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Interest rate risk management in a rising rate environment

Connor Siegelski
March 21, 2023
Read Time: 0 min

Strategies for earning more in rising rates

Financial institutions need to be intentional with funding strategies and loan pricing models.

You might also like this video on managing interest rate risk.

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Asset/liability management

Managing interest rate risk requires strategy

A rising-rate environment -- isn't that exactly what banks and credit unions have been hoping for in order to increase profitability and net interest margins?

On the surface, rising rates may appear to be the solution to the desired outcome of increasing net interest income after such a long earnings drought. There are indeed myriad ways by which financial institutions can earn more income and mitigate interest rate risk through these periods of rising rates.

However, it isn’t as simple as being able to charge higher rates on loans, earn higher rates on the investment portfolio, and call it a day.

Being poised for this type of rate environment prior to it occurring is oftentimes the most effective strategy for reaping the rewards of higher rates. If an institution wasn’t fully prepared, however, it can nevertheless meet its goals using tailored asset/liability management (ALM) strategies. But before examining ALM interest rate risk management strategies for banks and credit unions, it’s important to look at the current economic situation surrounding the banking industry and exactly why profitability isn’t a given for many institutions.

Balance sheet management

Rising rates and overnight borrowing

Federal Reserve Chairman Jerome Powell has increased the Federal Funds Target Rate from 0-0.25% to now 4.50-4.75% over the course of 2022 and 2023. With signs continuing to point toward additional rate hikes, albeit smaller, many financial institutions are uncertain how they can and should manage their balance sheets to effectively combat interest rate risk both in the present moment and to come in 2023 and beyond.

The graph below shows the stepwise increase in the federal funds target rate from Jan. 1, 2022, to the current day. The gray line represents the federal funds target rate, the interest rate the Federal Reserve sets for overnight borrowings made between financial institutions. The blue line shows the effective funds rate, or the average rate at which institutions are actually lending and borrowing funds from one another.

chart of the fed funds rate

The black line showing the volume of overnight borrowings displays the large percentage increase from Q1 2022 to Q4 2022. Specifically, Q1 2022 volume averaged $72.27 billion, while Q4 averaged $100.97 billion – a 39.7% increase in overnight borrowing activity. Even with the significant drop off from March 10, 2023, average overnight borrowings in the first quarter ($104.38 billion) are averaging higher than in the fourth quarter of 2022.

Financial institutions that were at one point flush with liquidity to the point of not knowing what to do with it have now found themselves in borrowing positions.

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One could presume that the cost of overnight borrowings would almost always be higher than the cost of funds through core deposits alone and that borrowing rates will increase more rapidly than the cost of deposits.

Therefore, one could also presume that financial institutions finding themselves in a borrowing position may be decreasing their net interest margin.

Liquidity and capital impacts

Funding competition and the yield curve

Competition for funding can be extremely aggressive in a rising rate environment. To add insult to injury, many banks and credit unions that had large surge deposit balances from COVID have been seeing those funds leave. Without a large pool of very loyal customers, institutions continually will be at risk of losing funding from their customers to competitors who were first to raise rates on their deposits.

As mentioned earlier, the best strategy to prepare for an oncoming rising rate environment is to secure and lock in funding before there is “blood in the water.” Banks and credit unions who were late movers and are now scrambling to lock in funding for the short term to meet liquidity and capital needs may come to realize that the so-called greener pastures of a rising rate environment aren’t that green after all.  

Coupling this dynamic with the current state of the Treasury yield curve, it’s easy to see how banks and credit unions are in search of answers for effectively managing interest rate risk and remaining profitable.

When the short, left end of the Treasury yield curve, typically associated with interest rates paid on deposits, begins to rise closer to or higher than that of the longer right end of the curve, which is aligned with loan rates, there is a constant battle for financial institutions to stay profitable.

What started out in 2022 as a somewhat “normal” yield curve – one that slopes up gradually – later flattened and then inverted back in July. Economists and investors label the yield curve as inverted when the 2 Year Treasury is higher than that of the 10 Year. The blue line in the graph below shows the yield curve as of Jan. 3, 2022. The red line shows the yield curve as of March 16, 2023, when it was deeply inverted with the 2 Year Treasury at 4.14% and 10 Year at 3.56%.

Inverted yield curves are typically a sign of an overall sense of unease and panic within the financial markets, investor uncertainty, an unwillingness for people to lock in their money for long periods of time, and a compression of interest rate spread for banks and credit unions.

US Treasury yield curve, 2022 vs. 2023

This inversion between the 2 Year and 10 Year Treasuries has often been viewed as a strong indicator of an economic recession being likely to occur within the following 12- to 18-month period. As the saying goes, history tends to repeat itself. That maxim is portrayed in the graph below, which follows the spread between the two Treasuries since 1976.

Spread between 10-Year Treasuries and 2- Year Treasuries

Whether the inverting of the yield curve is the cause of an economic recession or is merely correlated with a recession is up for debate. Two things are not up for debate:

  1. The depth of inversion between the 2 Year and 10 Year Treasuries is currently at its highest since the 1980s economic collapse.
  2. The inversion of the curve puts direct pressure on both banks and credit unions in their ability to increase net interest margin and return a profit.

Again, with the current rising rate environment, it isn’t necessarily a clear-cut path to obtaining higher interest margins.

Actionable ideas

Strategies to combat risk and remain profitable

Now that we’ve outlined the current economic conditions affecting banks and credit unions alike, the question that remains is how are those same institutions able to combat interest rate risk and remain profitable? Although the following list is not all-inclusive, it provides key takeaways that are both actionable and rooted in logic that can help provide a means to that end during economic environments such as the current one.

 

Take a deeper dive into deposit pricing.

As outlined above, the cost of funds (interest expense) that financial institutions incur can become challenging during rising rate environments. This can become even more of an issue if leadership and the Asset Liability Committee (ALCO) are unable to make informed strategic decisions due to being unaware of the sources and reliability of their funding. Reacting to the market without a strategy can be one of the most common mistakes financial institutions can make during a rapidly changing environment.

A core deposit analysis can arm decision-makers with confidence moving forward, knowing they have detailed information and data backing their next moves. Having data related to depositor demographics and behaviors, along with key competitor movements, is vital to staying afloat through rising rates. Pricing deposits at a level that allows financial institutions to retain or attract customers is of utmost importance. If you cannot retain or attract any depositors, it will force a borrowing position, which in turn will likely lead to increased interest expense and lower margins.

Making use of a core deposit study can be one of the most important tools a financial institution can employ during a rising rate environment so they can learn more about their core funding sources and how to best implement a strategy to increase interest margins. Oftentimes, banks and credit unions get caught up in narrowly focusing on the pricing of their assets and place less of an emphasis on their liabilities. Betas, lags, and decays are all key assumptions for any ALM model. Failing to have a thorough deposit study performed that provides those assumptions could be leaving dollars on the table for the institution and its stakeholders. These key assumptions are formulated using historical consumer behavior. If the last time a study was performed was three years ago, the assumptions are not only outdated, but they also could be steering management in the wrong direction in strategic planning.

An accurate core deposit analysis allows management to learn a great deal about their core funding and, in turn, how to effectively make and implement decisions surrounding that funding.

Regularly update the ALM model.

Sometimes, especially given the current economic climate, a quarterly update to an institution’s offered rates on loans and deposits, coupled with new assumptions and inputs, will not provide the outlook needed to effectively manage interest rate risk and institute measures to protect the best interests of the bank or credit union. Conditions are changing, and they have been changing rapidly. The Federal Reserve has hiked rates by an additional 150 basis points since the increase in September 2022. Given the latest rate hike was only 25 bps (compared to the prior five being 50-75 bps each), the Fed may be slowing down the pace. However, it’s difficult to believe that financial institutions will see any sort of pivot from increasing the fed funds rate from where it is now.

Keeping inputs and key assumptions updated regularly provides management and the board with the best reporting by which they can develop a clearer path to success.

Maintaining the status quo on assumptions when the economic environment is so dynamic could lead to lost opportunities if management is not continually informed on the forecasted spread between interest income and expense.

During all the current uncertainty, there is another point to consider. Is your current ALM model robust enough and sufficient to execute the inputs and assumptions that you’d like to see in order to feel comfortable with the data then presented to you? Are there key elements missing in the model that could have a material impact on forecasting income and expenses for the upcoming month, quarter, and year(s) ahead?

The output of a model can only be as accurate and precise as the model will allow it to be. The one “behind the wheel” also needs to be comfortable with the model to be able to make confident inputs and assumptions. ALM consultants can assess the adequacy of the financial institution’s ALM model and inputs or assist with assumptions and reporting to provide added confidence in decisions.

Have an ALM model validation completed with the goal of strategic gains.

There are typically two schools of thought around regulatory compliance among financial institutions and their leaders. One is a view of compliance as seemingly unnecessary, burdensome, and an additional task added to an already full plate. The other is as an opportunity to improve upon policies, procedures, tools, and the like, which can benefit both the institution and shareholders. Having an ALM model validation completed for the sake of the institution’s performance rather than for regulatory compliance will likely create greater benefits due to the goals for which the validation is undertaken.

When a bank or credit union is looking for a model validation to be performed by an external third party for the sake of regulatory compliance, there can be a collective sense of “checking off the box.” Going with the lowest bidder oftentimes brings lackluster results, improvements, and suggestions. Having a third party do a thorough validation of the ALM model with an intention of making improvements allows teams to dig further into inputs and assumptions, gather advice on how to better implement changes, and likely shift the ROI from “checking off the box” to providing management and ALCO useful, pertinent information.

Consider the impacts of loan pricing models and loan portfolio composition.

With interest rates rising, loan demand is beginning to slow. While loan pricing will often get more attention than deposits, if left alone for too long, it could leave the financial institution with two suboptimal outcomes: missing out on valuable customers or lending at rates that do not align with the risk being taken on. A key take-home point here: Are you being compensated for the risk that is presented when lending out money to borrowers? Is the reward worth the risk?

Institutions using a loan pricing model can effectively manage and regularly update their loan pricing so they can keep up with economic conditions such as the current ones. Factors such as credit quality, changes in risk appetite, increased competition for credit, and changes in cost (among other things) can lead to a much different pricing decision on a loan than even just a month or days prior. Loan demand may be trending downward, but pricing loans strategically and effectively becomes even more important to attract quality customers and meet profitability goals.

Another related consideration is that liability-sensitive banks and credit unions – meaning that their liabilities reprice more frequently than their assets – are at increased risk during times of rising interest rates. When a large majority of financial institutions’ balance sheets are composed of fixed-rate loans rather than variable-rate loans, it leads to a narrowing spread between interest income and expense. This is especially so when the Treasury curve has inverted.

Take, for example, Bank “A” with a loan portfolio composition of 50% fixed and 50% variable rate versus Bank “B” with a 40% fixed rate and 60% variable rate. As rates increase, Bank “A” will be at a disadvantage because half of its portfolio will be fixed at lower rates, leading to decreases in potential earnings and a decrease in economic value of the loan. On the other hand, having a portfolio in which 60% of loans can reprice as rates increase helps Bank “B” hedge against potential losses and combats the increase in rising funding costs. If an institution’s loan portfolio is heavily disproportionate in fixed rate loans, it may be worth looking into offering more adjustable-rate loans to ward off a narrowing spread during rising interest rates.

Controlling risk

Conclusion: act now for best results

Rising-rate environments – something that most bankers believed would be sweet music to their ears – can actually turn out sounding like a scratched vinyl record. This is an unprecedented economic cycle, and it’s proving to be one in which many financial institutions are struggling to manage. While the strategies outlined above are not and never will be all-inclusive, they can help institutions take direct, actionable steps toward managing interest rate risk and improving the knowledge and decision-making power of those involved in the process to achieve growth and profitability.

Learn more strategies and tactics that are useful in managing funding in volatile environments with this on-demand webinar.

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About the Author

Connor Siegelski

Analyst
Connor Siegelski, an Analyst with Abrigo Advisory Services, assists with delivering asset/liability management and interest rate risk information to numerous Abrigo clients. He also facilitates client data integration transfers to Abrigo’s ALM solution and provides ALM stress testing formulation and report delivery. Connor held financial reporting roles in healthcare and

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