Interest Rate Risk: Critical to Review Assumptions

The adverse and unprecedented repercussions of the Covid-19 pandemic are being felt across all industries and sectors in the economy. Community Banks in particular face challenges to generate profits during this unusual period of slow economic growth and low interest rates,  where:

1). The impact of the pandemic extends to all sectors of the economy (employment, services, transportation, etc.).

2). The economy is expected to recover slowly, with subdued levels of consumer spending and low levels of business investment.

Given the current unprecedented conditions the economy is going through, it is critical to assess how changes brought about by these most unusual economic conditions impact interest rate risk at Community Banks and Credit Unions.

Although the Federal Government reacted quickly with the enactment of the Corona Virus Aid, Relief and Economic Security (CARES) Act, providing relief options for federally backed loans (which nearly 70% of homeowners have) the mortgage industry and Community Banks in particular are likely to continue to experience new high levels of economic stress and face new challenges, after years of relative market calm.

Overall, Banks are constantly exposed to financial risk when they lend out money at rates that are different to rates paid to depositors. Interest rate risk is the metric that quantifies the level of potential credit losses a financial institution is likely to experience if interest rates change. Under the current pandemic economic conditions, nearly every asset class  in a bank’s balance sheets has been or is likely to be exposed to interest rate risk  as changes in interest rates impact the return on assets differently. It is therefore critical for financial institutions to have in place flexible, risk modeling capabilities to allow them to assess the impact of changes in interest rate risk impact on NII and NIM.

For Community Banks at large, interest rate risk reduces to the management of the spread between interest paid on deposits and the interest received on loans over time. With lending as a major source of income, the current low interest rates coupled with the current economic slow-own have created a difficult environment for Community Banks to increase NII, NIM and maintain earnings performance.

Deposits are typically short-term investments with rates that adjust more rapidly to changes in interest rates than the rates banks charge on fixed-rate loans. In an environment of rising interest rates, Community Banks can charge a higher rate on their variable rate loans and a higher rate on new, fixed-rate loans.

The challenge for Community Banks today is that deposit rates do not typically adjust as much as the long-term rates they use to price loan rates, consequently:

1). If interest rates rise, banks tend to earn more interest income, but

2). When rates fall, banks face earning risks since their interest income declines.

Given that the low rate environment of the last few months has been accompanied by deposit growth and a shift in the deposit mix, Community Banks need to revisit their interest rate risk management assumptions to see if they still hold today for their current deposit bases and deposit levels.