Pub. 5 2017 Issue 4

www.uba.org 12 Are Your IRR Assumptions Going up in Smoke? A fter the mortar sets on that new fire- place 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 some similar circumstances. All 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 ten 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’s 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 that 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 one’s 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 of 2008, never have rates been so low for so long. Add to that the historic lack of volatility, and we end up backtesting Ground Hog’s Day: the same thing over and over. While certainly not without value, it’s probably safe to say that the interest rate en- vironment since 2009 has not really put those assumptions to the test. Check Those Smoke Detectors This is a concern that isn’t new. Since the FFIEC Interagency Advisory on Interest Rate Risk was published in 2010, regula- tory 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. One can understand the concern since it’s 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 project- ed results to actual outcomes. Regulators understand this and have quite reasonably encouraged the sensitivity testing, or stress- ing, of NMD related assumptions. Receiving less attention are some of the pricing assumptions governing the behavior of interest-earning assets, like investments and loans. The preponderance of commu- nity banks’ modelling exercises assumes asset pricing betas of at least 80 percent and often 100 percent. Additionally, the timing lag between the change in market rates and the manifestation of that change on banks’ lending rates is often very short or non-exis- tent. It might be instructive, now that several increases in the prime rate have occurred, to compare the current schedule of lending rates at your bank to the rates that were in place before the Fed began its rate normal- ization process. As critical as NMD pricing assumptions are to the accurate projection of interest expense, the validity and reasonable- ness of asset pricing assumptions are just as crucial to the accurate projection of interest income. If your current lending rates are little changed from their pre-normalization levels, it might be time for the ALCO to re-eval- uate some of those assumptions before you start smelling smoke. n Lester Murray joined The Baker Group in 1986 and is an Associate Partner within the firm’s Financial Strategies Group. He helps community financial institutions develop and implement investment and interest rate risk management strategies. Before joining The Baker Group, he worked at two broker/dealer banks in Oklahoma City and was also an assistant national bank examiner. A grad- uate of Oklahoma State University, he holds Bach- elor of Science degrees in finance and economics. Contact: 800-937-2257, lester@GoBaker.com. By Lester Murray, The Baker Group