Interest rate risk models have been chewed up and spit out this decade. A record deposit surge, the biggest interest rate shock in 40 years, and massive bank failures hit the industry with a 1-2-3 Black Swan punch.
Deposit volatility ensued along with asset extension, unrealized losses, and quite severe margin pressure. That type of volatility can put a model to the test, and stakeholders have challenged the efficacy of earnings forecasts, budgets, and interest rate risk models.
It’s time to hit the reset button.
Having trust in your model can make a difference in the ALCO strategy discussion by:
Creating well-informed decision-making
Getting stakeholders on the same page
Allowing healthy dissension on ideas, not dismissal of the risk analysis
Letting data lead and intuition follow
I recommend five steps to regain trust in your model.
1. Gain Assumptions Confidence
An oxymoron, maybe? Besides, how can you gain confidence in something you know may be wrong? This should not deter a deep dive into assumptions each quarter.
Start to shift towards dynamic assumptions. For example, we know that deposit costs lag and the mix shifts as rates change. In fact, according to DCG’s Deposits360°® Cross-Institution Analytics database (which collects relationship-level data from nearly 300 financial institutions), MMDA costs went up over 60 bps and the deposit mix changed by 10% in the 12 months AFTER the last Fed hike in July 2023. Intuitively, the industry saw this coming, but many models missed the mark.
The same is happening now. Deposit costs are lagging through the first 75 bps of Fed cuts. And if the Fed cuts more slowly than in previous cycles, this may drive lower betas which could negatively impact a model’s interest expense projections.
Leverage the lessons from data analytics to be more pragmatic and forward-looking with assumptions.
2. Run Static AND Dynamic Models
Dynamic models may seem more realistic (after all, we live in anything but a static universe). However, growth models may mask inherent sensitivity within a balance sheet. Start with static, and then build pro-forma simulations. This can help shape how much risk mitigation you may need in a certain scenario.
Here’s a recent example…I recently had an ALCO discussion with a financial institution about their swap position. They had a decent size receive float / pay fixed book. So much that their static model suggested meaningful exposure to rates down. Should they unwind some of the position? Add alternative falling rate protection? By running a dynamic model, we can understand how much organic growth and potential deposit mix change in the other direction may insulate the exposure, and therefore, better assess the need for insurance.
3. Simplify the Scenarios
ALCOs today are forced to run dozens of scenarios each quarter. And if you’re not in the ALCO game as much as a DCG associate (a safe bet!), then the narrative can be confusing. Ask ALCO, what are the key three or four scenarios to focus on to triangulate the risk?
I recently presented this for a client as a “Higher for Longer,” “Hard Landing,” and “Re-Inflation” scenario narrative followed by the sensitivity results.
4. Let Your Balance Sheet Do the Talking
Rather than speculate on how you think the yield curve will play out in 2025 (fun, I know), let your balance sheet do the talking. What scenario causes the greatest pain? What is it about loan repricing trends that drive asset yields? How would deposit mix change impact margins in a re-inflation scenario?
5. Answer the Question, “So What”?
You do all this work. Build hundreds of pages of ALCO reports. Run scenarios. Present the results. So what? How comfortable are you testing CD resiliency? What is your funding plan if the Fed stays “higher for longer” in 2025? What is the future of your hedging program? When you have to start buying bonds once again, how do you visualize your portfolio allocation? The story goes on…
Risk models are battered and bruised. It’s time to fight back. Regain trust in your model. It will accelerate strategic collaboration and provide a sense of relief as we battle the challenges of tomorrow.
ABOUT THE AUTHOR
Joe Kennerson is a Managing Director at Darling Consulting Group. In this capacity, he works directly with financial institutions by providing solutions for their asset/liability management process in the areas of interest rate risk, liquidity risk management, ALM modeling, regulatory compliance, and executive-level education. He is a frequent speaker and author and directly advises clients in all aspects of ALM.
Contact Joe Kennerson at jkennerson@darlingconsulting.com or 978-499-8150 to work collectively to transform ALCO into a profit center.
© 2024 Darling Consulting Group, Inc.
Comments