interest rate risk basics - financial risk management · pdf filewhat is interest rate risk?...
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© 2015 FARIN & Associates Inc.
Interest Rate Risk BasicsMeasuring & Managing
Earnings & Value at Risk
Urum Urumoglu
Senior Consultant
FARIN & Associates, Inc..
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© 2015 FARIN & Associates Inc.
Session Overview
Session 1
• Define IRR within ALM
• IRR Management
Program
• IRR Measurement Tools
– Gap Analysis
– Income Simulation
– Market Value Analysis
(EVE/NEV)
• Define Earnings at Risk
– Key Measurements
– Major Assumptions
– Interpreting Results
• Define Market Value
– Key Measurement Points
– Major Assumptions
– Interpreting Results
• Common Faults in Market
Value Reporting
• Combining Income and
Value at Risk Analysis
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Session 2
© 2015 FARIN & Associates Inc.
What Is Asset/Liability Management?
Definition:
“asset/liability management” is the processes of
acquiring and deploying funds to maximize the
earnings, and value of the institution, while
controlling financial risks.
• How do we make money?
• Measure all Financial Risks
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© 2015 FARIN & Associates Inc.
What Is Asset/Liability Management?
• Financial risks are measured to determine if plan can be
met in reasonable risk situations
– When changes in credit quality occur
– When market interest rates move
– When liquidity needs or availability change
– When regulators modify expectations
• ALCO recognizes we manage risk to make money! We
are NOT risk minimizers.
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© 2015 FARIN & Associates Inc.
Understanding Financial Risks
• What Financial Risks Impact Core Earnings?
– Credit Risk: Will the borrower of funds repay the committed
amount?
– Liquidity Risk: Will we have enough funds to meet the demands
for loans or deposit withdrawals
– Interest Rate Risk: To what extent will the core earnings change if
market interest rates change?
• Factors in Measuring Risks
– Must be able to project cash flows (Principal & Interest)
– Must understand what may cause changes in flows
• Embedded Options
• Pricing/Customer Behavior
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ALCO’s Primary Responsibilities
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• Manage the level of Net Interest Income/Net Income
• Management of Balance Sheet Structure
– Loan/Investment & Deposit/Borrowing Mix
– Growth rates
– Controlled through Loan & Deposit Pricing
– Investment Portfolio Management
• Earnings impact
• Liquidity Needs
– Wholesale Funding
– Capital Utilization
• Risk Measurement and Management
• Interest Rate Risk
• Liquidity Risk
• Credit Risk
• Regulatory Risk
© 2015 FARIN & Associates Inc.
ALCO Controls for IRR
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• Loan and Deposit Pricing
– Most powerful ALM tool you have!
• Mix Optimization
• Growth Rate
• Wholesale Alternatives
– Borrowings/Investments
– Synthetics/Derivatives
• Leverage of capital
– Higher Leverage means lower capital/assets but
creates higher shareholder return
© 2015 FARIN & Associates Inc.
Financial Institutions Risk Management
Financial & Business Risk Management
Financial Risks
Liquidity Risk
Maturity Mismatch
Asset/Liability Imbalance
Cash Flow
Credit Risk
Default
Downgrade
Counterparty
Interest Rate Risk
Commodity Prices
Equity Prices
Interest Rate Changes
Business Risks
Management Risks
Strategic Risk
Operational Risks
People Risks
Legal Risks
System Risks
External Risks
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© 2015 FARIN & Associates Inc.
THE ALCO PROCESS
Capital Planning
Credit Risks
Liquidity Risk
Interest Rate Risk
Operational Risk
Reputation Risk
Regulatory Risk
Market Risk
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Balanced Financial Goals
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Growth
Scenario
Beginning
Assets Total Capital
Long Term
Capital
Ratio
Annual
Asset
Growth
Assets After
Growth
New Total
Capital to
Maintain
Ratio
Additional
Capital
Needed
Average
Assets ROA
1 100,000$ 8,500$ 9.50% 0.00% 100,000$ 9,500$ 1,000$ 100,000$ 1.00%
2 100,000$ 8,500$ 9.50% 5.00% 105,000$ 9,975$ 1,475$ 102,500$ 1.44%
3 100,000$ 8,500$ 9.50% 10.00% 110,000$ 10,450$ 1,950$ 105,000$ 1.86%
4 100,000$ 8,500$ 9.50% 15.00% 115,000$ 10,925$ 2,425$ 107,500$ 2.26%
5 100,000$ 8,500$ 9.50% 20.00% 120,000$ 11,400$ 2,900$ 110,000$ 2.64%
6 100,000$ 8,500$ 9.50% 25.00% 125,000$ 11,875$ 3,375$ 112,500$ 3.00%
Growth
Scenario
Beginning
Assets Total Capital
Capital
Ratio
Annual
Asset
Growth
Assets After
Growth
New Total
Capital to
Maintain
Ratio
Additional
Capital
Needed
Average
Assets ROA
1 100,000$ 8,500$ 8.50% 0.00% 100,000$ 8,500$ -$ 100,000$ 0.00%
2 100,000$ 8,500$ 8.50% 5.00% 105,000$ 8,925$ 425$ 102,500$ 0.41%
3 100,000$ 8,500$ 8.50% 10.00% 110,000$ 9,350$ 850$ 105,000$ 0.81%
4 100,000$ 8,500$ 8.50% 15.00% 115,000$ 9,775$ 1,275$ 107,500$ 1.19%
5 100,000$ 8,500$ 8.50% 20.00% 120,000$ 10,200$ 1,700$ 110,000$ 1.55%
6 100,000$ 8,500$ 8.50% 25.00% 125,000$ 10,625$ 2,125$ 112,500$ 1.89%
© 2015 FARIN & Associates Inc.
MEASURING EARNINGS @ RISK
IRR
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© 2015 FARIN & Associates Inc.
What Is Interest Rate Risk?
• Interest Rate Risk is the risk that an institution’s
earnings AND market value will change as
market interest rate change.
– Measures the amount of change in earnings or value
under different rates.
– The earnings at risk portion measures short-term
changes to the income statement.
– The market value at risk element measures long-term
risks to earnings and relative value of assets &
liabilities.
– Both measures indicate the impact on earnings
capacity – only difference is the horizon evaluated.
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© 2015 FARIN & Associates Inc.
Understanding Interest Rate Risk
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• Net interest margin depends on how rates impact
– Changes in interest incomeVs.
– Change in interest expense
• What drives the levels of interest income or expense?
– Mix of rate sensitive assets (loans vs. Investments)
– Mix of rate sensitive liabilities (deposits, non-interest deposits &
borrowings)
– How fast the rates can reset on each
• Fixed rate vs. Variable
• Your pricing behavior
• What horizon do we measure
– 1-2 years
© 2015 FARIN & Associates Inc.
Common Types of Interest Rate Risk
• Mismatch/Repricing Risk: The risk that assets and liabilities reprice or mature at
different times, causing margins between interest income and interest expense to
narrow.
• Basis Risk: The risk that changes in underlying index rates used to price assets and
liabilities do not change in a correlated manner, causing margins to narrow.
• Prepayment/Extension Risks: The risk that asset repayments accelerate at a
time when interest rates are low, resulting in diminished interest income and the need
to reinvest repaid funds in lower-yielding assets. This risk intensifies when loan
customers or bond issuers exercise their explicit call options to pay off the bank’s asset
prior to maturity and interest rates decline. The flip side of prepayment risk is
extension risk, which stems from the lengthening of asset payoff rates in a rising rate
environment, thereby reducing the funds available to invest at higher yields.
• Yield Curve Risk: The risk that nonparallel changes in the yield curve will
disproportionately affect asset values or cash flows.
• Reinvestment Risk: The risk that as one instrument matures and is replaced with
another, the funds being reinvested will carry a different interest rate than the funds in
the original instrument.
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© 2015 FARIN & Associates Inc.
Interest Rate Risk
Financial Instrument Sources
• Four Reasons Why or When Financial Instruments
Are Rate Sensitive
– Maturity
• Example: 90 day CD with P&I due at maturity
– Amortization
• Example: 30 year fixed rate mortgage reprices gradually as the
principal and interest payments are received.
– Prepayment
• Example: 11% fixed rate mortgage with market rates of 8%. It
reprices when owner refinances to obtain a better rate.
– Contractual repricing terms on arm or variable rate loan
• Example: 30 year ARM with annual resets.
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Interest Rate Risk is Caused by Changes in Actual vs. Expected Cash Flow
© 2015 FARIN & Associates Inc.
Four key elements of a risk
Management program for IRR
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Board & Management Oversight
• Ultimate responsibility & delegation (ALCO)
• Understanding types of risks
• Risk tolerance / appetite
• Providing appropriate guidance – policies
• Management governance
• Overseeing appropriate risk controls & limits
• Monitoring risk exposure limits
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© 2015 FARIN & Associates Inc.
Policies & Risk Limits
• Institution’s objectives for ALM
• Standalone documents or housed in boarder
ALM policy
• Describe risk tolerance / appetite
• Methods to identify, quantify and report
exposures
• Responsible parties, clear lines of authority
• Permissible activities that an institution may
conduct
• Control & risk limits
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© 2015 FARIN & Associates Inc.
Risk Measurement & Reporting
• Senior management responsibilities
• Types of tools or models
• Complexity and size of the institution
• Reporting frequency, how often
• Compliance with established risk limits
• Potential noncompliance
• Action plans
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© 2015 FARIN & Associates Inc.
Internal Controls & Audit
• Regulatory Expectations
• Review of data accuracy
• Reporting compliance w-policy limits
• Reasonableness of assumptions
• Outputs are reasonable and accurate
• Independent reviews
• Minimum annual compliance check
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© 2015 FARIN & Associates Inc.
Common IRR Measurement
Techniques
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© 2015 FARIN & Associates Inc.
IRR Measurement Techniques
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Picking the Right Tool to match the job…
• Gap Analysis– Measures dollar volume difference between rate
sensitive (repricing) assets and liabilities
• NOT ACCEPTABLE AS A PRIMARY TOOL
• Income Simulation– Measures impact of interest rate changes on earnings
• Economic Value of Equity (EVE)– Present value of all asset, liability, and financial
derivative cash flows
© 2015 FARIN & Associates Inc.
Gap Analysis
• Inventories Timing of Repricing of RSA & RSL
– Future divided into time bands (buckets)
– Balances slotted based on
• Cash flows (fixed)
• Scheduled repricing (variable)
– Total RSA & RSL totaled by time band
– Control ratios are
• Gap/Assets (+/-10%)
• RSA/RSL (0.8 - 1.2)
• Goal of GAP: Provide a Proxy on Earnings at Risk
• Advantages
– Easy data availability
– Can be done manually
– Inexpensive
• Disadvantages
– How soon but not how much
– Fails to consider option risk
– Not a good market value tool
– Difficult to explain to boards &
non-financial managers
– Measures risk but not return
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© 2015 FARIN & Associates Inc.
ALCO Decisions
• Describing the Basic Balance Sheet Positions…
– Asset Sensitive: More assets reprice than liabilities
• If rates increase Income should increase
• If rates decrease Income should decline
– Liability Sensitive: More liabilities reprice than assets
• If rates decrease Income should increase
• If rates increase Income should drop
– Is it possible to have a neutral position?
• Option risks make this nearly impossible for retail financial
institutions
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© 2015 FARIN & Associates Inc.
Examining IRR Measures
• Let’s look at a sample institution
– $900 MM Commercial bank
• 85% Loan/Assets
• 10% NIB Funding
• 17% Checking & Savings
• 56% CDs
• 9% Capital
– Gap Analysis used as primary IRR tool
• As of date = June 2006
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© 2015 FARIN & Associates Inc.
Case Study – Gap
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Month 1 Month 2 Month 3 2nd Quarter 3rd Quarter 4th Quarter
Total RSA 371,634,902 22,487,784 14,125,103 41,131,542 33,236,705 41,011,583
Total RSL 52,728,663 96,652,568 7,002,470 151,943,964 135,255,369 108,188,666
Gap (RSA-RSL) 318,906,240 (74,164,784) 7,122,634 (110,812,421) (102,018,664) (67,177,083)
Cum RSA 371,634,902 394,122,686 408,247,789 449,379,332 482,616,037 523,627,620
Cum RSL 52,728,663 149,381,230 156,383,700 308,327,663 443,583,032 551,771,699
Cum Gap (RSA-RSL) 318,906,240 244,741,456 251,864,090 141,051,669 39,033,005 (28,144,078)
RSA/RSL 7.05 0.23 2.02 0.27 0.25 0.38
Cum RSA/RSL 7.05 2.64 2.61 1.46 1.09 0.95
Gap/Assets 37.76% -8.78% 0.84% -13.12% -12.08% -7.95%
Cum Gap/Assets 37.76% 28.98% 29.82% 16.70% 4.62% -3.33%
Positive Gap at 1 month indicates VR loans and extra Cash investments
Negative cumulative gap at 1 yr. says little chg. in earnings projected
© 2015 FARIN & Associates Inc.
Actual Rate MovementsTreasury Rate Comparisons
4.00
4.20
4.40
4.60
4.80
5.00
5.20
5.40
1 M
onth B
ill -
BEY
3 M
onth B
ill -
BEY
6 M
onth B
ill -
BEY
1 Yea
r T-B
ill R
ate
18 M
onth T
-Bill
Rat
e
2 Yea
r Note
Yie
ld
3 Yea
r Note
Yie
ld
5 Yea
r Note
Yie
ld
10 Y
ear Note
Yie
ld
30 Y
ear Ext
rapola
ted B
ond Yie
ld
2006M06 2006M12 2007M06
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© 2015 FARIN & Associates Inc.
Actual Change in NIM
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Actual NIM drops from June 06 by nearly 10%
© 2015 FARIN & Associates Inc.
Components of NIM ChangeChanges in Net Int Margin Components
-0.40%
-0.30%
-0.20%
-0.10%
0.00%
0.10%
0.20%
0.30%
0.40%
Mar 2006-YTD Jun 2006-YTD Sep 2006-YTD Dec 2006-YTD
Ch
g in
NIM
-0.50
-0.40
-0.30
-0.20
-0.10
0.00
0.10
0.20
0.30
0.40
0.50
Ch
g in
Ma
rke
t R
ate
s
Chg in Int Inc/AA Chg in Int Exp/AA Chg in NIM/AA Chng in 6 Mo Treas Chg in 1 Yr Treas Chg in 10 Yr Treas
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Change in Interest Expense Killed Margin!
© 2015 FARIN & Associates Inc.
Issues
• Prior graph shows:
– Lines Graph – Changes in Qtrly. interest rates
– Int. Inc.. and Int. Exp. both rise in 2nd Qtr.
– Int. Exp. rises faster than Int. Inc..
– Result - NIM Declines 10%
• Institution raised deposit costs when rates
had actually decreased - PRICING
• It’s not enough to measure WHEN something
reprices but HOW MUCH it will reprice
• Modeling risk requires realistic assumptions
on institution pricing actions
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© 2015 FARIN & Associates Inc.
MODELING INCOME @ RISK
Income Simulation
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© 2015 FARIN & Associates Inc.
Income Simulation Choices
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• Static Simulation
– Hold balance sheet constant. No change in mix or size
– Reinvest cash flows back into same account and assumed market rates
– Only change is earnings/net income
– No assessment of strategy
• Modified Static Simulation
– Hold balance sheet size constant, but reinvest flows from products not
offered, not favored to real offerings/real rates
– No assessment of strategy
• Dynamic Simulation
– Measure risk in planned changes in balance sheet size/mix
– Advanced simulation changes growth/mix by rate
– Provides assessment of strategy for comparison to “What-If”
© 2015 FARIN & Associates Inc.
Income Simulation
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Static
• Projection of balance sheet
assumes no change in level or mix.
– Reinvest from one line back into
same line at new rates
• Apply interest rate changes
(shocks, ramps or forecasts) to test
impact of rate changes on income.
• Income at risk = Projected changes
in income level from base rate
forecast to a different forecast.
Dynamic
• Projection of institution’s financial
statements based on a set of
assumptions.
– Total Assets may change
– Loan/Investment &
deposits/borrowings levels change
– Consistent with Budgeting and
Liquidity management
• Measure effect of rate changes on
income by measuring multiple rate
forecasts.
• Income at risk is measured by
fluctuations in income
measurement under the different
rate environments
© 2015 FARIN & Associates Inc.
Dynamic Income Simulation
• Advantages– Model used for dynamic
income at risk analysis can be
used for multiple purposes.
• Budgeting
• Strategic Planning
• Interest Rate Risk Analysis
• Liquidity Risk
– Measures most important
management issue:
• short and medium term
earnings –
• the effect of rate changes
performance
• ROA, ROE, EPS, etc.
• Disadvantages– Cost of software
– People costs for skills to
manage
– Data and Time Intensive
• Ideally your plan should be
incorporated into model.
• As we see more regulatory
action on Enterprise Risk
Management, expect more
acceptance and expectation for
integrated plans and risk
management…
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© 2015 FARIN & Associates Inc.
Static vs. Dynamic IAR
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How does your view of income sensitivity change?
© 2015 FARIN & Associates Inc.
Static vs. Dynamic IAR
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© 2015 FARIN & Associates Inc.
Static vs. Dynamic IAR
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© 2015 FARIN & Associates Inc.
Static vs. Dynamic IAR
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© 2015 FARIN & Associates Inc.
Advanced Issues in Dynamic IAR
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• When running dynamic IAR institution’s must
consider
– How rate changes impact
• Growth rates by rate environment
• Impact on resulting balance sheet mix
• How offering rates change on key products
• Often assumptions held constant
– Will loans continue to grow in +300 bp rates?
– Are deposit rates going to move the same amount for
all rate changes?
© 2015 FARIN & Associates Inc.
IRR Question
40
• Why if we are running a dynamic projection
of our plan/balance sheet do we have to run
a static analysis too?
– Guidance says so…
– Build confidence/trust in modeling process
– Help show how future balance sheet impacts risk
© 2015 FARIN & Associates Inc.
Major Assumptions in Income Simulation
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Static IAR
• Betas on loans & deposits
– How will offer rates change
with market moves?
• Loan/investment prepayment
expectations
– Anticipated early pay
down/payoff of loan
balances
– How do these “speeds”
change when rates move?
– See option risk!
Dynamic IAR
• Asset growth/mix
– One set of assumptions for
all rate changes (most
common)
– Separate assumptions
based in interest
rate/economic projections
(emerging)
• Funding mix
– Growth assumptions on
deposit categories
– Growth/plug assumptions for
borrowings
© 2015 FARIN & Associates Inc.
FFIEC IRR ADVISORY
The time has come to do more in ALCO
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© 2015 FARIN & Associates Inc.
Joint Agency Policy on IRR
• First Adopted in 1996 – Added the S component to CAMEL Rating
– Developed Qualitative Assessment process for Examination
• No Uniform Supervisory Measure
• Major Components– Board & Senior Management Oversight Roles
– Risk Management Processes• Controls & Limits
• Identification & Measurement
• Monitoring & Reporting
• Internal Audit & Review
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© 2015 FARIN & Associates Inc.
Joint Agency Policy Statement5 Areas of Risk To Model
1. Repricing Risk: Impact of mismatch of repricing timing or amount on earnings/capital
2. Basis Risk: How different balance sheet components respond to market rate movements due to driver response– Example: Libor vs. Prime movements
3. Yield Curve Risk: Recognition that Yield Curves do not move the same amounts for all maturities (non-parallel movements)
4. Price Risk: Changes in market values of financial instruments and the impact on the market value of capital.
5. Option Risk: Changes to cash flows resulting from rate movements
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© 2015 FARIN & Associates Inc.
2010 FFIEC IRR Guidance
• 2010-1A IRR Regulatory Guidance
– Issued December 2009
• Restatement of 1996 Joint Agency Policy Statement on Interest Rate Risk– FIL-52-96 Joint Agency Policy Statement: Interest Rate Risk
– http://www.fdic.gov/news/news/financial/1996/fil9652.html
• 3 Major Issues:
– Effective Policies & Governance
– Effective Measurements
– Meaningful & Adequate Reporting
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© 2015 FARIN & Associates Inc.
2010 FFIEC IRR Guidance
• What to Measure– To obtain “Well Managed” rating, must measure both
earnings & economic value at risk
– Must extend simulation of Income at Risk to minimum
of 2 years.
– If you are using dynamic balance sheet modeling, you
must also run a static balance sheet.
• Why? Minimize Assumption Risk
• Must be able to prove your model is effective at measuring
real risks
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© 2015 FARIN & Associates Inc.
KEYS TO BUILDING A VALID
MODEL
Managing Internal Assumptions
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Assumptions in Modeling
• Internal Assumptions: Those inputs that ALCO
can control
– Offering rates
– Growth & mix projections
– Deposit assumptions; beta and decay rates
• External Assumptions: Assumptions that
influence results that are outside of ALCO control
– Future interest rate levels
– General economy
– Loan prepayment speeds
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© 2015 FARIN & Associates Inc.
ALCO Model Keys
• Models depend on accurate assumptions
• Most critical of all assumptions is the speed of cash flows
coming due and repricing - CONTROLLABLE
– More asset flows, faster the response to rate movements
• Recent years have seen regulatory pressure to Validate
models
– Model Validation is designed to ensure proper flows, management
assumptions, and market assumptions
• Ideally, ALCO and Budget processes would share
assumptions and monthly variances validate projected
flows vs. actual
– Can be used to directly impact earnings and production
expectations
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© 2015 FARIN & Associates Inc.
Common Issues in ALCO Models
• Bad input data skews projected cash
flow/repricing information
– Begin monitoring cash flows behind Income at Risk
results
– Explain and document all discussions of variance and
production (minutes)
• Deposit repricing rates versus expected or past
performance don’t match
• Little time spent assessing “What-if” or real world
plans
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© 2015 FARIN & Associates Inc.
Deposit Assumptions in IRR Model
• Major source of margin concern centers on
deposit rate movements in rising rates.
• Following analysis tracked actual rates to
historical through last rising rates
• Comparison of margin performance to projection
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Historical Rate Comparison
52
Current concern is that rates will move as they did in ‘04-’07
© 2015 FARIN & Associates Inc.
Model Assumptions: Deposit Rates
Account Flat Rates Pricing Rule Rising 3%
Rates over 12
months
Shock +2%
Immediate
Savings 0.05% Move by 50% of rate
change
1.55% at end
of 1 yr
1.05% in 1
month
NOW 0.05% Move by 50% of rate
change
1.55% at end
of 1 yr
1.05% in 1
month
MMDA 0.25% Move by 75% of rate
change
2.5% at end of
1 yr
1.75% in 1
month
Rewards 1.13% Move by 50% of rate
change
2.98% at end
of 1 yr
2.48% in 1
month
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© 2015 FARIN & Associates Inc.
Sample Bank NMD Rates
54
MMDA rates reached a “cap” in last rate rise
Checking rates mirrored MMDA and new
Rewards Account introduced as cost control
Measure
Savings rates are on life support…
© 2015 FARIN & Associates Inc.
Rate Comparison Actual to Forecast
Actual Real Changes
‘04-’07
Actual %
change
Savings 0.00% 0%
NOW 2.5% 58%
MMDA 2.0% 48%
Rewards ??? ???
Projected Projected %
Change
Savings 50%
NOW 50%
MMDA 75%
Rewards 50%
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Need to rethink deposit rate changes in model then
rerun income @ risk to determine true sensitivity
Areas of pricing concern:
Savings – significantly different real response than projected
MMDA – Moderately overstated
NOW – reasonable but how does the addition of Rewards
account change response this time?
© 2015 FARIN & Associates Inc. 56
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Impact of Pricing Betas
Questions:
1. Which of these cost of funds profiles would you prefer to have with rising rates?
2. What would that information allow you to do with asset and funding allocation?
© 2015 FARIN & Associates Inc.
EXTERNAL RATE FORECASTS
What Rate Projections Do I Use?
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What Rate Projections Should I Use?
• Most ALCO’s focus on
rate shocks
– Little Probability
– Misstate earnings levels
• Some use rate ramps
– No bearing to real rate
movements
– When rates change impacts
performance
• Often one “index” used to
control all offering rates
– “simplify” the model
– Ignores Basis Risk
• Budgets built on single
rate forecast
– off track when Fed moves
– Assuming 100% probability
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© 2015 FARIN & Associates Inc.
FFIEC IRR Guidance
• What Interest Rates To Measure?– Traditional measures have been shocks
• +/- 100, 200, & 300 basis points
• Not enough stress, implied a 400 bp test
– Rate movements must be both severe and
plausible
• Must recognize current cycle and possibility for scenario
• Should consider changes in slope, & twists in curve
• Who defines plausible?
• Are parallel shocks plausible?
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© 2015 FARIN & Associates Inc.
Historical Rate Comparison
60
What do you think the concern is over rising rates?
• In the past decade has there ever been an immediate and parallel
rate shock?
• This graphs explains both yield curve and basis risk management!
© 2015 FARIN & Associates Inc.
Global Insight – December 2012 Forecast
61
Probability
Base: 60%
High: 20%
Low: 20%
© 2015 FARIN & Associates Inc.
Rate Forecasts – Best Practices
• Policy must address actions when outside limits
in relative rate probability
– If rate forecast probability < 10%, no actions required
– If rate forecast probability > 10% but < 20%, ALCO
prepares list of possible strategies, timeline & impact
– If rate forecast probability > 20%, immediate actions
taken to return to compliance
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© 2015 FARIN & Associates Inc.
New OCC Data Collection - IRR
• Beginning in Late 2013 OCC began collecting
IRR information from regulated institutions
– Interest Rate Risk Information on
• Short Term Earnings at Risk (1 & 2 Year Measures)
• Value at Risk (Long Term Exposure)
• Investment Portfolio Risks
– Key Non-maturity Deposit Assumptions
• Decay Rate
• Model repricing Rates (+/- 1% Rates)
• Market Value Result (+/- 1% and Flat Rates)
• Interesting Rate Movements Requested on
Earnings at Risk
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© 2015 FARIN & Associates Inc.
OCC Interest Rate Risk Form
• Requesting Traditional +/-4%
movements
– Allowing them to be either shocks or
ramps in the input selections
• Added in 5 new movements
– Bull Flattening
– Bear Flattening
– Inversion
– Steepening
– Twist
• These are not “required” but how
does it look if you don’t have them
and your peers do?
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© 2015 FARIN & Associates Inc.
New Rate Movements - OCC
• Interest Rate Movement Definitions
– Bull Flattening
• A yield-rate environment in which long-term rates are decreasing at a
rate faster than short-term rates. This causes the yield curve to flatten
as the short-term and long-term rates start to converge
– Bear Flattening
• A yield-rate environment in which short-term interest rates are
increasing at a faster rate than long-term interest rates. This causes
the yield curve to flatten as short-term and long-term rates start to
converge.
– Inversion
• An interest rate environment in which long-term debt instruments
have a lower yield than short-term debt instruments of the same
credit quality. This type of yield curve is the rarest of the three main
curve types and is considered to be a predictor of economic
recession.
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New Rate Movements - OCC
• Interest Rate Movement Definitions
– Steepening (Bear or Bull)
• A widening of the yield curve caused by long-term rates increasing at
a faster rate than short-term rates or short-term rates declining faster
than long-term. This causes a larger spread between the two rates as
the long-term rate moves further away from the short-term rate.
– Twist
• A yield curve change predicated on government intervention through
monetary policy to manipulate long-term interest rates lower. Used in
recent QE approach to manage long-term costs when short-term
rates were already at or near 0%.
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For Additional Information
• Visit our Encyclopedia for more definition of new
terminology and past articles related to IRR
www.farin.com
• If you have any questions, please email me with
the session name in the subject line.
• Thank you for attending. I hope to see you on
next session.
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How We Can Help
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