Western Independent Banker - May/June 2013 - (Page 17)

By Greg Webb Managing Interest Rate Risk to Achieve Strategic Profitability DURING MOST STRATEGIC planning retreats, facilitators make sure that community bank boards of directors and executive management consider expanding through mergers and acquisitions, raising capital through stock issuances, improving bank stock liquidity, etc. These may be good ideas, but facilitators often overlook discussing legitimate threats to long-term profitability simply because they do not sell those services. One such threat is interest rate risk, which is rising despite the Federal Reserve’s actions that stabilized interest rates since the financial crisis began. To address this, community bank boards and executive management should develop and implement plans that proactively mitigate interest rate risk. Definition Interest rate risk is the risk that a community bank’s earnings will decline because of unanticipated and untimely changes in interest rates. This risk includes: • Re-pricing risk, which is caused by timing differences between contractual rate changes and cash flows among assets and liabilities. For example, interest rates on long-term fixed-rate loans will change more slowly than short-term deposits that are used as funding. • Basis risk, which is caused by the weak correlation among various types of interest rates used to price assets and liabilities. An example would be interest rates on prime-rated loans changing by 25 basis points while the rate on LIBORbased deposit changes by 50 basis points. • Yield curve risk, which is caused by the changing rate relationships among different maturities of the same interest rate index. A common example would involve interest rates among various maturities of Treasury securities changing by different amounts of basis points. • Option risk, which is caused by the amount and timing of a bond’s cash flow changing as market interest rates change. The most common example would be an issuer calling a bond before maturity because market interest rates have significantly declined below its contractual interest rate. • Price risk, which is caused by changes in the value of mark-to-market bonds as market interest rates change. Measurement Interest rate risk measurement tools are, at best, imprecise tools that generally indicate the level and direction of a community bank’s interest rate risk. These tools are estimates based on (1) projected earnings using various interest rate scenarios, or (2) projected net present value of the cash flows of assets and liabilities using various interest rate scenarios and assuming that all financial instruments are held to maturity (also known as the economic value of equity or EVE approach) or (3) a blend of both. These measurement tools include: • Gap Analysis, which identifies maturity and re-pricing mismatches between assets and liabilities and separates them into rate-sensitive assets (RSA) and rate-sensitive liabilities (RSL) according to their re-pricing time horizons. The most common gap ratio formula is (RSA – RSL)/Average Earning Assets. Normally, the examiners do not like to see that a community bank’s one-year cumulative gap ratio exceed + or – 10 percent. • Simulation Analysis, which determines the effect changes in interest rates have on a community bank’s short-term net interest income, net income, and EVE. Most banks that use simulation use more than one model and apply several interest rate scenarios, because these models are dependent on the accuracy of the assumptions and data used. • Duration Analysis, which calculates the weighted average term to maturity of the cash flows of the community bank’s assets and liabilities. Management Community bank boards and executive management should do the following: continued on page 20 Interest rate risk measurement tools are, at best, imprecise tools that generally indicate the level and direction of a community bank’s interest rate risk. Western Independent Banker May/June 2013 17 http://www.wib.org

Table of Contents for the Digital Edition of Western Independent Banker - May/June 2013

A Message from the Chair
Data Mining for Profits in 2013
Banks Must Face Their Own Fiscal Cliff
Boost Your Bottom Line with Lending Process Enhancements
Managing Interest Rate Risk to Achieve Strategic Profitability
Moving Mobile Banking Toward Acceptance – and Profitability
Alternative Revenue Strategies to Improve Bank Profitability
Analyzing Customer Performance to Increase Bank Profitability
WIB Service Corporation Report: Secrets to Success in 2013
Professional Development Resources
Welcome New Members
Index of Advertisers/ Advertiser.com

Western Independent Banker - May/June 2013

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