RIDINGOUT THE STORM Focus on Interest Rate Risk Management “The relative calm in financial markets recently has caused a significant degree of complacency. The truth of the matter is that we are probably in the eye of the hurricane, and once the eye passes, the banking industry will once again be buffeted by winds of great force in the form of volatile interest rates.” – Dr. James V. Baker, 1984 In the wake of unprecedented changes in market conditions and a historic jump in interest rates, regulators can be expected to focus intently on interest rate risk management in coming examinations. Knowing this, it’s worth stepping back to review how we got here and consider some key points regarding policies, processes, and procedures to ensure your institution’s Asset/ Liability Management (ALM) framework is solid. Market Conditions The two years immediately following the arrival of the COVID pandemic were an extraordinary period of ultra-low interest rates and bond yields coupled with massive growth in excess liquidity and paltry loan demand. Coming into 2023, bank balance sheets around the country had seen an intense etching of this low-rate environment into their current rate structure – deposit rates, loan rates, and bond yields – everything had steadily moved lower to the point where low rates and yields were deeply embedded into the balance sheet. This was not negotiable; these cards were dealt to every bank in the country. Moreover, the effect on capital ratios of the enormous Jeffrey F. Caughron, Chairman of the Board, The Baker Group inflow of deposits and liquidity added an additional challenge. Then suddenly, as Dr. Baker warned all those years ago, the “eye of the storm” passed, and interest rate volatility returned with a vengeance. Now Asset/Liability Management is once again a critical point of focus. Regulators are well aware of the convulsive market developments since the first of the year and the industry-wide effect on bank balance sheets. Even for banks exhibiting little interest rate risk exposure, examiners can be expected to emphasize corporate governance, stress testing, back-testing, and a general demonstration that management and the board are “on it” regarding interest rate risk. The risk management protocol and processes need to be in compliance. Principals of Sound Interest Rate Risk Management The FDIC provides observations about best practices for IRR management and frames a prudent approach to interest rate risk. Key points include the following: Reporting System – Financial institutions should have timely and accurate information about the exposure of their balance sheets to changes in interest rates. This includes separate analysis and reporting of earnings at risk and capital at risk. It’s important that the system include simulations or rate shocks of different rate environments and stress tests of the behavioral assumptions used in the model (e.g., changes in A/L mix, non-maturity deposit behavior, etc.). 10
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