Written by: Toni Molinari
“It’s only a matter of time before we get higher interest rates.”
Sound familiar? Most of the interest rate talk today, like this quote, is about rising rates. While this sounds like the title of a current news article, believe it or not, it’s actually the title of a Fortune magazine article from May 2004 when the fed funds rate hovered around 1%.
The article continues, “What people forget is that the uptick actually is a natural indication that things are getting better. As things get better, this is what is supposed to happen. We’d be more concerned if the Fed wasn’t increasing interest rates.” The more and more I read that article, the more it reminded me of today – rates have to go up at some point, but when? And by how much? In reality, although there has been much talk about the Fed raising rates the past few months, the talk hasn’t resulted in any action. Rates are still at near record lows and at each Fed meeting the FOMC finds another reason to not raise rates.
The fed funds rate in May 2004 when the Fortune magazine article was published was 1% and the Fed increased it steadily to 2.25% by year end.
Many institutions set IRR risk exposure limits over a 2-year time horizon related to various shock scenarios of down 200bp through up 400bp, with the down 100bp and up 400bp scenarios run more to appease regulators than for actual strategic decision making. Thus, when the results of the extreme scenarios exceed risk exposure policy limits at either end, institutions are quick to rule them out as unlikely, and accept the policy exception without much consideration given to altering the current IRR management strategy.
While an upward 300bp or 400bp shock is unlikely, significant short term increases and decreases in the fed funds rate have occurred in the recent past. Between the FOMC meeting in June 2004 and the FOMC meeting in June 2006 Fed, the fed funds target rate rose from 1% to 5.25%, with 25 bp increases at each FOMC meeting. The increase continued until the September 2007 FOMC meeting when rates were cut 50bp to 4.75% and continued to be cut at each FOMC meeting through the December 2008 meeting when they bottomed out at 0.25%. That was a 425 bp increase in 2 years followed by a 500bp decrease over the next 2 ½ half years – while not shocks, these are pretty significant changes! These are similar to the scenarios many institutions run today but consider unlikely and unreasonable – but the recent past has shown us, it can happen.
It is largely thought that rates in the US can’t get any lower and while the Fed funds rate may have bottomed out, mortgage rates do not seem to have hit their floor yet.
This is concerning as mortgages are the bread and butter of most community financial institutions. According to data from the St. Louis Federal Reserve, the average rate for a 30 year fixed rate mortgage has decreased 59bp this year, from 4.01% at December 31st to 3.42% as of September 29th. This is not quite the down 100bp scenario considered unlikely by many last summer when they ran their down 100bp scenarios, but it’s pretty close, and with competition for mortgages continuing to intensify its probably not the bottom.
ALM model results should be an input into strategic decision making for institutions, used to support the evaluation of strategic choices involved in short and long term business planning, and capital and liquidity planning – no matter how unlikely the scenarios. Similarly, ALCO meetings should be strategic decision making sessions where the possibilities of different interest rate scenarios and economic conditions and their impact on the institution’s loan and deposit products are discussed.
Additionally, IRR risk tolerance guidelines should be periodically reviewed and revised to ensure they are consistent with the risks the bank faces in the current economic environment and the current interest rate risk environments. If the risk tolerance guidelines were set in a rising rate environment with an upward sloping yield curve that will be different from the acceptable risk tolerance limits and the strategy that should be executed in today’s low rate, flattening yield curve environment. Policies should also take into account changing business conditions and changes in the way people bank. Deposit behavior studies should consider today’s mobile technology and its impact on deposit flow to and from the institution, in addition to the effects of interest rate changes.
M&M can help institutions assess the effectiveness of their ALM programs. M&M provides independent evaluations of asset liability management programs, including review and validation of:
- The adequacy of, and compliance, with the established internal control system.
- The appropriateness of the risk measurement system given the nature, scope and complexity of the institution’s activities.
- The accuracy and completeness of the data inputs into the institution’s ALM models.
- The reasonableness and validity of scenarios used in the ALM models.
- The validity of the risk measurement calculations, which are tested in part by comparing actual versus forecasted results.