Interest rate risk model assumptions are a very important component of an institution’s risk management process. We are all too familiar with the cliché “garbage in – garbage out” referring to the importance of having valid assumptions when measuring risk. This topic has always gotten the attention of management teams, boards of directors, and regulatory bodies. Having appropriate institution-specific assumptions may be even more important today as interest rates are likely to start increasing later this year, making it more challenging to accurately measure risk. Despite the prevalence of interest rate risk models, many bankers continue to struggle with understanding key assumptions that drive interest rate risk output. Having a supportable set of assumptions for your institution is not just about making an examiner happy. It is a critical step to making your interest rate risk model an integral part of the strategic planning process at your institution. With that in mind, deposit decay terms, deposit repricing betas, and loan prepayment speeds are three key assumptions we will focus on in this eBrief.
Deposit Decay Terms
Deposit decay terms are designed to measure how long accounts remain at the institution. Do your accounts have high turnover, or do they tend to stick around for longer periods of time? Being able to answer these questions can be tough because non-maturity deposits, as the name suggests, do not have stated maturities. However, estimating decay rates/terms will help give you an idea about the tendencies of your depositors and enable you to make strategic decisions based on that knowledge.
Decay term assumptions should reflect the risk of changing customer behavior given different environments. For example, an institution with surge balances that are more likely to leave when rates increase can adjust the assumptions in the model to project faster decay rates (or alternatively, shorter average lives).
In interest rate risk models, deposit decay assumptions have their greatest impact on the Economic Value of Equity (EVE) calculation. Economic Value of Equity is defined as the present value of assets minus the present value of liabilities. Normally, an institution that has stable NMDs with longer decay rates will reflect more stable EVE in changing interest rate environments.
Deposit Repricing Betas
The second major assumption relating to deposits is the repricing beta. We use betas to measure the rate of change of deposit rates relative to a market index. More specifically, it is a measure of how deposit pricing at an institution changes in response to changes in market rates, such as the Federal Funds Rate or the 3 Month Treasury Bill.
For example, assume that the rate paid on savings accounts in 2006 was 1.50%. At this time, the Fed Funds rate was at 5.25%, and we were on the doorstep of a financial crisis that would see this rate fall to 0.25%, a full 500 bps, over the next 3 years. If over that same time, the rate paid on savings account fell 100 bps to 0.50%, then the beta on your savings account would be 100bps/500bps, or 20%. Typically, traditional Savings and NOW accounts have lower betas than more rate-sensitive accounts such as MMDA and CDs. Naturally, this measurement should be taken over various rate environments.
Because beta assumptions relate directly to the interest expense that will be incurred by an institution in various rate environments, it is important to input reasonable estimates into the model. Besides using historical data to estimate betas, bankers can also use other factors such as the deposit pricing strategy going forward or an adjustment for rate-sensitive surge balances.
Loan Prepayment Speeds
Prepayment speeds impact both the earnings simulation and the fair value analysis. There are several different ways to measure prepayment speeds that, in general, will produce similar outcomes (Conditional Prepayment Rate – CPR and the Public Securities Association prepayment rate – PSA, are two common ones). When interest rates decline, there is an incentive for people to refinance their loans, which often results in higher prepayment cash flows forcing reinvestment at lower market rates. When interest rates increase, borrowers have less motivation to refinance, prompting them to pay no faster than contractually scheduled. In this scenario, you may be holding a portfolio of fixed rate loans priced below current market rates.
Measuring historical prepayment cash flows by major loan category is one way to develop bank-specific loan prepayment speed assumptions. Some core systems also provide reports that can help derive these estimates.
Bank Specific Assumptions or Industry Defaults
In general, it is a best-practice for institutions to develop their own unique set of assumptions. Institution-specific assumptions will allow you to fine-tune the interest rate risk model to produce meaningful simulation results. Regulatory bodies favor well-supported assumptions because they give a clearer picture of risk. In some cases it is acceptable to use industry averages for certain assumptions components, especially if these averages are based on recently performed regional deposit and loan studies.
It is also important to periodically stress key modeling assumptions. This will test sensitivity of the risk profile to changes in these key assumptions, and also provide a more conservative or “worst-case” picture of institution’s risk exposure.
No interest rate risk model will ever be perfect. However, the goal for institutions should be to have a model that is useful in helping management and the board to monitor exposures to changing interest rate and economic scenarios. Determining assumptions specific to your institution is a key first step in achieving this goal. A model with reasonable inputs can help provide an accurate picture of how your balance sheet and income statement will change in response to changing interest rates and allow your team to develop business strategies accordingly. With many economists forecasting that interest rates will increase, ensuring that you have a useful model in place will be key in helping navigate what could be the first rising rate environment in many years.
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