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SAMPLE BANKCapital Plan for 2014-2019

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ContentsManagement Summary...............................................................................................................................4

Overview.................................................................................................................................................4

Strategic Financial Goals..........................................................................................................................4

Compliance Analysis................................................................................................................................4

SWOT Analysis.........................................................................................................................................4

Capital Failure Definition.........................................................................................................................5

Linkage to Business Plan..........................................................................................................................5

Capital Plan..............................................................................................................................................5

Earnings, Growth and Capital Targets..................................................................................................5

Risk Factors..............................................................................................................................................6

Credit Risk:...........................................................................................................................................6

Asset Concentration............................................................................................................................7

Allowance for Loan Loss......................................................................................................................7

Interest Rate Risk.................................................................................................................................8

Liquidity...............................................................................................................................................8

Future Capital Needs and Capital Compliance.....................................................................................8

Detailed Report.........................................................................................................................................10

Capital Failure Definition.......................................................................................................................10

Compliance Analysis..............................................................................................................................10

Static Unstressed...............................................................................................................................10

Static Stressed...................................................................................................................................13

Financial SWOT Analysis........................................................................................................................15

Strengths...........................................................................................................................................16

Weaknesses.......................................................................................................................................17

Opportunities....................................................................................................................................20

Threats...............................................................................................................................................20

Dynamic.................................................................................................................................................20

Business Plan Assumptions................................................................................................................21

Unstressed and Stressed Business Plan Results.................................................................................23

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Contingency Capital Plan.......................................................................................................................25

Triggers..............................................................................................................................................26

Key Actions........................................................................................................................................26

Contingency Capital Plan Scenario 1 Assumptions............................................................................27

Contingency Capital Plan Scenario 1 Results.....................................................................................28

Contingency Capital Plan Scenario 2 Assumptions............................................................................30

Contingency Capital Plan Scenario 2 Results.....................................................................................31

Capital Goals..........................................................................................................................................32

Summary...............................................................................................................................................34

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Management SummaryIn the Fall of 2013 we engaged FARIN & Associates to assist us with the development of a formalized capital planning approach that helps determine the appropriate levels of capital given the higher requirements imposed by the regulators under BASEL III and the risks associated with the institutional balance sheet. This capital plan is the result of our collaborative efforts. The goal of the capital planning process is to align the work done on strategic planning with the financial risk management process to “right size” the capital for known and potential risks in order to maintain a well-capitalized rating under the CAMEL rating system. In this process we will identify those risks that have the most significant impact on the plan, develop a process for building “scenarios” for testing the plan, and discuss the use and implementation of sensitivity testing within the plan.

OverviewThe continuing downturn in the economy and resulting challenges posed to financial instructions has highlighted the importance to all financial institutions to strengthen their capital planning process. A robust planning process is needed in order to enable financial institutions to maintain sufficient levels of capital to meet known, and unknown potential risks from stressed conditions or unforeseen events that may constrain the ability to maintain safe and sound operations. Such capital planning is and has always been a key concern of the Board and management of this institution in order to meet market needs and ownership concerns.

In order to ensure proper controls, it is the belief of our Board of Directors and management team that an effective internal capital planning process be managed at a minimum of annually to assess current risks in operations, financial conditions, and market concerns to prioritize the inevitable tradeoffs between capital levels, growth expectations earnings required to satisfy these divergent goals as well as dividend expectations for shareholders. This capital planning process must be realistic in its undertakings when considering the overall risk levels of the institution, the market conditions in which we are operating, and the regulatory environment that governs our safety and soundness parameters.

Strategic Financial GoalsAs part of the capital plan, we developed long range financial goals relating to earnings, growth, dividends and other capital actions needed to meet our capital goals. These goals were set annually for a time frame beginning 1/1/2014 and ending 1/1/2019.

Compliance AnalysisAs part of the capital planning process, we tested our capital compliance relative to Basel III capital standards. We performed that analysis on both a static and dynamic balance sheet. In the static analysis the balance sheet is held constant as the regulations phase in. In the dynamic analysis the balance sheet changes are based on our business and strategic plan.

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SWOT AnalysisWe conducted a financial SWOT with particular emphasis on financial strengths and weaknesses. It is our goal to capitalize on the financial strengths and execute strategies to address the financial weaknesses where appropriate. Many of the opportunities will be acted on in developing our business plan. The threats are a major input into the stress tests performed as part of this capital plan. The stress tests are designed to evaluate the effect of these threats on our viability should the threats materialize.

Capital Failure DefinitionThe Basel III capital requirements set a variety of standards that institutions must meet or exceed including well capitalized minimums, adequately capitalized minimums, and adequately capitalized minimums plus the new Capital Conservation Buffer. I t was our goal to establish a definition of failure that was specific to our risks, business plan and ownership structure. From this discussion we set our definition of capital failure as falling below well capitalized minimums under the Basel III Capital Regulations at the bank level. In addition, we would also consider capital failure to be falling below adequately capitalized minimums plus the capital conservation buffer at the holding company level.

These definitions of failure set capital minimums after applying stress tests. It is our objective to accumulate and sustain sufficient capital that when stress tests are applied we remain above our definition of failure after executing on a contingency capital plan.

Linkage to Business PlanThe assumptions contained in this capital plan draw upon assumptions in our business plan in 2014 and 2015. Assumptions beginning in 2016 are based on assumptions spelled out in our strategic plan.

Capital PlanThe following sets forth the capital plan goals of Sample. The plan includes detailed steps that the bank will follow to maintain the desired capital levels, growth expectations, and necessary earnings to meet these objectives.

Earnings, Growth and Capital TargetsThe following schedule outlines the agreed upon goals for regulatory capital, anticipated asset growth and required earnings & dividend payments to achieve these capital goals. Note that the goals reflect our institutional expectations for potential buffer needs, risk levels and overall market opportunities. This combination of growth, earnings, and dividend targets is based on our business plan and strategic plan.

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Incorporated in the capital plan is an assumption that during 2015 we will retire off the $10 million in small business capital we currently carry at the holding company level leaving us with $5.155 million in Trust Preferred Stock as qualifying Additional Tier 1 Capital as of 1/1/2016.

This set of business plan assumptions and actions results in the following capital ratios under the four Basel III regulatory capital requirements. All are well above regulatory capital minimums.

As part of the annual planning process our Board has reviewed these goals and the requisite tradeoffs should either the earnings or growth levels exceed or fall short of these targets by foreseeable amounts. As part of that review the Board has directed management to follow a priority for goals (high to low) as follows.

1. Capital – regulatory compliance2. Dividends – meet the cash flow requirements of our different forms of capital.3. Earnings – produce the earnings needed to compensate stockholders and accumulate capital to

support growth.4. Capital actions – Retire forms of capital that are expensive. Raise new capital if needed to

support growth.5. Growth – grow the bank over time that allows it to take advantage of opportunities while

meeting capital goals

In the event of a capital stress, the lowest priority items will be modified first when taking actions to maintain adequate levels of capital.

Risk FactorsWith respect to the capital plan, the key risk factors that the bank is exposed to include credit quality, asset concentrations, earnings and liquidity. Earnings can be affected by credit risk, interest rate risk and liquidity risk. The capital plan considers these risks, as well as other factors, that could potentially impact the capital goals as follows:

Credit Risk:Credit risk can have a significant effect on the bank’s ability to maintain sufficient levels of capital to stay above the bank’s definition of failure. The potential effect of credit risk on this plan was taken into

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Sample Bank – Fox Valley

consideration by running credit risk stress tests in determining whether sufficient capital buffers were in place to stay above the our definition of failure.

Asset ConcentrationThe nature and level of the bank’s asset concentrations can have a major impact on capital levels that need to be maintained due to changes in underlying factors that impact the assets beyond control of the bank. Our bank’s highest level of asset concentrations are in commercial real estate loans, residential real estate loans and C&I loans.

This table assumes no major changes in loan concentrations from the current mix based on call report data.

In our favor is the fact the Fox Valley market has a fairly diversified economic base, becoming less and less dependent on the one major industry (paper) that characterized this market in the past. Today the Fox Valley has major components in insurance, health care and education in addition to a relatively stable industrial base. For that reason a stress to a particular industry is far less likely to damage our portfolio than occurs in many other markets. A recent example is in the recent financial crisis, the Fox Valley felt less stress than was felt at the state and national levels.

Credit concentrations by loan type and by industry were taken into consideration in designing the magnitude of the stress tests performed in the credit risk area.

Note that the bank has historically targeted lending on properties secured by real estate as a core business practice. The historical loss rates experienced with respect to the overall exposure to this segment of the market does not warrant a strategy to reduce these loan levels, but rather better plan for potential losses and hold capital cushions for reasonable risk events. A change in strategy to focus on other lending products would require the bank to acquire talent, systems and knowledge that is costly, and may not prove to provide required returns on the diversification to sufficiently add to or maintain overall capital levels, commensurate with the risks associated with the new loans.

Allowance for Loan LossThe regulatory capital levels require us to maintain a fully funded allowance for loan loss. Our calculation methodology for the allowance for loan loss is based upon the loan classifications and loss

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rate experience, internal loan review results, trends in loan performance including delinquency, non-accrual and charge off by loan class. We feel our current ALLL is more than adequate to cover the credit risk in our loan portfolio.

Interest Rate Risk Our interest rate risk stress tests show the effect of a variety of changes in rates on both net interest income and economic value of equity. At the time this capital plan was developed, our most recent tests effective 10/31/2013 show Sample to be moderately liability sensitive. Results of our October 31, 2013 stress tests were incorporated in the stress tests run as part of this capital plan.

LiquiditySAMPLE BANK has developed a contingency funding plan that lays out the actions we will take in a liquidity stress situation should a liquidity stress event occur. Because liquidity stress tests are run as part of our contingency funding plan analysis, the potential effects of a liquidity stress were not explicitly considered in developing this capital plan.

Future Capital Needs and Capital ComplianceWe ran a variety of scenarios in evaluating our compliance with the Basel III capital requirements. All were based on our holding company capital structure which includes $10 million in SBLF capital and $5.155 million in Trust Preferred Stock, both Additional Tier 1 Capital items under the Basel III standards. The holding company test is the more severe of the two tests in that its balance sheet includes $15.115 million of Additional Tier 1 Capital in the form of Trust Preferred Stock and SBLF Capital. Those two capital items show as Common Equity Tier 1 Capital at the bank level.

The first scenario was a static balance sheet test where our balance sheet was held constant through the full phase-in of the Basel III standards. Our capital position remained well above PCA Well Capitalized capital standards and above the Adequately Capitalized Standards plus the Capital Conservation Buffer through the entire phase-in under all for regulatory capital measures.

In the second scenario we ran a stress test on the static balance sheet plan that considered both credit risk and interest rate risk. Details on stress tests are spelled out in the detailed section of this report. For three of the four ratios, we remained well capitalized through the entire phase-in and met or exceeded Adequately Capitalized Standards plus the Capital Conservation Buffer. The stress tests took the fourth ratio, the Common Equity Risk Based Capital ratio just below the Adequately Capitalized minimums. The fact that in this ratio we do not pass our definition of failure is dealt with in the Contingency Capital Plan that is touched upon in this management summary and elaborated on in detail in the Detailed Report.

In the third scenario we based projections for future periods in the business plan assumptions for growth, earnings and dividends listed in the first table in the management summary. In addition we assumed repayment of the $10 million of SBLF capital during 2015. The balance sheet mix was modified in 2015-2017 to reflect the fact we expect loans to grow 1% faster than assets during that period. Unstressed, the dynamic business plan has Sample in Compliance with Basel III well capitalized

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requirements as well as Adequately Capitalized plus the Capital Conservation Buffer under all four measures.

In the fourth scenario, we ran the same credit risk and interest rate risk stress tests to the business plan that we had run on the static balance sheet. In this fourth stressed scenario, SAMPLE BANK remains above well capitalized as well as adequately capitalized plus the CCB for the Tier 1 Leverage requirement. On the other three ratios, stressed results fell below failure definitions, the worse two being the Tier 1 Risk Based Capital ratio, and the Total Risk Based Capital ratios that fell well below Well Capitalized minimums and below Adequately Capitalized Minimums throughout the bulk of the forecast through 2019. Those failures indicate that SAMPLE cannot continue to execute under business plan assumptions in a capital stress scenario of the magnitude modeled. So the remaining two scenarios looked at the actions that would be required to maintain a spread over the failure definitions by taking actions not anticipated in the current business plan.

The fifth scenario, Contingency Capital Plan Scenario 1, incorporates modifications to the assumptions in the business plan we would take if we found ourselves in the capital stress scenario like that used in this capital plan. The actions considered the prioritization of our goals discussed earlier in this management summary. In this scenario we made two major changes to business plan assumptions. During the two stress years we shrunk 8.25% per year rather than growing at the speeds indicated in the business plan. We also incorporated changes in balance sheet mix assumptions that would reflect a decline in loans as a percentage of assets and an increase in non-performing loans. We felt these changes were appropriate in that our loan officers would be focused on dealing with asset quality issues rather than originating new loans. Also during the two year stress period, the availability of quality loans would diminish.

The results of this scenario show SAMPLE maintaining capital ratios that met or exceeded Well Capitalized minimums and above Adequately Capitalized minimums plus the CCB all through the forecast.

In the sixth scenario, we evaluated a decision to defer the repayment of the SBLF Capital. While this scenario improved performance under the Tier 1 Leverage, the Tier 1 Risk Based, and Total Risk Based ratios, it slightly worsened performance on the Common Equity Risk Based Ratio because of the increased dividend payout requirements for the SBLF funding. We still needed to shrink at least 8.25% per year to remain in compliance with the Common Equity Risk Based Well Capitalized and the Adequately Capitalized plus CCB requirements.

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Detailed Report

Capital Failure DefinitionOur definition of capital failure is to have the bank’s regulatory capital ratios fall below well capitalized minimums under the Basel III Capital Regulations at the bank level. Doing so would jeopardize our ability to raise funds through brokered CDs and CDARS. At the holding company level, our definition of failure would be to fall below adequately capitalized minimums plus the Capital Conservation Buffer (CCB) as it is phased in between 2016 and 2019. Doing so would cause restrictions to be placed on payment of dividends, discretionary management bonuses and on retiring capital.

While these definitions of failure may be different than those used by regulators or by other institutions, it is our objective to develop a capital plan that keeps our capital ratios above the failure definition after applying a stress test that combines a credit risk stress with an interest rate risk stress. Should execution of our business plan take capital ratios below the failure definition, we will develop a Contingency Capital Plan that spells out the actions we anticipate taking in a real world stress scenario to keep us above failure ratios defined in this capital plan.

Compliance Analysis

Static UnstressedA static compliance analysis holds the projected balance sheet at current levels, and applies the new capital regulations based upon the regulatory phase-in periods. This analysis shows whether your current balance sheet would be in compliance as phase-in changes are made. Note that this analysis assumes no growth, earnings, balance sheet modifications, capital actions, or dividend payments.

The purpose of this analysis is primarily regulatory focused. Most regulators like to see the “static” approach to eliminate questions on the source and validity of major assumptions. Most regulatory models released to deal with risk management have been focused on static approaches, despite guidance language indicating a need for more “scenario” or “plan” review of risk.

The following shows the results of the “static” projections with the current BASEL III phase in schedule:

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On this Tier 1 Leverage graph, the red line indicates the well capitalized minimum, and the purple line the adequately capitalized minimum. The blue bars represent Case Institution’s Tier 1 Leverage ratio as the regulation phases in resulting from a combination of its current position and a set of forecast assumptions that hold the balance sheet constant over time. The red bars show the results for this static scenario after running a stress test. We’ll discuss the stress assumptions a few paragraphs further down this section. Unstressed, SAMPLE maintains a 5.48% buffer over the well capitalized minimum throughout the forecast.

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On this Common Equity Risk Based Capital graph, the red line indicates the well capitalized minimum, and the purple line the adequately capitalized minimum. The light blue line represents the adequately capitalized minimum plus the Capital Conservation Buffer. The blue bars represent Sample’s Common Equity Risk Based Capital ratio as the regulation phases in resulting from a combination of its current position and a set of forecast assumptions that hold the balance sheet constant over time. SAMPLE maintains a buffer over the well capitalized minimum that ranges from 0.89% down to 0.66% throughout the forecast. The reduction over the time is as a result of phase-in of certain capital deductions from Additional Tier 1 and into CET1. The minimum buffer over the adequately capitalized minimum plus the Capital Conservation Buffer is 0.16% on 1/1/2019. Stressed results (red bars) will be discussed a bit later.

On this Tier 1 Risk Based Capital graph, the red line indicates the well capitalized minimum, and the purple line the adequately capitalized minimum. The light blue line represents the adequately capitalized minimum plus the Capital Conservation Buffer. The blue bars represent Case Institution’s Tier 1 Risk Based Capital ratio as the regulation phases in resulting from a combination of its current position and a set of forecast assumptions that hold the balance sheet constant over time. Sample maintains a 4.38% buffer over the well capitalized minimum throughout the forecast. The minimum buffer over the adequately capitalized minimum plus the capital conservation buffer is 3.88%.

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On this Total Risk Based Capital graph, the red line indicates the well capitalized minimum, and the purple line the adequately capitalized minimum. The light blue line represents the adequately capitalized minimum plus the Capital Conservation Buffer. The blue bars represent Sample’s Total Risk Based Capital ratio as the regulation phases in resulting from a combination of its current position and a set of forecast assumptions that hold the balance sheet constant over time. The bank maintains a 3.46% buffer over the well capitalized minimum throughout the forecast. The minimum buffer over the adequately capitalized minimum plus the capital conservation buffer is 2.96%.

Clearly Sample is in compliance with the minimum Basel III standards before any stress tests are applied and has a buffer over these minimum requirements. The binding Basel III capital ratio is the Common Equity Risk Based ratio as the buffer over regulatory minimums is the smallest for this ratio.

Static StressedIn order to run a static (or dynamic) stress test we needed to define a stress scenario. In defining a stress scenario you:

Identify an event or combination of events that is likely to create a significant capital stress. Make assumptions as to the credit stress and interest rate environment that is likely to occur. Develop loss assumptions for the credit risk portion of the stress. Make assumptions as to the specific interest rate environment that is likely to occur. Make assumptions as to the operating income effects of the combined scenario – legal and

collection expenses, net interest margin impact etc.

This type of stress test is referred to by regulators as a Scenario Stress Test where a given set of market or economic conditions are assumed and relevant factors are modified to reflect potential adverse impacts. Defining a meaningful stress test was challenging for Sample as we went through the recent

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financial crisis with only a moderate effect on credit risk. Were it not for a single but significant fraud related loss, the effect on our performance and on execution of our business plan was moderate. So what kind of event would cause a significant capital stress on our shop? It would certainly need to stress us in the areas of our greatest portfolio concentration, single family mortgages, commercial real estate, and C&I loans. We settled on the following scenario:

Defense cutbacks do damage to a major area employer, Oshkosh Corporation (“Oshkosh”). This has a negative effect on area employment as well as on area businesses directly and indirectly dependent on Oshkosh and would affect the three major concentration areas of our loan portfolio.

A significant rise in rates takes a number of performing variable-rate and balloon real estate and business loans and turns them into non-performing loans.

The rising rates also have a negative effect on our net interest margin as our institution is liability sensitive.

Could both the local economic and interest rate scenario exist concurrently? Given the federal government’s deficit spending and the fact we are pulling troops out of war zones, the first part of the scenario is feasible. Given the fact the Fed is talking about cutting back on economic stimulus actions that have held interest rates low, the second is also feasible.

Developing the loss assumptions is also challenging because in order to test capital compliance we have to make credit loss assumptions that we have no historical basis to make. What we did is assume losses on most Schedule MR-C categories run 3 to 5 times our 10 year averages per year or 6 to 10 times our 10 year average annual loss over a 2 year stress period. Specific assumptions made include:

The two year stress test ran from 1/1/2015 through 1/1/2017.

In addition to the stressed effect on credit losses we added a $1.1 million reduction in net interest income per year shown in our most recent (10/31) interest rate risk stress test per year for the two years being modeled for a 300 bp rising rate environment.

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An additional $400,000 per year reduction in pretax income was added to cover increased legal, collection and asset holding costs. Finally, we assumed the shift away from loans and into lower yielding investments and non-earning assets would cause a further reduction in net interest margin of $1.5 million per year for the two year stress test.

These stress tests were applied to both the static and dynamic (business plan) forecasts. Results for applying the stress test assumptions to the static (constant balance sheet) analysis are reflected in the red bars in the above tables and graphs covering each of the four Basel III regulatory capital ratios.

As the first graph shows, applying the stress test assumptions to the static analysis results in post shock Tier 1 Leverage ratios that run 2.76% above the well capitalized minimums.

The second graph shows the stress test taking the Common Equity Risk based capital ratio 0.45% below adequately capitalized minimums, and 2.45% below well capitalized minimums. The Common Equity Risk Based ratio ends 2.95% below the adequately capitalized minimum plus the fully phased in CCB.

In the third graph, the Tier 1 Risk Based ratio remains 1.61% above the well capitalized minimum and 1.11% below the adequately capitalized minimum plus the fully phased in CCB.

In the fourth graph, the Total Risk Based Capital ratio remains 0.69% above the well capitalized minimum and 0.19% above the adequately capitalized minimum plus the CCB.

Clearly, the one ratio that is problematic under a stressed static analysis is the new Basel III Capital ratio, the Common Equity Risk Based capital ratio. That comes as no surprise as Sample made significant use of the opportunity to build capital through what is now classified as Additional Tier 1 under Basel III, while operating under Basel I where there was no CET1 capital requirement.

Static analysis is useful in identifying potential problems but does not provide an effective mechanism for evaluating potential solutions as called for in the Basel III capital requirements. Shortcomings as a planning tool in Sample’s stressed situation include.

There is no opportunity to build CET1 through retained earnings. There is no opportunity to model injection of additional CET1 capital. There is no opportunity to model management actions that might be taken in capital stress

situations as called for in the regulations by modifying the growth rate or shrinking, curtailing dividends, injecting new capital, manipulating the composition of the balance sheet, etc.

Dynamic analysis that incorporates Sample’s business plan and potential actions the bank might take in a stress situation are far more useful. But before running dynamic business plan based analysis we thought a financial SWOT would be in order.

Financial SWOT AnalysisThe internal portion of the financial SWOT analysis lays out our financial strengths and weaknesses. This review should include a review of the results against a relevant peer group. Any deviation from peers

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should be discussed. The external portion of the SWOT analysis identifies the opportunities and threats we face in implementing our business plan.

Strengths Enumerated list of major financial strengths

1. Net Interest Margin (Before Provision) /EA – historically and currently runs above peers.

2. Yield on Earning Assets – Has moved from a slight weakness to a slight strength over the last few years primarily because of management’s ability to maintain a high loan/earning asset ratio

3. Loans/Earning Assets – Has turned from a slight weakness to a slight strength as management continues to produce loans more effectively than peers.

4. Net Non-Interest Income / AA – This ratio reflects the fact the institution does a better job covering operating expenses with fees than most institutions and has done so for the last few

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years.

5. Non-Interest Expense/AA – This ratio has moved from a slight weakness to a strength over the last few years contributing to the fact the institution does a better job covering operating expenses with fees than peers.

6. Strong Tier 1 Capital Position – The two ratios with Tier 1 capital in the numerator are both well over regulatory minimums because of the presence of Small Business Capital (SBLF) and TRUPS as a source of capital. The strong Tier 1 Capital Position is reflected in post-stress results.

WeaknessesEnumerated list of major financial Weaknesses

1. ROAE – Had historically run better than peers but dropped well below peers in 2013 due to high PLL in response to asset quality problem caused by a single fraud incident. Once the effect of

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Sample Bank – Fox Valley Sample Bank – Fox Valley

the subsequent write-off is behind us, ROAE should return to peer or better.

2. ROAA - Had historically run better than peers but dropped well below peers in 2013 due to high PLL in response to asset quality problem. Once the effect of the subsequent write-off is behind us, ROAA should return to peer or better.

3. Net Interest Margin After PLL/AA - Had historically run better than peers but dropped well below peers in 2013 due to high PLL in response to asset quality problem. Once the effect of the subsequent write-off is behind us, Net Interest Margin After PLL/AA should return to peer or better.

4. Provision for Loan Loss / AA – Had been running better than peer until 2013 asset quality problem. Once the effect of the subsequent write-off is behind us, this weakness should resolve itself.

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5. Average Earning Assets / AA – In recent years dropped well below peers. Is improving but still well below peers.

6. Deposit Costs – Had historically run below peers in recent years, but are currently above peers.

7. Common Equity T1 Capital/Risk Assets (Holding Company) – Provides a minimal buffer over well capitalized minimums and/or adequately capitalized minimums plus the capital conservation buffer. The buffers are not adequate to cover the results of the stress test defined in this capital plan and allow the stressed ratio to fall below our definition of failure. This is a weakness that needs to be addressed in the business plan and Contingency Capital Plan.

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OpportunitiesEnumerated list of major financial Opportunities that have the potential to improve financial performance.

1. Opportunity to grow market share in that some local banks are still feeling the effect of the financial crisis and need to build capital. This opportunity was considered in the business plan in that we plan to grow assets and loans faster than the growth rates in the market.

2. The “megabanks” and larger regionals have cut local staff and reduced service levels, especially to business customers allowing us additional opportunities.

3. We remain locally owned and make local decisions. The characteristic is highly important to many demographics and especially business clients.

4. We provide product set in line with “megabanks “when combined with our high service levels delivers a compelling value proposition.

5. We are perceived as the most progressive community bank in the market. Leverage technology providing near leading edge for customers’ in relation to community banks and credit unions in our market.

6. We have expertise in business and commercial lending closer to that of the larger institutions. Combined with local decision making provides a compelling value proposition for business clients.

ThreatsEnumerated list of major economic and competitive Threats that may damage financial performance.

1. Reduction in employment of a major employer, Oshkosh, due to defense cut backs. This threat was considered in designing the stress test.

2. Rising rate environment causes reduction in net interest margin due to liability sensitivity combined with credit losses on variable rate loans due to increased cash flow burdens being placed on consumer and business customers. This threat was considered in designing the stress test.

3. Area banks continue to be aggressive in pricing residential and commercial mortgages as well as C&I loans making it difficult to originate these loans at profitable levels. This would potentially have a negative effect on net interest margin. This threat was not considered in designing stress tests as the stress tests are based on a problematic local economy where banks would be shrinking rather than growing loans.

4. Area banks and credit unions price deposits aggressively in rising rate environments to fund increases in loan demand, making it difficult for SAMPLE to manage its cost of funds in a rising rate environment. This threat was not considered in designing stress tests as the stress tests are based on a problematic local economy where banks would be building rather than shrinking liquidity.

DynamicThe development of a dynamic based plan is an on-going, iterative process. The process begins with the initial assessment using input from the strategic planning process and business planning process.

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Assumptions used in this capital plan are taken from our business plan for 2014 and 2015 and from the strategic plan for years 2016 and beyond. Dynamic results from this capital plan provide a look at the impact of the major plan assumptions for growth, earnings, dividend payout, and changing regulatory capital landscape in relation to the institutional goals for capital.

Moving from the initial business plan assessment to the modified stage requires institutional review of the individual stress test assumptions for the major risk areas, development of the key stress scenarios and sensitivity testing with each scenario. The scenario testing combines risk assumptions from the major financial risk areas that are complimentary in nature, providing a cross-risk framework to help determine the multi-factor impact of a stress situation. The assumptions used in stress testing of the business plan are the same as those used in applying stress tests in the static assessment discussed earlier.

From the results of the scenario testing management reviews the results with the Board of Directors to outline the overall risk profile, focusing on the key risks that may impact the plan, and determine if the plan as built when stressed maintains capital goal compliance with Board goals. In the event it doesn’t maintain capital goal compliance and management feels the business plan itself is sound, a contingency capital plan is developed that lays out the actions management would take to deal with a capital stress similar to that run in the stress test and maintain capital ratios above Sample’s definition of failure.

Business Plan AssumptionsThe following table lays out the major assumptions incorporated in the business plan forecast used in the capital plan.

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Growth/Earnings/Capital ProjectionsImpact of initial projections on capital requirments

Initial Assesment

Plan showing results of scenario stress tests within areasImpact of scenario stress testing (inculding sensitivity testing)

Modified Assessment Incpororation of Modified

Assessment results Focus on what actions would be taken to mitigate risk and preserve capital relative to plan goals

Contingency Capital Plan

Sources of data and assumptions are as follows:

Retained Earnings and Assets - 9/30/2013 – 3rd quarter call report Asset growth, ROA, Dividends - 1/1/2014 – Estimated results for 4th quarter 2013. Asset growth - 1/1/2015 & 1/1/2016 – Business plan growth estimates for 2014 and 2015. Asset growth - 1/1/2017 - 1/1/2020 – Strategic plan growth estimates. ROA - 1/1/2015 & 1/1/2016 – Business plan ROA estimates for 2014 and 2015. ROA - 1/1/2017 - 1/1/2020 – Strategic plan ROA estimates. Dividends - 1/1/2015 & 1/1/2016 – Business plan dividend estimates for 2014 and 2015. Dividends - 1/1/2017 - 1/1/2020 – Strategic plan dividend estimates. Assumes SBLF capital is

paid off in 2015.

In addition to these general assumptions in developing the business plan we made the following capital assumptions.

The reduction in 22(c) Instruments meeting additional Tier 1 Criteria in 1/1/2016 was due to the assumption that Sample will pay off its $10 in SBLF capital, half during 2015 and the other half during 2016.

The final set of assumption changes had to do with balance sheet mix, specifically allocation of assets by risk weight.

In the business plan, Sample anticipates growing loans roughly 1% per year faster than assets over the first three years of the plan. As the bulk of loans are at a 100% risk weight and the bulk of investments are at a 20% risk weight, we modeled the effect of on risk assets by reducing 20% risk weight assets from

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13.36% of total assets to 10.36% of total assets between 1/1/2014 and 1/1/2016. 100% risk weight assets were increased from 67.35% to 70.35% over the same three years.

Unstressed and Stressed Business Plan ResultsThe following tables and graphs show the effect of the assumptions in this business plan on regulatory capital compliance under Basel III before and after applying stress test assumptions. Stress assumptions used are laid out in the section on static analysis. Unstressed results are the blue bars and stressed results, the red bars. Green and yellow lines are capital goals that will be discussed later in this document.

Sample’s unstressed business plan results show a cushion of 4.62% over Tier 1 Leverage well capitalized minimums on 1/1/2017. The drop during 2015 and 2016 was due to the payoff of $10 million in SBLF capital (Additional Tier 1). Because capital grows faster than assets through the rest of the plan, the cushion grows to a high of 4.59% by 1/1/2019.

The stress test drops the Tier 1 Leverage ratio to 0.80% above the well capitalized minimum on 1/1/2017. The cushion peaks at 1.95% over well capitalized minimums by 1/1/2019.

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The Common Equity Risk Based Capital ratio unstressed builds throughout the forecast as capital growth through retained earnings exceeds capital growth, peaking at 3.26% above well capitalized minimums and 2.76% above adequately capitalized plus the CCB by 1/1/2019.

As might be anticipated from the static analysis, the CET1 ratio stressed drops to 0.05% above adequately capitalized minimums on 1/1/2016. However, the fact growth in CET1 capital exceeds asset growth throughout the rest of the forecast takes the CET1 stressed ratio to 0.22% above well capitalized minimums and 0.28% below adequately capitalized minimums plus the CCB by 1/1/2019. The fact the unstressed capital ratio builds throughout the plan suggests that the business plan is fundamentally sound. The stressed results indicate that a contingency capital plan implemented in the years in which the stress occurs may be enough to keep the stressed CET1 ratio above Sample’s definition of failure.

The unstressed Tier 1 Risk Based Capital ratio drops to a buffer over well capitalized minimums of 2.08% on 1/1/2017 as a result of the $10 million in SBLF capital being retired in 2015 and 2016. That ratio builds to a buffer of 3.01% by 1/1/2019 due to capital growth exceeding asset growth.

In a manner very similar to the CET1 ratio, the stress test drops the Tier 1 Risk Based ratio to 0.66% above adequately capitalized minimums on 1/1/2017. The Tier 1 Risk Based Ratio builds to a ratio 0.02% above the well capitalized minimum and 0.52% below the adequately capitalized minimum plus CCB by 1/1/2019. Once again, these results indicate that a contingency capital plan implemented in the years in which the stress occurs may be enough to keep the stressed Tier 1 Risk Based ratio above Sample’s definition of failure.

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The above graph reveals the Total Risk Based Capital ratio to be the most problematic from a compliance standpoint under this dynamic business plan analysis for two reasons:

Other than qualifying ALLL, SAMPEL has no Tier 2 capital. The repayment of the $10 million in SBLF capital affects ratios with Tier 1 and Total Capital in the

numerator.

The repayment of the SBLF capital during 2015 and 2016 reduces the unstressed Total Risk Based Capital ratio to a buffer of 1.13% above the well capitalized minimum on 1/1/2017. That buffer builds to 2.06% above the well capitalized minimum and 1.56% above the adequately capitalized minimum plus the CCB by 1/1/2019.

The stress test applied in 2014 and 2015 takes the Total Risk Based Capital ratio to 0.29% below the adequately capitalized minimum on 1/1/2017. It builds to a level 0.97% below the well capitalized minimum and 1.47% below the adequately capitalized minimum plus the CCB by 1/1/2019.

The stress tests run in this capital plan were designed to hit SAMPLE at the worse possible time:

About the same time that the SBLF capital is repaid, and Before SAMPLE has the chance to accumulate additional CET1 capital through retained

earnings.

Clearly a contingency capital plan is in order.

Contingency Capital PlanThe purpose of a contingency capital plan is to lay out the actions that management would take should the institution find itself in a position where the major elements of a stress event seem to be occurring or about to occur. The indicators of a need for action are governed by the “triggers” we will use to monitor risk levels and performance. Note that triggers are not to be confused with our risk limits. In many cases triggers may be areas of focus outside the institution that will have an impact of the

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potential performance. Instead, triggers act as leading indicators of events or issues that may cause capital compliance issues to arise. When triggers are reached, the plan outlines key actions and reporting processes that management and Board should expect in order to act in accordance with the capital goals established.

TriggersBelow are a listing of key triggers for the capital stress scenario and trigger limits. These stress points are to be formally reviewed by the board quarterly along with managements comments as to each variance.

SCENARIO NAME: CAPITAL STRESS SCENARIOTrigger Limit/Action PointCuts in defense spending raise issues of layoffs at Oshkosh

Lay-offs announced. Also monitor local news regarding the Company

Interest rates begin to rise causing compression on net interest margin

Two, five and ten year Treasury hits .5%; 2% and 4%, respectively

Rises in interest rates cause borrowers to struggle with meeting cash flow requirements of loans

Rise in 10 year Treasury to 4% and/or fed funds increase of 50 bps

Delinquencies rise significantly above historical levels

Non-accruals > 1.5% of loans, past dues > 2% of loans for two consecutive quarters

Asset growth rates exceed those in business plan Exceeds 10% annual rateROAs fail to reach the levels spelled out in the plan Below .85% ROARegulatory capital ratios fall below those forecast in the capital plan

Compare actual to those in the plan.

Key ActionsThis section outlines the basic management actions that will be taken to preserve capital should Sample find itself in a capital stress scenario. Our testing was designed to identify the minimum actions that would be necessary in order to keep regulatory capital ratios above our definition of failure. Therefore these actions represent a Contingency Capital Plan for FNB-FoxValley.

In developing the Contingency Capital Plan we looked at two alternatives.

In the first alternative we took capital preservation actions that did not affect the capital actions built into the business plan. – specifically, retirement of SBLF capital and dividend payments.

Under the second alternative we looked at the option of not paying off the SBLF capital should we find ourselves in a capital stress scenario.

Both are options under the Contingency Capital Plan. Which of the two is chosen should we find ourselves in a capital stress scenario will be based on the actual regulatory capital positions at the time a capital stress occurs and the magnitude of the stress event. Note that in designing these Contingency Capital Plans we considered the prioritization of our goals laid out in the Management Summary section of this capital plan.

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Contingency Capital Plan Scenario 1 AssumptionsThis scenario focuses on changes in assumptions relating to growth rate and balance sheet mix that would be executed in the event a capital stress is developing.

The major changes to base plan goals are to shrink 7.50% per year for the two years of the stress rather than grow as in the base plan. Once the two year stress has passed, the asset growth rate returns to normal over 2 years. While the ROA forecasts appear to be unchanged, that is before adjustments for credit losses, margin compression because of rising rates combined with liability sensitivity, increases in operating expenses because of legal and collection costs, and reduction in net interest margin due to the shift of assets from relatively high yielding loans and into lower yielding investments and non-accrual loans. The following chart compares unstressed and stressed ROAs after considering these factors.

Dividends are the same as in the business plan and fall beginning 1/1/2016 due the fact the SBLF capital is assumed to be paid off during 2015.

In addition to the changes in growth rate, the Contingency Capital Plan anticipates a number of changes to balance sheet mix.

In the business plan Sample assumes loan growth would exceed asset growth for three years with the excess loan growth being funded out of the investment portfolio, the bulk of which are 20% risk weight assets. You can see the drop of 20% risk weight assets from 13.36% to 12.36% between 9/30/2013 and 1/1/2014. However, that trend reverses itself in the Contingency Capital Plan with 20% risk weight assets rising to 16.36% by the second year of the stress. Once the stress is over, 20% risk weight assets as a percentage of total assets return in the direction of normal levels.

This change will happen naturally as the capital stress scenario we defined is characterized by economic damage occurring in our market which will lead to lower loan demand levels combined with the fact more of our loan officer time would be spent addressing asset quality issues.

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Non-performing loans will spike in a material manner. This was modeled by increasing 150% risk weight levels by 6% of assets during the two years of the stress then returning to normal levels over the two years following the end of the stress.

The combined effect of the previous two changes is a significant reduction in 100% risk weight assets as a percentage of total assets to a low of 58.35% by 1/1/2016, returning to normal levels over the next few years following the stress. These three sets of changes affect the level of risk assets serving as the denominator for three of the four Basel III capital ratios.

Contingency Capital Plan Scenario 1 ResultsThe changes in the business plan assumptions in this Contingency Capital Plan had a significant effect on Sample’s ability to keep all four Basel III capital ratios above failure definitions.

This graph compares unstressed and stressed results for the Tier 1 Leverage ratio under the modifications to assumptions in the Contingency Capital Plan. The unstressed results are not relevant in that the strategy changes leading to the unstressed ratios would only be made if Sample finds itself in a Capital Stress Scenario. Only the red bars showing the stressed results are relevant. The same can be said for the other ratios that are presented in the tables and graphs that follow.

With the modifications contained in the Contingency Capital Plan, stressed results have a minimum buffer over well capitalized minimums of 3.16% in 1/1/2017, increasing to 4.99% by 1/1/2019.

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Stressed results for the Common Equity risk Based ratio show a buffer of 0.38% over well capitalized minimums on 1/1/2017 growing to 2.37% over well capitalized minimums and 1.87% over adequately capitalized minimums plus the CCB on 1/1/2019.

Stressed results for the Tier 1 Risk Based ratio show a buffer of 1.64% over well capitalized minimums on 1/1/2017 growing to 2.61% over well capitalized minimums and 2.11% over adequately capitalized plus the CCB by 1/1/2019.

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Stressed results for the Total Risk Based Capital ratio show the smallest buffers over Sample’s definition of failure. The stressed ratio exceeds the well capitalized minimum by 0.72% on 1/1/2017, growing to 1.69% over the well capitalized minimum and 1.19% over the adequately capitalized minimum plus the CCB by 1/1/2019.

Contingency Capital Plan Scenario 2 AssumptionsGiven the fact the Total Risk Based Capital Ratio buffer is tightest in Scenario 1, in developing Scenario 2, we looked at deferring the redemption of the $10 million in SBLF preferred stock. In all other ways the scenario 2 assumptions are the same as the Scenario 1 assumptions with the exception of the additional dividends that must be paid if we retain SBLF capital. The changes to assumptions between the two scenarios were made as follows.

The $10 million in SBLF capital was not paid off in 2015 as it was in Scenario 1.

Dividends were increased by $800,000 per year beginning in 2016 to reflect the higher dividend requirements on that capital. The effect of these two changes will be to increase Tier 1 and Total Risk Based capital by $10 million. But the higher dividend payouts reduce accumulation of CET1 capital through retained earnings.

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Contingency Capital Plan Scenario 2 Results

The stressed Tier 1 leverage ratio improves dramatically, maintaining a buffer ranging from 5.45% over well capitalized minimums on 1/1/2016 to 5.86% over well capitalized minimums on 1/1/2019.

A similar improvement happens with the stressed Tier 1 Risk Based Capital Ratio with a buffer over well capitalized minimums of 2.02% on 1/1/2015 increasing to 4.82% over well capitalized minimums and 4.32% over adequately capitalized minimums plus the CCB in 1/1/2019.

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The stressed Total Risk Based Capital also sees significant improvement with the buffer over well capitalized minimums jumping to 3.44% on 1/1/2016 growing to 3.90% over well capitalized minimums and 3.40% over adequately capitalized minimums plus the CCB by 1/1/2019.

The improvement in the above three ratios comes at a cost to the Common Equity Risk based ratios because of reduced retain earnings accumulation due to the higher dividend payouts. The buffer over the well capitalized minimum on 1/1/2016 drops to 0.07% as compared to scenario 1 buffer of 0.38%. It grows to 1.19% over the well capitalized minimum and 0.69% over the adequately capitalized minimum plus CCB by 1/1/2019.

Capital GoalsOur final step was to set capital goals for each of the Basel III regulatory capital ratios. We felt that we need to maintain a sufficient buffer between our goals and our definition of failure so that a capital stress event countered with an effective contingency capital plan kept us above our definition of failure.

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Buffers were determined by comparing unstressed business plan ratios to stressed ratios under our contingency capital plan. For example, our business plan forecast capital ratios for the Common Equity risk-based capital ratio appear in the following graph.

As the blue bars show, trends in this ratio show significant buffer above well capitalized minimums (red line throughout the forecast. But is the buffer sufficient to handle a significant stress test as laid out earlier in this capital plan. Results of our stress test show that with an unmodified business plan, the answer is no. We fall below our definition of failure (red bars). But if we invoke the strategies discussed in Contingency Capital plan Scenario 1, the damage to the Common Equity Risk-based ratio is reduced as shown in the following graph.

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As you can see, the stressed Common Equity tier 1 Risk Based Ratio (red bars) stays above both well capitalized minimums and adequately capitalized plus capital conservation buffer minimums throughout the plan.

Our capital buffer over our definition of failure needs to be at least as large as the drop in the ratio between our business plan unstressed and our contingency capital plan stressed. Our worse year ends in 1/1/2016. The drop in CET1 from the business plan unstressed (8.17%) to the contingency capital plan stressed (6.88%) is 1.29%. We rounded that drop up to 1.5% and set our capital goal under the business plan to 8.0% (green line). We set the ratio at which we would need to take corrective action under our business plan 50 bp lower at 7.5% (yellow line.) Note that both goals were increased 50 bp on 1/1/2019 as the adequately capitalized minimum plus the capital conservation buffer breaks through the well capitalized minimum effective that date.

Once the goals were in place we looked at our performance under the business plan relative to our capital goals (Blue bars - two graphs up) While our business plan starts out below the goal through 1/1/2016, it breaks remains above the corrective action level (yellow line). As our business plan builds capital from that point it breaks through and remains above the minimum for the remainder of the plan. The second test shows that maintaining capital (red bars) at or above the our goals as part of our business plan allows us to stay above our definition of failure if a stress occurs by implementing our contingency capital plan as shown in the last graph above.

We took a similar approach for setting capital goals for the other three Basel III ratios and ended with the following capital goals.

The results of for our business plan before and after stress tests as well as the results of our contingency capital plan incorporate these goals as an output on the graphs. A review of these graphs illustrates that our business plan reaches and maintains capital levels above goals in all cases. The results of both contingency capital plans under stress tests indicate an ability to remain above our definition of capital failure for all four ratios.

Summary In summary, testing of the business plan goals and assumptions show that the relationship between growth, earnings, dividend, and capital retirement assumptions in the base plan build capital over time

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due to the fact the capital growth rate exceeds the asset growth rate. Without applying stress assumptions, the business plan has SAMPLE operating with capital buffers over well capitalized minimums and above adequately capitalized minimums plus the CCB in all forecast years through full phase-in of the Basel III requirements. In addition the same graphs have us reaching and exceeding capital goals laid developed in the previous section for all forecast years.

Stress testing of this business plan with its assumptions drops the three risk-based capital ratios below Sample’s definition of failure. Of course it would be unreasonable to assume that we would execute on our business plan without modification should a capital stress occur.

Should we find ourselves in a capital stress scenario, we have a solid sense for the types of actions that would need to be taken to offset the effects of the capital stress while keeping the four Basel III regulatory capital ratios above our definition of failure. We feel the stress assumptions are aggressive in that they do far more damage than we have experienced from any stress event in our recent history. In spite of the fact the stress assumptions are aggressive, we feel that the actions in our two Contingency Capital Plan scenarios are well within our ability to execute.

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management summary - farin€¦ · web viewabove well capitalized as well as ... anticipate...

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