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Isolating Interest Rate Risk with a Static Balance Sheet

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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?

  • Interest rates change and cash flows do not change
  • 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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One Tip for Evaluating the Reasonableness of Non-Maturity Deposit Assumptions Used in Net Economic Value

Should decay assumptions change as rates are changing? Absolutely!

When we complete model validations of credit union or vendor-supplied interest rate risk results, we see all too often that decay assumptions don’t change as rates are changing. This assumption is like saying non-maturity deposit cash flows will remain constant and unchanging regardless of what rates do. History shows that this is not a valid assumption and, if used, can provide a false sense of security regarding NEV results.

It can be difficult to tell if the decay rates are changing as rates are changing by looking only at results. A good way to check this assumption is to review your model setup to see if decay rates are increasing as rates are assumed to rise. If they are not, it is a good investment of time to discuss options for representing the risk of decay rates changing as the world around us changes. Keep in mind as you do this it is not about getting the “right” assumption, because that is virtually impossible.  It is about reasonably representing changes in consumer behavior in your base-case risk analysis.