Pub. 7 2012-2013 Issue 2

www.nebankers.org 12 Extraordinary Service for Extraordinary Members. I F YOU’VE EVER OWNED A CAR, YOU probably know about mainte- nance schedules. When followed, items such as oil, spark plugs, and tires are periodically reviewed and replaced to ensure the vehicle will continue to run properly. As regula- tors continue their increased scrutiny of interest rate risk (IRR) models, financial institutions should consider adopting their own “maintenance schedule” for model assumptions. Just like an automobile, a robust IRR model should be reviewed at least peri- odically to determine whether current behavior assumptions are appropriate and reasonable. When opening the hood of your interest rate risk model, the following assumptions should be reviewed: Critical Assumptions for Interest Rate Risk Modeling • Interest Rate Scenarios to Be Modeled • Reinvestment/Discount/Driver Rates • Rate Sensitivities (Betas) and Time Lags • Average Lives of Non-Maturing Liabilities • Asset Prepayment/Liability Decay While the list above is certainly not exhaustive, these assumptions could be considered the most critical and impactful to your reporting for both earnings-at-risk and long-term fair value analysis. Rate Adjustments/Shocks While it is commonly known that examiners are expecting +400 bps rate scenarios for earnings simula- tions, they are also expecting to see non-parallel rate moves as well. This is where the short- and long-term rates of the curve move by different magnitudes. Historical yield curve analysis will help assist with selec- tion of the most realistic rate change scenarios. Reinvestment & Discount Rates The earnings-at-risk simulation relies heavily on reinvestment rates and other re-pricing rates to calculate the changes in interest income and expense. Discount rates, on the other hand, are used more specifically to determine the present value of future cash flows used more for long-term fair value analysis (Economic Value of Equity or Net Economic Value). Man- agement should use current offering and other market rates to consistently adjust these, especially after recent rate changes and new products. Rate Sensitivities & Time Lags Sensitivities, sometimes known as “betas,” are numbers that help describe the pricing relationship of a particular account in response to movement in market rates. Time lags specify how much time would pass before the account will begin to experi- ence a rate change. For example, an account with a rate sensitivity of 30 percent and lag of three would imply that if market rates increased 100 ba- sis points, the account would increase by only 30 basis points three months after the initial market rate move. Management should spend time re- viewing historical rate performance to confirm that current sensitivity and lags assumptions are reasonable for their current activities. Interest Rate Risk: Assumption Junction Matt Harris , The Baker Group