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Understanding the Risk Involved in Maintaining Current Spread and Margin

By: Lonnie Harris

Most community bankers have done an outstanding job in the last few years reacting to the great recession and the lowest rates in 50 years. Most have slashed their cost of funds and circled the wagons to protect capital.

Yet, almost every community bank is still faced with the daunting prospect of a decreasing spread and margin. In most cases, the culprit is now on the income side. As we know all too well, loan customers are demanding lower rates and longer fixed terms. And, with rock-bottom benchmark rates most have had to reach for acceptable yields. Almost universally, community banks have extended the duration of their fixed-rate assets in an effort to maintain current income.

What happens when rates increase? Without getting into the economic morass of predicting rates, we can all agree that rates will increase, “someday.” It sounds like a scratchy, monotonous, broken record but now, more than ever, is the time to understand the interest rate risk inherent in your balance sheet.

Knowing where you stand is critical to implementing current strategies. Is there room on the balance sheet for another $5 million of fixed-rate loans at 3.75 percent, to mature in five years? What about meeting a demand to lower the floor on a variable-rate loan with a repricing lock-out of three years? These specific changes may not greatly impact the bank’s risk profile, but given the reality of the industry’s tendency to extend loan terms and lower rates, you may be nearing your risk limit on both net interest income and market value of equity as defined by the asset-liability management policy.

Take a close look at the bank’s projected net interest income in the base case (no rate change) and rates up 100 through 400 basis points. Obviously, you should know where the bank’s projected income stands in relationship to the policy guideline at each point of measurement. Then, step back and think about it. Do you really understand how these projections are being calculated? Do you agree with them based on your understanding of the balance sheet? Can you explain the results in detail to a third party who questions the numbers, or to your board that really needs to know?

For starters, compare the results from the ramped income simulation to the results in the shocked income simulation (both are required). In some cases, the results can be quite dissimilar. Be ready to explain any differences.

Next, understand exactly how the repricing on both sides of the balance sheet is being calculated. Is the model using actual loan repricing rates or rate assumptions that you hope are accurate? In any event, understand where the repricing rates are coming from, and test their reasonableness. Is each loan being repriced or is the pricing executed “en masse” by loan type? Are you taking floors, collars and caps into account on the variable-rate loans? How far must rates move before the floored loans begin to increase in yield?

What about the liabilities? As rates increase, will the cost of the transaction accounts reprice in lock-step or lag the overall increase? How is the lag or beta (the rates liabilities must move to maintain balances) actually determined? Is it empirical, or hopeful?

Lastly, understand the importance of the market value of equity, and how it is calculated. Understand how the balance sheet is “marked-to-market” and how the discount rate for each class of assets and liabilities is calculated. Check your policy guidelines for post-MVE shock, determine where you stand and understand why. Just as importantly, MVE should be calculated to measure proposed changes to the balance sheet to see if there is room to extend assets, lower rates or shorten liabilities, among other options.

All of the above sounds quite technical but really, it is just common sense. The bottom line is simple. Most banks have added interest rate risk and it is imperative that you understand the risk to income and MVE, by critically reviewing the assumptions, conclusions and accuracy of the bank’s ALM model.

If you don’t understand how your model works, or you are not getting adequate or reasonable answers from your personnel (or your third-party vendor), bringing in outside expertise to assist may be a good decision. This issue is far too important to ignore.

Lonnie Harris is executive vice president in the Asset Management Group Inc. of Country Club Bank, Kansas City.

Copyright (c) April 2013 by BankNews Media