34 NOVEMBER / DECEMBER 2018 Matt Harris Senior Vice President The Baker Group mharris@GoBaker.com DIRECTORS / SENIOR MANAGEMENT Interest Rate Risk Assumption junction The Baker Group is a Preferred Service Provider of the Indiana Bankers Association and an IBA Diamond Associate Member. If you’ve ever owned a car, you probably know about maintenance schedules. When followed, items such as oil, spark plugs and tires are periodically reviewed and replaced to ensure the vehicle will continue to run properly. As regulators continue their increased scrutiny of interest rate risk (IRR) models, financial institutions should consider adopting their own “maintenance schedules” for model assumptions. Just like an automobile, a robust IRR model should be reviewed at least periodically to determine whether current behavior assumptions are appropriate and reasonable. When opening the hood of your interest rate risk model, the following critical assumptions should be reviewed: • Interest rate scenarios to be modeled; • Reinvestment/discount/driver rates; • Rate sensitivities (betas) and time lags; • Average lives of non-maturing liabilities; • Asset prepayment/liability decay. While the list above is certainly not exhaustive, these assumptions could be considered the most critical and impactful to your reporting for both earnings-at-risk and long-term fair value analysis. Rate adjustments/shocks. While it is commonly known that examiners are expecting +400 bps rate scenarios for earnings simulations, they are expecting to see non-parallel rate moves as well. This is where the short- and long-term rates of the curve move by different magnitudes. Historical yield curve analysis will assist with selection of the most realistic rate change scenarios. Reinvestment and discount rates. The earningsat-risk simulation relies heavily on reinvestment rates and other repricing rates to calculate the changes in interest income and expense. Discount rates, on the other hand, are used more specifically to determine the present value of future cash flows used more for longterm fair value analysis (economic value of equity or net economic value). Management should use current offerings and other market rates to consistently adjust these, especially after recent rate changes and new products. Rate sensitivities and time lags. Sensitivities, sometimes known as “betas,” are numbers that help describe the pricing relationship of a particular account in response to movement in market rates. Time lags specify how much time would pass before the account will begin to experience a rate change. For example, an account with a rate sensitivity of 30 percent and lag of 3 would imply that if market rates increased 100 basis points, the account would increase by only 30 basis points three months after the initial market rate move. Management should spend time reviewing historical rate performance to confirm that current sensitivity and lags assumptions are reasonable for their current activities. Average lives of non-maturing liabilities. Widely considered the most mystifying assumptions for the model, the question here is, what kind of maturities
RkJQdWJsaXNoZXIy MTg3NDExNQ==