Let’s face it. The Fed raised rates in June 2018, and it may not be the last time this year. The more banks we visit, the more we realize that banks have been very relaxed in their approach to Interest Rate Risk (IRR) assumptions. They’ve been equally or even more relaxed to having an independent review of the IRR function.
Utilizing an IRR model is foundational to making data-driven decisions for changing loan and deposit rates. When the Interagency Guidance on Internet Rate Risk was published in 2010, it required banks to validate their IRR model with the following decree:
“Validating IRR models is a fundamental part of any institution’s system of internal controls. An important element of model validation is independent review of the logical and conceptual soundness. The scope of the independent review should involve assessing the institution’s measurement of IRR, including the reasonableness of assumptions, the process used in determining assumptions, and the backtesting of assumptions and results.”
We won’t blame you if you forgot all about this. It’s easy to publish something in 2010, only for rates to stay put for six years. It’s hard to institutionalize it and give it much credence.
Now that banks are facing increasing rates, the need for an independent review is the highest it has been since that Interagency Guidance was released.
Here are three reasons why you should get an independent review of your IRR immediately:
1. Banks are facing a flattening yield curve
It’s old news by now that the Fed raised the Fed Funds rate to a target range of 1.75-2.00% in mid-June 2018. It was the sixth rate increase since December 2016, and all indications are that two more increases are likely this year. The era of cheap funding is over in most markets, and we are looking at a flattening yield curve dead in the eyes. The gap between the Fed Funds target and the 10-year Treasury rate has shrunk considerably since December 2016:
|Date of Fed Rate Increase:||New Fed Funds Rate||10-Year Treasury the following day:||Spread:|
This flattening of the yield curve is impacting community banks’ net interest margins. This also makes the decisions that come out of Asset/Liability Committee (ALCO) all that more important to get right. How much should we raise deposit rates? What deposit products should we increase? When should we do it? How long is too long for fixed loan rates?
The problem is you’ll never get the answers to these questions 100% correct. However, you can make strong informed decisions by utilizing your IRR model, if we have good assumptions. Speaking of…
2. Your assumptions may be wrong and you not even know it
While the Fed has raised rates from 0.50% to 2.00% in the last 18 months, it went SEVEN YEARS without changing the Fed Funds rate from 2008 to 2015.
Even in December 2015, it raised the rate only a quarter of a percent. So from 2008 to 2016, your bank’s assumptions could be incorrect and chances are it had little impact on your IRR model forecasts because rates were not moving.
It is a different story now.
With rates changing, the inaccuracy of your IRR assumptions are being magnified and will impact the decisions you make.
The independent review is the set of checks and balances to help ensure your IRR assumptions can be relied upon by your ALCO and Board. It is prudent risk management. It’s also a regulatory requirement.
SETTING YOUR IRR ASSUMPTIONS: HOW IT SHOULD WORK
This is an annual process for establishing and reviewing assumptions. It should work like this:
3. If you don’t have an independent review, count on an MRIA or MRA on your next exam
The Interagency Guidance requires a bank to have an independent review performed. It should be an annual review to accompany the annual backtest of your IRR model.
When rates were not changing, there was leniency among the regulatory agencies regarding enforcement of this Interagency requirement. Now that rates are moving, the first question examiners are asking when they review sensitivity to market risk is “Can you provide a copy of your most recent independent review?”
We’re passionate about community banks and we don’t want this issue to catch you by surprise. Give us a call or send us an email to discuss this issue with a Community Bank Advisors team member. We’ll work with your bank leadership to have you prepared for your next exam.