Maximizing the Effectiveness of Your Risk Management Practices
With two recent raises from the Federal Reserve and an anticipated two or three more on the way this year, plus an increase in regulatory scrutiny, interest rate risk should be top-of-mind for every financial institution. However, not all interest rate risk methodologies are created equal. Bank management must review their practices to ensure they incorporate interest rate risk management with the bank's overall strategic plan, address the most likely risks, and utilize their risk management tools for more than just satisfying regulatory requirements.
Interest Rate Risk and the Strategic Plan
The first step in aligning the bank's interest rate risk practices with the strategic plan is to define an acceptable level of risk, typically dictated by the board of directors. Too little risk can be just as harmful to the bank (via lost profits) as too much risk. "Risk management isn't risk avoidance," said Marc Gall, vice president at BOK Financial Institution Advisors. "The bank takes risks all the time, so you're not trying to avoid it. You're trying to manage it." Bank management must determine whether they believe the risk profile they use accurately represents the bank's risk. "Many of the tools and approaches we've used in the past have been driven by regulatory requirements, not the bank's needs," explained Dave Koch, president and CEO of FARIN & Associates. "Reconcile the reports with what everyone actually believes the bank's risk position actually is."
The exact strategy for managing that risk will be different at every institution. "It's always important for bank managers to recognize the unique characteristics of their institution, business model, customer base and local market area," said Jeff Caughron, president and CEO of The Baker Group. "There's no cookie-cutter approach to interest rate risk strategies because every single balance sheet has its own unique considerations." Those include the mix of assets and liabilities and their rate sensitivity as well as any unusual instruments or off-balance sheet derivatives. The bottom line is: what works for one bank may not work for another, even within the same market. "There are so many nuances," said Gary J. Young, president & CEO of Young & Associates, Inc. "For every rule of thumb, there are exceptions." For example, while most Wisconsin banks will benefit from keeping interest rates as low as possible on deposit accounts, a small branch in a large market with few deposits may benefit from being extremely aggressive in raising rates.
The Usual Suspects: Common Risks
Despite each bank needing a unique interest rate risk management strategy, they share many of the same risks. After all, the entire industry is operating under the same prolonged low-rate environment. One common risk associated with that environment is the speed at which different banks will respond to rising rates. Many risk models show all loan rates going up by the same amount at the same time, when in reality the change is much more varied. "One vulnerability is the disconnect between the reality of how loan rates move versus how they're being modeled," said Koch. At the time of this writing, the Fed has increased its rate by 75 bps, yet there has been virtually no change in non-maturity account rates. "The bank needs to establish a strategy with respect to what they're going to do when other banks raise their interest rates, because it's going to happen," said Young. "It's best to think those things through before the event occurs."
Another, more widespread concern is the question of how funds will move between non-maturity accounts and certificates as rates rise. The ratio of non-maturity accounts to CDs is very different today than it was prior to the Great Recession and subsequent rate collapse. According to Young, the average bank's pre-recession ratio of CDs to NMAs was 60%/40%. Today, a ratio of 30%/70% is not uncommon because of the prolonged low cost of funds. That dramatic swing has caught the attention of regulators because it has massive potential for interest rate risk as the spread widens between CD rates and NMA rates and depositors begin moving their money. "Trying to get a good understanding of how price-sensitive those [deposit] accounts are and how long those funds will stay there is one of the biggest challenges today," said Gall. Of course, the entire situation is uncharted territory, so there are no guarantees. "A core deposit study will absolutely help you manage that deposit relationship better and understand how to best control those costs while still meeting the customers' needs," Koch advised.
Another common risk is overlooking dynamic liquidity risk analysis, according to Caughron. Because liquidity has been ample for so long, banks must ensure they have the tools at their disposal to prepare for different conditions. "For banks to survive and thrive, they need solid liquidity risk tools at their disposal," said Caughron. In general, lack of effective tools can be a risk for any bank. "Proper analysis of institution-specific data is critical to effectively manage interest rate risk," Caughron explained, adding that common "old tools" like rate-sensitive GAP analysis aren't enough anymore. "These days we know that GAP is a starting point and doesn't tell the whole story," he said. "We have to ensure that we're doing deeper dives into analysis of the data characteristics of our banks."
Invalid or untested assumptions in the bank's interest rate risk models are another common area of concern. "The key thing is understanding your report model and the assumptions that go into it," said Gall. "These reports are not as cut-and-dried as financial statements." It's also important for bank management to understand the severity of risk associated with each assumption. "Nobody is going to get all of the assumptions right," Koch explained. "You need to understand which assumptions could kill you quickly so you know what you have to keep a close eye on. Accurate sensitivity testing is essential." Gall recommends running an alternate assumption scenario annually. These "what if?" scenario models can help the bank build out strategies and tactics for unlikely but highly impactful possibilities.
Finally, a risk that is common throughout the industry is the need to adapt to change. "Demographic changes are having an impact on the behavior of depositors and borrowers," Caughron said. "Those strategies that make sense going forward may be quite different from what made sense in the past."
More Than Just a Regulatory Requirement
Perhaps the most impactful change that can be made to a bank's interest rate risk practices is to use them not only to satisfy regulatory requirements, but also to manage the bank holistically. "The banks that really use interest rate risk well are the ones who take it one step further and ask what that means about how they can improve the quality of the bank," said Young. "If interest rate risk is only ever about measuring where you are, it's not doing you much good. You're just meeting the regulatory requirement." To realize the full potential of the information gleaned during the interest rate risk management process, bank management must use that data to inform small tactical shifts that will improve the bank's performance in the future.
Costs associated with purchasing or upgrading risk management tools should be viewed as investments due to their ability to improve the bank's overall performance. "If you invest in the risk management function wisely, it will make you money," Koch assured. He also recommends placing all of the bank's risk management tools into once overall forecast, because interest rate risk, liquidity risk and credit risk are all interdependent. "That's why modeling that tries to isolate one set of risks is problematic," he explained.
Embracing interest rate risk and ALCO management also helps the bank improve profitability because the reports can give bank management a glimpse at where their current strategies will lead, according to Gall. "The interest rate risk report is a tool to determine where the bank is headed without additional action," he explained. "But the future is not set in stone. The report isn't a forecast. It's a guide."
BOK Financial Institution Advisors is a WBA Gold Associate Member.
The Baker Group is a WBA Bronze Associate Member.