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How Rate Sensitive (or Insensitive) Is Your Balance Sheet?

By: By Lonnie Harris

Have you ever had one of those Ground Hog Day experiences? You know, you repeat the same behavior (in this case basically write the same thing) because the situation is almost exactly the same every day? Well, the day has changed but the situation hasn’t, so here it is again: How will the bank’s net interest income and market value of equity be impacted when “rates” finally move up?

We all know Treasury rates have dropped like a rock since the Fed lowered overnight target rates to 0 to 25 basis points in December 2008. In fact, rates have been so low for so long that most loans and a good part of most investment portfolios have turned over (repriced) in this lower rate environment. The rate drought has smashed the yield on earning assets while the duration on both the loan and investment portfolios have “drifted” longer, “stretching” for yield in most cases.  So, while the issue of interest rate risk is tiresome, the  truth is, most banks have substantially greater interest rate risk on their balance sheets today (while sporting lower spreads and margins) than they had last year, or even the year before.

Try to be creative and experiment (in your ALM model) with loan structures that will get the job done with the least amount of heartburn down the road. Hopefully, you have access to a loan pricing model (or software) to help analyze several alternative loan structures that will appeal to your customer base while adding the least amount of risk. In any event, it is imperative to quantify the risk, as new loans are added to the balance sheet.

 Be defensive and run a simple “what-if” for any major change in strategy. One elementary example might include replacing overnight Funds sold with fully amortizing 10-year loans. This will clearly detail not only the new spread and margin, but the impact on MVE and NII in a rising rate environment. This is an extremely simple example but you get the picture. The magnitude of the loan addition and funding source (our example has a simple asset mix change) will vary with each institution but it is important to know what interest rate risk you are adding before you add it.

The good news on the liability front is that most community banks have squeezed a significant amount of interest expense out of the balance sheet. Cost of funds in many institutions is now in the 50 to 60 basis point range and it is not uncommon to see some institutions in the 30 basis point range. The bad news, of course, is predicting how these inexpensive accounts (customers) will behave as rates increase.

The betas (the rate sensitivity measured in each account class) experienced in the last six years (mostly a declining rate environment) may not be completely predictive if rates rise dramatically.  NOW accounts might have a current beta of 30 percent (account rate change measured against Treasury rate changes). If rates increase 100 basis points NOW account rates would have to move 30 basis points to maintain current balances. This movement actually sounds reasonable in almost all cases, but, what happens when a competitor decides to shock the world and raises NOW accounts a full 100 basis points? In this case, the 30 percent beta may not be adequate.

The same logic applies to the calculated retention rate (or, decay rate) in the transaction accounts.  We can assume the math is sound, which it is, but if rates shoot up will we retain our expected (predicted) number of accounts for the predicted length of time? Well, again, the math will most likely stand up, but should we test it?

The above two issues may be extreme but, a check of the assumptions is actually quite easy. Once a year, run a test report that overstates the betas (in the above case assign a beta of 70 percent rather than the calculated 30) to see an absolute worst-case scenario. Likewise regarding retention rate, use an extreme measure rather than the calculated rate. This doomsday report will provide management and the board with a net interest income and a market value of equity scenario that most likely will not occur, but it might motivate management to plan accordingly, and show your regulator that you have the capacity to be proactive, and not just reactive.

Lonnie Harris is executive vice president of Asset Management Group Inc., a wholly owned subsidiary of Country Club Bank, Kansas City. His email is lharris(at)

Copyright (c) August 2014. BankNews Media.