By Evan Sparks
As we progress into uncharted waters on monetary policy, it may be time for bankers to revisit their interest rate risk models and procedures. Combine an economy that continues to grow robustly very late in the economic cycle, a massive Federal Reserve portfolio waiting to be unwound, and a gradual path of projected rate hikes that could be scrambled by pending Fed personnel shifts and there are a lot of icebergs about: looking innocuous from above, but with possibly large downsides should anything go wrong.Key among them: the need for more and newer ways to calculate interest rate risk, the need for better IRR management practices and the emerging issue of price risk—all of which intersect to make IRR a growing challenge for risk managers, CEOs and business line leaders alike.
With economic growth projected to approach 3 percent this year and other economic indicators in good shape, “that does suggest a rising interest rate environment,” says ABA Senior Economist Rob Strand, who moderated a panel on interest rate risk at ABA’s Risk Management Conference this year. In addition, with the Fed’s portfolio at five times its “normal” size, “at some point, we’ll start to see this portfolio tapering off.” Strand expects these factors—plus an exploding federal deficit—to drive long-term rates up, but not as much as short-term rates.
“Rates can hurt us in a couple of ways,” notes Tally Ferguson, SVP and director of market risk management at BOK Financial, a $32 billion institution based in Tulsa, Okla. They can ding the bank’s net interest margin or erode the value of assets held. In that environment, he emphasizes that it is important to determine asset or liability sensitivity under a variety of rate scenarios and manage the balance sheet accordingly.
There are a variety of metrics that risk managers use, ranging from simple methods with a current view, such as gap analysis, to complex and forward-looking techniques like forward net income at risk and economic value of equity. More advanced techniques might reveal that interest revenue declines when rates decline and when they grow by more than 300 basis points, but that it grows with smaller rate increases. These techniques can also model revenue with different customer behavior—differentiating between a deposit surge and deposit runoff, for example.
“Where you position your balance sheet has real-life impacts on earnings and capital,” says Ferguson. He points to the net interest income and NIM of midsize and regional banks in the first three quarters of 2017, a time when rates were gently rising. Banks that reported being asset-sensitive in September 2017 saw their NIM grow by 26 basis points, while those that were interest-rate-neutral saw NIM rise by 19 basis points. But banks with liability-sensitive balance sheets saw a 20-basis-point hit to NIM and a corresponding decline in net interest income.
Of course, managing the balance sheet to address IRR is always an optimization exercise, notes Steve Scott, SVP and head of IRR at U.S. Bank in Minneapolis.
“You’re always making a tradeoff on any given decision,” he explains. Credit risk, liquidity, capital, stress testing: all of these factors apply. “Every bank is going to have its own set of goals, objectives, constraints. There’s no silver bullet here.”
For risk managers in the second line of defense, Scott emphasizes that the key is understanding the business units and the variety of products being put on the balance sheet, including their rate structures, promotional elements, repayment or repricing features, the deposit product mix, accounting designations and convexity, among other dimensions. “Making sure you can understand how product choice in the business affects rate structures is important,” he says. “Interest rate risk is a risk that you can manage in isolation, but I would caution you to think across the organization: all of the risks, all of the constraints and your objectives.”
One of those intersecting risks is price risk—that is, the risk to current or projected financial condition that arises from changing values of trading portfolios and other obligations entered into as a way of distributing risk. “Price risk is here,” says Strand. “Reported IRR is not the full story.”
When Joseph Varcelli joined Third Federal in Cleveland as market risk officer, he had to build out a price risk management capability for the $14 billion thrift’s all-mortgage loan portfolio. Starting with the OCC handbook and federal agency data, he set a benchmark and then created a rating matrix that tracks the “quality, quantity, duration and direction” of price risk.
“Over time, we started to get better about how we think about these things,” Varcelli says. “Having different scenarios to run trying to bookend the exposures is going to create meaningful targets that you can start to communicate different stakeholders.” Beyond the challenge of developing a price risk model was just “getting acceptance from the bank that we did have price risk,” he adds. The process led the bank to do “substantial sales” to test the liquidity of its adjustable-rate mortgage portfolio, which had never seen an interest rate cycle, Varcelli explains. “We also do a lot of testing around how much incentive or basis points a customer needs to re-lock.”
Even with the interest rate environment changing—and also subject to a number of possibly unpredictable political inputs—banks are responding with growing sophistication. As Rob Strand notes, “interest rate risk should be back on the priority discussion board.”
