Why Are My Income Simulation Results so Strong in a Shock?
In performing model validations for credit unions, we often see income simulation results that show significant improvement in net interest income (NII) and net income (NI) as rates rise, even for credit unions that have material positions in long-term, fixed-rate assets. Why does this happen, and is it reasonable?
Income simulations are commonly run with a static balance sheet, in which the asset and liability mix remains constant regardless of the rate environment, and loan yields are often assumed to move in lock step with market rates. However, this approach can lead to simulations calculating material returns on new business and increases in margins as rates rise.
The example below illustrates why this often happens. The calculations assume an average industry loan-to-asset ratio; yield on loans, yield on investments, cost of funds and net operating expense continues into the future, shown for both the base rate environment and the up 300:
In the base rate environment, the new business calculation above is producing an ROA of 0.80%, roughly in line with the current ROA for the industry. Said differently, if rates do not change the new business would be neither helping nor hurting NII or NI. However, if you incorporate typical new business assumptions in an income simulation utilizing a static balance sheet, the new business ROA for the up 300 rate environment is 2.30%, a 150 basis point (bp) increase over the new business ROA for the base rate environment.
Combining a 2.30% new business ROA with the earnings on existing business helps explain why NII and NI results often improve as rates rise, even if the ROA on existing business is decreasing. However, does a 2.30% new business ROA in a +300 bp rate environment pass the reasonableness test?
Consider the implication; this infers that if rates go up 300 bps, over time the entire industry would earn over 200 bps, more than double any peak the industry has experienced. Following this logic, a +500 bp rate change would show an ROA exceeding 3.00%.
The purpose of ALM/interest rate risk analysis is to understand risks, not ideal situations. What are risks that could cause earnings to not be this good?
- What if our deposit mix becomes more heavily weighted toward member CDs as rates rise? In the largest credit union peer group, the last time rates went up, Reg Shares+Share Drafts dropped from 43% of funds to 33%; currently the ratio is 45%. When rates were higher, CDs were the largest deposit type, costing credit unions much more than non-maturity deposits. Does your base analysis incorporate members shifting funds like they did in the past?
- What if loan yields don’t move at 100% of the market? Competition to generate loans can often lead to irrational pricing. It is reasonable to expect that competition for loans may restrict the ability for institutions to move loan rates up 100% of the rate change.
- What if our loan-to-asset ratio is pressured as rates rise? Rates don’t only go up due to a thriving economy; the material drop in loan-to-asset ratios over the last five years has squeezed margins. Lending has picked up over the last year, but there is no guarantee that loan-to-asset ratios can’t drop again.
The earnings on the new business would most likely still be positive in the 300 bps shock, but would be significantly lower than the default assumption. These are real risks that can greatly impact earnings and need to be incorporated in the base risk analysis. The exposure to risk should then be compared against policy limits for ALCO to understand the risks being taken. Beyond the base case the stress of additional pressure should also be tested.
