Because my mother’s family has researched our family tree and traced our lineage back to Ireland, St. Patrick’s Day has always held special meaning to me. This year it was even more meaningful for my family. My husband recently took a DNA test to find out more about his ancestry and lineage, and the results of the test indicated that his heritage is mainly Irish as well. Growing up he had always been led to believe that he was of Scandinavian decent. I realize that I sound like a popular commercial when I say this, but knowing more about his heritage has changed my husband’s outlook on the present and the future.
Examining our past can be a good starting point for determining our future behavior. Regulators anticipate that banks will analyze past assumptions such as changes in offering rates on deposits compared to changes in market rates, changes in historical non-maturity-deposit balances and average lives, and changes in historical loan prepayment rates in order to develop meaningful assumptions. The resulting historical assumptions should then be applied in the Bank’s Asset/Liability Management or Interest Rate Risk model in order for the model to more accurately reflect the behavior of the related balances in future rising and falling rate shock scenarios.
It is difficult to rely on the accuracy of historical data as a predictor of future behavior, particularly given the fact that we have not experienced a rising rate environment in over a decade. And you know the old saying, “Past performance is not a guarantee of future results.” That is why the historical assumption analysis is only a quantitative starting point for assumption development. Additional qualitative discussions should be held by management and the bank’s ALCO to determine whether the assumptions resulting from the historical analysis accurately reflect the bank’s anticipated behavior in future rising and falling rate scenarios. Assumption development can be part science (or math), part art, and perhaps a bit of “the luck of the Irish.” The most critical components of assumption development are the documentation of the methodology applied to the historical analysis and the documentation of the qualitative discussions held by management and the bank’s ALCO. The members of Wipfli’s Asset/Liability Management team can provide additional guidance regarding the assumption development process.