Observations from ALM Model Validations: Optimistic New Volume Rate Assumptions
November 5, 2015
When running static or dynamic balance sheet income simulations, assumptions regarding the interest rates received on new business are needed. On the surface, this seems to be an easier assumption to make relative to some of the other assumptions needed in asset/liability management modeling (ALM modeling). However, in model validations we have performed, we have seen several issues with this assumption that result in far reaching consequences on the modeling.
For example, most credit unions tout that their rates are better than bank rates. Assuming new production at lower rates can make sense from an earnings and risk to earnings perspective.
The challenge is that many will assume that their net economic value (NEV) discount (market) rates are the same as their new production rates. To represent the fair value of assets (NEV), it is important to represent the yield that the market would demand to purchase the loans from the credit union. Assuming a low discount rate creates optimistic market values. Therefore, it is necessary to increase the discount rate to make the NEV more reasonable.
A Modeling Challenge
While, in this example, increasing the discount rate helps to produce more reasonable NEV results, it creates more optimistic earnings projections because quite often institutions use the same assumption for both new production and NEV discount rates.
If your credit union is running a model that uses offering rates as discount rates, and any adjustments to the offering rate affects both the income simulation and the NEV, consider doing two different model runs—one for the income simulation with new volume rates representative of recent production and one for NEV with the adjusted discount rates.
One other consideration is the new volume rate in shocked rate environments. The most common assumption seen is that loan rates will go up 100% of the rate change and the rate increase will not hurt new volume production. Considering that the industry has been experiencing significant loan growth, resulting in an increased loan-to-asset level; is it reasonable to assume that current levels will be maintained (or assumed growth continued) despite taking all loan rates up 300 bps?
Competitive forces may not allow pricing to move this fast. Consider adjusting the base case to incorporate a slower pricing change. If not making this assumption in the base, minimally run a what-if scenario to understand the sensitivity of the results to the assumption.