So you have the responsibility to update the interest rate risk management program for your institution. As if you didn’t already have enough to do! The effectiveness of your redesigned IRR program depends to a great extent on your response to five key questions. First, what are you attempting to measure and how will it be measured? Second, what is your philosophy toward interest rate risk? Third, should your measurement system be static or dynamic? Fourth, what kinds of interest rate shocks should you use in stress testing your institution? Fifth, what thought processes will you use to establish policy limits for interest rate risk. The first three questions will be discussed in this article. The fourth and fifth topics will be discussed in part 2 of this series in the next issue of the newsletter.
Interest Rate Risk – What Are We Attempting to Measure?
Let’s face it! The definition of interest rate risk used by managers and regulators isn’t the same! Managers tend. to focus on the effect of a movement in rates on income over the next quarter, semiannual period, or year. The manager’s viewpoint is understandable. Managers are accountable to directors for putting net income on the bottom line. Anything that would mess with the bottom line net income is appropriately a concern of management.
On the other hand, regulators focus on liquidation value. If it becomes necessary to liquidate an institution, they are concerned about what price they’ll receive for the institution’s assets and whether they will have to tap the insurance fund to pay off the depositors.
With the regulatory focus on liquidation value, it's not too surprising that our interest rate risk measurement tools are moving away from gap analysis and toward market value measurement tools like duration analysis, discounted cash flow, and option-adjusted spread analysis. But the movement to tools measuring the regulatory definition of interest rate risk raises an interesting issue for managers. Do you change your focus from income to market value as an IRR measurement tool? Or do you adopt a measurement system that measures the effect of rate shocks on both income and market value?
Measurement systems that measure both income and market value risk best meet the needs of both managers and regulator. No matter how hard the regulator pounds away at the importance of market value analysis, your board will hold you responsible for what you put on the bottom line. So your measurement system needs to focus on the effect of rate shocks on income for management purposes. Your system also needs to focus on the effect of rate shocks on market value for regulatory compliance purposes.
Your IRR Objective – Minimize or Manage?
The objective of many financial institutions is to maintain interest rate risk at a level as close to zero as possible. Such an approach would certainly keep a smile on the face of the institution’s primary regulator.
But in an environment of generally low loan/deposit ratios, lots of liquidity, and no interest rate risk, an institution may have difficulty putting enough money on the bottom line to keep directors happy. Minimizing interest rate risk can lead to a real world demonstration of the old saying “No risk, no return!”
Other management teams take a more aggressive approach. They take on interest rate risk if it improves their ability to accomplish long-range profitability, growth, capitalization, and dividend goals. These managers set policy limits that keep potential losses due to adverse movements in market rates at affordable levels. They see interest rate risk in the same way they see credit risk – an opportunity to make money through effective risk management. Financial institutions, for the most part, choose from the following four approaches.
The Retail Liability Driven Approach – “Lets not portfolio assets unless our depositors offer the right kind of funding”
This approach is the most conservative and traditional approach. An institution’s managers pursuing this strategy raise virtually all of their funding in the retail markets. Because their objective is to maintain zero interest rate risk, they place retail loans in their portfolio only when ideally suited retail funding is available. Any loans that don’t match up against the institution’s retail funding are originated and sold in the secondary market or no loans are made.
In today’s market, long-term CDs are hard to find. Regulators, especially bank and credit union regulators, tend to treat transaction accounts as relatively short-term’ sources of funding. As a result, managers in institutions pursuing the retail liability strategy primarily portfolio variable rate loans and fixed rate loans with relatively short-term maturities. Long-term fixed rate loans like mortgages are only made if they conform to secondary market standards and are immediately sold in the secondary market. The retail liability approach minimizes interest rate risk. Such a strategy can result in low loan/deposit ratios and less than optimal net income by limiting the list of acceptable loans.
The Economist Approach –“I believe I can make money forecasting rates”
The economist approach begins with an interest rate forecast. Whether the rate forecast is the institution’s or from someone they trust is irrelevant. It is crucial the management team believe there is a better than average chance rates will move in the direction of the forecast. They make their money by running the institution so it will benefit when rates move in the forecast direction. As Figure 4 indicates, those taking the Economist approach will run a positively rate sensitive institution when they believe rates will rise and a negatively rate sensitive institution when they believe rates will fall. The table also shows how a properly set up institution would appear to gap analysis, income simulation, duration, and MVPE oriented measurement systems.
In one form of the economist approach managers of institutions use the slope of the yield curve to enhance net income. As this article was written, the treasury yield curve appeared as shown in Figure 5. Because the yield curve was positively sloping, an institution could make money by booking longer duration assets funded by shorter duration liabilities. In Figure 5, the institution books five-year duration assets (priced off five-year Treasury yields of 5%). It funds them with four-year duration liabilities (priced off four-year treasury yields of 4.5%). As long as rates remain fiat it will pick up the 50 bp spread in the yield curve as additional income.
Managers of institutions using the yield curve to enhance income are making an implied rate forecast. If long-term rates are higher than short-term rates, the market is predicting that rates will rise. Managers using short-term funding for long-term assets are betting that the market’s rate forecast is wrong. If rates rise, institutions will suffer a decline in both income and market value.
For the economist approach to work, rate forecasts have to be accurate more than 50% of the time. If rate forecast accuracy is less than 50%, managers in institutions employing the Economist’s approach will show less profit over the long haul.
The Farin & Parliment Retail/Wholesale Approach
The F&P approach recognizes that retail customers are risk-averse because most have no effective way of hedging their interest rate risk. How many ARM customers will see their salaries increase to cover their increased mortgage payments in a rising rate environment? The F&P approach also recognizes that retail customers are willing to pay a premium for what they consider to be desirable options (annual and lifetime caps, prepayment options, conversion options, early withdrawal options, etc.).
With rates at the bottom of the cycle, loan customers, particularly nonconforming loan customers, are willing to pay a premium for fixed-rate loans. They need to be bribed heavily with rate, caps, and other incentives to accept adjustable rate loans. Retail deposit customers are often willing to accept treasury or sub-treasury rates on short-term CDs but require a significant premium over treasury before committing funds to long-term CDs.
Under the F&P approach, the institution’s managers accept all retail instruments that are well priced considering their risk characteristics. They accept fixed rate loans for portfolio purposes, especially nonconforming loans offering significant spreads over secondary market rates. They also accept short-term CDs and core deposits, as long as they can find them at sub-treasury rates. They don’t pay up for long-term CDs.
“But this is insane,” you say. “Long-term assets funded by short-term liabilities!” Let’s look at the rest of this approach. Those pursuing the F&P approach use pricing to control the level of short-term liabilities. They use the wholesale markets to offset the interest rate risk they are incurring in the retail markets. This may mean investing primarily in short-term securities to balance long-term loans. Using the F&P approach may also mean raising long-term funding to balance short-term deposits through wholesale market sources like FHLB advances. More sophisticated institutions may use instruments like interest rate swaps and caps.
The objective of the F&P strategy is not to bring interest rate risk to zero. Rather, the management team is attempting to maximize performance while keeping interest rate risk within its policy limits. Review the MCNB case in the previous issue. It compares a retail liability approach to the F&P approach for a $100 million institution. The results are startling.
To the extent managers employing the F&P approach take on interest rate risk and rates move in an adverse direction, declines in income and market value will occur. The damage is limited by setting and maintaining compliance with appropriate policy limits.