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Interest Rate Risk & Liquidity

Interest rate risk (“IRR”) is defined as the exposure of a bank’s financial condition to adverse movements in interest rates.  After 11 years without a fed funds rate increase, including seven years without any changes in the target fed funds rate, we saw one increase in December 2015 and another a year later.  At the time of this writing, it appears that the Federal Reserve is poised for yet another increase.

Potential increases in the fed funds rate certainly lead to increases in the prime lending rate, resulting in increased interest income. However, increases in these rates may result in similar rises in money market and savings rates.  While increases in deposit rates may not have happened in your market in 2015 or 2016, that trend may not continue.

Here are a few pointers to keep in mind as you navigate these waters.

Look to the past

Look around the Asset Liability Committee (“ALCO”) table.  Many of the members are sitting there with smartphones in front of them. When we last began a tightening cycle in 2004, the smartphones weren’t there. How many of the current ALCO members were there? Their experience is vital.  In fact, their experience navigating the rate increases is more important than simply using past data to support current expectations.

Review assumptions

Banks have assumptions built into their IRR and liquidity forecast models.  It may have been a while since key assumptions have been reviewed.  We suggest a review of key assumptions including:

  • Beta – This is the rate of change of deposit rates given a change in market rates. How much do you really expect money market rates to rise for the next increase (or two) in fed funds rates? How much after that?
  • Decay rates – How long will non-maturity deposits last? Did your bank experience an increase in deposits since 2007 because customers simply didn’t have many other options? Logic suggests that as short-term rates increase, those deposits may be at risk of leaving.
  • Line of credit utilization – Will line utilization increase? If the fed funds target rate increase is a result of increased business activity, banks could see increased loan balances due to higher line utilization. What assumptions are in your liquidity forecast model?

Review liquidity plans

Do you need to dust off your contingency funding plans?  Is your list of funding sources up to date? Have you tested the mechanics of your funding sources?  Now is a good time to make sure all of your documentation, including signature cards or resolutions, is up to date.

Annual reviews

Banks should have annual reviews, including model validation, of their interest rate risk program.  See Financial Institution Letter (“FIL”) 2-2010 – Financial Institution Management of Interest Rate Risk.

Banks should also have periodic reviews of their liquidity risk management program.  See FIL 13-2010 – Funding and Liquidity Risk Management.

Be Proactive

This is not an area, and now is not the time for a “rubber stamp” of your interest rate risk and liquidity management. Proactive utilization of these models affords the Bank the ability to navigate potentially choppy waters. Seek out assistance from trusted advisors who specialize in these areas.  Take advantage of their certifications, training, and most of all, their experience.

If you have questions, please contact Sam LaFollette, CTP at, or visit for more information.

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