KPN Consulting Webinar Series

Part 4 of 6

Interest Rate Risk Management

Interest Rate Risk

Let’s Start With What The Regulators and Your Institution Are Trying To Discover:

In The 1970’s and Into the 1980’s, Most of Us Were Not Concerned With This Issue.

The Reason Had To Do With the Basic Nature of our Model – Floating Rate (Prime Based) Assets Supported By DDA’s, MMA’s, and Less Than One Year CD’s.

Interest Rate Risk

With That Model, We Had Little Concern Over What Interest Rates Were Doing As Most of Our Assets and Liabilities Were Adjusting Whenever Rates Did Move.

With That Model, Our Asset Yields and Liabilities Costs Tended To Move Together – This Mitigated Interest Rate Risk Concerns.

Interest Rate Risk

For Many Thrifts, However, This Issue Was A Concern as That Model Tended To House Residential Mortgages That Often Had Longer Term Maturities, and …

The Liability Structure Was Short – With The Possible Exception of Federal Home Loan Bank Advances.

Interest Rate RiskIn Fact, The FHLB System Was Created With This

Issue In Mind …

Unfortunately, Most Thrifts Did Not Use Longer Term Funding From The FHLB System As They Had Concern About Prepayment of the Mortgage and The Harm That Could Do To Their Profitability.

Many in Our Audience Remember The Crisis That Brought To That Industry in the 1980’s.

Interest Rate Risk

Today, The Secondary Market Which Was Created With Fannie Mae’s Appearance in the1930’s Handles Much of the IRR in the Residential Mortgage Business.

However, Other Kinds of Longer Term Assets Have Come On To Our Balance Sheets and This Is Where We Find Our IRR Today.

Interest Rate RiskThere Are Three Main Assets That We Now

Have On Our Balance Sheet That Cause IRR Issues …

Residential Mortgages – Typically With 3 or 5 Year Resets. Some Institutions Will Do 15 or 30 Year Fixed Rate Mortgages But Tend To Use Prepayment Fees If Held On Their Books

Commercial Mortgages (“Mini Perms”) With 3, 5, or 15 Year Reset Dates

Agency Bonds or Mortgage-Backed Securities.

Interest Rate Risk

Unfortunately, Unless You Use Longer Term FHLB Advances or Brokered Deposits, The Funding For These Kinds of Assets Tends To Be DDA’s, MMA’s, and CD’s Under One Year.

This Is What Brings IRR To Our Business Today.

Interest Rate Risk

There Have Been Two New Guidance Statements Pertaining To the ALCO Process This Year – IRR and Funds Management/Liquidity Risk Policy.

At Our Last Session, We Did Discuss Funds Management/Liquidity Risk Guidance …

Let’s Focus On IRR For Today.

Interest Rate RiskFFIEC Financial Institution Letter FIL-2-2010

Was Issued on January 6, 2010 …

This Is Viewed As Reinforcing Their 1996 Policy Statement on IRR.

Though Many of Us Do Not See A Rapidly Rising Interest Rate Environment in The Next 6-12 Months, This Guidance Will Be Emphasized More and More This Year and Next As We Get Ready For An Expected Rise in Rates.

Interest Rate Risk

Effective Corporate GovernancePolicies & Procedures

Risk Measuring & Monitoring ProceduresStress Testing

Internal Controls

This Advisory Re-emphasizes the Importance of:

Interest Rate RiskRegulators Also Wanted To Use This Guidance To

Discuss How Certain IRR Management Techniques Are Being Used By Effective Risk Managers.

This Was Also A Reminder That A Steep Yield Curve Can Create Unusual Profit Opportunities (Funding Long Terms Assets With Short Term Liabilities) …

But, Can Also Bring Significant Risk If The Yield Curve Flattens.

Interest Rate RiskCorporate Governance

Identifies The Board As Having The Ultimate Responsibility for Bank Risks, Including IRR.

Senior Management is Responsible for Ensuring That Board-Approved Strategies, Policies, and Procedures For Managing IRR Are Appropriately Executed.

Director Education!

Interest Rate RiskPolicies and Procedures

Institutions Are Expected To Have Comprehensive Policies and Procedures Governing All Risks Of Their IRR Management Process.

IRR Tolerances Articulated in Policies Should Be Explicit and Address the Potential Impact of Changing Interest Rates on Earnings and Capital From a Short and Long-Term Perspective.

Interest Rate RiskMeasuring and Monitoring of IRR

Supervisors Expectations Are That Institutions Have Robust IRR Measurement Processes and These Processes Should be Commensurate With the Complexity of the Institution.

Third Party Models Are Acceptable But Must Be Understood By the Institution and Must be Incorporated into Short and Long-Term Strategy.

Interest Rate RiskStress Testing

Scenario Analysis – Using the Model To Predict A Possible Future Outcome Given an Event or Series of Events.

Sensitivity Analysis – Tests The Model’s Parameters Without Relating Those Changes To an Underlying Event or Real World Outcome.

Interest Rate Risk

Internal Controls

Must Ensure The Integrity of All Elements of The IRR Management Process – Adequacy of Corporate Governance, Compliance With Policies and Procedures, and Comprehensiveness of IRR Measurement and Management Information Systems.

Model Validation – Internal or External Review May Be Used.

Interest Rate Risk

Interestingly, GAP Analysis Is Only Mentioned Briefly In This Guidance Which Makes Me Think That Use of That Technique Is No Longer Considered As Relevant As NII or EVE Analysis.

GAP Analysis – A Review of The Differences Between Rate-Sensitive Assets and Rate-Sensitive Liabilities That Mature, Re-Price, Amortize Over A Discrete Period. We Typically Look At A One-year Horizon.

Interest Rate RiskGAP Analysis – Our Goal Is To Ensure That We

Do Not Have Too Many Assets or Liabilities That are Mismatched.

For Instance … If We Are a Fixed Rate Lender with A Majority of Our Assets Having Fixed Rates of Five Years and We Fund With One Year CD’s …

A Rising Rate Environment Would Be Difficult, However, A Falling Rate Environment Would Be Advantageous.

Interest Rate RiskExample: $100 million in Five-Year Fixed Rate

Loans At 6.00% Funded With $100 million in One-Year CD’s Priced At 2.00%.

No Movement in Interest Rates Implies a 4.00% Spread.

A Rising Rate Environment of 1.00% Per Year Implies a Decreasing Spread of 4% to 3%, etc.

A Falling Rate Environment of 1.00% Per Year Implies An Increasing Spread of 4% to 5%, etc.

Interest Rate Risk

GAP Analysis – If you Use This Measurement Technique, The Board’s Role Is To Set Limits on How Much “Gap” Over a Discrete Period You Will Allow The Institution To Have. The “GAP” Is Simply The Difference Between The Dollar Amount of Assets and Liabilities in The Time Periods Measured.

But, As We Indicated, We Believe GAP Analysis Is Less Relevant Today and Simulation Appears To Be What Regulators Are Looking For.

Interest Rate Risk

Simulation Analysis – Measuring The Impact On Earnings and Capital Of A Changing Rate Environment.

Typically, Our Earnings Measure is Net Interest Income (NII) and our Capital Measure is Economic Value of Equity (EVE).

Objective Is To Simulate Rate Increases and Decreases On Those Assets and Liabilities Whose Yield/Price Will Be Impacted by These Changes.

Interest Rate RiskIt Should Be Noted That Very Few Institutions

Would Have a Goal of a Perfect Match Between Their Assets and Liabilities …

This Strategy Would Likely Provide Unsatisfactory Profitability As This IR Mismatch Is A Key Method For Creating Profits in our Industry.

The Goal is to Take IRR On The Basis Of Your Shareholders Desires which Are Set By Your Board Of Directors.

Interest Rate Risk

Simulation Analysis – the Basic Idea Then Is To Simulate Interest Rate Increases or Decreases (Called Shocks) On Your Balance Sheet. Assets and Liabilities That Can Re-Price Are Then Moved Up Or Down.

Typically, These Movements or Shocks Are In 100 bps or 1.0% Increments and Should Be Simulated In Both an Up and Down Scenario.

Interest Rate RiskTypically, These Shocks Are Handled As

Instantaneous Even Though We Would Rarely Experience Immediate Shocks of 100 bps.

However, More Sophisticated Institutions Will Handle These Shocks in Various Ways …

For Instance, Some Might “Ramp” (Up or Down) These Shocks Over Time So That The Impact Is Viewed In The Light Of More Normal IR Movements.

Interest Rate Risk

Simulation Analysis – May Also Be Static or Dynamic.

Static Simulation – Based On Current Exposures and Assumes a Constant Balance Sheet With No New Growth.

Dynamic Simulation – Rely on Detailed Assumptions Regarding Changes in Existing Business Lines, New Business, etc.

Interest Rate RiskSimulations Can Also Be Conducted Over Different

Time Horizons With Regulators Appearing To Prefer Two-Year Simulations for Earnings Measures.

Longer Horizons Appear To Be Best Suited For Economic Value Methodologies – Guidance Suggests 5-7 Year Horizon.

In All Cases, The Objective Is to Simulate The Impact on Earnings or Equity of Changing Rates.

Interest Rate Risk

Institutional Challenges – Choosing The Right Simulation For Your Institution Can Be Difficult. Issues Like Instantaneous Vs. Ramped Shocks, Parallel Vs. Non-Parallel Shifts in The Yield Curve, 300 bps or 400 bps Shocks, Giving Deposits Various Shock Experience, etc Can Make IRR Management The Biggest ALCO Challenge.

And, No Matter What You Do, It Is Only A Simulation Based on Known Facts.

Interest Rate Risk

That Said, It is In Your Best Interest To Use and Understand Simulation Techniques For IRR Management.

And, You Will Likely Use an Outsource Concept for This Issue – Darling, Farin, ProfitStar, FinPro, etc.

And, Based On The New Guidance, You Should Be Using Minimum 300 bps Shocks Today.

Interest Rate Risk

Board’s Role – Is To Set Limits On How Much Deterioration In NII or EVE You Will Allow With Your Simulations.

These Limits Vary From 10% - 30% Depending on IRR or EVE Measurement and Shock Concept.

These Limits Are Typically Measured and Shown To The Board on a Quarterly Basis And You Should Be Reviewing Your Limits Based On This New 300 or 400 bps Suggestion.

Interest Rate RiskThe Limits Your Board Sets Truly Do Define How

Much Risk You Are Willing To Take Through IRR.Remember That Going Out of Limit Simply Means

You Should Adjust Your Strategy To Come Back Into Compliance As Quickly As Possible.

This Can Be Accomplished by Increasing/Decreasing Asset Maturities, Increasing/Decreasing Liability Maturities, Expanding/Contracting The Balance Sheet.

Interest Rate Risk

Some Recent Interest Rate History …

June 2000 – June 2004: Fed Funds Target Dropped From 6.50% To 1.00%. During That Period, The Largest Single 12 Month Move Was in 2001 and Was A Move of 475 bps Down.

June 2004 – June 2006: Fed Funds Target Increased From 1.00% To 5.25%. During That Period, The Largest Single 12 Month Move Was 200 bps Up.

Interest Rate Risk

August 2007 – Today: Fed Funds Target Dropped From 5.25% To .25%. The Largest Single 12 Month Move Was 325 bps Down.

During The Period From June 2000 To Today, The Largest Single Instantaneous Shock To The Fed Funds Target Was 75 bps (Both Occurred In Down Environments).

The Largest Single Upward Instantaneous Shock Was 25 bps.

Interest Rate Risk

Summary …

Regulators Are Concerned About Rising Rates And Their Impact On Our Industry In The Coming Years.

The Fed Has Been Vocal About Rates Staying Low, However, This Is A Dangerous Time For Us Given The Historically Low Asset Yields in The Investment Arena.

Prime-Based Lending Is A Great Way To Avoid IRR.

Interest Rate Risk

For Many, Taking On Interest Rate Risk As Opposed To Credit Risk May Be a Great Strategy.

If You Do This, You May Want To Also Take Advantage Of Historically Low Funding Rates To Hedge Some Of This Risk.

Is This The Time To Lengthen Your Liability Structure?

Recent Exam ExperienceReid Pollard Is An Old Friend Who Recently

Experienced An Exam And We Are Delighted To Have Him With Us Today To Highlight His Experience As It Relates to IRR Issues …

Reid Has Been In Banking For Over 30 Years Operating In Both The States of North Carolina and Colorado …

He Is the CFO of Rocky Mountain Bank & Trust in Colorado Springs and Has Agreed To Share His Experience With You Today ….

Investment Risk Management – July 5th (1:00 EDT)

Capital Management – August 8th (1:00 EDT)

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