Regulatory Bootcamp Part 2: Interest Rate Risk – Preparing for your Next Exam

Part 1 of the Regulatory Bootcamp series addressed liquidity, which has understandably been a focus of examinations this year.  Not to be overlooked is interest rate risk.  The Fed Funds rate currently stands at 5.50%, levels not seen since 2001, and has risen 525 bps since March 2022.  The rapid rise in interest rates has led to changing behaviors among depositors, causing many to withdraw funds from institutions in the pursuit of higher interest rates elsewhere.  Financial institutions have seen increasing competition for a shrinking supply of deposits forcing them to adapt and react with new deposit pricing strategies.  As your institution prepares for the next regulatory exam, a few factors to consider as part of the interest rate risk management process include: 

• Deposit Betas – Betas are not static, they are dynamic!  While it is no surprise that funding costs have been increasing, what may be a surprise is the rate at which they have been increasing.  The banking industry as a whole has had a beta of 37% throughout this rising rate cycle (1Q2022 – 2Q2023).  However, more recently, the beta from 3Q2022 – 2Q2023 has been 69%.  Just as we are seeing now, betas historically accelerate throughout rising rate cycles, which points to the importance of having up-to-date beta assumptions in your interest rate risk model.  An updated study will be an important piece of information to have on hand during your next exam. 

• Deposit Outflows and Migration – For the first time in over 30 years, the banking industry experienced net deposit outflows in 2022.  Through the first two quarters of 2023, outflows intensified, causing many institutions to have to replace these funds with more expensive, higher beta, wholesale funding.  On top of this, many institutions have seen depositors migrate funds out of low-cost non-maturity deposits and into higher cost money market and time deposit accounts, adding to the pressure on cost of funds and net interest margin.  This dynamic movement of funds is typically not captured in most interest rate risk models, which often assume a static balance sheet.  For example, if the beta on an account is 5%, but 20% of those balances left and were replaced by wholesale funding, the impact on cost of funds could be understated.  Updating deposit decay studies and performing ‘what-if’ scenarios in your interest rate risk model to simulate deposit run-off and migration will be important from a risk management perspective.

• Loan Prepayment Speeds – With the rapid increase in interest rates, prepayment speeds for many loan categories have slowed compared to recent years.  This is especially true for fixed rate mortgages, as borrowers have little to no incentive to prepay.  Evaluating these assumptions is another way to help improve the accuracy of the model and satisfy examiners that key assumptions are regularly reviewed.

• Non-Parallel Shifts – We did not get into this deeply inverted curve via a parallel move in the curve and we’re not going to get out of it with one either.  Simulating alternative yield curve movements, including a further inversion of the yield curve, can help demonstrate to examiners that your institution is actively monitoring more than just the standard parallel shock scenarios.

• Back-Testing – The changes in terms of the rate environment and shifts in the balance sheet experienced in the industry will undoubtedly put models’ forecasts to the test.  While variances in some cases can be explained by factors such as changing interest rates and migration of deposit balances, evaluating the back-test can also identify if there are opportunities to fine-tune assumptions and enhance the accuracy of the model.

• Independent Reviews – A review of the institution’s overall methodology of monitoring interest rate risk should be conducted periodically.  Some examiners prefer this to be completed every 12 months, some prefer up to 24 months.  This review should include areas such as a review of the IRR/ALM Policy, the proper use of the interest rate risk software, back-testing, ALCO meeting minutes, and assumptions.  This can be done internally by individuals independent of the interest rate risk process, or externally, for example, by internal auditors.

Taylor Advisors’ Take:  One word that can summarize this rising rate cycle is “Dynamic”!  Everything from deposit betas to deposit balances, to the shifts in the yield curve have changed meaningfully during this cycle.  All of this points to the need for evaluating assumptions in the interest rate risk model, which will benefit your institution from both a regulatory perspective and a risk management perspective.  Examiners will want to see support for key model assumptions, as well as evaluation of alternate/stressed scenarios.  Thorough documentation and preparation in the interest rate risk area will go a long way in helping prepare for your institution’s next exam.