14 Hoosier Banker September 2014 DIRECTORS / SENIOR MANAGEMENT Thanks to some specific and oft-repeated exhortations from various supervisory authorities, community bankers have learned over recent years just what risks are of the greatest concern to bank examiners. Whether one goes back to 2010’s FFIEC Advisory on Interest Rate Risk, or the more recent FDIC Financial Institutions Letter-46 from last October, this message is clear: Regulators are afraid that the traditional modeling assumptions applied to the behavior of nonmaturing deposits may be producing results that mask some real and significant risks to both earnings and capital. Their point is a good one. Nonmaturing deposits (NMD) have historically been considered to be very stable as to balance, and very insensitive as to price volatility. One can readily see that, even though one’s earnings projections and economic value of equity measurements might look pretty rosy, a change in NMD behavior could significantly darken that bright outlook in a hurry. If a stronger economy sparks the threat of disintermediation, what happens to the stability of those stable deposits? If a higher rate environment suddenly makes NMD owners much more sensitive to the rates they’re receiving for their deposits, what does that do to their price volatility and resulting interest expense? These are valid questions and have been the basis for the regulatory disquiet surrounding the assumptive inputs of NMD modeling, along with the need to stress those assumptions. Who can trust the output of an exercise that uses unrealistic inputs? Two Sides to Everything While the need for accurate-aspossible modeling treatment for liabilities is important for projecting accurate-as-possible interest expenses and accurate-as-possible fair values, there are also assumptions governing the behavior of income-producing assets. For modeling purposes, it is generally considered a given that earning assets, precisely because they are earning assets, will participate fully in whatever rate increase occurs. That makes sense. Why would a lender, living in a time of rising rates, limit his or her earnings potential by not charging borrowers a rate that reflects the rising-rate environment? Well, maybe it’s because the competition won’t allow it, and therein lies the rub. In the last seven months of 2013, the yield on the 10-year Treasury note rose by about 140 basis points, but the loan rates at most community banks stayed pretty much unchanged. So while some earning assets, like investment securities, are bringing in substantially higher yields than they were in the first About the Author Lester F. Murray joined The Baker Group in 1986 and currently serves as a senior vice president within the firm’s financial strategies group, helping community banks develop and implement investment and A/L management strategies. He is a frequent speaker at investment conferences and educational seminars. Prior to joining Baker, Murray worked at two broker/dealer banks in Oklahoma City and also was an assistant national bank examiner. He is a graduate of Oklahoma State University. For more information, contact Lester Murray at 800-937-2257, email: lester@gobaker.com. The Baker Group is a Diamond Associate Member of the Indiana Bankers Association and an IBA Preferred Service Provider. Don’t Look at Interest-Rate Risk Through Rose-Colored Assumptions
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