Industry Insights

April 9, 2018
Leadership For An Industry 4.0 World
By David E. Perry and Ron Wiens

The world is entering its fourth Industrial Revolution, often called Industry 4.0. While Western economies ruled the first three industrial revolutions, the economies that will dominate the 4.0 World have yet to be determined. With the future up for grabs, what will the differentiator be for winning organizations?

Ushered in by the steam engine, the first Industrial Revolution led to the mechanization of work. The second, led by the electrification of factories and machinery, enabled mass production on a grand scale. The third, occurring in the second half of the twentieth century, introduced computers to the workplace and led to the automation of everything from back-office administration to the teller’s window.

The common theme of these revolutions has been a decline in the dependence on human capital. But Industry 4.0 is about to change that.

Knowledge + Connectivity = Industry 4.0
Industry 4.0 is driven by an electronically connected world. In the emerging 4.0 World, people are connected not only to each other, but also to each other’s knowledge. The impact of this connectivity is best summed up by the following observation from Dr. Nick Bontis of McMaster University: “In the 1930s, the cumulative codified (i.e., written down) knowledge base of the world doubled every 30 years; in the 1970s… it doubled every 7 years.” Bontis predicted in 2000 that by 2010, the world’s codified knowledge would double every 11 hours.

Maybe we haven’t reached that fateful 11-hour figure, but we now live and work in a world in which knowledge is growing exponentially. Since knowledge equals opportunity, the opportunities available to organizations are also growing exponentially. And because everyone is connected to this knowledge, everyone is connected to these opportunities. Therefore, competitive advantage today lies in an organization’s ability to exploit this knowledge and spot opportunities before anyone else – companies that can consistently do this faster than their competition will thrive.

An interesting by-product of this knowledge explosion is that the days of the all-knowing, all-seeing manager are over. Knowledge workers today are often more aware of new knowledge than management is. It’s not that managers have gotten dumber, but rather that employees have gotten smarter – or at least better educated.

Organizations are ripe with highly educated knowledge workers. That’s a key difference between now and the first Industrial Revolution, when our current management systems were invented. Here’s a nice bit of alignment: we have an explosion of knowledge, and at the same time that we have growth in the capability of the organization’s employees to understand and make use of this knowledge. The continued prosperity of already successful organizations now depends directly on the ability of their workers to continuously generate new value. Winning organizations have awoken to this fact.

The Power of Leadership
What does ‘waking up’ mean? At its core, it means a fundamental shift in how people are managed and led. The 4.0 World is all about leadership.

The current approach to managing people tends to focus almost exclusively on maximizing the productivity of individuals. This is Leadership 1.0 – steam age leadership, in which the whole is viewed as the sum of its parts. Industry 1.0 leadership can be summed up by the following philosophy: “We all have a job, and if we each do our job we will be successful.”

In an Industry 4.0 World, the view is quite different – the whole can be much more than the sum of its parts. 4.0 leaders still work at maximizing the performance of the individual, but they also focus on maximizing the performance of the team. This means looking at recruiting leaders through a new lens. In a 4.0 World, the skills and behaviors needed in a leader have changed considerably.

Building an environment that facilitates the ongoing creation of new value means managing not only the individuals who make up a team, but also the interaction space between these individuals. A lesson learned from the IT industry – which was the forerunner to Industry 4.0 and provides insight to the 4.0 World – is that between any two individuals on a team there is a hidden creative force. When the interaction space between individuals is effectively managed, this force emerges and the creative impact of the team is multiplied. In a 4.0 World, an organization’s ongoing prosperity now directly depends on its leaders’ ability to draw out this creative energy.

Building an organizational culture that facilitates the ongoing creation of new value is not rocket science. But it requires a fundamental change in perspective on the part of the organization’s managers – a change that will challenge current management practices, including how a manager’s performance is measured and evaluated. To be successful in a 4.0 World, organizations will now need to evaluate their managers not only on the basis of what they have delivered, but also by the readiness of their teams to deliver in an unknown future. Contrary to popular belief, winning in the fourth Industrial Revolution is not about speed – it’s about non-stop strategic change that constantly advances the organization toward its stated goals.

What does a 4.0 leader look like? 4.0 leaders not only manage the space in between people while building a high-performance culture. They never rest. They never allow the organization to crest. They know success is not a sprint but a marathon. Change is ongoing in a 4.0 World, which is why the 4.0 Leader is constantly developing and strengthening the organization’s change muscle. The successful organization in a 4.0 World reflects this kind of leader by constantly moving forward – never stopping, never resting.

Building a 4.0 Team
The goal in hiring isn’t to find the best talent looking for work, or at least it shouldn’t be; what it should be is finding the best talent period. Today that means recruiting leaders who are comfortable in a 4.0 world, and therein lies the recruiting challenge. The best leaders – the 4.0 talent – already have good jobs. The key to recruiting successfully in a 4.0 world now means going after talent that isn’t looking for work.

But hiring the best is not about money – it never was. Surprisingly enough, the best will come to an organization not to make more money, but because of what the organization stands for and what it’s trying to achieve. Work is personal to 4.0 talent, which is why you have to first engage their heart. Once you’ve spoken to the heart, the next step is to speak to their head – the best will want to understand the organization’s business goals, its challenges, its assumptions and its blind spots. Once the head is engaged, you next have to address the feet – the best will want to understand the organizational culture that drives the way people interact and how things get done. To do all of this, you need a systematic approach to finding 4.0 talent by engaging their interest and assessing their alignment with your goals.

Two Alternatives
In the ‘Old West’, it was said that there were two kinds of people – the quick and the dead. In the Industry 4.0 world, there are just two types of banks and credit unions – the quick and the dying.

The quick embrace new ways of leading and creating value, while the dying hang on for dear life to what brought them success in the past. Which will you choose to be?

Disclaimer: The views and opinions expressed in this article are those of the authors and do not necessarily reflect the official policy or position of the Financial Managers Society.

About the Authors

A well-known name in executive search circles with over 30 years of work as an executive recruiter under his belt, David Perry helps companies find and bring aboard Industry 4.0 leaders as the founder and managing partner of Perry-Martel International. A noted speaker on the topics of leadership and cultural change, Ron Wiens ( has spent the past 35 years helping organizations build high-performance cultures.

April 2, 2018
Applications of Risk Ratings
By Alison Trapp, Sageworks

Risk rating is integral to underwriting and managing commercial loans. Regulators expect that lending institutions not only assign risk ratings in an accurate and timely manner, but also that they use them in their processes.¹ Institutions should benefit from this expectation, as aligning processes to risk rating can impact their financial performance and human resource efficiency – particularly when used in the following areas.

New Originations
Risk rating is a means for ensuring an institution is originating and renewing loans in a safe and sound manner. For that reason, the underwriting process should include an assessment of risk rating early, rather than leaving it for a “check-the-box” exercise right before approval (or worse, closing). Accurate rating within the Pass grades is important to ensure that other processes are correlated to the proper risk levels.

An institution may also tie approval authority levels to risk rating. In this instance, so as to avoid biased results, it is especially important that the person responsible for assigning the risk rating is not influenced by the person with the approval authority.

Risk rating may also govern commitment and hold levels, when a guarantor is required, or what structures are available to a given borrower. For example, some borrowers have weaker cash flow that would result in an unacceptable rating unless there are structural enhancements that reduce that risk.

Loan Pricing
Intuitively, risk managers and lenders understand that higher-risk loans should have higher fees or interest, or a shorter tenure. Explicitly tying loan pricing to risk rating allows an institution to implement these structural elements more consistently. It also allows the institution to evaluate any exceptions to the pricing policy within a framework. In certain cases – for instance, the institution may deem it advantageous to stray from its own policy for a bigger purpose – having the policy in the first place allows it to understand the cost of such a move.

Resource Management
Risk rating can be a powerful guide for managing resources. A starting point is to align experience levels with accounts from different risk grades. A more experienced analyst should be the lead on lower-rated assets, while less experienced analysts may have a secondary role on these accounts or a lead role on more highly rated assets with oversight.

When the portfolio is managed with risk rating, the institution can use data to understand how changes to the portfolio will affect the resources required to manage the assets effectively. For example, if the institution is planning to acquire a portfolio of loans and it knows (a) the risk rating distribution of those assets and (b) the amount of a full-time resource that each risk grade requires to manage to its standards, it can estimate the additional resources it will need. The institution can thereby determine if it has enough current resources to absorb the acquisition, if it needs to find efficiencies (perhaps through the use of software or by streamlining processes) or if it needs to hire additional resources.

Portfolio Rhythms
An institution should align distinctions in risk ratings to its ongoing portfolio management processes. For example, the institution can tie the frequency of review to risk ratings. An institution with five grades of Pass along with Special Mention, Substandard, Doubtful and Loss might set account review frequency as follows:

Additionally, the institution can use its data to understand how changes to a process will impact it. For example, if an institution with the above structure decided it was spending too much time in meetings and wanted to move Pass 3 from a semi-annual review to annual, it could estimate how much time would really be saved. Performance of the Pass 3 credits should then be monitored separately for a time to make sure that the change did not have a detrimental impact to overall portfolio quality.

Allowance for Loan & Lease Losses (ALLL)
There is a logical correlation between risk rating and ALLL as supported by the OCC calling risk rating the underpinning of ALLL.² Embedding risk rating in the ALLL process explicitly systematizes what institutions would be doing instinctively – aligning reserve levels with risk levels. Most institutions are already using risk rating in their ALLL process, while those not currently doing so are likely contemplating including it as part of the transition to their upcoming Current Expected Credit Loss (CECL) calculation.

By developing a robust risk rating policy and applying it consistently to all loans, financial institutions can glean benefits across the life of the loan, from origination to portfolio risk management.

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Disclaimer: The views and opinions expressed in this article are those of the author(s) and do not necessarily reflect the official policy or position of the Financial Managers Society.

About the Author

Alison Trapp leads the credit risk practice for Sageworks’ Advisory Services team, with expertise in the areas of credit administration, risk rating development and policy implementation.

February 26, 2018
FMS Quick Poll: Tax-Inspired Raises and Bonuses
By Financial Managers Society

In the weeks following passage of the Tax Cuts and Jobs Act last December, it was rare for a day to go by without a bold headline trumpeting how another company was passing a small portion of its sudden tax windfall along to its rank-and-file employees in the form of a wage increase or one-time monetary bonus. But the news was decidedly more muted for FMS members.

In our latest Quick Poll, we asked members whether the tax changes were inspiring their institutions to give out raises or bonuses. The resounding sentiment among the 125 members (86% from banks or thrifts and 14% from credit unions, representing a broad cross-section of asset sizes) who responded to the survey? Nope. While 6% of respondents were indeed paying out one-time bonuses and 2% were raising their minimum wage and 7% were working on some combination thereof, the overwhelming majority of 85% were opting to take a pass on the notion of passing along any tax largesse (Figure I) – although 17% of these were at least taking the issue under consideration.

Lest the hard numbers suggest that these institutions are either thoughtlessly spendthrift or somehow anti-employee, the explanations of their answers from 57 of the poll respondents provide a window into the thinking behind these decisions, highlighting the fact that not every business is in exactly the same position, and no tax cut affects every organization in exactly the same way.

For example, one respondent whose $569-million bank was giving $1,000 bonuses to each of its 60 employees felt justified in distributing a small piece of the estimated $1 million the institution was expecting to save from the tax cuts. Meanwhile, a $126-million bank opted to look longer term rather than pay out one-time bonuses, with the CFO reasoning that “the tax benefit gives the company the ability to increase wages to better match our peers and help retain talent.”

But even some of those institutions who answered the poll question “no” were still planning to reinvest in human capital in less direct ways, with one CFO of a $956-million bank noting that his institution was using its tax savings to hire on more employees rather than paying out raises or bonuses to those already in the organization.

On the other hand, many of those standing pat on raises and bonuses stood by their decision, with a number of respondents pointing out that they already had robust wage and bonus structures in place prior to the tax cuts, and therefore saw no reason to make additional moves at this time. Others explained that in forgoing payouts they were simply making a business decision based on the reality of how the tax “cut” had impacted them.

Several members noted, for instance, that the deferred tax asset (DTA) revaluation included in the tax bill had resulted in a substantial end-of-year hit on their balance sheets, making it difficult to justify paying out raises or bonuses. Still, one CFO remarked that her $1.1-billion bank managed to reward its employees for the year despite its DTA setback: “We had a DTA revaluation that would have killed the regular bonus, so we excluded it and maintained our traditionally attractive bonus payout.”

Thanks again to everyone who participated in our latest FMS Quick Poll. If you didn’t have a chance to complete the poll, be sure to weigh in with your views on social media or on FMS Connect!

February 12, 2018
Auto Lending at a Crossroads
By Alec Hollis, Director – ALM Strategy Group, ALM First Financial Advisors, LLC

“Transitions to delinquency show persistent increases for auto and credit card debt; auto loan delinquency rates especially problematic for subprime auto finance loans.”

So reads the press release from The Federal Reserve Bank of New York for a recent Quarterly Report on Household Debt and Credit. Headlines like these are becoming more common in relation to auto lending as regulators cite concerns over several years of strong growth alongside eased underwriting standards and unabated flows into delinquency.

The unprecedented growth in auto debt can be derived in part by the underlying demand for the collateral. Annual auto sales have seen several consecutive years of growth, setting an all-time high of 17.5 million units in 2016. This growth has trickled down to auto lenders, as total auto loan debt notched a new all-time record at $1.21 trillion in outstanding balances at the end of the third quarter of 2017. This represents a 48% increase from ten years ago – second only to a 157% increase in student loan debt – while total household debt increased 7% over the same time period.

This growth has the OCC’s attention – the agency took notice as early as the spring of 2012, citing banks launching new products, services and processes to catalyze asset growth, and specifically mentioning the growth in indirect auto lending. While growth in and of itself is not necessarily bad, the OCC has consistently discussed auto lending, which is why it is important for financial institutions to understand the reasons behind the elevated risk status.

Total originated auto loans surpassed $430 billion through the first three quarters of 2017, with roughly $88 billion of those loans considered to be subprime (credit scores below 620). Subprime auto loan originations have not been growing as fast as in preceding years, as some major market participations have capped subprime production, but overall originations continue unabated, with an ongoing streak of year-over-year increases.

At the close of 2017, roughly 20% of auto loan originations were subprime, compared to 21% in 2016, 23% in 2015 and 29% pre-crisis in 2007. Despite this decrease, Figure 1 shows that subprime origination volume has nevertheless has accelerated to roughly pre-crisis levels today, while originations with excellent credit have far surpassed pre-crisis levels.

Figure 1

Delinquencies in the auto lending space have likewise ticked up. Auto loans 90+ days delinquent measured 3.97% of the outstanding balance in the third quarter of 2017, continuing a streak of quarterly increases. Delinquency flow (newly delinquent loans) has also been increasing steadily for several years. Figure 2 shows the outstanding seriously delinquent balance, which has increased steadily since 2014.

Figure 2

Although widespread delinquencies have yet to materialize, there are certainly problematic sectors. Auto finance companies represent $602 billion – or roughly half of the $1.21 trillion outstanding – in auto loan debt. When it comes to subprime lending, auto finance companies dominate, representing 74% of outstanding balances with credit scores at origination of less than 620.

Auto financing companies might not look quite so dominant, though, when digging into delinquency flows. Figure 3 shows the flow into serious delinquency for auto loans originated with a credit score of less than 620. These flows have diverged from banks and credit unions in a major way, and are currently at levels not seen since the financial crisis for this major subset of subprime auto lenders.

Figure 3

The OCC has been consistently discussing and monitoring the trends in delinquencies since they first mentioned the drift higher in 2013. Asset quality indicators such as delinquency ratios and net charge-offs are trailing indicators, meaning that they take time to materialize as the credit lifecycle matures for a particular vintage of loans. Many are expecting delinquencies to continue to rise, as aggressively underwritten vintages continue to mature. To prepare for this, it is important for financial institutions to ensure collections operations can meet the potential delinquencies and that reserves are appropriate given this expectation.

Indirect Auto Lending
As it relates to auto lending, the OCC has widely discussed fair-lending risk, a result of yielding underwriting decisions to auto dealers or other third parties. Not only does this practice create a risk to credit standards, but it also carries significant compliance risk.

A notable case in 2013 involved Ally Financial, a large lender in the indirect auto space. The Consumer Financial Protection Bureau (CFPB) and the Department of Justice (DOJ) took action against discriminatory lending practices present in Ally’s program. Incentivized by dealer markups, minority borrowers were being charged higher interest rates at the discretion of the auto dealer. As a result, Ally was required to pay a total of $98 million in damages and penalties.

This example demonstrates how crucial it is for financial institutions to have adequate controls and appropriate compensation for dealer relationships. The last thing an institution needs is a dealer making underwriting decisions – not to mention the potential multimillion dollar penalties that may accompany them.

Action Plan
Recent news is riddled with coverage on auto loan delinquencies, subprime auto lending and large institutions scaling back from auto lending. Most recently, TCF Financial Corporation, a Minnesota-based bank holding company with $23 billion in total assets, announced discontinuation of all indirect auto lending. Other big banks have announced the limitation of auto loan originations in general, citing rising stress and protection from credit risk. As far back as 2015, Wells Fargo announced a cap on subprime production, after years of being aggressive lenders in the space. Moves like these could indicate some concern.

Particularly in regards to indirect lending, institutions need to understand the importance of assessing the additional risks posed by dealer relationships, as well as the additional fees. Return-on-capital models can objectively assess the profitability of product lines – if risks are mounting, institutions can take a cue from TCF and perhaps take a step back from the market.

Overall, auto lending can be a very important part of the balance sheet for many consumer-focused financial institutions, and indirect lending and dealer relationships can be an excellent tool to expand the institution’s reach. However, if ensuring safe and steady growth is the goal, history has shown that loosening credit standards to increase loan volume is not often successful in the long run.

Disclaimer: The views and opinions expressed in this article are those of the author(s) and do not necessarily reflect the official policy or position of the Financial Managers Society.

About the Author

Alec Hollis is a Director in the ALM Strategy Group at ALM First Financial Advisors, LLC.

January 29, 2018
Swaps: Margining And Accounting Considerations
By Ira G. Kawaller, Managing Director, HedgeStar

Due in large part to regulatory pressures, an increasing number of swap transactions undertaken by financial institutions have been – or will be – subject to margining requirements. Current industry practice is still evolving, but depending on exactly how these margining practices are implemented, different accounting treatments could follow.

The Case for Margining
In any discussion of margining, it’s useful to first distinguish between cleared swaps and non-cleared swaps. Cleared swaps are reported to clearing entities that apply well-defined and standardized margining practices that require posting of initial margin (i.e., collateral that may be in the form of cash or other qualifying assets) and variation margin that must be settled in cash, every day. Non-cleared swaps, in contrast, are bilateral contracts between two entities – often a swap dealer and an end user – where any margining practices would be carried out independently from a clearing entity.

Broadly speaking, over the next several years, virtually all financial institutions will be subject to mandatory margining for most, if not all, of their derivative positions. The rationale is that margining serves to eliminate credit risk as a function of losses being collateralized or settled in cash. Thus, the process assures that winners get paid. These margin adjustments could be stipulated with specific frequencies (e.g., weekly or daily) and/or when threshold valuation markers are breached.

Cash v. Non-cash Margin
The form of the margin is critical. Specifically, it’s important to distinguish between cash and non-cash margin. In regulated futures markets, where the most well-established margining practices have long precedent, both cash and selected non-cash securities are permissible for initial margin, but variation margin settlements must be satisfied exclusively in cash. Futures market practice further expressly distinguishes initial margin from variation margin, designating the former as collateral, while the latter is a bona fide settlement against the futures position.

For example, with an initial margin requirement of $1,000, a futures market participant would put up the $1,000 in cash or in securities at the start of the trade. This initial margin would be used only if the losing party failed to meet its variation margin obligation. In most cases, however, where variation margin adjustments occur as prescribed, this original margin would remain untouched until the trade is terminated, at which point the initial margin would be returned to the posting party.

To illustrate, let’s say Trader A enters a long futures position at a price of $50 per unit, and at the end of the day the closing futures price reaches $51. In this instance, Trader A would receive a variation settlement of $1 times the number of units per contract (the contract multiplier). It should be clear that the opposing trader (Trader B) would be the loser in this transaction, such that Trader B would be required to pay that same variation margin amount. These types of cash flows are settled at the exchange clearing house at or before the start of trading on the following business day.

In fact, in the futures environment, individual traders don’t deal directly with the clearing house. Instead, all traders are represented by clearing members and futures commission merchants (FCMs) who act as the traders’ agents – both as execution agents and as cash flow intermediaries. Thus, subsequent to settlements between clearing member firms and the clearing house, a parallel settlement between the trader and his or her FCM and then the FCM and the clearing member would be performed (note that clearing members and FCMs may be either distinct entities or the same company performing distinct functions). Initial margin amounts are intended to cover the credit risk associated with FCMs or clearing firms paying out their customers’ variation margin obligations prior to receiving reimbursement from their customers.

Under this process for futures contracts, variation margin assures that gains and losses will be settled every day, such that the value of the futures contract effectively resets to zero with each variation margin settlement. These aggregated gains or losses are considered to be unrealized until the contract is liquidated, at which point all unrealized gains or losses are redefined as realized. This terminology obscures the fact that unrealized gains or losses results are “real” in the sense that the money that moves from the loser to the winner does so without restriction – that is, any funds in excess of the initial margin requirement can be redeemed from the FCM and used for any purpose.

Contrast this margining process with one that allows for all margin adjustments to be satisfied with non-cash collateral. The trade would still involve an initial margin, but subsequent margin adjustments would be made periodically – up or down – as position values change, and securities (i.e., non-cash) may be used for this purpose. Ultimately, all collateral posted would be returned to the posting party following the termination of the contract.

Margining for Swaps
With the evolution of clearing facilities designed to handle swaps and other derivatives, a margining practice has evolved that mimics that of futures margining, with a twist. In this arena, (a) the initial margin obligation can still be satisfied with cash or securities, (b) variation margin requires a cash settlement and (c) variation margin is settled no less frequently than daily. The twist is that an extra cash flow adjustment is added into the mix – the price adjustment amount or price adjustment alignment (PAA), formerly termed the price adjustment interest (PAI).

What is the rationale behind the PAA? Prior to the advent of cleared swaps, when bilateral swaps operated with an International Swap Dealers Association (ISDA) credit support annex that required non-cash collateral adjustments, whichever party posted collateral still enjoyed the earnings that the collateral generated (e.g., dividends or accrued interest). In other words, posting collateral is purely a custodial issue, but it doesn’t alter the security’s ownership. Thus, it should be clear that a key difference between posting cash collateral and non-cash collateral is that, unless otherwise compensated, those posting cash give up the earning potential from that cash, while those posting non-cash collateral get to keep the associated incremental earnings. The PAA adjustment compensates for this difference – and thus strives to equalize the two practices – by returning an amount to the losing party (i.e., the party that pays the variation margin) roughly equal to this incremental income that would otherwise have been earned on the cash settlement.

Under existing and proposed margining rules, a single net settlement amount is calculated daily by the clearing entity, composed of the PAA netted from the variation margin. While these combined values will typically be settled with a single cash flow, if one wants to evaluate gains or losses of derivatives under different margining regimes, these two components should be differentiated. Put another way, the PAA component of an aggregate gain or loss associated with any derivatives position would more appropriately be considered to be other interest income (or other interest expense), as opposed to a component of the derivative’s gain or loss.

Different Accounting Approaches
Unfortunately, at this point, accounting practices are less than scrupulous in distinguishing between these two different margining orientations – variation margin as a settlement or variation margin as a type of collateral. While some entities account for variation margin as collateral and others account for it as settlement against derivatives values, the different treatment seems to be largely independent of underlying economics.

In fact, these two orientations foster distinct balance sheet presentations. When variation margin is treated as a settlement, gains or losses from derivatives are entirely reflected in the trading entity’s cash balance position, and simultaneously the derivatives carrying value reverts to a zero balance with each variation settlement. On the other hand, when financial reporters treat variation margin as collateral, adjustments to the value of posted collateral have no effect on the carrying value of the derivative.

Although both of these methods are widely practiced, the underlying economics should be the key to determining the proper approach – the critical factor should be whether cash is transferred to the winning party with or without restrictions. If those funds are available to be spent or used by the winning party, treating it as anything other than a settlement (i.e., treating it as a collateral adjustment) is frankly at odds with reality. Unlike traditional collateral, which is expected to be returned, the return of unrestricted cash settlements would be predicated upon a price reversal for the derivative in question – it could happen, but it certainly shouldn’t be expected.

Consider a case where cash variation margin settlements are treated as collateral. If the position generates a gain of $100 during the first accounting period – such that the entity receives $100 of cash designated as collateral – this receipt of cash must be journalized where the counter journal entity would be a payable. Assuming the position is liquidated in the next accounting period with no further value change, both the derivative position and the payable would have to be reversed. Thus, the associated journal entries (assuming no hedge accounting) would follow as in the table below.

Under this approach, at the end of the first period, the balance sheet shows assets consisting of (a) cash and (b) derivatives – both valued at $100 – while liabilities include a $100 payable account, and recognized earnings for the period are $100. In the second period, with no further market value changes, no further income is realized, and both the derivative and the cash collateral are treated as if they were cash settled, but the associated cash amounts are equal and opposite, such that no cash movement actually happens in the second period.

Cash $100
           Collateral payable $100
Cash collateral settled in period 1

Derivative $100
           Gain on Derivative $100
True-up derivative at period 1 end

Cash $100
           Derivative $100
Close-out derivative in period 2

Collateral payable $100
           Cash $100

On the other hand, if variation margin is treated as a settlement, the following journal entries would apply:

Cash $100
            Derivative $100
Variation margin during period 1

Derivative $100
           Gain on Derivative $100
True-up derivative at period 1 end

Under this second orientation, there are no derivative-related non-cash items on the balance sheet at the end of the first period or after. That is, cash is the only asset, but the same $100 of earnings arises in the first period. To be clear, the two methods yield identical reported earnings amounts, but the balance sheet presentations are different.

Note that the above journal entries ignore the treatment of the PAA amounts. When PAA is received, cash should be debited and (most likely) other interest income should be credited; when PAA is paid, other interest expense should be debited and cash should be credited.

As noted, both of these accounting methods appear to have been sanctioned by audit firms, but the indiscriminate application of the two methods is unjustified, as the “cash collateral” label is a source of confusion. The proper accounting should follow from whether cash settlements are exchanged between the derivative counterparties and, if so, whether those cash amounts are restricted in any way. Unrestricted cash settlements shouldn’t be treated the same way collateral is treated. Posting collateral is a custodial concern that generally has no impact on a firm’s balance sheet. Moreover, collateral is typically deposited with an independent party, and is something that is expected to be returned in full, assuming all associated cash flow obligations are satisfied. If a cash settlement is not handled in this restricted way, it shouldn’t be considered to be collateral, making the term “cash collateral” inappropriate.

Whether reporting entities or audit firms come to respect these economic distinctions is yet to be seen. If no consensus develops, however, resulting balance sheet presentations will be inconsistent, making it difficult to compare assorted financial ratios across institutions. When financial institutions issue debt and add an equal volume of assets, the net worth is unchanged, but such an action adds to the riskiness of the enterprise (assuming those balance sheet items are real). In the context of derivatives, when derivative positions are cash settled, credit risks pertaining to those positions evaporate. Therefore, to the extent that financial ratios fail to respect this economic reality, the associated credit risks and leverage calculations will be misstated.

Disclaimer: The views and opinions expressed in this article are those of the author(s) and do not necessarily reflect the official policy or position of the Financial Managers Society.

About the Author

As a managing director with HedgeStar, Ira Kawaller draws on his more than 40 years of industry experience to provide hedge strategy services, training and hedge program implementation.

January 22, 2018
Kick-Start Your Institution’s Cybersecurity Awareness
By Emily Larkin, Chief Information Security Officer, Sageworks

Just as information security awareness programs are a regulatory requirement for many financial institutions, they likewise represent a major pain point for most. The value of a strong awareness program is often difficult to quantify and thus gets little funding or attention, but once implemented, it can be an invaluable defense against both internal and external cyber attacks.

There are countless options for those looking to pay for security awareness materials or consultants to deliver those materials, but these measures only cover part of the challenge. How do you make information security part of your institution’s culture? How do you get buy-in across departments and leadership?

Getting started is often the hardest part for financial institutions. Here are five proven ways to kick up the buy-in and acceptance:

Start at the top
While board and executive buy-in is widely believed to be essential to a successful information security awareness program, getting to that point can be a challenge for some financial institutions. The key is to find what drives your leadership team, and in most cases, it is the revenue – presenting the potential financial impact of a cybersecurity incident and breach will quickly get the board’s attention.

This is not a scare tactic, but rather an educational opportunity for those who focus on growth and financials. There is an assumption that information security lives with the IT team and that a strong firewall will protect the company, but an effective 15-minute presentation on the risks and vulnerabilities that exist at the employee level will quickly turn around executive and board perceptions. Such a presentation might highlight:

- The regulatory requirements for an information security program;
- The average cost of a breach;
- The potential for reputational risk; and
- Some examples of the current vulnerabilities within the institution

Make information security part of every employee’s orientation
A formal introduction to a member of the information security team and hands-on training in the information security program will go far with new employees, helping to demystify information security and make it part of the welcome package. Employees will appreciate meeting new people and gaining a better understanding of the importance of information security at the institution.

Make sure information security awareness is presented as part of the company culture. Encourage new employees to report any suspicious activity – assuring them that no question or incident is too minor to report, and outlining the protocol for reporting such potential incidents.

Put information security as an agenda item on your institution’s staff meetings and individual team meetings
Give the institution’s information security team a captive audience and a high-profile platform from which to speak and share news to help create positive energy around cybersecurity awareness and encourage participation.

Topics can range from recent vulnerabilities and projects in process to new controls and, most importantly, a thank you to users for their ongoing input and vigilance. Users tend to respond to statistics and data, such as the number of threats detected or the number of phishing attempts blocked in a month, so be sure to include some numbers that will help employees understand that they are part of a company that is committed to protecting the overall business.

Exercise your information security program
One of the most effective ways to raise cyber awareness is to involve users, and phishing tests represent a great example of this effort.

There are a number of tools available that allow organizations to send a mock phishing email and track who opens the email, who clicks on the links or who opens the attachment and/or provides their credentials. The key is to pick an influential figure in the organization and have an email come from some variation of his or her email address. While some may argue that this type of exercise sets employees up for failure, in truth this is simply the reality of how attackers infiltrate institutions – since most organizations have leadership teams posted on their public websites, this information is all a potential attacker needs to launch an effective phishing campaign. Employees can benefit from seeing how easy it is to gain confidence with a short email from the right sender.

Once the data from this type of exercise is collected, it is critical to share it with employees. Of course, there’s little value to be had in shaming people by name, but certainly showing the percentage of users who bit on the phish and how they could have spotted it is extremely beneficial for everyone. Phishing tests also allow an institution to exercise its incident response plans and better understand its employees’ comfort level in reporting suspicious activity. With this type of test data, the institution can then tailor targeted training for teams that fell below the company average and improve the means for reporting incidents.

Require an annual acknowledgement of your information security awareness program
While this is a regulatory requirement for many companies, it is a best practice for all companies. The acknowledgement should apply to all employees, including executives and board members. An efficient way to do this is to make it part of the annual information security policy and program approval process – thus promoting buy-in at the top, while also receiving the required approvals.

There are countless ways to deliver and track awareness training, with online delivery that interacts with the user and allows the organization to reach remote employees being one of the most effective and efficient options. This can be accomplished through a company intranet or learning management system that provides short quizzes after the training, thus ensuring accountability and easy tracking.

Often, one of the greatest challenges in the annual training and acknowledgement process is getting full participation. Be sure to set expectations up front with the initial delivery of the annual training, then reach out to non-compliers with a friendly nudge or reminder when they miss the deadline. As a last resort, work with the IT team to have a non-responsive employee’s email and/or chat account suspended until he or she completes the annual training.

When it comes to cybersecurity, improved employee awareness is often an institution’s best defense – it just takes the right strategies and consistent and timely delivery to get your employees on board. They will appreciate your efforts, understand the importance of protecting the institution and its assets and recognize that doing so is part of everyone’s job.

Disclaimer: The views and opinions expressed in this article are those of the author(s) and do not necessarily reflect the official policy or position of the Financial Managers Society.

About the Author

Emily Larkin is the chief information security officer at Sageworks, where she helps manage corporate information security, business continuity, disaster recovery and technology-related audit and compliance activities.

December 26, 2017
Community Mindset: Bearing the Burden

One of the most welcome developments for financial institutions over the past several years has been the optimistic conversation – and occasional action – surrounding the topic of regulatory relief. Particularly for community institutions, many of which felt unfairly scapegoated and unduly put-upon in the wake of the financial crisis, efforts by several agencies to ease the burden and costly drain on scarce resources associated with often disproportionate regulation have been long in coming.

The truth, however, is that there is quite a burden to unload, and it’s going to take time for institutions to truly see and feel the effects of this easing. Perhaps that’s why so many of the executives surveyed for Community Mindset: Bank and Credit Union Leadership Viewpoints 2017 still view the regulatory burden to be among the greatest challenges facing their institutions (Figure 1). At 62%, it registered as the top concern from a slate of eleven possibilities, outpacing the challenges posed by competition from other institutions and attracting new/younger customers.

Although responses across all asset ranges reflected the challenge of the regulatory burden to roughly the same degree, those institutions in the smallest asset category ($200-$499 million) stood out as the most challenged – likely due to the proportion of resources encompassed by regulatory-related tasks in a smaller institution – with 40% of these respondents identifying it as their top challenge versus 31% on average of other asset sizes. Likewise, banks seem to be feeling the pressure more acutely than credit unions, with almost 66% of bank executives viewing the regulatory issue as either extremely or somewhat challenging, compared to just 51% of their credit union counterparts.

Further, nearly two-thirds of survey participants ranked regulatory compliance first or second among a slate of five risk management priorities (Figure 2).

While 53% of respondents are getting by with what they feel to be a “reasonable or manageable” regulatory burden, 34% characterized their regulatory load as “a little too heavy” and 14% labeled it “overwhelming.” Trying to pinpoint the most common regulatory headache plaguing institutions, however, yielded an extremely wide range of responses – compliance costs (14%) and changing laws/regulations (14%) were the only two concerns to muster double-digit percentage consensus.

Regulation is, and will continue to be, a reality and cost of doing business for financial institutions. And while regulators’ incremental efforts to help reduce the burden are likely well appreciated throughout the industry, it’s clear from the opinions of community bank and credit union leaders that there’s still a long way to go to get to a level that both sides can accept as reasonable.

Research taken from the FMS-commissioned study Community Mindset: Bank and Credit Union Leadership Viewpoints 2017, a survey of 400 senior executives representing community-based banks and credit unions.

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