Interest Rate Risk Measurement August 10, 2018 Ricky Brillard, CPA Senior Vice President Strategic Solutions Group 901-762-6415 rbrillard@viningsparks.com 1
Outline Trends Impacting Bank Balance Sheets Ways to Manage Liquidity Managing Interest Rate Risk 2
Trends Impacting Bank Balance Sheets Bank profitability should benefit from lower tax rates in 2018; ROA and ROE expected to exceed post financial crisis highs set in 2Q17 Credit quality remains strong; provisions low Community bank margins stable to slightly improved; increasing pressure on cost of funds Loan growth is outstripping deposit growth, but capital and liquidity to absorb The 12-month growth rate in loan balances at community banks is 7.3%, which exceeds the industry growth rate of 4.9% Deposit growth not exceeding loan growth, which impacts liquidity High level of long-term assets; however, IRR positions slightly asset sensitive Composition of funding remains weighted towards non-maturity deposits with longer duration and lower beta sensitivity 3
Community Bank Growth Billions $120 $100 $ Change YoY $80 $60 $40 $110 5% March 2018 Year-Over-Year Change $107 16% $74 7% 5% 9% 20% 18% 16% 14% 12% 10% 8% 6% % Change YoY With loan growth exceeding non-brokered deposit growth, liquidity is stressed Brokered deposits and borrowings represent small piece of overall funding, but percentage changes are increasing $20 $13 $11 4% 2% $0 Total Assets Gross Loans Non-Brokered Deposits Brokered Deposits Borrowings 0% Sources: FDIC 4
Wholesale Funding Trends 25.00% 20.00% 15.00% 10.00% 5.00% 0.00% Commercial Banks Assets $100M to $1B 17.3% 17.6% 21.9% 16.4% 16.5% 15.4% 15.9% 16.4% 16.7% 17.0% 17.3% 17.1% 18.7% 18.7% 12/05 12/06 12/07 12/08 12/09 12/10 12/11 12/12 12/13 12/14 12/15 12/16 12/17 03/18 Borrow FF & Repos Brokered Listing Service Public Funds Total Wholesale funding to total assets at a low 15.4% (2012) Loan growth has been accompanied by an increased reliance on wholesale sources Wholesale funding reliance has increased, but not to 2008 levels Increased use of nonstable liquidity sources increase liquidity risk Sources: FDIC 5
Wholesale Funding Mix The increase in Public Funds, which require collateral such as securities in most cases, may pressure the liquid asset ratio (Cash, FFS, and Unpledged HTM and AFS Securities) Commercial Banks Assets $100M to $1B Public Funds 48% Borrowings 18% FF & Repos 5% Public Funds 31% Borrowings 31% Brokered 21% Listing Service 0% Brokered 25% FF & Repos 13% March 2018 Listing Service 8% March 2008 Sources: FDIC 6
Cost of Funding Earning Assets Asset Distribution March 2018 September 2015 Change Beta All Insured Banks 0.60% 0.33% 0.27% 18.00% Less than $100mm 0.50% 0.44% 0.06% 4.00% $100mm to $1bn 0.56% 0.46% 0.10% 7.00% $1bn to $10bn 0.60% 0.40% 0.20% 13.00% More than $10bn 0.60% 0.30% 0.30% 20.00% Fed Funds Target 1.75% 0.25% 1.50% NA 0.65% All Insured <$100mm $100mm to $1bn $1bn to $10bn $10bn+ 0.60% 0.55% 0.50% 0.45% 0.40% 0.35% 0.30% Q3'15 Q4'15 Q1'16 Q2'16 Q3'16 Q4'16 Q1'17 Q2'17 Q3'17 Q4'17 Q1'18 Low COFs have mitigated margin contraction Low beta sensitivity Insured banks have increased COFs by 27 bps since the Fed began hiking Community bank COFs have fared well Larger banks rely more on higher costing wholesale funding Sources: FDIC 7
Surge Deposits $14 $12 $10 NIB Deposits Other IB Deposits Time Deposits Brokered Deposits 1-Year Growth Rate 12% 10% 8% Regulators are concerned about the surge in deposits and the impact an outflow of deposits may have on liquidity and IRR positions Trillions $8 $6 Growth Rate 6% 4% $4 $2 2% $0 0% 2008Q1 2009Q1 2010Q1 2011Q1 2012Q1 2013Q1 2014Q1 2015Q1 2016Q1 2017Q1 2018Q1 Sources: FDIC 8
Long-Term Asset Exposures Have Risen 55% 50% 45% 40% 35% 30% $100mm-$300mm $300mm-500mm $500mm-$1bn All Banks 45.7% 46.1% 44.3% 34.3% Long-term assets (loans and securities maturing or repricing over 3 years) for community banks remain elevated compared to non-community banks Community banks have put on longer duration assets by funding with longer duration deposits 25% 20% 2005Q1 2006Q1 2007Q1 2008Q1 2009Q1 2010Q1 2011Q1 2012Q1 2013Q1 2014Q1 2015Q1 2016Q1 2017Q1 2018Q1 Sources: FDIC 9
Funding Composition Time & Brokered Deposits Non-Maturity Deposits 90% 80% 77.79% 70% 54.35% 60% 50% 40% 45.65% 30% 22.21% 20% 10% 0% 2008Q1 2010Q1 2012Q1 2014Q1 2016Q1 2018Q1 NMDs are ideal in a falling rate environment where they can reprice quickly Banks have a high % of NMDs in a rising rate environment NMDs may seek higher returns in a rising rate environment Regulators remain concerned about how the change in mix of deposits may have on liquidity and IRR positions Sources: FDIC 10
Net Interest Margin (NIM) Trends 4.00 3.75 3.50 3.25 3.00 All Insured Institutions Community Banks 3.76 3.74 3.71 3.67 3.60 3.59 3.61 3.57 3.57 3.62 3.64 3.42 3.32 3.26 3.25 3.14 3.13 3.07 2010 2011 2012 2013 2014 2015 2016 2017 Q1'18 Community bank NIM has been stable/slightly increased due to: - Limited increase in COFs on deposits - Extension of duration on assets - Liquid assets have declined to fund higher yielding loans Community bank and non-community bank NIMs have been converging YoY since 1Q15 Sources: FDIC 11
Vining Sparks ALM Statistics The median Risk Manager client is modestly asset sensitive with the primary exposure being to declining rate scenarios from both an earnings and economic value standpoint Earnings at Risk Economic Value of Equity 4.0% 2.0% 1.6% 2.4% 1.7% 10.0% 3.4% 3.8% 1.2% 0.0% 0.0% -8.7% -2.0% -3.4% -10.0% -4.0% -6.0% -20.0% -24.6% -8.0% -9.5% -30.0% -10.0% -12.0% -12.9% -40.0% -42.8% -14.0% EAR Year 1 Down 300 EAR Year 1 Down 200 EAR Year 1 Down 100 EAR Year 1 Up 100 EAR Year 1 Up 200 EAR Year 1 Up 300-50.0% EVE @ Risk Down 300 EVE @ Risk Down EVE @ Risk Down 200 100 EVE @ Risk Up 100 EVE @ Risk Up 200 EVE @ Risk Up 300 Sources: Vining Sparks 12
Vining Sparks EAR and EVE +300bps Banks have reduced their exposure to higher rates in recent years, but have reduced asset sensitivity over the last year 4.0% 2.0% 0.0% Earnings at Risk +300 bps 2.9% 2.3% 10.0% 5.0% 0.0% Economic Value at Risk +300 bps 9.6% 3.6% 0.4% -2.0% -5.0% -4.0% -6.0% -3.5% -5.1% -3.4% -10.0% -15.0% -10.0% -7.5% -8.0% 2013 2014 2015 2016 Q1'18-20.0% 2013 2014 2015 2016 Q1'18 Sources: Vining Sparks 13
Why Focus on Liquidity Management? Deposits as a percent of assets flat since surge of 2009 and beginning to decline Changing core deposit dynamics More aggressive competition Deposit pricing pressure Shrinking securities portfolios/unfavorable allocations can not provide the same level of liquidity or interest rate risk management capability Unrealized security portfolio losses constraining on-balance sheet liquidity Fed in tightening mode 14
Ways to Manage Liquidity Five ideas for managing liquidity: - Add on-balance sheet liquidity - Diversify across funding sources - Diversify funding across maturities - Carefully manage the use of collateral and collateralized funds - Targeted loan sales 15
Add On-Balance Sheet Liquidity Borrowing money might prove to be a timely decision 16
Add On-Balance Sheet Liquidity Why is this such a good idea? 1. Liquidity is plentiful and inexpensive now 2. Reduces liquidity uncertainty 3. Pre-funds loan growth at today s potentially lower rates 4. Stores liquidity that can generate cash flows to help support loan growth 5. Adds income depending on the specific funding and investing strategies employed 17
Add On-Balance Sheet Liquidity Keep in mind that this is first and foremost a liquidity strategy meaning that the funding strategy used should: - Diversify across funding sources - Diversity across maturities - Maximize use of unsecured funding The bonds purchased should: - Provide stable, predictable cash flows to fund cash needs - Provide eligible collateral for pledging needs 18
Diversify Funding Across Sources Core deposits are the most valuable funding source Wholesale funding can be used to supplement core deposits FHLB funding is most reliable wholesale funding source, but may not be the most efficient Efficient funding is one that does not require the use of collateral - Brokered CDs - CD listing services - Insured cash management deposits - Fed Fund 19
Diversify Funding Across Maturities A portfolio of multiple funding sources with multiple maturities to protect in different rate environments A well-structured funding ladder will include maturities out on the curve Wholesale funding provides liquidity with terms that augment the core deposit portfolio For most depositories, a 3-year to 5-year funding ladder is appropriate This ladder provides the term, on-balance sheet liquidity to: - Improve most liquidity ratios - Handle maturities as they occur 20
Carefully Manage the Use of Collateral and Collateralized Funds Using collateral for wholesale funding encumbers liquid assets and reduces your available funding capacity Maintain free, pledgeable collateral when funding is plentiful Utilize collateralized funding during difficult periods when it s more readily available and needed the most If you use collateralized funding, prioritize your collateral by providing the least liquid forms of collateral to the funding source that will accept them Keep your liquidity powder dry by not pledging your most liquid forms of collateral 21
Targeted Loan Sales The loan portfolio can be another source of untapped liquidity Consider having your loan portfolio reviewed the establish marketability Strategy allows depositories to create fee income, reduce capital usage, and manage liquidity Loan sales also provide a method to reduce credit concentrations and/or reduce interest rate risk 22
Regulatory Focus on IRR The Winter 2014 Supervisory Insight from the FDIC had the entire issue dedicated to Interest Rate Risk. IRR was briefly mentioned in Part III of the OCC s Semiannual Risk Perspectives from the Spring of 2018. 23
Governance and the Board of Directors The BOD is ultimately responsible for the degree of IRR taken by an institution The BOD do not need to be well versed in the technical aspects BOD and ALCO minutes at well-rated institutions include comments/questions about pricing strategies, product mix, the rationale behind policy deviations, and the causes of changes in the bank s risk profile Senior management s objectives should be: - Administering board-approved policies including day-to-day oversight of risk taking - Maintaining an effective IRR measurement system - Collecting and interpreting meaningful data to inform the BOD of exposures According to the 1996 Policy Statement, senior management and BOD should review reports on the bank s IRR profile at least quarterly 24
Sample IRR Policy Limits Rules of thumb exist in the industry, but each bank is unique, and it is difficult to apply a uniform set of limits 25
The Role of the ALCO In addition to ALM oversight, one important ALCO function is the formulation and periodic review of key assumptions At well-rated institutions, examiners have observed that assumption reviews are conducted quarterly before each model run ALCO members at well-rated institutions are familiar with deposit and loan pricing and customer behavior in the local market 26
Common Risk Mitigation Strategy Slowly reposition the balance sheet over time to align an institution s repricing, maturity, and duration profile - Example: An institution exposed to rising interest rates may need to shorten the duration of assets or extend the duration of liabilities Before repositioning, analyze the impact on earnings and capital - Example: The sale of illiquid long-duration securities could result in significant losses Banks working to reduce their IRR exposure will likely see a reduction in their interest income Regulators strongly support efforts to reduce exposure to rate volatility and will not criticize an institution for temporary consequences to earnings resulting from a rebalancing strategy 27
Developing Key Assumptions Unrealistic or overly optimistic assumptions can result in an inaccurate picture of exposure, resulting in flawed ALM strategies One of the most common IRR issues identified by examiners is the use of unsupported or stale assumptions Assumptions should be commensurate with institution s complexity and sophistication - Simple balance sheet = Conservative assumptions = Less scrutiny - Complex analysis = Aggressive assumptions = Greater scrutiny Critical assumptions include deposit price sensitivity (betas) and decay rates, and asset prepayment assumptions 28
Qualitative Adjustments Historical data on deposit pricing provides a starting point and some perspective for developing assumptions, but banks should consider qualitative adjustments to deposit betas to reflect the possibility that surge deposits will be strongly rate-sensitive once interest rates start increasing. 29
Deposit Beta Assumptions Beta Factor - Represents the magnitude of deposit re-pricing for a given market rate change Beta Example = Critical component of income simulations (Earnings at Risk) Analysis need not be highly complex Large institutions may use enhanced analytics (i.e. regression analyses) Effects on deposit pricing differ depending on rising and falling rates 30
Deposit Decay Rate Assumptions Decay rates are an assumption about the average life of non-maturity deposits (term structure) Commonly associated with the Economic Value of Equity analysis Longer average lives generally result in higher economic value and less exposure to higher rate scenarios Surge of funds into NMDs poses challenges in determining decay rate assumptions Calculate historic decay rates and consider adjustments for qualitative factors 31
OCC Non-Maturity Deposit Assumptions 32
Prepayment Assumptions Prepayments are early repayments of a loan Prepayment risk results when cash flows contract or extend more than expected - Leads to reinvestment risk - Increased / decreased volatility in Economic Value of Equity Generally, if rates rise, all else equal, prepayments will slow and WAL is extended Generally, if rates fall, all else equal, prepayments will rise and WAL is shorter 33
Sensitivity Analysis & Stress Testing Assumptions with the most influence should be analyzed to determine the impact of changes to those assumptions The objective of sensitivity analysis is to isolate the impact of a single assumption on the results Change one assumption, re-run the analysis, and compare the results Hypothetical sensitivity analysis comparing a 20% beta against a 30% beta 34
Recommendations for Developing Assumptions Use peer averages, but consider bank-specific factors Don t over rely on generic vendor-provided assumptions Differentiate between rising- and falling-rate scenarios Don t oversimplify balance sheet categories Perform sensitivity testing to determine how changes in assumptions would impact EAR and EVE If assuming growth in the balance sheet, also generate no growth analysis to be conservative Consider the following: - Cost of non-maturity deposits is unlikely to decline further - A higher run off factor for surge deposits - Segregating surge deposits from more stable NMDs - Time depositors may not be sensitive to early withdrawal penalties - A minimal level of prepayments in a rising-rate scenario to be conservative 35
Frequent Exam Recommendation Concerning IRR Establish appropriate risk limits Perform 300bp to 400bp interest rate shock scenarios Enhance/support key assumptions used to analyze IRR, especially deposit and prepayment assumptions Refine sensitivity testing of key assumptions Strengthen the independent review process 36
Disclaimer Thank You Ricky Brillard, CPA Senior Vice President Vining Sparks rbrillard@viningsparks.com INTENDED FOR INSTITUTIONAL INVESTORS ONLY. The information included herein has been obtained from sources deemed reliable, but it is not in any way guaranteed, and it, together with any opinions expressed, is subject to change at any time. Any and all details offered in this publication are preliminary and are therefore subject to change at any time. This has been prepared for general information purposes only and does not consider the specific investment objectives, financial situation and particular needs of any individual or institution. This information is, by its very nature, incomplete and specifically lacks information critical to making final investment decisions. Investors should seek financial advice as to the appropriateness of investing in any securities or investment strategies mentioned or recommended. The accuracy of the financial projections is dependent on the occurrence of future events which cannot be assured; therefore, the actual results achieved during the projection period may vary from the projections. The firm may have positions, long or short, in any or all securities mentioned. Member FINRA/SIPC. 37