C. Myblog

Isolating Interest Rate Risk with a Static Balance Sheet

September 26, 2014

Some will say that a static balance sheet income simulation achieves its objective of isolating interest rate risk by reducing the variables in the simulation. The question then is: What risk should be isolated?

  1. Interest rates change and cash flows do not change
  2. Interest rates change and cash flows change in response

If the answer is A:

  • Callable bonds would still be called as rates increase
  • CMO/MBS cash flow assumptions wouldn’t extend
  • Prepayment assumptions wouldn’t slow as rates increase
  • Deposit balances wouldn’t migrate to higher cost deposits (such as CDs) or reverse their flight to safety

Note that holding these assumptions constant would result in less “moving pieces” but would disregard material features of interest rate risk. The answer must be B.

Regulators state that assumptions in modeling should be “reasonable and supportable.” History has demonstrated that ignoring the extension of asset cash flows is neither reasonable nor supportable.

If it is obvious that asset behavior must change, why then isn’t it obvious that the risk of changing deposit behaviors must also be included? Does history support the assumption that the deposit mix will not change as rates change?

Below is the distribution of regular shares and share drafts for NCUA’s largest peer group (credit unions >$500M in assets).

History proves that assuming low-cost deposits will not change as rates change is neither reasonable nor supportable.

There has been a lot of discussion on the need to analyze non-maturity deposit behavior and to understand the threat of surge deposits. Assuming that deposit behavior remains constant (static) while interest rates are changing does not capture the threat of surge deposits leaving. Why analyze this exposure and then ignore this risk in an income simulation?

Sometimes the reason given for ignoring this risk is for simplicity or comparability. However, if A/LM models were not sophisticated enough to factor in prepayment assumptions, in the name of simplicity and comparability, they would be considered unacceptable. In order to incorporate the exposure on the liability side of the balance sheet, the sophistication of modeling needs to be increased.

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