Group of Four Meet

Interest rates are difficult to predict, so financial institutions should use their asset liability management model to guide future decisions.

Reducing Risk

Is Your Institution’s Balance Sheet Increasing Your Interest Rate Risk?

  • Jon Markfort
  • 3/14/2019

On December 19, 2018, the Federal Open Market Committee increased rates for the ninth time since the great recession. While CLA has seen net interest margins steadily rise over the last several years, we have also continued to see pressure on deposit pricing, which has resulted in many of our financial institution clients experiencing tightened credit margins. This interest rate volatility may impact your institution’s budgeting, incentive plans, and overall profitability.

Net Interest Margin US Banks

While we can only speculate what 2019 and beyond holds for rates going forward, there is one thing we know for sure: Any changes to the rate curve will affect your institution’s balance sheet.

Identify balance sheet risk with an ALM model

Your institution must evaluate its interest rate risk (IRR) position through a well-executed asset liability management (ALM) model. This ALM model is the basis for determining what, if any, balance sheet maneuvers are necessary. Having a sound, well-supported ALM model is key to management’s overall assessment of the risks embedded within your institution. Using this model, you may find that a large-scale change could benefit your institution, leading you to put a new plan into motion to better manage your IRR.

Common balance sheet management strategies

While there are many ways to address your interest rate exposure, it generally comes down to whether your balance sheet is asset-sensitive or liability-sensitive. Many common approaches for addressing balance sheet risks include:

  • Shortening or lengthening deposits
  • Utilizing external funding
  • Varying the fixed rate vs. floating rate mix within the loan portfolio
  • Adjusting investment decisions to complement the balance sheet composition

While these are effective strategies in addressing IRR, many financial institutions are implementing alternatives that may allow them greater balance sheet management flexibility while meeting the needs of your customers.

Alternative strategies for hedging interest rate risk exposure

Recent changes to the hedge accounting standard can provide increased flexibility to solve complex IRR problems with the use of plain-vanilla derivatives. When structured and accounted for properly, you can utilize these new strategies to efficiently achieve the IRR you desire without the need to alter the composition of loans, securities, or the funding mix. As the divergence of opinions on the potential direction of interest rates has recently increased, the relevance of incorporating these tools into the Asset/Liability Committee framework cannot be understated.

“We have seen a meaningful uptick in the use of derivative strategies by banks and credit unions as the increased volatility in capital markets only adds to the difficult operating environment for financial institutions. The inverted yield curve also has added a new sense of urgency for institutions who find themselves to be more asset-sensitive than they prefer.” — Todd Cuppia, Managing Director of Balance Sheet Risk Management, Chatham Financial

Implementing a hedging strategy

A sound entity-wide hedging policy will give your board of directors and management the foundation to build a well-developed strategy. But implementing a hedging strategy comes with additional governance oversight. Accounting Standards Update No. 2017-12, Derivatives and Hedging (Topic 815), was intended to reflect the economic results of hedging in the financial statements and simplify hedge accounting. You should determine any impact to your financial statements prior to implementing a hedging strategy.

How we can help

CLA can help your institution prepare for your year-end audit through proper documentation, financial and governance reporting, and ALM controls. Our professionals can provide best practice recommendations to enhance your bank or credit union’s ALM policies and procedures, strategies, and the tools you use in the ALM process to enhance your institution’s earnings and manage exposure to interest rate and liquidity risk.