These five areas of focus can help financial institutions improve their standing and prepare for the future. When it comes to managing interest rate risk, data-driven strategies can be the difference between a financial institution and its competition. Consider the following items a checklist for equipping your bank or credit union for rate changes.
Robust interest rate risk models
Sharbel emphasized the importance of having a robust interest rate risk model. "You should be using the most robust interest rate risk model that you can afford," she said. “It's not just about current conditions but also about where your strategies are leading you. Your model should be able to capture all relevant risks and assumptions.” Some common pitfalls Sharbel sees are the inability to incorporate lag on deposits or capture balloon payments in the loan portfolio. “Certainly, in this volatile market, we want to see that you’re checking every assumption that is going into your model to make sure that you can identify, measure, monitor, and control your risk.”
Dynamic scenario analysis
One effective way of managing interest rate risk is through dynamic scenario analysis. This involves incorporating strategic pricing and growth projections into your earnings at risk models. By doing so, you not only manage the risk in your current portfolio but also anticipate risks in your future portfolio. This comprehensive approach ensures that you are prepared for various economic scenarios.
Diversification of loan and investment portfolios
Diversifying your loan and investment portfolios can mitigate concentration risk and enhance stability. Sharbel noted that the infamous Silicon Valley Bank failure began as a concentration risk that became an interest rate risk and, ultimately, a liquidity risk, which can happen quickly if risk is not managed correctly. By spreading investments across different asset classes and sectors, banks can reduce their exposure to any single economic event or market downturn.
Backtesting, core deposit studies, and loan prepayment studies
Backtesting is not new, but regulators have increased their scrutiny of institutions’ backtesting practices. “Backtesting gives you a confidence level in your model that will help you depend on your model and make decisions based on your model comfortably,” Sharbel said. Even if the results of a backtest aren’t what you expected, regulators will appreciate that your financial institution is documenting what has happened and why you think you can still have confidence in your ALM model.
Sharbel also recommends a loan prepayment and core deposit study if your financial institution hasn’t done one recently. Performing these tests on key assumptions helps banks understand how different economic conditions could impact their portfolios and overall financial health. For instance, what happens to your liquidity if there is a significant runoff of large deposits? Understanding these scenarios can reveal vulnerabilities and guide your strategic planning.
Capital and liquidity management
Maintaining a strong capital position and managing liquidity are foundational to managing interest rate risk. A capital buffer is essential to handle unexpected events like global pandemics or economic crises. Ensuring adequate capital and liquidity buffers can help absorb shocks and stabilize during turbulent times. Sharbel also noted that it's important to understand both your institution’s pricing behavior and your customers’ behavior in terms of longevity. Customers are paying attention to your rates, and you need to understand what will happen when those rates fall.
