Rising Interest Rates: Not Just a Liability-Side Risk

By Leonard DeRoma

While the timing and magnitude may be uncertain, one thing we know for sure is that interest rates will rise.  If history and market tendencies are any indication, the yield curve (the difference between longer and shorter rates) will also shift.  These two forces will create pressure on bank balance sheets. 

Traditionally banks tested their interest rate sensitivity through the ALCO process by running several scenarios against their aggregate fixed and floating assets and liabilities.  These scenarios were fairly standard, laddering several shocks and testing the results.  This methodology is unrealistic given the current market environment and the changes that have taken place in bank balance sheets since the 2008 financial crisis.  Given the Fed’s proclivity to keep rates low, a more realistic scenario will show a slower grinding increase that may be accompanied by rotations in the yield curve.  But more interesting than the potential scenarios has been the change to the composition of many banks’ balance sheets. 

Invictus Consulting Group has worked with many banks that have employed a greater use of caps and floors in their loan pricing.  While the floors have supported the interest income in a falling rate environment, the opposite will take place as rates rise. 

Simply put, the net interest margin sensitivity response will be non-linear, or asymmetric.  As rates grind upward, many of the floors in the extant loan structures will still be in effect, mitigating the bank’s ability to get better rates, while the liability side will be responding instantaneously.  The floors, the spreads, maturities and durations of the loans all depend on the time or vintage of loan origination, the same factors that play an important role in determining relative credit quality and the resulting impact to regulatory capital requirements.

Similarly the influx of deposits since 2008 has forced banks to take on more investment portfolio assets, and in their search for yield, longer-dated assets.  Aside from having an impact on the new methods of computing bank liquidity, these assets, many of which are mortgage-based (FHLMC or FNMA) have an embedded repayment optionality, which means their duration can extend as rates rise. Potential market value losses that might be assumed for a given duration of a security will actually be greater because the duration will increase due to their convexity.

Invictus assists its bank clients in gaining an accurate read of the sensitivity of securities and loans under different interest rate scenarios through its LoanLayering™ methodology.  Taking a bank’s strategy, the vintage of its existing portfolio, the implied duration of new loans, the liability structure, and the investment portfolio, Invictus constructs incisive interest rate stress tests that are unrivaled in the marketplace.

We would be pleased to discuss how we can help you generate meaningful strategic information, and prepare for your next exam.