30 JULY / AUGUST 2022 Interest Rate Risk in 2022 Assumption junction DIRECTORS / SENIOR MANAGEMENT Matt Harris Senior Vice President The Baker Group mharris@GoBaker.com The Baker Group is a Preferred Service Provider of the Indiana Bankers Association and an IBA Diamond Associate Member. In March this year, the Federal Reserve lifted interest rates for the first time since 2018. Today, both the bond market and Federal Open Market Committee have set the stage for an aggressive rate path, given current inflation challenges. With this outlook, there will be a renewed focus from regulators relating to interest rate and liquidity risk. Since you’ve likely 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 for IRR modeling 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 also expecting to see nonparallel 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 help assist with selection of the most realistic rate change scenarios. Reinvestment and discount rates. The earnings-atrisk 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 and for long-term fair value analysis (economic value of equity or net economic value). Management should use current offering 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 will pass before the account begins to experience a rate change. For example, an account with a rate sensitivity of 30% 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 lag assumptions are reasonable for their current activities. Average lives of non-maturing liabilities. Because non-maturing liabilities are widely considered the most
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