Tuesday, May 29, 2012

Sweat the big stuff: Interest Rate Risk

I have been thinking about interest rate increases for some time now. The Fed lowered the Fed Funds rate to a target of 0 – 25 bps in December 2008. Since that time we all knew that the next move would be up, and pundits have been predicting the “when” like sportscasters predict the next champion.

Once the Fed senses economic recovery and inflation indicators start blinking red, they will move. And if past is prologue, they will move relatively quickly. Take the last time the Fed raised rates as an example. On June 29, 2004 the Fed Funds rate stood at 1%. Two years later, the rate was 5.25%. Four hundred twenty five basis points in 24 months. See the recent history of Fed Funds and Discount Rate moves here.

This should give FIs pause as they manage their balance sheet. Some banks, by strategic design, are weighed heavily in 1-4 family mortgages funded by certificates of deposit. In asset liability management (ALCO) parlance, they are funding short and lending long. This means as rates increase, their funding will become more expensive and a significant part of their assets will remain mired in historically low yields.

One such bank, a west coast financial institution with between $10-20 billion in total assets, had greater than 60% of their deposits in CD’s and over 70% of their loans in residential mortgages. Although if you had the time to dig you can figure out the bank because all information I give is public, I will keep them nameless.

In a note in their annual report, the bank reported the following structure to their balance sheet;

According to the same note, the Bank is estimated to experience the following net income impact given rate increases of 100 bps, 200 bps, and 300 bps respectively.

In other words, if the Fed raised rates 300 basis points (3%), the Bank would have $37 million less in net income. A large number, but it only represents 33% of their actual net income. But that number includes many assumptions. For example, in the bank’s 10k, they disclosed that their loan prepayment assumptions incorporate their recent portfolio experience.

Now, I’m no ALCO genius, but I have to believe that residential mortgage loan pre-payments have been up recently due to people refinancing to lower rates. When rates rise, I doubt borrowers will be knocking at the bank’s doors to trade their low rate mortgage for a new, higher rate one. By my calculation, if the Fed raised rates in Year 1 by 300 bps, and the bank had to follow suit basis point for basis point, this bank’s net income would decrease by $43 million, or 39% of their net income. Years two through six would see an additional $58 million decline. If I ran this bank, I would be concerned.

Bank risk is so compartmentalized, and asset-liability management has numerous assumptions that impact results significantly. But at the end of the day, FI senior managers need to use common sense to estimate the collective behavior of their customer base in a rising rate environment. Making strategic decisions regarding the structure of the balance sheet may result in decreased profits today but position your FI to continue serving clients needs, hedge against rising rates, and protect against declining profitability in a changing environment.

Is your balance sheet protected against rising rates? Really?

~ Jeff


  1. Hi Jeff,

    Excellent post! On a day when the 10 year hit a record low yield, this is actually a bigger issue than ever. Banks now have to REALLY reach to get yield, adding either duration or credit risk (or both) to try to keep the lights on. I fear that whenever the tide turns it will get very ugly very fast.

  2. It always makes me a little nervous when an assumption driven model can change so significantly when assumptions are changed. Such is the case with ALCO models. We are trying to predict the collective behavior of our customers.

    I do see banks taking gains in their investment portfolios and re-investing short to mitigate this risk. So it is not all doom and gloom.

    Thanks for the comment!

    ~ Jeff

  3. Institutions are also setting themselves up for problems, if their asset/liability matching assumes that the massive influx of new deposits in recent years has the same long-term characteristics as deposits made in the past.

    See Big Idea No. 2 in our list of "12 Big Ideas for 2012" for more details on that issue: