We have mentioned this trend briefly in other posts, but since it seems to be becoming ever more prevalent, I thought it deserved its own post. The "it" in this case is the extra attention that market value of equity (MVE) or economic value of equity (EVE) has been getting from field examiners. Of course, as with all things exam related, the questions and issues cited are rarely the real problem.
Regulators, from Ben Bernanke all the way down to your local field office, are becoming increasingly wary of the growing interest rate risk on bank balance sheets. The reasons have been discussed here many times, but the basic issue is duration drift on the asset side where the banking's business model is significantly challenged in today's interest rate environment. With deposit costs near zero and fierce competition for loans driving down yields, many banks are running on fumes.
As higher yielding loans mature, banks are replacing them with lower yielding assets, resulting in significant net interest margin (NIM) compression across the industry. Regardless of whether the Federal Reserve’s accommodative monetary policy has helped or hurt the economy, it is wreaking havoc on banks’ profit models.
Which inevitably leads to:
To combat the NIM squeeze, some banks are taking more interest rate and credit risk. By venturing further out on the yield curve and underwriting riskier assets, banks can generate more revenue; however, the risks may not justify the returns. In the short-term, the strategy could increase profits. In the long-term, it could create less stable institutions and the conditions for another credit crisis.
The concern is more for community banks than with larger banks, mostly because some small banks are still reluctant to consider risk mitigation tools like interest rate swaps. Regulators know that we are moving further out on the curve in a reach for yield. Moreover, the kind of risk being taken will not easily be found in the 12 or even 24 month income simulations. This is long term interest rate risk, specifically in the form of price risk, that will show up in the MVE shocks. For this reason, examiners are taking a hard look at this often ignored (and misunderstood) metric. In short, they are concerned that banks are too complacent about longer assets because of the huge growth in non-maturing core deposits. But what happens when rates rise and some of these surge deposits shift back over to shorter and more rate sensitive time deposits?
Because of these concerns, we have seen a couple of important shifts in exam expectations. Here is a short list of things your ALCO should be thinking about:
- Does the bank (management, ALCO, and the board) really understand MVE and what it means? Make sure everyone involved is on the same page about what it measures, and the bank's current position.
- Do you know what parts of the balance sheet drive the results? We have created additional reports in the BancPath model to determine which components contribute how much to the change in MVE as rates move, and you should do the same in your own model.
- Are you measuring MVE instantaneously, or do you also look at future dates? Examiners are now expecting that pricing betas be applied to core deposits, which requires a roll forward of the balance sheet in the MVE calculations. Many models used by community banks cannot handle this task.
- Do your decay rates on non-maturing deposits change as rates change? Much like assets extend as rates rise, it is likely that these accounts will shorten as rates increase and depositors seek higher yields. Again, this is functionality that is lacking on most models.
- Do you have well documented support for your prepayment speed assumptions? Extension risk is going to be a serious problem as rates rise, and those relying on outdated OTS assumptions or simple historical speeds from your own loans will not adequately capture this risk. We have been in this low rate environment for too long, and these assumptions are just plain wrong. After all, how can you build good models from your recent speeds when we have not seen meaningful increases in loan rates in 6+ years?
As you can see, the concern is about the long term interest rate risk, but the questions are all about the assumptions that drive the MVE calculations. At AMG, we have been making adjustments to our methodology in the BancPath model, and spending a lot of time making sure our clients are prepared for this discussion in their exams. Make sure you don't get caught by surprise, and as always, let us know if we can help.