysis, financial institutions will typically raise loan rates faster than they will lower them. The results of the correlation and regression analysis for this account group is shown in the following table:

Account Highest

Correlation Index

(Driver Rate) Sensitivity

(Beta) Spread

(Then Add) Lag

(Months) R-Square

Value 1st Mortg Loans 83.97% 6MLIB 0.2455 3.9278 0 70.51%

The First Mortgage offering rates showed a 83.97% correlation to 6 month LIBOR rates over the time period of the analysis. This value appears in the ‘Highest Correlation’ column. The predictive ability of the market rate in determining future offering rates is shown by the ‘R-Square’ value, or last column in the table above. For both the correlation and R-Square values, the closer to +100%, the greater the correlation and predictive ability, respectively. A graph depicting the rate movement of first mortgage rates and three different market rates is shown below:

0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

Jan

-09

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-09

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-09

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09

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-09

No

v-0

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11

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Mar

-12

First Mortgages

1st Mortg Loans 6MLIB 6MTreas 10YTreas

55

Second Mortgages In reviewing the bank’s second mortgage loans, the majority of this portfolio’s rates correlated to changes in the 2 year and 5 year Treasury rates. The study also showed that the bank has historically reacted relatively fast to changes in market rates as signified by the zero or one month lag on each of the accounts analyzed. The results of the analysis for this account group is shown in the following table:

Acccount Highest

Correlation Index


(Beta) Spread

(Then Add) Lag

(Months) R-Square

Value 2nd Mortg Loans 93.51% 2YTreas 0.3060 5.6795 1 87.45% 2nd Mtg 1-5 Yr 90.80% 5YTreas 0.3264 4.8984 0 82.45% 2nd Mtg 6-7 Yr 93.75% 2YTreas 0.2040 5.6552 1 87.89%

2nd Mtg 8-10 Yr 93.75% 2YTreas 0.2040 5.6552 1 87.89% 2nd Mtg 16-20 Yr 94.81% 2YTreas 0.3522 5.8979 0 89.90%

A graph depicting the rate movement of second mortgage rates and two different market rates is shown below:

0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

8.00

9.00

Au

g-0

6

Oct

-06

De

c-0

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-07

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r-0

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-07

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-07

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-08

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-08

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-09

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-11

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r-1

2

Second Mortgages

5YTreas 2YTreas 2nd Mortg Loans 2nd Mtg 1-5 Yr 2nd Mtg 6-7 Yr 2nd Mtg 16-20 Yr

56

HELOCs In reviewing the bank’s HELOCs, the majority of this portfolio’s rates correlated to changes in the 3 Month Treasury and Federal Funds rates. The study also showed that the bank has historically reacted relatively fast to changes in market rates as signified by the zero or one month lag on each of the accounts analyzed. The results of the analysis for this account group is shown in the following table:

Acccount Highest

Correlation Index


(Beta) Spread

(Then Add) Lag

(Months) R-Square

Value HE with floor 99.18% 3MTreas 0.8823 3.8333 1 98.37% HE no floor 99.71% FF 0.9725 3.1168 0 99.43%

A graph depicting the rate movement of HELOC rates and two different market rates is shown below:

0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

8.00

9.00

Au

g-0

6

No

v-0

6

Feb

-07

May

-07

Au

g-0

7

No

v-0

7

Feb

-08

May

-08

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g-0

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-11

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-11

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g-1

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v-1

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-12

HELOCs

FF 3MTreas HE with floor HE no floor

57

Vehicle Loans In reviewing the bank’s vehicle loan rates, the analysis indicated that there was no clear correlation between any of the vehicle loan accounts and market rates. The offering rates for two account groups (Rec Vehicle and MAPS loans) have remain unchanged since the rates began being tracked in the PROFITstar model. Assuming that these rates were accurately input, this indicates a fixed pricing strategy by the bank. Therefore, since rates are set by the bank and do not change with the ebbs and flows of the market, it is advised to NOT set up key rate ties to these accounts. The other two account groups (New and Used Auto Loans) show some pricing movement. However, again there is not a high degree of correlation between the rates that are extended for these loan products relative to market rates. These accounts also appear to be priced independently from either current or recent market conditions. To continue modeling this type of pricing strategy in the future, it is advised to refrain from setting up key rate ties for these accounts as well. Although there is no evidence to support that the bank should set up key rate ties on any of the vehicle loan accounts, it is still advised to set absolute rate floors and ceilings on these accounts based on what the historical low and high rates have been. This will constrain pricing to a lessor degree, but still adds plausibility to the modeling assumptions. The results of the analysis for this account group is shown in the following table:

Account Highest

Correlation Index


(Beta) Spread

(Then Add) Lag

(Months) R-Square

Value Rec Vehicle Lns n/a n/a n/a n/a n/a n/a New Auto Loans -31.23% 10YTreas -0.3421 7.7571 9 9.76% Used Auto Loans 37.11% 1MLIB 0.1237 6.5673 3 13.77% MAPS New-5 Yr n/a n/a n/a n/a n/a n/a MAPS New-6 Yr n/a n/a n/a n/a n/a n/a MAPS New-3 Yr n/a n/a n/a n/a n/a n/a MAPS New-4 Yr n/a n/a n/a n/a n/a n/a

Correlation and R-square values that are low and therefore suspect have been highlighted in red. For these accounts, care should be taken when setting up any key rate-based pricing assumptions, as there is no historical evidence that such a relationship exists.

58

A graph depicting the rate movement of vehicle loan rates and two different market rates is shown below:

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2.00

4.00

6.00

8.00

10.00

12.00

14.00

Au

g-0

6

No

v-0

6

Feb

-07

May

-07

Au

g-0

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No

v-0

7

Feb

-08

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-08

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-11

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-11

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g-1

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No

v-1

1

Feb

-12

Vehicle Loans

10YTreas 1MLIB Rec Vehicle Lns New Auto Loans Used Auto Loans MAPS New

59

Other Loans In reviewing the bank’s other loan rates, this portfolio correlated to changes in several different market rates, including 1 month LIBOR, 6 month LIBOR and 10 year Treasury rates. The offering rates for three account groups (Mobile Home, Student and Business Loans) have remained unchanged since the rates began being tracked in the PROFITstar model. Assuming that these rates were accurately input, this indicates a fixed pricing strategy by the bank. Therefore, since rates are set by the bank and do not change with the ebbs and flows of the market, it is advised to NOT set up key rate ties to these accounts. The other four major account groups (Secured, Vacation, Christmas and VISA loans) show some pricing movement. However, again there is not a high degree of correlation between the rates that are extended for these loan products relative to market rates. These accounts also appear to be priced independently from either current or recent market conditions. To continue modeling this type of pricing strategy in the future, it is advised to refrain from setting up key rate ties for these accounts as well. Although there is no evidence to support that the bank should set up key rate ties on any of the other loan accounts, it is still advised to set absolute rate floors and ceilings on these accounts based on what the historical low and high rates have been. This will constrain pricing to a lessor degree, but still adds plausibility to the modeling assumptions. The results of the analysis for this account group is shown in the following table:

Account Highest

Correlation Index


(Beta) Spread

(Then Add) Lag

(Months) R-Square

Value Mobile Home Lns n/a n/a n/a n/a n/a n/a Cert Secured Lns 62.86% 10YTreas 0.2573 3.5777 0 39.51% Signature Loans 77.15% 6MLIB 0.2299 11.8078 6 59.53% Savings Secured 62.86% 10YTreas 0.2573 3.5777 0 39.51% Vacation Loans 41.51% 10YTreas 0.3449 8.6723 0 17.23%

Christmas Loans 57.82% 10YTreas 0.9696 6.1614 0 33.43% Net Generation 79.85% 6MLIB 0.2538 11.3915 9 63.76%

NORWESCAP Lns 87.83% 6MLIB 1.3269 6.6428 9 77.15% Student Loans n/a n/a n/a n/a n/a n/a Business Loans n/a n/a n/a n/a n/a n/a

VISA Loans -91.71% 1MLIB -0.2151 10.9126 6 84.11%

Correlation and R-square values that are low and therefore suspect have been highlighted in red. For these accounts, care should be taken when setting up any key rate-based pricing assumptions, as there is no historical evidence that such a relationship exists.

60

A graph depicting the rate movement of other loan rates and three different market rates is shown below:

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12.00

14.00

Au

g-0

6

No

v-0

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Feb

-07

May

-07

Au

g-0

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No

v-0

7

Feb

-08

May

-08

Au

g-0

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No

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-09

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-09

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g-0

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No

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-10

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g-1

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v-1

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-11

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g-1

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No

v-1

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Feb

-12

Other Loans

10YTreas 6MLIB 1MLIB Mobile Home Lns

Secured Lns Signature Loans Vacation Loans Christmas Loans

Net Generation NORWESCAP Lns VISA Loans

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Savings Accounts In reviewing the bank’s savings accounts, the analysis indicated that all of the savings accounts best correlate to changes in the 6 Month LIBOR rate. The study also showed that the bank has historically reacted relatively fast to market rate changes as signified by a lag period of one month for all accounts. The bank’s cost of non-maturity deposits has declined since 2008, which mirrors the rest of the industry. Typically, financial institutions will react quicker when market rates fall in order to take advantage of lower dividend expense. Rate spreads (rates offered by the bank compared to market rates) compressed as the ‘surge deposits’ came flowing into financial institution starting in early 2008. This pricing strategy and quick reaction by the bank has allowed the bank to keep funding costs low while still maintaining a solid core deposit base. This behavior should also allow the bank to slow the cost of funds growth in a future rising rate environment. The addition of lags and betas create a sense of realism in forecasting and can also be a supporting source of risk mitigation with regards to pricing risk. The results of the analysis for this account group is shown in the following table:

Account Highest

Correlation Index


(Beta) Spread

(Then Add) Lag

(Months) R-Square

Value Regular Savings 97.96% 6MLIB 0.1576 0.0509 1 95.96% Other Savings 97.77% 6MLIB 0.1559 0.0526 1 95.59% Vacation Club 97.77% 6MLIB 0.1559 0.0526 1 95.59%

Christmas Club 97.77% 6MLIB 0.1559 0.0526 1 95.59% Sav Bond Savings 97.77% 6MLIB 0.1559 0.0526 1 95.59% Trad IRA Savings 97.70% 6MLIB 0.1679 0.1016 1 95.45% Roth IRA Savings 97.70% 6MLIB 0.1679 0.1016 1 95.45%

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A graph depicting the rate movement of non-maturity savings rates and 6 month LIBOR rates are shown below:

*Includes Vacation Club, Christmas Club and Savings Bond Savings.

Certificates of Deposit

In reviewing the bank’s CD rates, the analysis indicated that this portfolio is best correlated to changes in the 6 month LIBOR rate. The study also showed that the bank has historically reacted relatively fast to changes in market rates as signified by zero, one and three month lags. The results of the analysis for this account group is shown in the following table:

Account Highest

Correlation Index


(Beta) Spread

(Then Add) Lag

(Months) R-Square

Value Sh Cert 3 Mo-500 97.65% 6MLIB 0.5951 -0.0737 3 95.36% Sh Cert 6 Mo-500 97.46% 6MLIB 0.5955 0.0347 3 94.99% Sh Cert 6Mo-2500 97.46% 6MLIB 0.5955 0.0347 3 94.99% Sh Cer 6Mo-10000 97.78% 6MLIB 0.7898 0.0705 1 95.62% Sh Cer 12Mo-500 97.29% 6MLIB 0.7505 0.3830 3 95.94%

Sh Cer 12Mo-2500 97.90% 6MLIB 0.7319 0.3631 0 95.83% Sh Cer 12M-10000 98.00% 6MLIB 0.7898 0.0705 1 95.62% Sh Cer 30Mo-500 94.33% 6MLIB 0.6112 0.9310 3 88.99% Sh Cer 60Mo-500 92.99% 6MLIB 0.4680 1.9537 0 86.47% Sh Cer 9Mo-500 98.04% 6MLIB 0.7649 0.1754 1 96.12%

0.00

1.00

2.00

3.00

4.00

5.00

6.00

Au

g-0

6

No

v-0

6

Feb

-07

May

-07

Au

g-0

7

No

v-0

7

Feb

-08

May

-08

Au

g-0

8

No

v-0

8

Feb

-09

May

-09

Au

g-0

9

No

v-0

9

Feb

-10

May

-10

Au

g-1

0

No

v-1

0

Feb

-11

May

-11

Au

g-1

1

No

v-1

1

Feb

-12

Savings Accounts

6MLIB Regular Shares Other Shares* Trad & Roth IRA Shares

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A graph depicting the rate movement of CD rates and the 6 month LIBOR rates is shown below:

IRA CDs In reviewing the bank’s IRA CD rates, the analysis indicated that this portfolio correlated to changes in the 2 Year Treasury rate and 6 Month LIBOR rate. Compared to the CDs, the IRA products showed a higher beta as well as a greater lag period, indicating less historical price sensitivity. The IRA accounts tended to move more in lockstep with the market rates they were correlated to. The results of the analysis for this account group is shown in the following table:

Account Highest

Correlation Index


(Beta) Spread

(Then Add) Lag

(Months) R-Square

Value Trad IRA 30 mo c 94.32% 6MLIB 0.6106 0.9340 3 88.95% Trad IRA 1 yr cd 91.44% 2YTreas 0.9820 0.1129 6 83.61%

Roth IRA 30 mo c 94.32% 6MLIB 0.6106 0.9340 3 88.95% Roth IRA 1 yr cd 91.44% 2YTreas 0.9820 0.1129 6 83.61%

0.00

1.00

2.00

3.00

4.00

5.00

6.00

Au

g-0

6

No

v-0

6

Feb

-07

May

-07

Au

g-0

7

No

v-0

7

Feb

-08

May

-08

Au

g-0

8

No

v-0

8

Feb

-09

May

-09

Au

g-0

9

No

v-0

9

Feb

-10

May

-10

Au

g-1

0

No

v-1

0

Feb

-11

May

-11

Au

g-1

1

No

v-1

1

Feb

-12

Certificates of Deposit

6MLIB Sh Cert 3 Mo/500 Sh Cert 6 Mo/500 Sh Cer 6Mo/10000 Sh Cer 9Mo/500

Sh Cer 12Mo/500 Sh Cer 12M/10000 Sh Cer 30Mo/500 Sh Cer 60Mo/500

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A graph depicting the rate movement of IRA CD rates and two different market rates is shown below:

The tables on the preceding pages summarize the best combination of market index rates and lag periods for each rate-bearing loan and deposit account which results in the highest degree of correlation and predictive ability. The spread is dependent upon the current index rates and current offering rates and should be updated each month to reset to the current prevailing rates. As previously mentioned, the index, beta, and lag fields can be used to determine the validity of the assumptions currently being utilized in PROFITstar. In some cases, such a relationship does not appear to readily exist and therefore using a key rate tie based on historical analysis is not supported.

0.00

0.50

1.00

1.50

2.00

2.50

3.00

3.50

Jan

-09

Mar

-09

May

-09

Jul-

09

Sep

-09

No

v-0

9

Jan

-10

Mar

-10

May

-10

Jul-

10

Sep

-10

No

v-1

0

Jan

-11

Mar

-11

May

-11

Jul-

11

Sep

-11

No

v-1

1

Jan

-12

Mar

-12

IRA CDs

Trad & Roth IRA 30 mo cd Trad & Roth IRA 1 yr cd 6MLIB 2YTreas

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Additional Notes for Modeling Interest Rate Shocks in PROFITstar Historically, there has been much more volatility observed on the short end of the curve compared to the long end of the curve. This is illustrated in the graph below, which shows the range of spot rates that comprise the Treasury Yield Curve:

This behavior is frequently termed “yield curve risk”. Because of the presence of yield curve risk, ProfitStars recommends giving consideration to modeling of non-parallel rate shocks. The “Projections” line of the IRSA Matrix and the Fair Value Matrix reports the results of simulations using the key rates and offering rates forecasted in Projections. The projection can be set up to twist the shape of the yield curve or otherwise shift the model’s rates in a non-parallel (and generally more likely) manner.

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Review of Assumptions Decay Rates In the past, demand type deposits used the book value for all valuation purposes. This treatment meant there was no interest rate risk associated with demand deposits when performing equity/capital valuation. Another theory called the "Decay Rates" approach believes that each deposit account has an implied life and at any point in time, there is an implied maturity schedule, very similar to a maturity schedule on a loan. The differences between Core/Noncore and Decay Rates are:

Core/Noncore: This theory assumes that a certain percentage will mature this month (Non-Core deposits) and the remaining balance will never mature (Core deposits).

Decay: This theory assumes that these Non-maturity demand accounts have a ‘life’. A certain percentage of the deposit balance will ‘mature’ each month. That ‘life’ is modeled by using prepayments.

Comments:

Weighted average life (WAL) is commonly used as a reference term for maturing accounts. This can also be applied to deposit accounts with an implied maturity schedule. Even though non-maturity deposits don’t have a stated maturity schedule, the bank will experience run-off within this portfolio. Decay assumptions are designed to capture the banks expected run-off and provide more accuracy in Fair Value calculations. Not all deposit types are the same though so choosing an accurate decay assumption is important. For instance, ‘hot money’ sources such as money market accounts are estimated to have a faster decay than more ‘sticky money’ sources such as checking accounts.

The bank is currently using decay estimates based on an analysis performed on their non-maturity deposit base. For the majority of accounts, the decay estimates vary nominally in the changing rate environments. This makes sense and can best be explained by non-rate factors (such as branch convenience, direct deposit ties, auto-bill pay ties, liquidity, etc.) playing a larger role than rate factors in a customer’s decision to keep their account where it is, particularly on core checking-type of accounts.

The current decay assumptions seem appropriate. Again, the bank should have strong documentation as to how the decay estimates are derived and the frequency with which they are reviewed/modified. Decay estimates are typically revised on a quarterly, semi-annual or annual basis. However, a dramatic steepening or flattening of the yield curve may warrant an analysis to be done on a more frequent basis.

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The current decay estimates and the resulting WAL calculation used on the bank’s demand deposit products are outlined on the following page:

Account # Account Decay Method WAL

346 Reg Ck-Personal SMM 9.007

347 Reg Ck-Business SMM 22.930

348 Reg Ck-Pub Fund SMM 11.513

349 Reg Ck-US Govt SMM 11.513

358 NOW PF SMM 8.254

359 NOW Bus SMM 8.254

360 NOW Other Var SMM 8.254

361 NOW Other Fixed SMM 8.250

362 NOW Int Type 8 SMM *

363 NOW Int Type 13 SMM 13.873

364 NOW Int 13 Fixed SMM *

365 NOW Int Type 16 SMM 13.854


367 NOW Int 17 Var SMM *

368 NOW Int 17 Fix SMM *

369 NOW Int 18 Var SMM *

370 NOW Int 18 Fix SMM *



373 NOW Int 25 Var SMM 13.854

374 NOW Int 25 Fix SMM 13.930

375 IOLTA SMM 14.152

379 Hi Fi-Pers SMM 18.140

380 Hi Fi-Corp SMM 18.140

381 Hi Fi-Bus SMM 18.140

382 Hi Fi Other SMM 18.140

383 Hi Fi Guardian SMM *

384 Hi-Fi Int 4 F SMM 1.604

385 HiFi Int 10 Fix SMM 1.604

386 HiFi Int Type10 SMM 1.604

387 Hi Fi Int 11 Fx SMM 1.604



390 HiFi Int Type15 SMM *




394 Hi Fi PF SMM *

400 Passbook Sav SMM 6.040

401 Sav Public Fund SMM *

402 Int Type 4 Fixed SMM 2.301

403 Int Type 4 Var SMM 2.301

404 Corp Bus Int 5 SMM 16.452

405 Special 3.1 SMM *

406 Int Type 7 Fixed SMM 2.301


408 Int Type 13 Fix SMM *


410 Spec Int Type14 SMM *



413 Stmt Savings SMM 6.040

414 Child Stmt Sav SMM 6.040

415 Int Type 12 Fix SMM 2.301

416 Int Type 12 Var SMM 2.301* includes no current balance and therefore no calculated WAL.

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ProfitStars recommends the bank have a current study performed to determine the historic decay behavior of its depositors. This analysis can be done internally or externally by a third party. If looking to commission a third party study, it is highly recommended that the bank first confirm with its regulatory body that the results of such an analysis are acceptable for use, particularly if the average life of accounts comes back higher than what is commonly observed using industry estimates. Longer lives could produce an over-stated deposit premium and further amplify the effect of deposits on the bank’s risk to capital (EVE) position. Given the current low rate environment and the fact that the cost of funds can’t get much cheaper, the longer these deposits can stick around the more value they have to the bank. The shorter the WAL, the value of these deposits erodes due to the threat of these deposits leaving.

One type of internal analysis the can be performed entails compiling data on current deposit accounts that have been closed, including account type, account open date, account close date and average balance information. Another popular approach is to calculate the ‘half-life’ for deposit accounts at a set point in time and determine how many of those accounts remain after time period 1, time period 2, time period 3, etc. (typical time periods analyzed may be months or years). Compiled and analyzed over time, this data can be used to help establish the bank’s retention/decay trends of its deposit members.

Prior to making any massive, global change to decay assumptions, we recommend doing the changes in a what-if scenario and comparing both the pre and post-change models. This will allow the bank to see the true impact the change in decay assumptions will have. No matter what approach the bank decides to do, I recommend that the bank continues to have strong documentation for the source of these inputs.

Prepayment Speeds Prepayments are the difference between the contractual payments that are to be paid monthly and the actual payments received. Prepayments can be tracked by taking the

first month maturity from the previous month's maturity schedules in PROFITstar and what was actually received in payments for the month. The actual payments for the month are: Current Month's Balance - Previous Month's Balance - New Volume for the month.

Prepayment assumptions affect liquidity risk, the amount of new volume needed to achieve monthly projected volumes, and interest rate risk. Downloading your loans into maturity/repricing captures the contractual maturities. However actual principal cash flows received may be more than what is contracted to be received. Additional cash flow from loans and investments means additional liquidity that if not planned for could

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result in a loss of potential revenues. The additional liquidity could also mean missing goals for growth in individual accounts or overall institution growth. The additional principal cash flows also mean that more volume is available to reprice. This means unanticipated interest rate risk. As rates change, so do prepayment patterns. Typically there is an inverse relationship between prepayment speeds and the movement of interest rates. When interest rates go up prepayment speeds slow down and when interest rates go down prepayment

speeds increase. This process can be modeled in PROFITstar using the prepayment elasticity factors. Typically there are six rate scenarios modeled: 3 Rising Rates and 3 Falling Rates. However, the institution can modify these scenarios as they see fit. As you project changes in offering rates, or as rate shocks are applied in an IRSA or Fair Value calculation, the prepayment speeds will fluctuate based on your elasticity settings. This allows you to further customize the prepayment effects in various rate scenarios.

Comments:

The bank is using the model to calculate the prepayments for the majority of its consumer and construction loans. These prepayments are based upon historical principal payment amounts received from the core system. The historical information only provides a prepayment estimate for the flat rate environment. Prepayments generally exhibit negative convexity, meaning that prepayments tend to increase in falling rate environments and decrease in rising rate environments. The bank is accounting for this by also including prepayment elasticities in the chart of accounts setup (as shown below):

The difference between the flat rate prepayment speed is used to calculate the resulting prepayment speed for a given rate environment. For example, based on the table above, the -100 bps rate environment’s prepay speed will be 5 basis points higher (0.300 less 0.250) than the flat rate environment’s prepay speed.

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For residential real estate loans, the bank is using the OTS prepayment tables. As with the OTS decay assumptions, this source will be unavailable at the end of 1st quarter 2012. The bank will need to find another source to replace the OTS prepayment assumptions on the residential mortgage loan portfolio. A couple options the bank has is to use PROFITstar to calculate the prepayments within this portfolio based upon historical principal payments. This option is based upon the bank’s customer behavior. The other option is to speak with your investment broker to see if they can provide prepayment assumptions of underlying loan collateral on MBS securities. They can run an analysis on MBS of similar term and rate which will provide prepayment assumptions that the bank may be able to apply to the residential loan portfolio.

Prior to making any massive, global change to prepayment assumptions, we recommend doing the changes in a what-if scenario and comparing both the pre and post-change models. This will allow the bank to see the true impact the change in prepayment assumptions will have. Given the current regulatory environment, ProfitStars recommends having strong documentation and understanding for all prepayment assumptions. This is an area of continued scrutiny with examiners. The bank’s current prepayment estimates used on loan products are shown on the table on the following page:

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Account # Account Prepay Method Auto-Calc +400 PP +300 PP +200 PP +100 PP Flat PP -100 PP -200 PP -300 PP -400 PP

123 Demand Loan Fix SMM Yes 0.042 0.092 0.142 0.192 0.192 0.242 0.342 0.442 0.542

124 Demand Loans Var SMM Yes -0.022 0.028 0.078 0.128 0.128 0.178 0.278 0.378 0.478

125 Demand Part Sold CPR No 0.1 0.15 0.2 0.25 0.25 0.3 0.4 0.5 0.6

128 Demand Loan TF SMM Yes 0 0 0 0 0 0.05 0.15 0.25 0.35

129 Demand Loan SBA CPR No 0 0.15 0.2 0.25 0.25 0.3 0.4 0.5 0

130 Demand SBA Var CPR No 0 0 0 0 0 0 0 0 0

132 Construction SMM Yes 2.249 2.299 2.349 2.399 2.399 2.449 2.549 2.649 2.749

133 Construction Var SMM Yes 0.895 0.945 0.995 1.045 1.045 1.095 1.195 1.295 1.395

134 Const Part Sold OTS Balloon FRM (CPR) N/A 1.657 1.657 1.657 1.657 1.657 1.657 1.657 1.657 9.865

136 Leases CPR No 0 0.15 0.2 0.25 0.25 0.3 0.4 0.5 0

138 Hann Leases CPR No 0 0.15 0.2 0.25 0.25 0.3 0.4 0.5 0

140 Mtg Res/EscrowOTS 30-year

Conventional FRM (CPR)N/A 5.613 7.934 13.234 25.452 36.438 40.959 43.014 44.146 44.527

141 Mtg Commercial SMM Yes 0.863 1.013 1.063 1.113 1.113 1.163 1.263 1.363 0.863

142 Mtg ResidentialOTS 30-year


143 Mtg Resid ABN AMOTS 30-year


145 Mtg Resid SeasonOTS 30-year


146 Mtg Parts Sold OTS Balloon FRM (CPR) N/A 1.657 1.657 1.657 1.657 1.657 1.657 1.657 1.657 9.865

149 Mtg Tax Free SMM Yes 0 0 0 0 0 0.05 0.15 0.25 0

150 FNMA MtgOTS 30-year


151 FNMA Parts SoldOTS 30-year


152 NJ Mtg & Fin AgeOTS 30-year

Conventional FRM (CPR)N/A 0 0 0 0 0 0 0 0 8.802

154 Install Comm Imp OTS Balloon FRM (CPR) N/A 1.657 1.657 1.657 1.657 1.657 1.657 1.657 1.657 9.865

155 Install Simple SMM Yes 0.404 0.454 0.504 0.554 0.554 0.604 0.704 0.804 0.904

158 H/E Fixed OTS 15-year FRM (CPR) N/A 9.33 12.877 19.519 28.616 35.18 38.68 40.628 41.827 42.249

161 H/E Line SMM Yes 0.431 0.481 0.531 0.581 0.581 0.631 0.731 0.831 0.931

162 H/E II SMM Yes 4.24 4.39 4.44 4.49 4.49 4.54 4.64 4.74 4.24

164 H/E III SMM Yes 0 0 0 0 0 0.05 0.15 0.25 0

165 H/E III PartSold OTS ARM (CPR) N/A 1.068 1.068 1.068 1.068 1.068 1.068 1.068 1.068 1.068

172 Overdraft Check SMM Yes 0 0 0 0 0 0.05 0.15 0.25 0

173 Visa/MC CPR Yes 0 0 0 0 0 0.05 0.15 0.25 0

174 Bus Visa/MC CPR Yes 0 0 0 0 0 0.05 0.15 0.25 0

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The prepayment speeds highlighted in yellow should be reviewed. For these accounts, they either have no active balance so the prepayment speeds in the table above are zero or they have an active balance but historical principal received is not greater than the contractual principal owed so no prepayment speed is calculated. When prepayment speed results are negative or zero, the elasticities in the chart of accounts should be reviewed and modified. The accounts highlighted in green don’t download from the loan file so no historical principal received is available to calculate prepayment speeds. These accounts cannot utilize the “auto-calculate” option in PROFITstar. The bank will need to remove the auto-calculate option and manually input prepayment speeds for these accounts. For amortizing investment accounts, the bank should also be applying a prepayment estimate in a similar manner to the loans. The Morgan Keegan prepayment estimates on the current portfolio can be used as a basis for estimating how future purchases may prepay.

Key Rate Ties Key Rate Ties provide a method of telling the model how to calculate projected offering rates based on a key rate account in Databank. Consider using the Key Rate Tie feature on your loans, investments, and deposits (savings). The benefits of this option are faster projections since fewer account offering rates have to be projected and more accurate rate shocks since the account offering rate is determined by the Key Rate tie.

Comments:

The bank is currently using key rate ties on the majority of earning asset and funding accounts. The regular use of key rate ties is recommended for four reasons:

1. It is not possible to model a curve twist or shift with just the offering rates as a starting point. In order to see the results of a steepening or flattening yield curve, key rate ties must be used. For most balance sheets, the relevant danger is not in parallel rate shock scenarios, but more likely in shifting yield curve scenarios.

2. The addition of lags and betas to create a sense of realism in the forecast can be a great source of risk mitigation. It allows the bank to slow cost of funds growth in rising rate environments and to slow interest income declines in falling rate environments. This can only be modeled using key rate ties.

a. The lack on pricing betas on the non-maturity deposit accounts reflects a one-for-one reaction to market rate change. These assumptions will have a significant impact on interest rate risk analysis and will potentially

73

overstate the amount of earning risk exposure. I strongly encourage the bank to have good documentation and understanding of how these inputs were derived. The current inputs can be usedful for IRR stress testing, but need to be refined in order to use the forecasted interest income and expense results for effective strategic planning.

b. Most of the non-maturity deposit accounts have rate lags assigned, varying from 1 to 9 months. This adds a sense of realism to the change of deposit pricing, as generally banks wait for a period after a rate change to see how the market responds. Like the betas, these lags are generally identified during the rate correlation study, so I encourage the bank to document when the study was last completed and update it if necessary.

c. On many deposit accounts, there is a noticeable difference between the rate being offered in the current month (December 2011) and the first projected month’s offering rate. This is indicative of key rate ties that have not been updated to reflect the current cost of funds climate.

3. In order to model variable rate investments, loans and CDs accurately, key rate

tie components need to be used. The initial key rate tie allows the bank to lock in the rate for an initial term, whereas the final key rate is also used when the rate changes after a set period. An example of this would be a ‘teaser rate’ on a HELOC product.

a. The bank currently has several floating investment products set up in the chart of accounts with key rate ties attached to them. The majority of these accounts are using a ‘manual historical correlation’ method to calculate their key rate tie components. The majority of the securities in the current portfolio are tied to National Prime, 3 Month LIBOR and 11th District COFI market rates. Therefore, it makes sense to set up the key rate ties to these indices and use a weighted-average spread. Currently, several of the accounts set up with a manual historical correlation have very low R-squared values. This indicates that the investment’s rate is not very correlated with the market index rate that it is tied to.

b. Loan accounts (both fixed and variable) are tied to National Prime plus/minus a spread. As long as the bank reviews these settings periodically and revises them as needed, I am fine with this setup. It makes sense to price new volume on fixed-rate loans in this way as well, as they will potentially come on at varying rates depending on the rate environment.

c. The bank currently has several CD products identified, but they don’t have key rate ties set up on them. I recommend setting up key rate ties in order to properly model the potential repricing characteristics.

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4. In order for the bank to utilize the “spread to key rate” field in the loan file, a key rate tie is required. This allows the bank to accurately model the rate each loan record will reprice to. Given the current low rate environment, the ability to model this properly is critical, as many loans may be at or below their floor right now.

a. As mentioned in the Review of the Monthly Update Process – Download Setup, the bank is capturing the “spread to key rate” field in the loan file. This allows the current portfolio to be modeled the closest to the actual terms of variable rate loan contracts.

The bank should review the current loan key rate ties to ensure that they accurately represent the index each loan record within the account is priced to. If there are multiple indices tied to a given loan product, the bank may need to add more detail to the loan chart of account section to create a one-to-one match with the key rate tie and the rate index in the loan file.

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Rate Ceilings & Floors Are Rate Ceilings & Floors set up in the chart of accounts to download? On adjustable rate loans, floors and ceilings can be added to reduce the risk to the consumer and the institution. Lifetime limits specify the maximum and minimum rates over the lifetime of the instrument. In addition, the change in rate may be limited each time the instrument reprices (periodic floor and ceiling).

If the download file includes ceilings and floors, this information for each loan can be incorporated in the repricing schedule for the current volume. If this information is not available you still have the option of manually entering the information into your maturity/repricing schedule.

Comments:

The bank’s loan extract file does contain absolute lifetime ceilings and floors. In order for these ceilings and floors to be applied to projected income and interest rate risk calculations, each variable rate account must have a setting within the chart of accounts set to “download”.

The bank has this option activated, which allows the ceilings and floors downloading from the loan file to be used in PROFITstar. This increases the precision of interest rate shocks for variable rate loans and follows our recommendation.

Rate Ceilings & Floors Setup on New Volume In addition to the option to download floors and ceilings on existing balances, you can also set floors and ceilings on new volume.

Comments:

The bank does not have new volume ceiling and floor spreads identified on variable rate loan and non-maturity deposit accounts. Given the current low interest rate environment, we recommend these limits get established in order to ensure that variable products are only repricing when they are eligible to. This has been an area of ALM modeling scrutinized by auditors and examiners.

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This feature allows the bank to model the repricing spreads on new volume to more accurately model how new volume can reprice during interest rate risk calculations.

Callable Instrument Option Callable instruments are difficult to model because their maturity date changes under different rate scenarios. Checking this option activates a number of options, which will help you model callable instruments more accurately.

If the callable feature is in use, fields for each of the seven scenarios in IRSA/FV will be active. The options are Call, Maturity or Calculate. If Call is selected, the instrument will mature at the call date specified. If Maturity is selected, the instrument will mature at the maturity date. If Calculate is selected, the user will determine during the download process the rate at which the instrument will be called.

Comments:

The bank does have callable securities and has identified callable accounts within Portfolio. However, there are non-callable securities as well as callable securities that are downloading into the accounts identified as callable, primarily the municipal and fixed corporate bond securities. As recommended in the Review of Account Setup – Account Detail section, the bank should separate callables from non-callables within the chart of accounts to more accurately model the cash flow schedules.

The following accounts are identified as callable within the current investment portfolio: Account # Account Name

49 Callable Agencies 50 Structured Agencies 73 Muni Tax Exe FR 74 Muni Taxable FR 91 Corp Bond Fixed

In conjunction with the callable instrument option, the call schedule within the chart of accounts and the call rate need to be identified in order to properly model the expected cash flows for these securities. Without these call triggers, all callables will be treated like bullet securities and won’t be called until maturity. This understates the amount of inherent interest rate risk, as call options generally benefit the issuer and not the bank. For the December 2011 callable portfolio, the bank is using the Yield Curve methodology of determining when the securities are likely to get called on an individual basis. Each callable security is tied to the treasury yield curve plus a spread. The spreads are zero

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for many of the accounts. Therefore, I recommend that the bank reviews these spreads regularly. In addition, the bank should document the methodology for determining the spreads and how frequently they are updated. Balance Sheet/Income Statement Ties The model can calculate the projected volume of one Balance Sheet or Income Statement account (target) based on the balance of another Balance Sheet account (source). When ties are set up the target accounts are non-editable in projections.

Comments:

There are currently no balance sheet/balance sheet or balance sheet/income statement ties set up in the bank’s model.

Projection Formulas Projection formulas can be used to calculate either the projected volume of an account or the offering rate. Formulas will not be available for accounts that already have a key rate tie, balance sheet or income statement tie, optimized or are already system-calculated. When formulas are active the projected values of the related accounts are not editable.

Comments:

As previously noted, the bank is calculating the treasury and FHLB yield curves using databank projection formulas. The bank is also utilizing projection formulas within the databank to calculate FTP rates for profitability analysis. If the bank has not already done so, I recommend documenting how these projection formulas are derived and how frequently they get updated within the model.

Instrument Level Detail Instrument level detail can be utilized in several areas of the model (Maturity/Repricing, Projections, IRSA, and Fair Value). For variable-rate accounts, this provides more precise income and expense results, by improving the accuracy of repricing calculations for detail records that have rate ceilings and floors. In addition, differences may be observed when instrument detail is used in conjunction with accounts utilizing the ProfitStar’s Loan Prepayment Estimates or PSA prepayments, which factor in the average age of the instruments.

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Comments:

The bank is currently utilizing instrument level detail (ILD) for the following variable rate loans:

Account # Account Name 124 Demand Loans Var 130 Demand SBA Var 133 Construction Var 161 H/E Line

The bank recently subscribed to the ProfitStar’s Loan Prepayment Estimates service. To properly use this tool, the bank should have ILD enabled for any residential mortgage accounts that are set up to use these prepayment rate estimates. This will ensure that the record-level detail of loan vintages and coupon rates are used to determine which prepayment rate to use. This includes accounts that are currently using the OTS prepayment estimates (which will soon be obsolete). While instrument level detail (ILD) is useful for adding precision to variable rate limits and prepayments, keep in mind that it does add time to the monthly download process. Therefore, it is recommended that ILD is only enabled on variable rate products that have valid ceilings/floors downloading and fixed rate products that are utilizing PSA prepayment assumptions.

Month-end Optimization When the Month-End Optimization option is used, the Projected Month-End balance, Average Balance and Income/Expense balance are calculated by the system based on the user-defined parameters. This option is only available for detail accounts.

Comments:

Month-end optimization allows PROFITstar to balance the bank’s forecast based upon the accounts with this setting active. This setting is currently activated on the following accounts:

Acct # Account Name 115 Fed Funds Sold 488 Fed Funds Purchased

These two accounts are the bank’s balancing accounts. If the bank doesn’t actively use these accounts then any projected balances associated with these accounts need to be shifted to other accounts on the balance sheet to properly allocate the bank’s balancing position.

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Maturity/Repricing Timing These options allow the user complete control over what day of the month accounts mature and reprice as well as what day new purchases are made.

The Maturity Day is used to determine when an instrument matures, and affects both an account’s current balance and new volume. The default value is Mid-month. No interest is accrued on the day the instrument matures. Changing from the default value may make your averages not balance.

The Repricing Day is used to determine when a variable-rate account will reprice. The default value is Mid-month. The Repricing Day setting affects an account’s current balance, as well as its new volume. Changing this setting will impact the income or expense generated for an account in the months when repricing occurs. Interest accrues at the new rate on the day the account reprices.

The New Purchases Day setting controls when new volumes are added during the month. The default value is Mid-month. Interest begins accruing on the Purchase Day.

Comments:

Loans, investments and deposit accounts are set to mature, reprice and purchase new volume in the middle of the month. This follows our recommendations as most maturities and purchases do not typically occur on a specific day of the month. However, if the bank has products that reprice on a specific day of the month then the bank needs to change this setting to reflect the appropriate repricing day. The same concept applies to any products that mature on a specific day or make new purchases on a specific day.

I recommend that the bank reviews the chart of accounts to determine if any other new, maturing or repricing volumes should be modeled at a point in the month other than the default, as it will impact both current and forecasted cash flows.

These settings can be modified within the chart of accounts | Advanced tab | Other options

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Review of General Model Setup Error Tolerance Levels These values determine your threshold for showing balance or rate errors in the model. These values are used in history and maturity/repricing to determine if you are out of balance.

Comments:

The bank has the following error tolerances currently set: Error Tolerance Error Tolerance Level

Out of balance error amount $500 Out of balance warning $1

Rate check warning 0.05%

Given the size of the bank’s balance sheet, the out of balance and rate warning settings are appropriate. Identify out of balance for average balances option When this option is checked, the system will display a # sign next to the date if the Calculated Average Assets and Calculated Average Liabilities & Capital, in that time frame, are not in balance. The balance sheet averages are important because they are used in the calculation of ratios and portfolio rates.

Comments:

This option is currently activated in the model. This follows our recommendations. Rate sensitivity cash flow option Often an institution will rely on either an investment analytic package or a broker to help them understand the IRR characteristics embedded in the products they own or may be purchasing. When performing IRSA or the Fair Value calculations, changes in the maturity schedule (and subsequent changes in interest income/expense) resulting from shocking the current interest rates, can be incorporated in the analysis.

The PROFITstar system offers three different levels of sophistication that can be used during the IRSA and fair value calculations. The simplest method is to use the maturity schedule from the Maturity/Repricing module, created during the monthly update process. This is the default setting. Users with many callable investment or borrowing instruments can approximate the maturity fluctuations due to interest rate shocks by selecting the Create cash flows for callable accounts option. When this second option is selected, the system creates

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multiple maturity schedules, during the download process, that are used in the IRSA and fair value calculations. These maturity schedules are based on the Callable Instrument Call Source settings found in the chart of accounts Setup and on interest rate information supplied during the download. The third option lets you incorporate different maturity schedules and interest income projections created by an investment analytic package or a broker, into the IRSA and fair value calculations. The system uses this information along with the offering rates to calculate the fair value. The IRSA calculation also incorporates each rate scenario’s maturity schedule and projected income in its results.

Comments:

The bank is currently using the cash flows generated from the ProfitStar’s Portfolio product to model the projected cash flow in different rate shock environments during interest rate risk calculations. This is a preferred method, as it allows instrument-level precision for embedded optionality such as callable and prepayment options.

First month maturity to history When this feature is activated, the system will take the Maturity Amount data from the first future month in Maturity/Repricing module and store it with the Contractual maturity data in History. This information can be used, with the historical Actual maturity amounts to calculate prepayment amounts and percentages.

Comments:

This feature is activated in PROFITstar which follows our recommendations. The bank is utilizing historical principal payments to calculate prepayment assumptions on several loan accounts, it is critical this feature remains activated. Minimize Balancing Account routine This will allow the projection to have a balance in only one of the balancing accounts. This option prevents the projection from being in both a buying and selling position in the same month.

Comments:

The model is currently set up to “minimize balancing accounts” during the balancing routine in projections. This is the most typical setting that I see for clients’ models and makes sense in most instances.

Tax Calculation Settings

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This setting is used to determine how the system will calculate projected taxes. Options include using an effective tax, a tax table or a deposit tax.

Comments:

The bank is currently using an effective tax rate to calculate federal taxable income and no tax rate to calculate state taxable income. In history, the effective federal tax rate has consistently been entered as 34%, whereas the effective state tax rate has consistently been entered as 6%. In projections, the federal tax rate continues to show 34%, but the state rate shows 0%. Based on this setup, the state tax rate is not currently being used to calculate taxable income at the state level. This follows our recommendations, but should continually be reviewed to ensure accurate projected taxes are calculated at the state level.

Global chart of accounts If this option is used then all chart of accounts settings, for all units, will be identical to the settings set up in the Root organization. Any organization-specific settings will be lost.

Comments:

The bank is currently set to have a ‘Global’ chart of accounts. This setting forces all sub-organizations (branches and cost centers) to have the same chart of account structure and assumptions as the top organization.

Consolidated Level Model When a model is consolidated, the data from all detail units is summed into the consolidated unit(s), based on the organizational tree structure. After the model is consolidated, the Consolidated Level Mode will cause consolidated models to behave in one of three ways:

Normal – Full calculations (edit mode) is the default setting. When this setting is selected, all accounts in Projections are recalculated. The recalculation is based on how the consolidated unit’s chart of accounts is set up. If the sum of the detail units does not equal consolidated unit it is usually because one or more the detail unit’s charts of accounts is not set up exactly as the consolidated unit’s chart.

Sum of subs – Minimal calculations (view mode) instructs the system to recalculate the balancing accounts, based upon the Balancing Routine specified for the model. All Historical and Maturity/Repricing data, as well as Projections assumptions, are not editable at the consolidated unit. All edits must be entered at the detail unit level.

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Sum of subs – No calculations (view mode) instructs the system to just display the results of the consolidation routine, in any consolidating organizations. Nothing is recalculated. All edit screens at the consolidated unit level are view only (no editing can be done). All Historical and Maturity/Repricing data, as well as Projections assumptions, must be entered at the detail unit level.

Comments:

Currently the bank is utilizing the “Normal – Full Calculation” consolidation method. This is the default setting in PROFITstar and follows our recommendations. During budgeting season the bank may find it necessary to change the consolidated level mode if branch level budgeting is being done. If this is the case I strongly encourage the bank to call our support department to review how this setting change will impact your projections.

Organizational Type/Branch Numbers The organizational type determines the balancing routine used in Projections. This is where you tell the system if your organizations assets should equal the liabilities and capital.

Branch Numbers are used in consolidated downloads. The download can be set up so that all records with the corresponding branch number are downloaded into the corresponding sub-organization.

Comments:

The bank has sub-organizations (branches and cost centers) set to ‘non-balancing’. This is the most common setting as most branches don’t balance assets to liabilities/equity. The bank is also utilizing an eliminations branch to eliminate balances that roll up to the top level.

The bank is also utilizing branch/cost center numbers within the general ledger and application files to download the amounts to the appropriate branch in the balance sheet and income statement.

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Additional Regulatory Guidance on ALM Modeling

For additional information on current regulatory guidance about ALM modeling, the bank is encouraged to refer to the following regulatory websites: Supervisory Guidance on Model Risk Management Interagency Advisory on Interest Rate Risk Management (IRR) FAQ on Interagency Advisory

Federal Deposit Insurance Corporation, Federal Reserve Board and Office of the Comptroller of the Currency Previous Interagency Policy Statement on Interest Rate Risk

Additional Federal Deposit Insurance Corporation Risk Management Manual of Examination Policies (section 7.1)

Additional Federal Reserve Board Commercial Bank Examination Manual (section 4090)

Comptroller’s Handbook- Interest Rate Risk Section

http://www.occ.gov/news-issuances/bulletins/2011/bulletin-2011-12.html

http://www.fdic.gov/news/news/press/2010/pr1002.pdf

http://www.occ.gov/news-issuances/bulletins/2012/bulletin-2012-5a.pdf

http://www.fdic.gov/news/news/financial/1996/fil9652.pdf

http://www.fdic.gov/news/news/financial/1996/fil9652.pdf

http://www.fdic.gov/regulations/safety/manual/section7-1_toc.html

http://www.federalreserve.gov/boarddocs/supmanual/

http://www.occ.treas.gov/handbook/irr.pdf

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