Rising Rates and Interest Rate Risk Management

After over a decade of relatively accommodative monetary policy, the Federal Open Market Committee began raising rates in 2022 to combat high inflation brought about by pandemic-related stimulus as well as supply and demand imbalances. While rising rates are often welcomed by banks as they can allow for margin expansion, there are challenges that can come with a rising rate environment. This article highlights some key trends and considerations related to balance sheet management and interest rate risk practices in a highly dynamic economic environment.  

Balance Sheet Management

The current environment presents challenges for banks to navigate related to balance sheet management, and forecasting has proven challenging. On the asset side, most banks are still holding excess liquidity, which can be an impediment to earnings. This excess liquidity, however, is expected to decline in the short term as loan growth continues to pick up steam. While we continue to observe strong loan growth across our District, fierce competition is putting pressure on loan yields, which is dampening margin expansion in the rising rate environment. From an interest rate risk perspective, much of the banking industry is positioned to benefit from rising rates in the short term with predominantly asset sensitive balance sheets. However, the flattening and inversion of the yield curve may present challenges over the longer term in managing interest rate risk and maximizing earnings. Additionally, most banks are experiencing a growing level of unrealized losses in their investment portfolios given the rapid increase in rates. While the regulatory capital of most banks is shielded from this effect, banks’ tangible common equity is still broadly exposed to it, potentially impacting bank stock prices and credit ratings. This could lead to liquidity implications as banks may be unwilling to sell securities at a loss and could face difficulties with regards to certain funding sources.

During the pandemic, bank balance sheets saw a significant influx of low-cost deposits, but that trend seems to be reversing and there is uncertainty around the sustained level of such deposits going forward. On a positive note, the excess liquidity on bank balance sheets has allowed for a reduced reliance on potentially volatile funding sources and for deposit rates to lag interest rate hikes. While many banks can afford some deposit runoff given the aforementioned influx, customers’ deposits could taper and cause some banks to turn to higher-cost and potentially volatile funding sources.

Interest Rate Risk Practices

Interest rate risk modeling has become increasingly difficult for banks given the significant balance sheet shifts and a rapidly changing macro environment. While interest rate risk modeling will continue to be a challenge, there are several practices management teams can incorporate to ensure that the range of interest rate risks and any exposures are well understood by both the bank’s management team and the bank’s board of directors. Some of these practices include:

• Rate Scenarios: Due to the rate environment during the pandemic, many institutions reduced the focus on down rate scenarios given the unlikely scenario of a negative rate environment. However, given the current rate environment, it may be beneficial for management teams to reinstate down rate scenarios in their modeling practices. Additionally, management may want to consider the importance of running and analyzing alternative rate scenarios (yield curve twist, inversion, etc.) given the unparalleled movement in rates experienced this year.
• Assumptions: Deposit assumptions typically have a significant impact on interest rate risk model results. Given the current deposit and rate environment, it may be a good time for management teams to revisit deposit assumptions, specifically betas and decay rates, to ensure that they accurately reflect current and forecasted customer behaviors.
• Sensitivity Testing: Given the difficulty of developing assumptions that are accurate for all scenarios, management teams may want to consider placing more focus on sensitivity testing to ensure that the range of interest rate risk is well understood by bank management and the bank’s board of directors. Effective sensitivity testing includes isolating one assumption and ensuring that it is appropriately stressed to understand how it drives a range of interest rate risk results.

All of these practices, and more, are discussed in SR Letter 10-1: Interagency Advisory on Interest Rate Risk Management and SR Letter 12-2: Questions and Answers on Interagency Advisory on Interest Rate Risk Management. For any questions, please reach out to your Richmond Fed central point of contact.

Disclaimer: The opinions expressed by the authors are their own and not necessarily those shared by the Federal Reserve Bank of Richmond or the Board of Governors of the Federal Reserve System.