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.
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:
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.
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.
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.