A steep yield curve usually results in strong financial institution net interest margins. Unfortunately, the Great Recession lowered both short- and long-term interest rates to record lows and flattened the yield curve, which decreased net interest margins. For the past eight-plus years, the market has been forecasting higher interest rates. Since November 15, 2016, the Federal Reserve has raised short-term interest rates four times, each by 25 basis points, so short-term interest rates have risen modestly, but less than forecasted. In the same time frame, the 5-year rate in the Treasury curve has not experienced any significant increases at all. This has resulted in a continuing flattening of the yield curve. As a result, financial institutions should be thoughtful about managing their interest rate risk profile. Managing for outstanding current results may have a significant impact on future period results. For example, funding fixed-rate mortgage loans with brokered money market accounts will result in higher net interest margin today, and dramatically lower interest margins if short-term interest rates increase faster than the past year and a half. In addition, current customer preferences may change, such as customers deciding to move to a fixed-rate loan from a variable rate loan or changing a deposit preference to faster repricing deposit products.
Because of the recent increases in short-term rates, financial institutions’ assets contractually tied to those indices have repriced (e.g., prime, LIBOR). Yet, on the retail deposit side, the Federal Deposit Insurance Corporation (FDIC) Weekly National Rates and Rate Caps shows that non-maturity deposits rates have not changed at all from December 14, 2015, just before the Federal Reserve’s first overnight interest rate increase. The result of these two events have allowed financial institutions to reduce the impact of a flatter yield curve on their net interest margin or, in fact, improve it.
Modeling interest rate risk results and liquidity forecasting is a challenging process. Your institution needs to utilize historical experience as a basis to project your future results. Your documentation to support the subjective, qualitative adjustments should be thorough and reflect your thought process. A few suggestions follow.
We recommend that deposit pricing and deposit life assumption utilized in the interest rate shocks reflect your financial institution’s historical analysis adjusted for qualitative factors that reflect your unique customer deposit base and customer preferences. These qualitative factors help address well-articulated regulator concerns that the historically low level of interest rates might have influenced deposit trends and that greater interest rate sensitivity may exist than previously thought or more balances may be withdrawn than the historical relationships would suggest. Your analysis should be specific to your institution.
We are seeing more focus on potentially volatile funding concentrations, sometimes called PVFC. This expands the definition of volatile funding from time deposits greater than $250,000 to all deposits greater than $250,000. Volatile funding still includes brokered deposits, listing service deposits, and borrowings. Your financial institution is encouraged to review deposits greater than $250,000 and review items that may reduce the concern about deposit volatility. These could include items such as the following:
- Collateral pledged to support the deposit (which if the deposit leaves, could be used to support a new collateralized deposit or borrowing)
- Additional deposit insurance obtained in excess of the FDIC amounts
- Strength of relationship such as board member or family relationships to executive management
Stress testing key assumptions, such as alternative deposit repricing, deposit life, or loan and amortizing securities assumptions, helps determine the potential effect on earnings and economic capital at risk from changes in assumptions. It also helps demonstrate your institution’s understanding of the impact of key assumptions and the sensitivity that the assumptions have on reported interest rate risk results.
You should also take credit for your hard work in analyzing your interest rate and liquidity risk and the robust discussions that your Asset Liability Committee (“ALCO”) has had. During our interest rate risk and liquidity management validations, we discuss and see firsthand this hard work and the thought processes that are part of the ALCO management process, but we rarely see robust documentation of this in the ALCO minutes. Minutes of the ALCO meeting should support the review of your key interest rate and liquidity assumptions and allow management to document the rationale as to why the assumptions are reasonable and any unique circumstances applicable to your financial institution.
Managing interest rate and liquidity risk together with running a profitable financial institution is a balancing act. These suggestions will add value to that process. If you need help or would like to discuss further, please contact me at 952.548.3387, at email@example.com, or contact your Wipfli relationship executive.