With the Federal Reserve rate increases in 2022, Interest Rate Risk Analysis (IRR) might become more relevant rather than just hypothetical. We use IRR to assess the potential exposure to earnings and capital due to rising or falling interest rates. The forecasts are based on estimates of future business activity and include a number of major assumptions, include repricing rates, replacement maturity terms, rate sensitivities, prepayment speeds, non-maturity decay rates, etc. For the Past several years, assumptions have been fairly constant with the occasional update for new pricing or new terms, but that may be changing soon.
Base assumptions along with base model results provide good information on the overall risk posture of the company, but what happens if one of these major assumptions needs to be changed? For example, we have estimated the sensitivity of interest rate (called Rate Betas) based on historical data or “educated” estimates of what we think might happen. However, what if in the next interest rate cycle we need to increase rates by a greater amount than what we have assumed? Over the past six or seven years, depositors have had very few options for alternative investments which may have created surge balances (or non-core funding) on the balance sheet. If depositor sensitivity to changes in interest rates in this next cycle is much higher than estimated, we may find that higher rates may need to be paid to maintain funding liabilities.
Sensitivity testing offers management additional information as to the impact of differing behavior in the next rising rate environment. Here, specific assumptions are modified, in this case the Rate Betas, and the impact to earnings and capital is determined. Such an analysis may provide information as to the impact to the institution should rates need to be changed based on customer or competitive behavior.
Other major variables, such as prepayment speeds or non-maturity deposit decay rates, can also be evaluated with sensitivity testing. Modify assumptions both up and down and evaluate the impact to earnings and capital. The analysis may show that some variables may have a much greater impact to interest rate risk than others. With this information, management can then begin to develop tactics and strategies to address exposure, should conditions warrant.