Question from the FAQ:
4) Should institutions with non-complex balance sheets use earnings simulations to measure risk to earnings?
Answer from the FAQ:
All institutions are encouraged to use earnings simulations. Advances in technology have made simulation modeling more accessible for all institutions. Financial regulators recognize that some institutions with non-complex balance sheets may have minimal levels of embedded options in both assets and liabilities, such as products discussed in response to question #3, and have few or no derivatives. In these limited cases, onsite financial regulators assess management’s alternative measurement processes to analyze the institution’s less-complex risk profile. Based on this assessment, regulators may determine that a less sophisticated measurement process may adequately measure earnings at risk.
What a cop-out. Here was a great opportunity to banish the gap report as an interest rate risk measurement tool, but they didn’t take it. The regulators could have easily said, “Yes, you must use an earnings simulation. You can no longer just use a gap report to measure earnings sensitivity.” I have no idea why they just didn’t say that.
Over and over regulatory publications on IRR use the term, “non-complex balance sheet” – this FAQ is no exception. “Financial regulators recognize that some institutions with non-complex balance sheets may have minimal levels of embedded options in both assets and liabilities.” Without getting too snarky I‘d like to know - which banks exactly? Really? Are there noticeable numbers of banks out there that have little or no optionality on their balance sheet? I don’t believe it for a second.*
It’s easy to make optionality sound complicated if you use examples like, “collateralized mortgage obligations, step-up notes, callable agency bonds, convertible Federal Home Loan Bank borrowings, and alternative certificates of deposit” (as discussed in question #3). But step outside the investment and wholesale funding portfolios and you find optionality pretty much everywhere on the average bank’s balance sheet:
- Commercial loans refinance and restructure
- Residential loans prepay and refinance
- Consumer loans prepay (especially those with “same as cash” periods)
- Non-interest checking accounts rollover and decay
- Interest Bearing Checking and Money Markets reprice, rollover, and decay
- CD’s withdraw before maturity
Aren’t all of these products quite common on the “non-complex” bank’s balance sheet? Optionality like this can’t be adequately captured in a gap report because a gap report is a single scenario, point in time measurement. Before this post morphs into a rant against the gap report let me just refer you to my blog category “Doh!, the gap report”.
So for question #4 from the FAQ, should institutions with non-complex balance sheets use earnings simulations? The answer should have simply been, YES!
* I don’t solicit many comments from readers of this blog because I’m usually deluged by spam. In this case I’ll make an exception. Please email me if you know of a bank that fits the profile of “non-complex balance sheet with minimal levels of embedded options.” I’ll be surprised if I compile a list of more than 10 banks. Send your emails to email@example.com