Developing the Key Assumptions for Analysis of Interest Rate Risk ystems for measuring and In this respect, a systematic approach managing interest rate risk to developing common-sense assump- S(IRR) are key analytical tools tions for use in IRR measurement for helping banks position themselves systems is an important part of a for potential changes in interest bank’s strategic planning. Conversely, rates. Using IRR measurement tools using unrealistic or overly optimis- effectively, however, requires banks tic assumptions in IRR systems can to make reasonable assumptions result in an inaccurate picture of about how the rates and volumes of a bank’s risk exposure, potentially its key product lines would change as resulting in flawed asset-liability interest rates change. After six years management strategies. of historically low interest rates, including notably little volatility in FDIC examiners review key assump- the federal funds rate, developing tions as a part of the Sensitivity to these key assumptions is both chal- Market Risk review at each exami- lenging and important. nation. The use of unsupported or stale assumptions is one of the most This article describes the impor- common IRR issues identified by tance of appropriate assumptions for FDIC examiners. Common weaknesses the analysis of IRR. Additionally, the found during the review of assump- article describes the process to develop tions are: some of the key assumptions necessary to evaluate interest rate sensitivity in Use of peer averages without consid- the current environment. The develop- eration of bank-specific factors ment of deposit and asset assumptions Lack of differentiation between will be explored in particular as these rising- and falling-rate scenarios inputs can have the largest impact on the results of an IRR analysis. As Over-simplification of balance sheet described in this article, it is generally categories leading to potentially possible for such assumptions to be faulty analysis developed by bank staff. Lack of qualitative adjustment factors to historic data (e.g., not considering a higher run off factor Importance of Assumptions for surge deposits) An effective risk management frame- Another issue that examiners observe work consistent with outstanding is that some institutions do not supervisory guidance can help banks attempt to evaluate how the results of position themselves for changes in the their IRR measurements would change interest rate environment. IRR analysis in response to a change in assump- is not intended to dictate how manage- tions (i.e., sensitivity testing). If results ment should react to changes in inter- would change significantly in response est rates, but should be used as a tool to change in a critical assumption, to understand how current actions may prudence suggests planning for a range affect future earnings. of values for that assumption. 11 Supervisory Insights Winter 2014 Developing the Key Assumptions for Analysis of IRR continued from pg. 11 In certain cases, banks have engaged outside vendors or consultants to General Considerations for formulate assumptions because of Developing Appropriate a lack of resources. In such cases, Assumptions management needs to satisfy itself that assumptions reflect the specifics Expectations for the development of the institution’s assets and liabili- of assumptions used to measure IRR ties and local markets, and should are commensurate with an institu- not categorically rely on universal tion’s complexity and sophistication. assumptions provided by vendors or A bank with a simple balance sheet consultants. FDIC examination reports employing conservative, common- sometimes cite overreliance on sense assumptions that are readily generic vendor-provided assumptions understood by senior management as a weakness in IRR management. and the board of directors will typi- cally not be criticized by the exam- While many banks use consultants to iners. Conversely, a bank that uses help develop assumptions, it is not a more complex mathematical analyses requirement to do so, and most banks to support aggressive assumptions can reduce expenses by generating may be subject to greater scrutiny. assumptions internally. This article focuses on ways banks can develop The IRR measurement process and support their assumptions with depends heavily on certain critical existing staff. It is important that assumptions to generate reason- management employ assumptions ably reliable results. At a minimum, that are based on an evaluation of key management should give particu- characteristics, such as loan prepay- lar consideration to non-maturity ment speeds, non-maturity deposit deposit price sensitivity (or betas)1 decay rates, surge deposit run off, and and decay rates, the reasonableness the likely extent of deposit re-pricing. of asset prepayment assumptions, Common Key Assumptions for IRR Measurement Asset Prepayment – represents the change in cash flows from an asset’s contrac- tual repayment schedule. The severity of prepayments fluctuates with various interest rate scenarios. Mortgage loans are a prime example of assets subject to prepayment fluctuations. Non-maturity Deposits • Sensitivity or Beta Factor – describes the magnitude of change in deposit rates compared to a driver rate. • Decay Rate – estimates the amount of existing non-maturity deposits that will run off over time. • Weighted Average Life – estimates the average effective maturity of the deposits. Driver Rate – represents the rate, or rates, which drive the re-pricing character- istics of assets and liabilities. Examples include Fed funds rate, LIBOR, U.S. Trea- sury yields, and the WSJ Prime rate. 1 In this context “re-pricing betas” refers to how changes in deposit rates compare to driver rates, such as the Fed funds rate. 12 Supervisory Insights Winter 2014 and key driver rates for each interest not reflect future trends. Generally, rate shock scenario. Non-maturity the most representative data source deposit assumptions are especially for deposit assumptions is the insti- relevant in today’s environment as tution’s own historical information. these deposits represent a historically Prepayment assumptions can be large volume of bank funding, and sourced from national averages, data customer behavior may not reflect vendors, internally generated analy- past behavior when market rates ses, or a blend of these approaches.2 change in the future. Furthermore, Generally, asset prepayment would institutions with significant invest- slow down in a rising-rate scenario, so ments in longer-duration securities for purposes of simple and conserva- should place additional emphasis on tive estimates of the effect of rising developing assumptions for rising-rate interest rates it may be sufficient scenarios where bond depreciation simply to assume only a minimal level may pose outsized or unintended risk of prepayments. to earnings and capital. Management should also ensure Generally, key assumptions used in it measures the IRR of the current an IRR measurement system should balance sheet. Optimistic assump- be reviewed at least annually. Manage- tions about the growth of loans or ment can employ a variety of tech- other income can potentially mask niques to develop key assumptions; the degree of IRR. Accordingly, banks however, all such techniques involve using growth assumptions as part of obtaining and analyzing relevant data, their measurement of IRR should also and making judgment-based adjust- generate “no growth,” or static analy- ments to reflect the possibility that sis, to evaluate exposures if no balance assumptions based on past data may sheet growth occurs. Qualitative Adjustments for Key Assumptions Bank management may want to explore qualitative adjustments for some assump- tions. Qualitative adjustments are applied to historically based analysis to account for unique bank-specific or environmental characteristics (such as a historically low- or high-interest rate environment or changes in competition). In light of a surge in deposits despite very low deposit interest rates, management could consider the following qualitative factors in determining whether to adjust assumptions: Flight to quality, seeking insured investments over alternatives Rate differentials between time deposits, non-maturity deposits or non-bank investments Customer decisions to park funds in non-maturity deposits until rates rise Diminished impact of early withdrawal penalties on time deposits Changes in technology, demographics, and competition 2 Typically, community banks that collect prepayment estimates from external sources obtain this information from a model vendor or an external vendor. 13 Supervisory Insights Winter 2014 Developing the Key Assumptions for Analysis of IRR continued from pg. 13 Chart 1 reflects how demand, nego- Deposit Assumptions tiable order of withdrawal (NOW), money market deposit accounts Deposit assumption development (MMDA), and other savings accounts typically addresses two factors: have increased during the past several years to represent 56 percent of total 1. Beta Factor, which repre- assets at institutions with total assets sents the magnitude of deposit less than $10 billion as of June 30, re-pricing for a given market 2014, up from 38 percent at the end rate change. This assumption is of 2008. The increase is attribut- a critical component in income able to the minimal rate differential simulations. between non-maturity products and term certificates of deposits, bank and 2. Decay Rate, which