Pub. 3 2013-2014 Issue 5

O V E R A C E N T U R Y : B U I L D I N G B E T T E R B A N K S - H E L P I N G C O L O R A D A N S R E A L I Z E D R E A M S March • April 2014 19 visit us online! www.coloradobankers.org www.coloradobankers.org increased rates may adversely impact future earnings, requiring careful monitoring of IRR exposure and effective management of risk. Additionally, there will be increased liquidity risk as interest rates rise. Nonmaturity deposits may flow out of com- munity banks as depositors shop for higher rates, and there will be increased competition for deposits to fund asset growth. This will require community banks to effectively plan for funding strategies and proactively monitor their liquidity position. Bank directors aren’t expected to be experts in IRRmanage- ment. However, they are expected to be knowledgeable enough to effectively perform their duties and protect the safety and soundness of their institution. Below are some key components of effective IRR management to be aware of. Risk Tolerance Levels IRR limits will differ for each institution and largely depend on the institution’s capital, strength, and quality of earnings. If capital levels are low and earnings aren’t of sufficient magnitude or quality, an institution will be less tolerant to IRR. Conversely, if capital levels are high and earnings are strong, an institution may be able to take on more IRR. When setting limits, consider the impact on the bottom line resulting from changes in interest rates. Risk limits should be regularly monitored and updated to reflect changes in the insti- tution’s risk profile and conditions, including new products or initiatives that will impact the institution’s IRR profile. If risk limits are exceeded, there should be a control to trigger appro- priate action by the institution. IRR Measurement Techniques IRR should be measured using a combination of models to provide a complete picture. Effective models include gap analysis, income simulation, and economic value of equity (EVE) simulation. A gap analysis looks at timing differences between the re- pricing of interest rates on assets and liabilities and the related impact on net income. Gap analysis shouldn’t be the primary tool for measuring interest rate risk, since it doesn’t measure the ef- fect of all items that could impact IRR. These items are generally captured using income simulation and EVE simulation models. Income simulation can include both short- and long-term simulations and reflects “what if” scenarios that include a declin- ing or rising rate environment. EVE simulation is a long-term model that forecasts the impact of rate changes on capital by evaluating the change in the net present value of an institution’s assets and liabilities. EVE simulation is effective, since it’s con- sistent with the long-termnature of assets and liabilities typically owned by institutions and allows an institution to understand the long-term implications of today’s strategic decisions. Assumptions to Measure IRR It’s important to understand the assumptions used in IRR modeling. A sensitivity analysis can help identify which as- sumptions have the most influence. Rate changes are generally a key assumption in IRR measurement, and it’s important to understand which rate scenarios are most problematic given the institution’s balance sheet. Rate change scenarios should include instantaneous rate shocks and prolonged rate changes. Additionally, the scenarios should be of significant magnitude (greater than +/- 200 bps) to adequately assess IRR exposure. In addition to interest rates, various deposit assumptions, including price sensitivity (beta), decay rates, and average lives, are typically significant in assessing IRR exposure. Prepayment estimates related to assets with fixedmaturities are also typically a significant assumption. Assumptions should be well documented, based on historical information, and adjusted as appropriate for qualitative factors impacting the institution. Additionally, the assumptions, data inputs, and model results should be subject to an independent review, including back testing and validation, to verify their reliability. n Derek Criswell has been in public accounting since 1999, providing financial state - ment audits, SEC filings, registration statements, credit reviews, internal control evaluations, due diligence, and board of director training to financial institutions and SEC-reporting companies. You can reach him at (916) 503-8115 or derek.criswell@ mossadams.com . Fred Peterson has been in public accounting since 1999. He focuses on auditing financial institutions and reviewing both privately held and publicly registered insti - tutions. He can be reached at (303) 893-7942 or fred.peterson@mossadams.com.