Frisco Financial (FF)

Bank Strategies Group (BSG)

The Bank Strategies Group (BSG) offers fixed income securities and value-added services to Banks and
Credit Unions. The Bank Strategies Group is customer balance sheet focused rather than product
focused. Our product recommendations are driven by the institutions balance sheet structure and income
objectives, not by a proprietary inventory. Financial performance comes from having the right balance
sheet structure given the institutions business expectations for loan and deposit growth and the current
and expected interest rate and economic outlook. Investing in the wrong asset at a cheap price doesnt
help the institutions performance. The same applies to the funding strategy. Taking on what appears to
be cheap funding but of the wrong tenor for the institutions Asset-Liability profile can hurt performance.
Our goal is to look at the whole balance sheet and create better synergies between loans, deposits, and
investments, and capital utilization so that ultimately net income, ROE , and the institutions competitive
position can be improved. The BSG can look at the institutions own internal A/L analysis and provide a
second opinion as to the appropriateness of the assumptions used and we can do our own independent
analysis of the timing and size of asset and liability cash flows under numerous interest rate scenarios and
quantify the institutions interest rate risk profile. We can then design an asset growth and investment plan
that better offsets the interest rate risk created from mismatches between loans, deposits, and borrowings.
Cash flow variability in the institutions balance sheet interferes with the institutions financial flexibility,
liquidity, and profitability objectives. We can help improve the institutions competitive position by
suggesting ways to better manage cash flows, mitigate interest rate risk, and generate more income
through a better understanding of the cash flow timing and re-pricing characteristics of the institutions
balance sheet.

The Frisco Financial Bank Strategies Group services include:

Competitive balance sheet analysis versus the bank or credit unions top 5 competitors
Funding solutions - deposit pricing analysis & strategies
Asset Liability Management (ALM) analysis and Liquidity strategies
Capital adequacy, Utilization, and leverage analysis
 Competitive balance sheet analysis versus the bank or credit unions top 5 competitors:
We recognize that a Credit Union or community bank for example in New Jersey is not
specifically competing with every bank in the U.S. of the same approximate asset size. Therefore,
we believe that it is much more relevant to the client institution to compare them to their local
competitors rather than compare the client institutions balance sheet mix, equity capital, loans,
liabilities, and investment portfolio, to the National peer averages.

Funding solutions and deposit pricing strategies:

Banks and Credit Unions primarily fund their assets with customer deposits. However, customer
deposits are not enough to fund the rate of growth necessary to compete effectively in todays
very competitive banking environment. Depository institutions must use other types of
borrowings beside deposits to fund their growth and they must be mindful of how they are pricing
their deposit offerings relative to their competition and relative to the impact a deposit product
may have on other deposits accounts that the institutions offers. More often than not borrowing
from the Federal Home Loan Bank or against their investment portfolio will be less expensive
than the cost of offering deposit products such as Certificates of Deposit (CDs).

For example, if an institution wanted to raise $10 million in a hurry in a 2 year CD program to
fund a Commercial loan, they will offer out an extra high rate on that 2 year CD product. This is
known as a CD special. That CD special may have a rate that is 100 basis points or 1.0% higher
than on a saving account. What happens more often than not is that rather than the Bank bringing
in $10 million in new money they end up cannibalizing some amount of the lower cost deposits
that they already have. When existing customers see the CD special rate they move some of their
money in savings that is paying maybe 0.25% over into the CD special that is paying 1.50%.
Lets say that at the end of the special when the goal of $10 million has been achieved the bank
finds that 30% of the $10 million or $3 million in the 2 year CD program actually was money
moved over from savings accounts that were paying only 0.25%. What is the actual marginal
cost of the $7 million in new funds? The actual cost would be 1.50% * $10 million = $150,000
per year in interest but since the bank only raised $7 million the cost of the $7 million is $150,000
per year which is a cost of funding 2.14% which is 64 basis points higher than the 1.50% or
42.67% more than what the bank thought the CD would cost them. Of course as the percentage
of migrated deposits goes up so does the marginal cost of the CD program.

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 Another example of the value of a deposit rates pricing analysis is as follows. We once had a
bank client that was paying 0.50% on $500 million in Now checking account balances, and from
our top five competitors competitive analysis we noted that the competition was only paying
0.25% on their Now checking balances. The client was paying $1,250,000 more per year in
interest on the Now checking accounts than was necessary. We ask the client why he was paying
0.25% more than his competitors. The client answered that he was afraid that if he lowered his
rate on Now accounts that some of his depositors might take their money out of his bank. Our
response was to where would they move their money if you would then be paying what all your
competitors are paying? Our second question was if you did have some depositors take their
money out of their accounts because you lowered the rate what percent of these balances do you
estimate would walk? The client said about 10%.

We responded as follows: So what you are saying is that you are willing to pay 0.25% more in
interest on the 90% of balances or $450 million that would not leave in order to keep the 10% or
$50 million that might leave. That means that your marginal cost on the $50 million is 0.25% *
$450 Million = $1,125,000 and $1,125,000 divided by $50 million is 2.25% . If a customer
walked into your bank today and demanded 2.25% interest on his checking account when you
were only paying 0.25% what would you tell him? Youd show him to the door wouldnt you?

Capital adequacy, Utilization, and leverage analysis:

Capital utilization is the identification of how much capital is necessary to meet regulatory
requirements and other contingencies (like loan losses and interest rate risk) and then maximizing the
income potential (return) of any excess capitalization. Equity Capital is the amount of money that the
institution is really worth. Another name for Equity Capital is Net worth. If the institution sold all
of their assets (Loans, investments, buildings etc.) on the balance sheet and then paid off all of their
liabilities (deposits, loans from other credit unions, borrowings from FHLB etc.) what would be left
over would be the credit unions capital. The Regulatory Agencies: Office of the Comptroller of the
Currency (OCC), the Federal Deposit Insurance Corporation (FDIC), and the National Credit
Union Administration (NCUA), have minimum requirements for an institution on how much capital
(Net worth) they must have. This minimum is expressed as a percentage of total assets. If the
institution falls below the required minimum capital ratio, the Regulator will start imposing
restrictions on the institutions business. Limiting the types and amount of loans and investments the
institution can make. Eventually, if the capital ratio continues to deteriorate, the Regulator will
assume control of the institution.
 For many smaller institutions leverage seems to be a dirty word. But the Banking business is all
about leverage and managing a spread between Cost of funds and earning assets. To be competitive
banks and credit unions must continually grow earnings to build capital to support as many earning
assets as possible. The objective is to target a reasonable capital to asset or leverage ratio and grow
earning assets while not growing the capital to assets ratio. This is why we have a banking system
based on fractional reserves and deposit insurance. The U.S. Government intended to maximize the
amount of economic growth that a limited supply of capital could support. Maintaining a capital to
asset ratio in excess of that required for the safe and sound operation of the financial institution will
place the institution at a competitive disadvantage. The FDIC requires a Tier 1 Leverage capital to
asset ratio of 5% to be classified as Well Capitalized and 4.0% to be classified as adequately
capitalized. By contrast the NCUA requires Credit Unions to have a Net worth ratio of 7.00%. The
right capital-to-assets ratio varies from bank to bank, but seldom have I seen the need for a capital
ratio in excess of 7% to 8% in a well-run bank or credit union. Banks run just fine at a 4% to 5%
capital ratio because we are not hearing about bank failures every year.

Many small banks and most credit unions tend to focus on ROA as a benchmark for their
Performance while the rest of the financial services industry focuses on ROE. But small banks and
credit unions are part of the same economic system, governed by the same laws of supply and demand
as larger Banks. In order to be competitive banks and credit unions need to maximize profitability
through the efficient use of capital. Competition wont allow them to grow earnings by increasing
their interest margins. These institutions cant grow their profit margins (ROA) every year but they
can grow earnings through steady asset growth. Then they need to manage their margin however
small on an ever growing asset base.

How can depository institutions increase earnings besides using leverage?

Raise loan rates?

Lower Cost of funds? (deposit rates and borrowings)
Reduce non-interest overhead expenses?
Charge higher fees?
Increase non-interest income?
Can they do any of these things and stay competitive?

ROE is a better performance measure than ROA because it measures how efficiently the bank or credit
union is using the shareholders or in the case of credit unions members equity. ROE equals the
ROA times leverage. Leverage is calculated as Assets divided by Capital. Therefore, a bank with a
7% capital to assets ratio would have a leverage factor of 14.2. With an ROA of only 1.0% at 14.2
times leverage the bank would be producing an ROE of 14.20%.

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To be competitive takes money. The institution needs a steady growing earnings stream that they can
reinvest back into The Business faster than their competitors. A Credit Union with $7 million in
capital could grow to a maximum size of $100 million before the NCUA would start giving them grief.
Why? Because $7 million divided by $100 million equals 7% Capital Ratio. A bank can grow to $7
million divided by .05% equals $140 million because they are considered Well Capitalized at 5%. That
means the bank has an advantage of $40 million more in earning assets.

Most Credit Unions maintain capital ratios in excess of 11%. This leaves plenty of room for strategic
growth. In fact, a credit union with $100 million in assets and $11 million in capital (11% Capital Ratio)
could grow to $157 million in assets if the Credit Union targeted a new capital ratio of 7%. It would still
have $11 million in capital and still be considered Well Capitalized by NCUA standards.

The institution can calculate how big they can grow by dividing the dollar amount of capital they have by
the capital ratio that they want to be. In this case $11 million divided by 0.07% = $157.143 million in
assets.

The additional assets times some spread equals the amount of incremental earnings the Credit union can
pick up from a growth strategy program. $157 million minus $100 million equals $57 million new
growth. $57 million new growth times a 2.50% Net Interest Margin (NIM) equals $1.425 million in gross
income. And at a 1.00% ROA equals $570,000 in incremental Net Income to compete with.

An institution wants to grow capital not for the sake of growing capital so they the regulators think they
are a safer institution, the reason for growing capital is to grow assets and thereby earning, not to grow the
capital ratio. In fact, isnt the stronger business the one with the best earnings and not the best liquidation
value? When investors choose a stock to buy they look for a company with good earnings.

Lets talk safety. The NCUA reports that loan charge-offs for credit unions average about 0.55% of
average loans, the average Credit union has only 63% of assets in loans. So, the average charge-off rate
as a percentage of assets is 63% * 0.55% equals 0.3465% of assets. Now, the average credit union has a
capital surplus of about 4.0% of assets (11% minus 7%) over and above what is needed to be classified as
Well Capitalized. 0.3465% goes into that 4.0% surplus 11.54 times. So, in other words, a credit
unions could experience charge-offs at 11.54 times the norm and they would still be Well Capitalized.
What kind of dooms day economic scenario do they know about that the rest of the financial industry
doesnt know about? Managing an institution to a capital ratio is managing to a liquidation value. This is
not a winning strategy. Is the institution expecting to be liquidated soon?

In our Capital adequacy and leverage analysis we look at the institutions capital and stress test the balance
sheet with loan losses and mark-to-market value losses on the investment portfolio due to a sudden and
sustained rise in interest rates. This stress test will determine the adequacy of the institutions current
capital ratio and also tell us if the capital is being utilized efficiently.
The graphic on the following page illustrates the value of prudent leverage. We start with an actual
Credit Union with about $725 million in assets and $79.2 million in capital for a leverage ratio of 10.94%.
The $79.2 million is really net of reserves for losses so the 10.94% ratio already includes a reserve or
allowance for loan losses and potential market value losses on the securities portfolio.

In the graphic example on the next page we reserve $500,000 for loan losses and $500,000 for investment
portfolio losses. So in the example we are actually double reserved for loss contingencies.

What the graphic is telling us is that if the Credit Union put on an additional $384.2 million in assets the
Credit Unions new capital to asset or leverage ratio would be 7.15%.

And if the Credit Union only earned a 1.00% ROA on those additional assets that would add $3.842
million in additional income to their bottom line and drive their ROE up from 11.68% to 16.53%.

Even in the event of unexpected loan losses of $500,000 plus another $500,000 in losses on their
investment portfolio from a spike up in interest rates, a $1 million hit to their net-worth, their capital ratio
would still be 7.06% . The NCUAs well capitalized threshold is 7.00%

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 Using Dec-14 Data Earnings / Capital Adequacy Chart

Foregone
Incremental Additional
Resultant Foregone Earnings Growth Capital
ROA ROE (thousands) (millions) Ratio
1.28% 11.68% NA Current Leverage $0 10.94%

1.26% 12.30% $489,011 $48,901,096 10.25%

10.12%
1.25% 12.54% $682,385 $68,238,487 10.00%
9.87%
1.25% 12.80% $885,675 $88,567,539 9.75%
9.63%
1.24% 13.07% $1,099,665 $109,966,542 9.50%
Under Utilized Capital 9.38%
1.23% 13.65% $1,563,310 $156,331,047 9.00%
8.89%
1.22% 14.31% $2,081,502 $208,150,200 8.50%
8.39%
1.20% 15.04% $2,664,467 $266,446,747 8.00%
7.90%
1.19% 16.08% $3,325,162 $332,516,167 7.50%
7.41%
1.18% 16.53% $3,842,628 $384,262,846 7.15%
Reserve for Loan Losses
Reserve for AFS portfolio losses
Reserve for Acquisitions
Assumptions: Regulatory Requirement 7.06%

Current Assets: $724,594,553

Current Equity $79,283,304
Earnings: $9,260,589
Incremental Spread: 1.00%

Assumptions for Contingencies:

Additional Reserve for Loan losses $500,000
For AFS Losses: $500,000
For Acquisitions: $0
Shaded ratio shows new capital ratio after taking additional Loans losses and AFS adjustment
and any other contingencies indicated under "Assumptions for Contingencies".
 Asset Liability Management (ALM) analysis and Liquidity strategies:

A Depository financial institution is essentially one big arbitrage. They borrow money (in the
form of a deposits) from one person at one interest rate and lend it to another person (or invest it)
at a higher rate. The institution makes money on the difference (the spread or margin)
between these two parties.

The Asset Liability Management (ALM) process involves a complete balance sheet study which is
designed to give management a concise tool to help measure and monitor interest rate risk and help
provide for optimal and stable earnings, liquidity, and capital utilization.

There are 4 main areas of focus in Balance Sheet Management (ALM):

1) Liquidity management
2) Capital Utilization
3) Interest Rate Risk Management, and
4) Profitability

Liquidity Management:
Definition:
Liquidity is cash or the ability to convert an asset into cash quickly.

Liquidity Management is the evaluation of the projected need (and contingent need) for future
liquidity, and making sure that the institution has the ability to meet those needs at the cheapest
cost at any given time. Liquidity is not just about how much cash the institution has on hand, but
about how much cash can the institution get their hands on when they need it. If an institution
had a short term 30, 60, 90, or even 120 day cash need until they had some investments maturing
it would be better from a profitability standpoint to borrow rather than sell a good yielding
investment or loan just to meet a short term liquidity need.

In theory a financial institution must maintain a certain level of liquidity in order to meet:
1) Loan demand (customers wanting a loan)
2) Deposit withdrawals
3) In extreme situation A run on the credit union

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 A credit union or bank can generate liquidity to meet these needs from many different sources:
1) Cash on hand
2) Borrow Fed Funds
3) Investment and loan principal & interest cash flow
4) Selling securities
5) Selling loans
6) Sell other assets (like a branch office)
7) Take on more deposits
8) Borrow against loans and/or securities from FHLB
9) Borrow against securities in a Repurchase (REPO) agreement
10) Borrow from their Corporate Credit Union

A Corporate Credit Union is the Credit Union for the Credit Unions. Every State has one. They
are Whole Sale Credit Unions, they do not take deposits or make loans to people. They only
make loans or take deposits for investment from other Credit Unions.

Another tool for measuring liquidity is the loan turnover analysis. Very few smaller institutions think
about this source of liquidity or take the time to do a loan turnover analysis. A loan turnover analysis
compares the monthly and annual loan principal pay-downs with the monthly and annual new origination.
If an institution has loan principal payments of $100 million per year but they only write or origination
$80 million in new loan per year than they have a cash flow surplus of $20 million per year that is a
source of liquidity and that can be used for making investments.

If an institution starts the year off with $100 million in loans on the balance sheet and by year end they
have $150 million in loans they see their loan portfolio has grown by $50 million. But when they check
their loan origination records they find that they originated $80 million in loans for the year. But if they
wrote $80 million in new loans why isnt their loan portfolio at $180 million? The reason is that they
must have had $30 million in loan paid downs so after writing $80 million in new loans they only had net
loan growth of $50 million. This means that $30 million of the $80 million in new loans were funded by
loan pay downs, or the recycling of principal. That means the institution could have maintained $30
million less in cash and cash equivalents, or used $30 million less in borrowings to fund that $30 million
worth of loans. That extra $30 million in the liquidity portfolio could have been invested for a better
yield.
Actual Credit Union. Showing 6 years worth of loan turnover and share (deposit) growth
LOAN GROWTH AND REPRICING ANALYSIS

Growth Interest Rate Risk Liquidity

Loans Annualized %
Loans sold in Refinancing of Loans written
Total Loans Secondary Total $ Loan Loans and/or Funded by Loan Total Share
Reported at Market during Growth for Written Paying down Sales, Refi's Deposits Total Share
Period end Period Period During Period During Period Pay downs Period end Growth
Dec-08 $177,537,480 $0 $228,600,512
Dec-09 $168,496,243 $0 -$9,041,237 $28,795,037 $37,836,274 100.00% $257,608,169 $29,007,657
Dec-10 $147,339,426 $0 -$21,156,817 $37,900,320 $59,057,137 100.00% $301,841,648 $44,233,479
Dec-11 $142,174,202 $0 -$5,165,224 $49,208,704 $54,373,928 100.00% $345,031,008 $43,189,360
Dec-12 $134,936,247 $0 -$7,237,955 $57,256,452 $64,494,407 100.00% $421,330,857 $76,299,849
Dec-13 $153,611,435 $0 $18,675,188 $85,938,331 $67,263,143 78.27% $527,840,083 $106,509,226
Dec-14 $172,074,842 $0 $18,463,407 $86,835,021 $68,371,614 78.74% $640,345,014 $112,504,931

AVG: $156,595,696 -$910,440 Averages: $58,566,084 92.83% $388,942,470 $68,624,084

-0.58% 17.64%

Historically entire loan portfolio turns over every: 2.61 Years

Historical loan portfolio average life is: 1.31 Years

Loan Growth versus Share Growth Analysis for Period Dec 2008 - Dec 2014

Loan's Written $345,933,865

Self-funded loans $321,145,660
Unfunded loan growth $24,788,205

Average monthly unfunded loan demand $295,098

Total Share growth $411,744,502

Average monthly Share growth $4,901,720

Average monthly investment cash flow needed to fund loans -$4,606,623

Actual average monthly investment cash flow ?

Credit Unions call deposits shares because a credit union deposit is a membership share in the credit
union that pays a quarterly stated dividend rate.

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This analysis also speaks to liquidity and interest rate risk. Notice that for every year since 2009 the
balances on interest bearing checking accounts increased even though interest rates were falling as
measured by the 1 year Treasury index and that the Credit Unions rates were consistently well below the
yield on the 1 year Treasury. There was no need for excess liquidity to fund deposit withdrawals.

% of Shares 26.05% Drafts Members FOM

Total # of current members is 18,619 Market Share 62.74% 7.59%
Total # of Draft accounts is 19,723
The average account size is $8,457

Share Drafts Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14

Drafts Yld 0.25% 0.10% 0.09% 0.02% 0.02% 0.01%
1YR T Index 0.48% 0.33% 0.19% 0.17% 0.14% 0.14%
Total Drafts $58,571,609 $75,078,402 $84,537,536 $110,365,201 $139,789,679 $166,804,012

Share Desposit Migration & Repricing Analysis

$180 0.55%
Millions

$167
$160 0.50%

$140 0.45%
$140
0.40%
$120 $110 0.35%
$100 0.30%
$85
$80 $75 0.25%

$59 0.20%
$60
0.15%
$40
0.10%
$20 0.05%

$0 0.00%
Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14
Total Drafts Drafts Yld 1YR T Index
The benefit to the institution of working with the Frisco Financial Bank Strategies group should be
maximized earnings through a better understanding of the institutions asset/liability profile which should
lead to an investment portfolio that better complements the balance sheet and income objectives of the
institution. If the institution has their asset/liability profile wrong then they will have the wrong
investment portfolio for their balance sheet, for their loan and deposit mix. Additionally, a proper
understanding of the institutions A/L profile will lead to better measure of capital adequacy and capital
utilization leading to improved Return on Equity (ROE).

For more information contact:

Steven DeVito
Frisco Financial
Bank Strategies Group
Institutional ALM & Fixed Income Trading
Frisco, TX
Main: 281-815-0427
Cell: 631-335-3115

BondRecon@Outlook.com

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