There’s a book called Interest Rate Risk Management that I’ve mentioned on this blog before. In it the author dedicates an entire chapter to “Income Simulation.” Essentially it’s an in-depth look at measuring IRR exposure using a future projection and then stress-testing or changing rates: i.e. earnings-at-risk. Throughout the book the author does a great job of presenting not only the benefits of using such measurements but the drawbacks as well. This chapter is no different. In fact the last part of the chapter labeled, “Disadvantages of Income Simulation,” lists no less than six very specific problems with measuring earnings-at-risk. The second item on the list is the following:
Assumptions can intentionally or inadvertently understate risk exposures
…income simulation permits rate risk managers to reflect potential balance sheet changes into their forecast. This can be both a strength and a weakness…assumptions used in the simulation may actually mask some or all of the current rate risk exposure. (emphasis is mine)
Chapter 3, Interest Rate Risk Management by Leonard Matz, 2003, Sheshunoff Information Services
Actually the potential impact of future assumptions is at the core of the static versus dynamic forecast debate. But “understating risk” and “masking current exposures”? What does this mean? How much of an impact can it have? More than you might think.
This was very clearly illustrated to us by a client’s recent forecast and IRR stress-test. Normally this client provides a budget projection to use as their base-case forecast (i.e. a dynamic forecast). It’s an aggressive balance sheet growth projection showing anywhere from 5 to 10% growth in various loan and deposit portfolios over the next year. The stress-test shows the bank is exposed to rising rates in the short-term. The shock up shows a potential decrease of -5.32% in the bank's net interest earnings. We also ran the stress-test using a static one-year forecast. The static forecast projects no balance sheet growth but rather projects a flat “static” balance sheet (only volume rolling off is replaced). After applying the rate shock-up we see a noticeably different result: a potential decrease of –9.65% in the bank’s net interest earnings; it’s almost double (see results below).
Many of you are probably looking at these results and saying, “so what?” It doesn’t look like that big of a difference. After all the latest interest rate risk peer data shows that the average Net-Interest Earnings at risk for banks $100M to $300M is around –8.2%. Is the difference here that big of a deal?
Well, it’s pretty obvious in this example that a dynamic forecast projecting balance sheet growth can easily mask or cover-up potential risk. That’s pretty significant especially given our current uncertain economic environment. Which stress-test should the bank pay attention to?
What if I told you this bank’s policy limit is –10.0%? Both measurements are within the limits, but one is clearly much closer to the limit than the other. What if I told you that while the bank’s commercial lenders were confident they would hit their targets (aren’t they always?), others on the management team weren’t so sure. The growth definitely combats the pressure on margin, but what if it doesn’t materialize?
In this case (as is the case with most of our clients) I think the static forecast is a much better stress-test. It helps eliminate many of the assumptions that can potentially “cover-up” risk.