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Is Your Interest Rate Risk Model Incorporating the Risk of Deposit Mix Changes?

August 1, 2014

Recently, we blogged about interest rate risk (IRR) modeling methodologies that can give credit unions a false sense of security. (See blog titled “Is Your Risk Methodology Giving You a False Sense of Security?” Posted on July 3, 2014.) We noted that traditional income simulation seldom incorporates the risk of non-maturity deposit withdrawals or member CD early withdrawals. Instead, it will either assume that the deposit mix never changes (static) or the forecasted deposit mix always comes true (dynamic) regardless of what happens to interest rates.

Let’s look at the reasonableness of assuming the mix of deposits remains the same by exploring the history of lower-cost deposits as a percent of total funds:

As shown above, history demonstrates the mix of deposits changes with the rate environment. There are two major exposures to the cost of funds if the rate environment increases: (1) having to pay more for deposits, and (2) lower-cost deposits leaving. Many institutions mistakenly think that the risk of deposits leaving is incorporated by using decay assumptions. This is typically not the case. Further, in many models, the decay assumptions are only applied to NEV.

Review the simulated balance sheet under various rate environments to see if the deposit mix is changing as rates change. If your income simulation modeling is ignoring this shift out of low-cost deposits, then your management and board may have a false sense of security caused by understating the cost of funds in higher rate environments.

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