Pub. 3 2014 Issue 1

l e a d i n g a d v o c a t e f o r t h e b a n k i n g i n d u s t r y i n k a n s a s 26 The Banking Environment: A S WE MOVE INTO A NEW YEAR, THE US economy continues to plod along at a slow and steady pace. Things are getting better, but we’re still far from where we were before the “Great Recession” began. Meanwhile, the banking landscape has improved markedly as earnings clocked sixteen consecutive quarters of year-over-year increase. Returns on assets remain below pre-recession levels, but they’re higher than a year ago and comfortably above one percent. Much of the improved performance comes from healthier asset quality. Loan losses have declined to levels not seen since 2007, and provisions have fallen nearly forty percent. All of this is good news, but make no mistake; banks face a multitude of challenges ahead. Spotlight on Interest Rate Risk: Not the least of these challenges is that of potential interest rate risk (IRR). Regulatory agencies have once again elevated IRR as a focal point for examiners, as evidence suggests that many financial institutions are taking on higher levels of interest rate risk. Balance sheets have changed noticeably in recent years as loan demand has been weak and short-term rates have hugged historic lows. This could leave them significantly exposed to a sustained increase in interest rates. In October, the FDIC released an FIL on Sensitivity to Market Risk. Simultaneously, the OCC conducted a webinar to address the IRR issues they thought most important. There is a consensus among regulators that the essential risk for banks stems from long-term (or high duration) assets funded by non- maturity deposits that have surged into bank balance sheets in the wake of the Great Recession. The influx of “surge deposits” has regulators concerned about the potential for fast rising interest expense from rate sensitive liabilities. At the same time, asset values could come under greater pressure than in past rate cycles because effective durations are relatively high. The price risk of some investment portfolios has increased significantly in the past few years due to lengthened maturities, options risk, and declining yields. Management Tools: The regulatory concerns should cause bank mangers to ponder several questions about the reporting tools that they have at their disposal: 1. Do we have reports that project securities depreciation relative to capital in a rising rate environment? 2. Does our IRR model shock the fair value of regulatory and risk-based capital ratios as well simple equity capital? 3. Do we have a way to model faster re-pricing liabilities relative to earning assets? 4. Are “floors” on loans modeled properly in our IRR system? 5. Do we have reports that show how our balance sheet liquidity is affected by rising interest rates? 6. What if we just want to look at securities cash flow? Risk Management decision-making depends on thorough and meaningful data in a useable report format. The five questions above are good ones to consider when assessing the adequacy of an IRR reporting system. Risk, Capital, and Stress Tests: It makes good sense to measure and monitor the relationship between unrealized losses and capital. And this extends to various measures of capital itself. For example, if we apply the mark-to-mark adjustment for securities to risk based capital measures, we can more closely capture a total picture of the bank’s relative risk. All else being equal, a bank that makes relatively few loans can sometimes justify a higher level of interest rate risk than a bank with a high loan/deposit ratio. Similarly, well-capitalized banks with pristine asset quality can tolerate more interest rate risk than those with high “Texas Ratios.” Institutions should run stress tests on assumptions for non- maturity deposits in IRR models to identify exposure to rising rates and higher interest expense. Back tests and assumptions reviews should ensure that floors on loans are being modeled properly. The dynamics of balance sheet cash flows should be reported and reviewed, and investment cash flow projections tracked for different rate environments. Banks have again been given a “heads up” from examiners on interest rate risk. With proper reporting tools, good policies, and sound processes, the regulatory challenge can be met and the potential risks managed for a smooth and profitable 2014. Since 1979, we’ve helped our clients improve decision-making, manage interest rate risk, and maximize investment portfolio performance. Our proven approach of total resource integration utilizing software and products devel- oped by Baker’s Software Solutions* — combined with our solid investment experience and advice — makes us the investment firm of choice for many community financial institutions. For more information, contact Jeff Caughron at The Baker Group: 800-937-2257, www.GoBaker.com, or email: jcaughron@GoBaker.com . The Baker Group LP is the sole authorized dis- tributor for the products and services developed and provided by The Baker Group Software Solutions, Inc. INTEREST RATE RISK: A PRIORITY FOR 2014 By Jeffrey F. Caughron Associate Partner, The Baker Group LP