The Hidden Risk Behind Earnings Projections
Over the last three months, a hidden risk dynamic has crept into many institutions’ interest rate risk profiles. The source of this risk lies within the deposit base, and it has materialized due to a combination of two factors: 1) the pace in which the Fed is tightening (225bp year-to-date) and 2) the optimal methodology employed when assessing interest rate risk – the use of a static balance sheet and static interest rates.
The concept of modeling a baseline scenario that employs a static balance sheet and static market rates is grounded in regulatory guidance and the principle that, when measuring IRR for policy compliance, the baseline scenario should be free of economic rate forecasts and growth assumptions. The rationale is that these types of forecasts can mask or mitigate the underlying risks inherent in the balance sheet.
Therefore, as the summer winds down and we wait for the Fed’s next meeting in late September, let’s be sure to understand what’s missing from today’s baseline IRR scenario: the cost of imminent deposit rate hikes. DCG’s Deposits360°® Cross-Institution database is clearly signaling that recent efforts to lag deposit rate hikes are beginning to wane. The levee is beginning to break, and we expect that deposit rates will soon move higher, regardless of what the Fed does next.
Source: Darling Consulting Group, sample Deposits360°® institution user as of Q3 2022. Data is representational only and is not predictive of any other institution’s performance.
Accounting for the Cost of Rate Hikes
There are three ways to ‘account for’ the cost of rate hikes that are all-but-certain to come down the pike.
1. Build an alternative baseline scenario that allows for price increases within the deposit base. This will allow ALCO to see the earnings impact of allowing deposit costs to ‘catch up’ to competition before the next Fed rate decision. However, unless this is run for a full complement of rising and falling rate scenarios, the impact on overall IRR sensitivity may not be apparent.
2. Account for this pent-up pressure by assuming that deposit betas in the Up 100bp or Up 200bp scenarios will be more pronounced than the betas used in the Up 300 or Up 400. This will allow fully adjusted ending rates to be more in-line with what an institution would typically expect to see for each product type in each of these rate environments. However, this option may create a blind spot in the baseline scenario.
3. Factor in assumed deposit pricing increases into the baseline scenario and further increases in rising rate shock scenarios, providing a complete picture of earnings sensitivity to recent market rate movements and future rate scenarios. DCG’s Deposits360° Forecasted Deposit Study with predictive analytics allows users to capture current rate predictions in the baseline scenario and forecast additional rate increases (or decreases) tailored to a specific suite of risk scenarios.
DCG’s pricing models indicate that most institutions have exhausted their ability to hold the line when it comes to deposit costs. This means that rate hikes will likely materialize in baseline scenarios sooner rather than later. Now is the time to be realistic about pricing decisions, and at least quantify the impact of tactical rate hikes on current earnings projections. Don’t allow pricing risk to remain in the shadows.
For more insights and information about how institutions are using data to drive deposit strategy, click to learn more about DCG's Deposits360°® solution.
ABOUT THE AUTHOR
Andrew Mitchell is a member of the Darling Consulting Group Products and Solutions team, supporting and educating subscribers of DCG’s data-driven software solutions Deposits360°®, Liquidity360°, and Prepayments360°™. He is a frequent author and thought leadership contributor.
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