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PCBB Banc Investment Daily July 22, 2015
Banc Investment Daily
July 22, 2015

A Much Closer Look At Interest Rates

An international team of researchers have created a contact lens that reportedly magnifies light in such a way it will let you zoom in your vision by 300% (and will reportedly be available for sale in the next 2Ys). We know what you are thinking - how does that compare to an eagle's vision? Well, the eagle has such great vision it can reportedly see an ant crawling on the ground from the roof of a 10 story building (about 700% better than we can). So, while you won't have vision that amazing with this new invention, you should be able to make out an ant crawling on the ground from a 4 or maybe 5 story building. That is truly amazing and we wonder what really interesting opportunities for the future it may create as well.
For bankers, when it comes to asset liability management (ALM), seeing into the future and trying to manage risk can sometimes be as tricky as making out something small on the ground. As with the super cool lens above, however, technology can be your friend and you can get much better ALM results.
Consider that when you are a regulator during a credit crisis occurrence; the first order of business is to tamp down credit leverage to reduce exposure, as you simultaneously push for higher capital levels to protect the system. Since this is now largely done, you may wonder what comes next. Well, low interest rates have been supercharging the economy for some time and now that unemployment has dipped into the full employment range (5.0% to 5.2%), talk is swirling the Fed will soon raise interest rates.
No matter what you think about the timing of potential rate hikes, the regulatory lens has definitely increased its focus around risk management here. Over the past few years, regulators have increasingly ramped up expectations around ALM (during exams), despite the fact that no new regulations have been released (no new FILs). That is likely because regulators have already done the job by releasing warning after warning over the past few years to bankers to be sure to have a handle on funding and rate risk in the event rates begin to rise.
For their part, bankers have been extremely busy trying to make money and originate loans after the credit crisis (plus rate hikes seemed far away), so focus has admittedly been blurry here in the past few years.
To avoid the sharp talons of the regulatory eagles that will swoop in over the coming months to examine your bank around ALM, we offer the following baseline advice: look closely at key modeling assumptions and make sure they reflect your historical experience and make sure you have stressed your assumptions to understand how they can impact your bank. The key assumptions we are talking about relate primarily to prepayment (how do assets prepay or extend as market rates move), decay (what is the average life of each deposit and what happens as rates move), beta (how do different deposits reprice as market rates move) and deposit shifting (what happens to liquidity and other factors when DDAs expand or contract as rates move).
We will be back in another edition of this publication soon to help you prepare further in this area. In the meantime, we hope the information provided here helps your team see rate risk through a sharper lens, as you consider the weaknesses and potential risks of using a less than robust ALM system much longer. Regulatory expectations are rising here, so we suggest ramping up your preparations and reporting in coming months as you put an eagle eye on the assumptions that drive your ALM model. The entire industry is shifting into a more dynamically challenging rate risk environment, so it is time to take flight.