Key Components of Managing Interest Rate Risk These five areas of focus can help financial institutions improve their standing and prepare for the future. Addressing each of these areas and utilizing data-driven strategies can be the difference between a financial institution and its competition. Consider the following items a checklist for equipping your bank or credit union for rate cuts: 1. Manage Deposit Costs Carefully Rate cuts can quickly put pressure on asset yields, but reducing deposit costs may not happen as swiftly. Koch advises financial institutions to carefully manage deposit costs in a falling rate environment. “Everyone hopes to cut deposit costs, but I don’t think they’ll come down as fast as yields will,” says Koch. Depositors are more expectant of higher rates today than in the past, and banks may face pressure to keep offering competitive rates, particularly on CDs and savings accounts. Understanding the source of deposit growth and the duration of deposits is critical for managing liquidity effectively. 2. Ensure Stability of Funding Stable funding is essential for maintaining liquidity during rate cuts. Koch recommends using longer-term instruments such as home loan bank advances or brokered CDs to ensure funding stability. “You can’t [lend] the money you don’t have,” notes Koch, stressing the importance of aligning funding durations with balance sheet needs. With limited deposit funding available to support increased lending, banks must strike a balance between loan growth and available liquidity. 3. Prepare for Earnings Pressure Rate cuts are likely to result in earnings pressure for many financial institutions, according to Koch. “I expect earnings pressure on bank margins over the next year because falling rates will impact asset yields quickly,” he said. “It will be harder to move down the cost of funds given liquidity concerns.” This could lead to a squeeze on net interest margins, as deposit rates remain elevated and loan rates decline. To mitigate this, financial institutions need a strong pricing strategy for both loans and deposits. 4. Monitor Prepayment Risks Prepayment risk is a significant concern during periods of falling rates, as borrowers may look to refinance their higher-rate loans. Koch emphasizes the need to break down prepayment speeds by loan age and rate to better understand the risks. “If 20% of your portfolio is sitting in rates that went up 150 to 200 basis points, those loans will likely refinance quickly,” he explains. By analyzing loan portfolio composition, institutions can better anticipate prepayments and adjust their lending strategies accordingly. 5. Understand Deposit Growth Sources A thorough understanding of where deposit growth is coming from — whether it’s new money from existing customers or external sources — is essential during rate cuts. By evaluating deposit growth and its duration, institutions can make informed decisions about pricing and manage liquidity more effectively. Koch advises financial institutions to “track where your deposit growth comes from” to ensure that their funding strategies remain aligned with market conditions. Leveraging Asset/Liability Management (ALM) Models as Rates Drop Another critical element Koch highlights is the importance of a solid ALM model. A quality ALM model allows financial institutions to simulate the effects of rate cuts using realistic scenarios tailored to their specific circumstances. “You need a quality ALM model that doesn’t just focus on satisfying a regulatory requirement using static assumptions,” Koch explains. Regular discussions with the board or asset/liability management committee (ALCO) are also key to making well-informed decisions that will help financial institutions navigate rate cuts successfully. A quality ALM model can help financial institutions prepare for changes in earnings, liquidity and pricing dynamics. By carefully managing deposit costs, ensuring stable funding, monitoring prepayment risks and leveraging a strong ALM model, institutions can position themselves to navigate the challenges posed by a declining rate environment. Rate cuts may introduce pressure, but with the right strategies in place, banks and credit unions can effectively manage interest rate risk and continue to serve their communities. 25
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