The Federal Reserve bank started to raise interest rates in March of 2022 to combat rising inflation. Knowing the critical importance of effective interest rate risk (IRR) management in such an economic environment, regulators made it an area of regulatory focus for 2023. Given the fact that inadequate interest rate risk management was a contributing factor to several bank failures earlier this year, effective IRR management can literally be a matter of survival for some banks, and the reason that regulators are now addressing weaknesses more aggressively.
Doran Jones has extensive insight into IRR management, in addition to extensive experience in risk management and compliance. Our team brings fixed income, portfolio management and trading experience analyzing yield-curves, forecasting interest rate changes and quantifying the effects of those changes on banks.
In this series of articles on interest rate risk, Doran Jones will share insight into best practices garnered from our holistic approach to IRR management. In this article we begin to discuss the pragmatic implications of risk management, compliance, quantitative analytical, technical model and forecasting, and data management expertise.
Interest Rate Risk Identification
The most fundamental and obvious interest rate risk is repricing risk. It is the result of differences in the timing of cash flows and rate changes due to the repricing of assets, liabilities, and off-balance-sheet exposures. For example, a bank makes a ten-year fixed-rate loan at 6% that is funded by a one-year certificate of deposit paying 4%. The bank is subject to repricing its source of funds every year so if it has to pay a higher rate to keep the funds at maturity its margin decreases and could potentially turn negative with a large enough increase in rates. A bank’s balance sheet could be either asset or liability sensitive:
- Asset Sensitive: The bank’s assets reprice faster than its liabilities resulting in its net interest margin (NIM) increasing when rates rise and decreasing when they fall.
- Liability Sensitive: The bank’s liabilities reprice faster than its assets resulting in its NIM decreasing when rates rise and increasing when they fall.
Basis risk is the result of a relative change in the timing or level of interest rates in different markets or instruments. For example, if the rate paid on an asset is tied to the prime rate and the funding of the asset is tied to the six-month Treasury rate, basis risk occurs when the spread between the two rates change.
The yield-curve plots the level of interest rates for a fixed income instrument or index at different maturities. Longer term rates are normally higher than short term rates, resulting in a positive yield curve. However, during an interest rate cycle the curve can get steeper, flatter, or even turn negative (inverted). Changes in the yield-curve can exacerbate a bank’s IRR by increasing the effect of maturity mismatches. For example, a bank that funds long-term assets with short-term liabilities experiences a greater decline in NIM in a market that is experiencing a flattening of the yield-curve.
Option risk results from the bank or its customer having the right to alter the level and/or timing of the cash flows of an asset or liability. Banks sometimes engage in the buying and selling (writing) of put and call options, resulting in options risk, but most banks also incur option risk from embedded options on assets and liabilities generally in the form of loans and deposits.
The ability of the option holder to choose whether to exercise or not creates an asymmetry in an option’s risk level, as they will only exercise their right when it is beneficial to do so. The option holder faces limited downside risk (the cost of the option) but unlimited upside potential. The option seller faces unlimited downside risk, but limited upside reward (they keep the premium that they collected selling the option).
A bank that has provided (sold) interest rate options to customers may have more downside risk from an unfavorable move in interest rates than upside reward from a favorable change.
Prepayment Options Duration and Convexity
The most prevalent embedded option on the asset side of the balance sheet comes from prepayment options on loans, predominantly mortgages. Homeowners typically have a contractual right to pay off a mortgage prematurely over time by increasing their monthly payment, or all at once. The occurrence and speed of prepayments can have a significant impact on the earnings and value of mortgage loans and mortgage-backed securities. For example, in a falling rate environment, banks experience diminished cash flows due to prepayments as higher yielding mortgage payments are replaced by having to issue new mortgages at lower rates. This is often exacerbated by the fact that homeowners will often prepay their mortgages in a falling rate environment to refinance their home at a lower rate. An understanding of the nature and measurement of IRR attributable to prepayments requires an understanding of duration and convexity.
Duration is the measurement of the price sensitivity of a fixed income instrument to changes in interest rates and is predominantly determined by the time remaining until the return of its principal and level of interest rate payment. Longer principal payment periods and lower interest rate payments result in longer duration (greater interest rate related price volatility).
The duration of an instrument changes as the level of interest rate changes. Convexity reflects the rate of change in duration as interest rates change and is an important component of IRR. As market rates rise, prepayment speeds slow (homeowners hold on to their lower rate mortgages), resulting in a longer time period for the return of principal and a longer duration. Conversely, as market rates decrease durations shorten. This direct correlation between rate changes and duration of mortgages means they have negative convexity.
This negative convexity causes adverse changes to mortgage duration in both rising and falling rate environments. If rates decrease, the mortgage duration shortens reducing the rise in value that would have occurred without negative convexity. If rates rise, duration extends increasing the drop in value.
Interest Rate Caps and Floors
Variable rate bank loans often contain rate caps or floors that can have a significant impact on IRR. The cap or floor is the strike price of the embedded option. If market interest rates increase beyond the cap rate, the customer’s option is “in the money”. Conversely, if interest rates drop below the floor, the bank’s option is “in the money”.
Variable rate loans without caps can have an explicit cap at the highest rate a borrower can afford to pay and the bank may have to renegotiate the loan or face default. Non-maturity deposits (NMDs) can also have de-facto caps and floors in the rate of interest the bank is willing to pay and depositors are willing to except.
Early Withdrawal and Deposit Pricing
The liability side of a bank’s balance sheet also has significant imbedded options. For deposits, the right of early withdrawal represents a put option to the customer. If rates increase, the customer can exercise their right so that they can reinvest at higher rates. The bank will then have to replace those funds at the current higher market rate. NMDs represent an option that favors the bank as they can lag markets by raising deposit rates at a slower pace than market increases and lead decreases when rates are falling. Such pricing decisions need to be carefully balanced as too much lag or lead time can create a competitive disadvantage.
Federal Home Loan Bank Borrowings
The Federal Home Loan Bank (FHLB) offers loans to banks that have the option (usually held by the FHLB) to convert from fixed to variable rate or be called by the FHLB. Such loans can be very complex and require thorough and careful analysis. Additionally, steep prepayment penalties can apply that leave banks vulnerable in a falling rate environment.
Interest rate risk is a complex and technically challenging subject that is critical to the financial stability of every bank and something that senior management and the board need to understand and manage accordingly. Bank management needs to have a thorough understanding of the different types and sources of IRR, including less obvious risks presented by imbedded options, both stipulated and implied. We will be discussing IRR measurement, monitoring, and controls in upcoming articles.
Contact us to learn how a strategic partnership with Doran Jones can provide you with cost-effective solutions by leveraging our expertise with these and other critical risk and compliance functions.