2022 is off to a challenging start, to say the least.
One major economic and policy issue financial institutions are facing this year is higher interest rates. At the time of writing this article, Goldman Sachs expected the Federal Reserve to hike interest rates seven times in 2022, while the market consensus was six hikes.
We’ve already seen changes in the Treasury yield curve that have impacted loan and deposit pricing for banks and credit unions. Since January, the Treasury yield curve flattened, as the 10-year Treasury yield increased from 1.63% to 2.14%, and the two-year Treasury yield increased from 0.78% to 1.97%. Banks and credit unions should be prepared for increases in short-term rates as the Federal Reserve uses its policy tools to fight inflation.
Based on the Interest Rate Risk Statistics Report from the Office of the Comptroller of Currency, banks look to be well positioned for an increase in interest rates. The report disclosed that generally, if rates increased, bank asset/liability models projected asset rates would move up faster and higher than rates on liabilities, and net interest margins would improve. Based on the data collected from 960 banks as of June 2021, if rates moved up 200 basis points from a parallel interest rate shock, the median bank net interest margin would improve by 3%. For the 75th percentile of banks, net interest margin would improve by 14%, and the largest expected gain in margin was 74%.
So, the prospect of higher rates is great news for financial institutions, right?
Not so fast. If you zoom out on the chart below, you can see the general trend for the past 30+ years for bank net interest margin and short-term interest rates was downward. Even in periods where short-term rates have increased, bank’s net interest margin appeared relatively unchanged.
Source: The Historic Relationship between bank net interest margins and short-term interest rates (fdic.gov)
So, is your asset/liability model incorrect? No. Is your model only as good as your assumption inputs and risk management function? Yes.
Translating real-world environmental risks into your asset/liability risk management function is a critical role of the asset/liability committee (ALCO). There are a variety of factors at play, but you can have high confidence in your asset/liability modeling if you have the right focus:
1. Model assumptions
Your asset/liability model assumptions are particularly critical to understanding your model results. We recommend that the ALCO monitor and adjust assumptions regularly. You should also be aware of these weaknesses that are common in asset/liability modeling assumptions:
- If you’re going to use peer averages, consider your institution-specific factors. Is your geography different than the peer institutions? Is your loan base more or less price sensitive than peers?
- If you’re using historic institution-specific data, always consider the context of those data points. Deposit growth has been particularly strong, but do you expect that to continue? Was that due to your deposit pricing or excess liquidity in the financial system?
- Whether you’re using historic institution-specific data or peer averages, it’s critical to consider qualitative adjustments. Will customer deposits run off faster than they have in the past? Will customers move deposits from checking to certificates? Will you have to reprice deposits faster in the future to win business?
- When rates increase, you should expect the timing and magnitude of price changes in your assets and liabilities that is different than if rates decrease. If you’re assumptions don’t differentiate between rising and falling scenarios, it’s time to take another look at your inputs.
2. Sensitivity testing
Sensitivity testing of your model assumptions is critical to understanding institution-specific risks. We recommend that banks and credit unions run sensitivity tests on their assumptions regularly. Particularly, asset prepayments, deposit price sensitivity and non-maturity deposit decay rates should be tested.
The goal of the exercise is to understand how your asset/liability model results change in response to the assumptions changes. If your results change materially, consider using a range of values for that assumption.
3. Non-parallel yield curve simulations
This year started with a flattening of the yield curve. Running non-parallel rate simulations might not be a standard part of your ALCO reporting. If not, it’s time evaluate whether the size and complexity of your institution necessitates reviewing non-parallel scenarios, and how changes in the slope of the yield curve impact your interest rate risk results.
Similar to sensitivity testing, it’s important to understand how your model results change in response to changes in the yield curve. Always consider your model results in context of the yield curve shift. Your institution may be well positioned for a parallel increase in rates, but not well positioned for a bear flattener, where short-term rates are increasing faster than long-term rates.
Prepare your institution for rising interest rates
The Federal Reserve has a tough challenge ahead of it, and 2022 looks to be less than typical. The Federal Reserve is navigating hiking rates into higher than expected inflation, dipping consumer confidence and global uncertainty.
While the consensus might be that financial institutions are well positioned for the coming rate increases, it’s important to understand your specific risks, modeling assumptions and how environmental characteristics may impact your earnings and capital. Regularly discussing key model assumptions, sensitivity tests and non-parallel yield curve simulations will ensure confidence in your interest rate risk position.
Contact Wipfli to learn how we can help your financial institution navigate the challenges ahead.
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