Fixed Income Strategies FINANCIAL INSTITUTIONS WEEKLY New OCC/FRB Supervisory Guidance on Model Risk OCC 2011-12: Sound Practices for Risk Management 

May 11, 2011

Mike Middleton 504-636-4904 mmiddleton@sterneagee. com

Introduction The OCC and FRB recently released new guidance on what they expect bankers to be doing regarding sound risk management associated with quantitative models used within their financial institutions. This new bulletin provides guidance on prudent model risk management policies, procedures, practices and standards. This guidance was released as OCC Bulletin 2011-12, titled “Sound Practices for Model Risk”, and supersedes the prior OCC Bulletin 2000-16 titled “Model Validation”. While model validation remains at the core of the new guidance, the broader scope now includes topics such as development, implementation, and use, as well as governance and controls related to models. While this update is not a substitute for a careful reading of the new requirements and expectations of the bank regulators, it will touch on some of the practical implications that result from it. While this new guidance is applicable to financial institutions that have the OCC or the FRB as their primary regulator, it should be expected that other regulatory oversight entities such as the FDIC and the NCUA will be mindful of its contents when conducting their field examinations.

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Why the need for a new Bulletin? When reviewing the financial system and market events of the last three years it became clear (as hindsight is always 20/20) that there was an over reliance placed on financial models by senior and executive management at banks, insurance companies, broker-dealers, asset managers and other market participants. The most obvious flaws were evident in risk models used to measure and control the level of price risk associated with marketable securities. These are commonly known as Value at Risk (VaR) models and they grossly underestimated the degree of price risk associated with holding certain securities during the meltdown. Risk models utilized to estimate credit losses on certain types of asset-backed securities also underestimated the declines in credit quality. In many cases the model itself did not fail as the mathematical algorithms were properly coded and calculating within the system, However, the assumptions used within those models may have been stale, not previously run in extreme stress scenarios, or not reviewed for proper logic both at the time the model was originally installed as well as during its regular use as a management tool. Finally, in the aftermath there has been a general observation that in several instances, executive and/or board level oversight revealed that they misunderstood several fundamental terms used to describe risk.

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Key Elements of Bulletin •

Regulators define model risk in the new policy as “The potential for poor business and strategic decisions, financial losses, or damage to a bank’s reputation when models play a material role”.

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Model risk should be managed like other types of risk: Banks should identify the sources of risk, assess its magnitude and establish a framework for managing that risk.

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Risk management should be commensurate with the nature and scope of the risk.

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Banks should objectively assess model risk using a sound model validation process, including evaluation of conceptual soundness, ongoing monitoring and outcomes analysis.

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A central principle for managing model risk is the need for effective challenge of models: critical analysis by objective, informed parties who can identify model limitations and assumptions and produce appropriate change.

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Practical application of this guidance should be commensurate with a bank’s risk exposures and business activities and with the extent and complexity of model use.

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Fixed Income Strategies FINANCIAL INSTITUTIONS WEEKLY 

May 11, 2011

Commentary Financial institutions will need to establish a formal policy that addresses all elements related to management of model risk. These required elements include the following: •

Model Development

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Model Validation

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Internal Models

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Third-Party Vendor Models

Since space in this newsletter does not permit a full review of every element within the new requirements, it is worth noting that for banks that run an ALCO model internally, they will be expected to demonstrate that they meet all elements of the new requirements. However, community banks that utilize the services of a third party vendor to produce their ALCO model reports will have to modify their model validation process. Vendors will be required by users to provide model developmental data and testing results that show the model works as expected. Vendors should also be expected to provide information regarding any standardized assumption set used within the model as well as provide ongoing performance monitoring and analysis. A bank’s customized assumptions should be well documented and justified as part of the validation effort.

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Summary Many of the elements found within the new regulatory guidance are not necessarily new. Banks have long been required to understand how their models work, what assumptions are contained within the model (along with documentation to support those assumptions), and to “periodically” perform a model validation exercise. What is new is the requirement to make the model validation process an ongoing one with much more involvement by senior and executive management than took place in the past. Banks that have robust risk management policies and procedures already in place should not see a material change in their model validation efforts. Banks that have historically not placed a high emphasis upon model validation will find that they will have to increase those efforts. As with many other issues, there is no one right answer but a range of right answers. Engaging in a conversation with regulators should result in them feeling that the bank is knowledgeable about the different types of assumptions, the interaction between those assumptions and the ongoing need to review and adjust those assumptions. The dialogue can be just as important as what the exact assumptions are within the model. Fortunately, there are a large number of educational and training resources available to bankers who are interested in broadening their knowledge of ALM theory and practices. Bankers do not need to become experts in every technical aspect of modeling. However, they do need to be able to demonstrate knowledge of the fundamentals. They also need to have policies and procedures in place to ensure that the technical aspects of the model are well founded, thoroughly reviewed and tested. Should you wish to discuss this topic further, please contact your Sterne Agee representative for additional information.

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Fixed Income Strategies FINANCIAL INSTITUTIONS WEEKLY

May 11, 2011

UPCOMING EVENTS Ryan Henley: Wolf & Company 2011 CEO & Board University June 7, 2011, Sheraton Framingham, Framingham, MA Sharon Stark and Ryan Henley: American Bankers Association CFO Exchange June 13-15, 2011, Hotel InterContinental, Kansas City, MO Ryan Henley: Alabama Bankers Association Annual Convention June 16-19, 2011, The Grand Hotel, Point Clear, AL Ryan Henley: Florida Bankers Association Annual Meeting June 19-22, 2011, Ritz Carlton, Orlando, FL Ryan Henley: Crowe Financial Institutions Conference Series June 29, 2011, World of Coca Cola – Bottle Cap Suite, Atlanta, GA

RECENT PUBLICATIONS Agency Fixed MBS Prepayment Report: May 2011 Factors – May 6, 2011 U.S. Employment: Surprising Strength – May 6, 2011 MBS Relative Value: Seasoned 30 year MBS Look Cheap to New 20yr MBS – May 4, 2011 AMT and Municipal Bond Portfolios: Reminder of Considerations for Tax Loss Carryforwards – May 3, 2011 Fixed Income Quarterly: Bank Strategies for the Second Quarter 2011 – April 14, 2011 MBS Relative Value: Spec Pool Pay-Ups Have Declined. It’s About Time! – April 7, 2011

FIXED INCOME PRODUCTS SABER | Sterne Agee Bank Earnings Report - a proprietary ALM solution for banking institutions. The goal of SABER is to provide clients with the ability to monitor interest rate risk exposure on the balance sheet, manage earnings, and protect franchise value. SACUS | Sterne Agee Credit Union Solutions - a proprietary ALM solution for credit unions. The goal of SACUS is to provide clients with the ability to monitor interest rate risk exposure on the balance sheet, manage earnings, and protect franchise value. SACE | Sterne Agee Credit Examiner - a proprietary credit analysis model for corporate bonds. SACE™ provides clients with a measurement of credit risk with regards to individual bonds and provides them with an easy yet responsive means to act on changes in credit for a particular bond or compare bonds. BondAdvisor | Portfolio Analytics - provides interest rate risk analysis for a fixed-income securities portfolio and highlights key measurements that are important in managing that risk. BondAdvisor also provides a yield and principal cash flow forecast as well as a peer comparison that allows users to identify weaknesses in the portfolio and plan for future purchases. IDEAS | ROE Decomp - a proprietary return on equity (ROE) analysis based on the DuPont Model. The report provides balance sheet and income statement strategies while providing an in depth group of 18 customized peers. This allows management to identify strengths and weaknesses in the balance sheet based on the chosen peer group.

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Fixed Income Strategies FINANCIAL INSTITUTIONS WEEKLY

May 11, 2011

STERNE AGEE Founded in 1901, Sterne Agee has been providing investors with high-quality investment strategies and opportunities for over a century. During the early years, our founders prominently established themselves in the financial securities industry in the southeastern United States. Today, we have expanded to serve all regions of the country. Sterne Agee is headquartered in Birmingham, Alabama with 70 Fixed Income professionals in 18 offices across the United States. Sterne Agee is one of the largest independent firms in the country. Sterne, Agee & Leach, Inc. is a division of Sterne Agee Group, Inc., which also includes The Trust Company of Sterne, Agee & Leach, Inc.; Sterne Agee Asset Management, Inc.; Sterne Agee Clearing, Inc.; and Sterne Agee Financial Services, Inc. www.sterneagee.com

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Fixed Income Strategies FINANCIAL INSTITUTIONS WEEKLY

May 11, 2011

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