As we have wrapped up year-end Rate Sensitivity Analyses (RSAs) for most of our clients which means now is a great time to review where financial institutions ended the year and how that compares to peers. A peer group comparison allows us to get a glimpse into how your institution’s balance sheet compares to your peers from an interest rate risk perspective. As the rate environment changes, the impact to balance sheets from a structural aspect, as well as an interest rate risk aspect, evolves.
After years of a prolonged low-rate environment, 2022 had no shortage of interest rate movements. The Federal Reserve’s Open Market Committee increased the Fed Funds Target rate seven times in 2022 with those increases ranging from 25 basis points (bps) to 75 bps a pop.
We started the year at a range of 0.00-0.25% and ended the year at 4.25%-4.50%. The rest of the yield curve increased as well, although not enough to keep up with the short end of the curve, leading to a curve inversion. The two-year point of the curve increased from 0.694% in December of 2021 to 4.71% in December of 2022 while the 10-year point of the curve went from 1.51% to 3.859%.
The Fed Funds Target Rate has already seen another hike this year. The rest of the yield curve has increased as well but does remain inverted The magnitude of the rate movements in 2022 serves as a reminder of how fast things can change and of the importance of interest rate risk management.
We have completed December 2022 RSAs for 106 clients so far this year . For comparison purposes we have broken down the results by asset size. A smaller sample size can be more easily skewed so keep that in mind if you fall into a group that has a smaller number of peers.
While each balance sheet is unique, there were some general trends that emerged over the past year. Liquidity is the current hot topic at financial institutions. The deposits that flowed onto balance sheets in 2020 have started to run off. At the same time, loan demand has picked up resulting in lower overnight investment balances. With tightening liquidity, many financial institutions have turned to a borrowing position or taken advantage of other wholesale funding sources. Loan to total assets were up for the year for many clients, as were securities to total assets.
Earnings at risk simulations
The results of the earnings at risk simulations show that, given the structure of their balance sheets as of December 31, 2022, most of our clients are positioned to see an increase in net interest income should market interest rates rise over the next 12 months. Those increases are smaller than what we were seeing at the end of 2021.
As previously mentioned, overnight cash balances have declined for the majority of our clients as deposits have declined. The result is lower asset sensitivity and smaller increases in earnings in rising rate shocks. Falling rate declines have been amplified this year with the higher rate environment. Asset yields have increased with market rate increases, but financial institutions have lagged increasing deposit rates.
As deposit rates are still close to the natural 0% floor, we now see income getting squeezed quickly as asset yields have more room to move in the down rate shock scenarios. It is important to remember that an individual institution’s estimates may vary greatly based upon the underlying assumptions of the model.
Industry wide, banks have benefited from the higher rate environment. The increase in market rates resulted in net interest margins (NIM) increasing as well. NIMs have increased so much over the year that the -400 bps rate shock results from 2022 reporting match up very closely with the base case results from the end of 2021. This is true for the return on assets (ROA) as well. The base case NIM and ROA for all RSA clients with December 2022 data came in at 3.526% and 1.475% respectively.
The projected average yield on earning assets for all clients is 4.235% in the base case scenario. This is up more than 100 bps from December 2021 which exemplifies the impact the higher rate environment has had on asset yields.
The cost of funds increased as well but not to the same extent of asset yields. The cost of funds for all RSA clients came in at 1.082% with December 2022 reporting. This is up 69 bps year over year.
Economic value of equity
The following tables show the results of the economic value of equity (EVE) simulations performed using December 31, 2022 data. (Note: Economic Value of Equity = Net Present Value of Assets – Net Present Value of Liabilities).
Overall, EVE volatility has increased in the rising interest rate shocks due to the trend of lower overnight investment balances and higher loan balances which have extended assets. The extended duration of assets creates a larger mismatch with liability duration, resulting in higher volatility. We are now seeing more natural results in the falling rate shocks with EVE increasing. This can be attributed to the higher rate environment, which now gives yields more opportunity to decline before being floored out at the natural 0% floor.
Note that the EVE volatility outlined below remains within healthy and acceptable levels. Leverage ratios have increased considerably with the higher rate environment. Deposits, particularly Non-Maturity Deposits, are still being held at low rates which benefit financial institutions not only from an earnings perspective, but also from a valuation perspective.
Looking forward, the Fed Funds Target Rate is expected to see another increase this year before trending back down.
If the last year has taught us anything, it is that having a robust interest rate risk program in place is crucial to the success of a financial institution.
In the ever-changing rate environment, balance sheet strategies and decisions should go hand in hand with interest rate risk management.
With the uncertainty of the future rate environment, what is the possible impact on your institutions earnings in varying rate environments? Is your potential risk to capital within a comfortable level? Asset-liability management (ALM) modeling continues to serve as a valuable strategic tool for better decision making and enhanced balance sheet management for all rate environments.
If you have any questions, or if you wish to discuss the results of this analysis in greater detail, please contact your UMB Investment Officer or Financial Services Group analyst for more details.
All graphs sourced from UMB Internal data.
The financial services group at UMB can offer ways to model these scenarios for you so that you are well-equipped and informed for the times that are ahead. Dynamic balance sheet modeling is an opportunity to alter your balances to even the most extreme scenarios to see how drastic changes could impact asset-liability outcomes.
We can couple this with a stress test showing the effect of changes in rates and changing balance sheet structure on your net interest income and equity capital. We can develop a scenario that determines the factors that contribute to a possible decline in equity capital to the point where the book value equity is negative (i.e., “break the bank” scenario). The changes we would apply include loan and deposit growth/shrinkage, loan and deposit pricing, deterioration in financial markets, etc. These also incorporate zero funding from FHLB borrowings or brokered CDs.
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This communication is provided for informational purposes only. UMB Bank, n.a. and UMB Financial Corporation are not liable for any errors, omissions, or misstatements. This is not an offer or solicitation for the purchase or sale of any financial instrument, nor a solicitation to participate in any trading strategy, nor an official confirmation of any transaction. The information is believed to be reliable, but we do not warrant its completeness or accuracy. Past performance is no indication of future results. The numbers cited are for illustrative purposes only. UMB Financial Corporation, its affiliates, and its employees are not in the business of providing tax or legal advice. Any materials or tax‐related statements are not intended or written to be used, and cannot be used or relied upon, by any such taxpayer for the purpose of avoiding tax penalties. Any such taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax advisor. The opinions expressed herein are those of the author and do not necessarily represent the opinions of UMB Bank or UMB Financial Corporation.
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