"Happy days are here again
The skies above are clear again
So let’s sing a song of cheer again
Happy days are here again"
(From FDR’s theme song for the 1932 presidential campaign)
The Federal Reserve increased interest rates … finally! Market rates are rising too. And more are to come, so they say. Let the good times roll!
Before the partying commences, let’s remember that interest rate risk (IRR) analyses from many, if not most, financial institutions indicate that net interest income (NII) will decline in rising rate environments. Why? Because most financial institutions have balance sheets where a majority of earning assets are fixed rate, while funding sources are largely variable rate.
Thus, an increase in non-maturing deposit rates increases the cost of an entire portfolio immediately. But, it takes time for fixed rate assets to turn over before those funds can be reinvested in higher yielding products. In many cases it takes one to two years before estimated NII starts to rise again.
Now that we are transitioning from a low rate environment to a rising rate environment, it’s a good time reevaluate interest rate risk assumptions. If your IRR analysis indicates declining NII in a rising rate environment it is even more important to reevaluate your assumptions to ensure the highest quality measurement of risk. Here are several high impact assumptions to evaluate:
- Cash flows. Accurately projecting how much principal repayment you will receive (or repay) in future time periods from loans, investments, deposits, and borrowings is a critical first step in the IRR measurement process. Does your model calculate future cash flows at the record level (i.e. loan by loan)? Estimating future cash flows using a top-level calculation based on an average life assumption will probably be less precise.
- Prepayments and calls. Estimating prepayment activity on loans and amortizing investments and projected call activity on callable investments is an important component of the cash flow measurement process. Regulators generally prefer prepayment assumptions based on the actual prepayment activity of an institution. Does your model capture the actual monthly principal amounts received on all loans? Industry-level prepayment data is acceptable on homogeneous loans (i.e. auto loans), but the process becomes more complicated on commercial loans where each loan may have differing payment characteristics.
Prepayment activity on amortizing investments is highly sensitive to movements in interest rates. Is your investment advisor providing such information? How often are updates provided? What source is used?
- Pricing betas. Estimating the amount deposit rates (or loan rates) will rise in rate shock scenarios has the highest impact on IRR estimates. For example, if rates rise 100 basis points, how much will you raise the rate on your savings deposits? Will you raise that rate the full 100 bp or something less? If you assume a pricing beta of 0.15, you are assuming that for every 100 bp increase in rates, you will raise your rate 15 bp.
This is an especially difficult assumption to evaluate because rates have been very low for many years. The habits of ten years ago may not be relevant in today’s environment. A good approach is to develop the best assumption possible, but periodically test other scenarios where higher betas are incorporated. For example, if betas are doubled from their typical levels, and it results in an out-of-policy result, that is an important piece of information to consider in the overall risk management process, especially as it relates to capital management.
Over- or under-estimating interest rate risk is not uncommon where these fundamental assumptions are not updated to current conditions. Cyber threats are getting all the headlines right now, but IRR management remains a critical component of every institution’s risk management process. This is an excellent time to re-evaluate core assumptions and test how any changes will affect IRR estimates. Remember to fully document your reevaluation process and report your conclusions to ALCO. Stakeholders (management, board of directors, examiners) will hopefully derive a higher level of confidence in the IRR management process and the resulting risk estimates. Higher rates may indeed mean happy days.
Bill Kirsten joined Profitstars in 2012 and serves as a Senior Advisor. Bill has previously served as a chief financial officer for three community banks, and as president of a community bank. His specialties include asset/liability management, interest rate risk, liquidity management, financial and regulatory reporting, capital management, and budgeting. As a CFO and consultant, Bill has participated in several de novo bank formations. Additionally, he has coordinated several capital transactions including common stock, trust-preferred subordinated debt, and merger and acquisitions. Bill is a graduate of Lawrence Technological University in Southfield, Michigan, with a Bachelor’s degree in Business Administration with an emphasis in finance.