For financial institutions to thrive in a fast-changing world, they must learn to manage interest rate risk (IRR).
IRR is the potential of an increase or decrease in earnings and the market value of equity from changes in market rates. For an institution to manage IRR, it first must understand its causes. Then, an institution must realize how it is positioned for exposure. This understanding will provide the blueprint to ensure that an institution builds a proper process or foundation to manage the risk and make good strategic decisions.
Learning how to manage IRR was the topic of a recent webinar held by MountainView Financial Solutions, a Situs company. The presenters were Christine Mills, Managing Director, Analytics; and Madonna M. Ritter, Director, Analytics.
They explained that IRR is inherent in any balance sheet, arising from:
• Repricing or a maturity mismatch of assets and liabilities;
• A driver rate relationship mismatch;
• Optionality (i.e. prepayments, rate caps and floors, CD early withdrawals, calls or puts);
• Non-maturity deposit behavior;
• Market and other economic factors.
Loans, investing, funding and equity can all be affected as interested rates change, whether fixed vs. variable, variable vs. adjustable or long term vs. short term.
There are at least two types of risk:
• Repricing risk, caused by maturity or repricing timing differences between assets and liability cash flows;
• Option risk, caused by timing differences in the embedded options of the cash flows (i.e. calls, prepayment rates, rate floors).
Regulators believe that well-managed institutions will consider earnings and economic perspectives when assessing the scope of their IRR exposure. Institutions need to take into consideration both the short term and the long term.
A primary goal of the institution is to identify the risk to its current balance sheet caused solely by changes in interest rates. Therefore, when measuring net interest income (NII), the preferred practice employs a constant current spots rates projection and is measured based on a static balance sheet across a range of immediate and parallel rate shocks. This approach should be applied for measuring against IRR policy limits, because it is consistent and limits the variables involved. However, it can be unrealistic, given the extreme and immediate rate shocks. Therefore, it should be conducted in conjunction with dynamic modeling.
Dynamic IRR reporting is a more realistic approach because it takes into account expected rate changes and forecasts a balance sheet with a change in growth and mix. This method provides management with a tool for making strategic decisions because it is based on a more realistic forecast. However, the disadvantage of dynamic IRR reporting is that a balance sheet can change every quarter, and this limits the ability to analyze trends.
An Institution’s interest rate risk exposure is typically determined relative to the current structure of the balance sheet. If an institution is asset sensitive – which means if interest rates increase – so does net interest income. This means that assets reprice faster than liabilities; as rates rise, the assets increase by marginally more than the liabilities. This arises typically from a balance sheet with assets that are primarily variable-rate or short-term funded by liabilities that are less rate sensitive, fixed or longer term.
When dealing with a liability-sensitive balance sheet, however, the situation is different. As rates increase, earnings decrease. Liabilities reprice faster than assets or liability sensitivity, and changes in interest expenses dominate. Most of the assets are fixed and/or longer term. The liabilities, including a large portfolio of short-term CDs, are more sensitive to rate changes. Earnings tend to decrease whether rates increase or decrease.
Therefore, based on its current structure and product base, the Institution is typically married to risk appetite and exposed to interest rate risk. While this can be changed over time, it is not something that the institution can mitigate quickly.
MountainView offers these balance sheet risk management solutions:
• Data assessments;
• Credit and interest rate risk;
• CECL credit risk services;
• Model validations;
• Model risk management;
• Deposit studies.
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