36 JANUARY / FEBRUARY 2018 Lester Murray Associate Partner The Baker Group lester@GoBaker.com DIRECTORS / SENIOR MANAGEMENT The Baker Group is a Preferred Service Provider of the Indiana Bankers Association and an IBA Diamond Associate Member. After the mortar sets on that new fireplace flue, the only way to know if it’s really going to work is to build a fire and see where the smoke goes. Some might not immediately discern how that relates to interest rate risk, but the comparison helps illustrate similar circumstances. All of the assumptions about how those rate-sensitive elements on the balance sheet will react to higher interest rates never get tested until the fire gets going – until rates actually rise. A False Sense of Security? Since the first rate hike in almost 10 years was implemented by the Federal Open Market Committee at the end of 2015, a handful of increases to the Fed Funds Target Rate have followed, and it is possible, even probable, there will be more. So now that the Zero Interest Rate Policy of the Fed is a couple of years behind us, it may be a good time to take a look and make sure the smoke is actually moving up the chimney. Or, in the context of interest rate risk, has the actual behavior of the balance sheet played out as your assumptions predicted? Many risk managers probably feel like they already have an answer to that question. Perhaps they do, but maybe they don’t. These are the risk managers who point to the “spot-on” results of their last several years of backtesting. After all, the purpose of backtesting is to compare projected results to actual results and, if the assumptions are materially “off,” those backtesting results won’t be so “spot-on,” will they? But what if there’s nothing to actually backtest? Since the Fed Funds rate became zero-bound in December 2008, never have rates been so low for so long. Add to that the historic lack of volatility, and we end up with backtesting Groundhog Day: the same thing over and over. While certainly not without value, it’s probably safe to say that the interest rate environment since 2009 has not really put those assumptions to the test. Check Those Smoke Detectors This concern isn’t new. Since the FFIEC Interagency Advisory on Interest Rate Risk was published in 2010, regulatory agencies of all stripes have reminded everyone, time and again, that assumptions development needs to be institution-specific and empirically justifiable. Some may have noticed that most of their attention has been directed toward the behavior of non-maturing deposits (NMD). Or rather, the behavior of the owners of all those non-maturing deposits. Particularly those assumptions governing their pricing behavior. The concern is understandable, since it is not uncommon for NMD balances to represent more than half of total assets. Because of their prominent position on community bank balance sheets, even small variations in behavior can translate into sizeable “misses” when comparing projected results to actual outcomes. Regulators understand this and have quite reasonably encouraged the sensitivity testing, or stressing, of NMD-related assumptions. Receiving less attention are some of the pricing assumptions governing the behavior of interest-earning assets, such as investments and loans. Most community banks’ modeling exercises assume asset pricing betas of at least 80 percent and often 100 percent. Additionally, Are Your IRR Assumptions Going up in smoke? Article author
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