How To Manage IRR In A Changing Economic Environment

January 2014

THE CEO CORNER: How To Manage IRR In A Changing Economic Environment

It is clear that coming out of the worst economic environment since the Great Depression, community banks face a challenging credit and earnings cycle. That is why many bank executives and boards of directors are concerned about liquidity and asset quality. Yet current evidence reveals that many financial institutions have high levels of interest rate risk during this period of historically low short-term rates.

Community banks are increasingly liability sensitive, exposing them to increases in interest rates. Also problematic are earnings pressures to offset high loan loss provisions. Community banks may have a heavy reliance on short-term and wholesale funding sources, which tend to be more rate sensitive and less stable than traditional deposits. When rates rise, deposit customers may rapidly transfer funds elsewhere, and wholesale funds may reprice quickly. The risk is particularly acute for institutions with high concentrations of longer-term assets.

During your next regulatory review, examiners might ask whether your institution has stress tested its Interest Rate Risk (IRR). For example, variable-rate assets in which interest rates are below embedded floors will behave more like fixed-rate assets until interest rates again rise above those floors.

Concentrations of longer-maturity assets funded with shorter-maturity liabilities can stress an institution’s earnings, liquidity, and capital in a rising rate environment.
It is important that financial institutions plan now for likely increases in interest rates and take steps to mitigate and control the associated risks. It is time for financial institutions to focus on the deposit base and seek ways of extending those deposits with a pricing discipline that considers IRR consequences.

Vito R. Nardelli is an Invictus executive director. During his 30-year financial services career, he excelled at building and maintaining excellent relationships with regulators. He served as the president and COO of OceanFirst Financial Corp, and the president of OceanFirst Bank in New Jersey before retiring in 2012. Prior to that, he served as the Senior Vice President and Retail Banking Director for Trust Company Bank. He held several leadership positions at First Union National Bank, including president of the Central New Jersey region. He also was executive director of the New Jersey Economic Development Authority in the 1990s. Mr. Nardelli was a Lieutenant Colonel in the United States Air Force Reserve. He received his BS and JD degrees from Fordham University and has an MBA in Executive Management from St. John’s University.