Interest Rate Risk (IRR) Management for Financial Institutions

Interest rate risk (IRR) management has become even more important given the numerous increases in rates by the Fed and the overall turmoil in the market impacting liquidity. Most institutions have tools that provide projected results for IRR and liquidity, but are they used to help manage risks properly?

Here are our top 10 best practices to help you manage risks properly.

1. Be sure to verify that IRR model inputs are complete and accurate.   You would be surprised how often significant assets or liabilities are missing and/or not categorized correctly. These types of errors can significantly distort model results.
   
   
2. Assumptions should be consistent with your institution’s anticipated market behavior. Assumptions can include changes to balances in interest-bearing assets and liabilities as well as beta, decay, and prepayment speeds. Industry standards can be helpful, but they might not be reflective of your institution’s profile. We have observed institutions using the same assumptions for several years. The current environment suggests that these need to be revisited.
   
   
3. Don’t assume the model’s results are correct. If something doesn’t look reasonable, investigate and make the needed corrections. Contact the third-party provider for assistance if you are using one.
   
   
4. More specifically, don’t assume that the model is working just because actual net interest income is within a small percentage of projected net interest income. Perform an analysis of backtesting results. The main drivers of net interest income are balances in interest-bearing assets and liabilities and their interest rates. We often observe that the impact of rate shocks is much different than actual interest rates. However, the rate impact is often mitigated by fluctuations in interest-bearing assets and liabilities that are significantly different than projections. These differences can be caused by inaccurate assumptions and/or an issue with the model’s calculations. While the model may appear to be working based on the overall reasonableness of projected net interest income, underlying issues may result in overreliance on the model and failure to identify significant interest rate risk.
   
   
5. In addition to the static model that is prescribed under regulatory guidelines, generate a model scenario that is consistent with your budgeted expectations for the coming year. Using this type of scenario may identify undesirable results that you want to avoid or mitigate.
   
   
6. Perform meaningful stress testing and analyze the results. Stress testing can be an invaluable tool to identify the potential negative impact that certain events can create. Carefully consider whether or not a plan of action is needed.
   
   
7. Analyze and manage IRR and Liquidity risks using an integrated approach, as decisions to manage liquidity risk generally impact IRR. Your institution should have a strong liquidity risk management program that helps you assess future cash flow needs and alerts you to significant concerns in order to change your plan of action.  For example, most institutions are offering higher rates on deposit accounts to retain deposit relationships compared to just a year ago. The institution’s IRR and Liquidity assumptions should be in sync with these and other market changes.
   
   
8. Action and contingency plans to minimize risk should be clear, realistic, and interdisciplinary across operating areas. It is imperative that Management and the Board understand the impact to IRR, earnings, and capital in developing these plans of action.
   
   
9. Ensure that policy includes guidelines and the model generates results for the impact of +- 100, +-200, +-300, and +-400 basis point shocks in interest rates.   Before March 2022, rates had not changed for two years, and some institutions eliminated the larger basis point shocks. We now operate in a rate environment where these rate shifts are applicable.
   
   
10. Board and/or ALCO meeting minutes should clearly document the results of the model, including stress testing scenarios. Minutes should also include a discussion of policy exceptions and whether additional action is warranted.

Management and the Board should maintain adequate tools to measure and manage interest rate risk. These best practices can facilitate the assessment of your ALCO model and make needed changes to effectively manage this risk and its impact on your institution.