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    Why you should merge liquidity stress testing and IRR

    May 2022

    Why you should merge liquidity stress testing and IRR

    Forecasting potential interest rate impacts on liquidity, deposits and earnings

    In times of economic uncertainty the interest rate cycle can be like a roller coaster ride. The slow climbs sometimes induce more panic and more of an adrenaline rush than the sudden falls. It’s not knowing what’s round the next corner that can get to you. And then when you hit bottom and get off it takes a while to calm your dizzying head and collect your thoughts: “Wow, what happened, I’m back where I started but everything feels different.” During the pandemic, the unprecedented liquidity stimulus by the U.S. Federal Reserve kept interest rates at record low levels for much of 2021, then we did a loop the loop, and now we are winding towards the top, bracing ourselves for a rate rise at the next meeting of the Fed.

    Now you really need to ask yourself, what is different about your institution today compared with where you were pre-pandemic, both in terms of balance sheet composition and what impact the various external pressures are having on your customers. What changed when interest rates were at X% – before the decline, when they hit lows, and where are you today? Thus on the balance sheet you need to be asking questions like:

    “What investments have we made that we didn’t have two months ago?”
    “Do we have credit line commitments that we didn’t have two years ago?”
    “Have we extended/contracted our loan product offerings?”
    “Now we are flush with cash, how has our deposits mix changed? Fewer Treasury bonds, more savings, more non-maturity deposits maybe?”

    The other side is customers. You need to ask how they have had to adapt, especially with regard to how they are responding to the highest inflation in 40 years. You need to examine where customer deposit growth has come from and movement between products.

    Liquidity stress testing

    Most institutions now conduct liquidity stress testing either in their own ALM software or through a third party. Some have done neither so far, but they are getting there. That may be an opportunity to avoid a common error of looking at them separately. What we recommend is merging liquidity stress testing with interest rate risk (IRR) analytics: we should not be operating in silos. Fundamentally, this involves looking at the two sets of changes mentioned above: what has changed in the balance sheet and how are customers reacting to the new environment. While liquidity and IRR are not identical, there is significant overlap in the factors to be considered. To start with, dynamic investment cashflow by product types. For example, did you extend your investment in municipal bonds (munis) or collateralized loan obligations (CLOs) and if so, how will that look after an interest rate rise, and will you get your cashflow back? Munis are among the least liquid assets and hard to maneuver so you may find yourself locked out of investing in other assets such as mortgage-based securities (MBS). Also, if you are using your investments to pledge against deposits that require collateral and interest rates go up, you will be taking a loss so you will need more investments to pledge up the difference.

    An interest rate rise is also going to impact prepayment speeds on loans for many institutions. Anyone who is heavily into adjustable-rate mortgages (ARM) is going to find customers coming in and requesting a relock. That’s not only an interest rate risk but also a liquidity risk, because it is pushing cashflow back out. Likewise with instalment loans such as recreational vehicles (RVs) terms are likely to be extended because (who would have guessed it?) used cars are actually increasing in value and are therefore less affordable.

    Think also about the customers. Some will be looking to early refinancing e.g. from ARM to FRM or other changes (also on other loans) that will impact the institution’s position. With rates likely to be going up, customers might want to withdraw cash now to make purchases that will be more costly in future.

    And think also about competition with deposit rates. You may be thinking that with all the extra liquidity there is no need to change deposit rates; but you really need to quantify this. Compare your deposits now with what they were two years ago. Where has the growth in the balances gone? If the growth is not in interest-bearing deposits, and you need to replace those deposits, you are probably going to take a hit on the earnings side because you will have to replace them through borrowings, which now cost a whole lot more than you are willing to pay the customer. So it is worth running some scenarios to see what will be the impact on liquidity of losing various specific quantities of deposits; for example how will things pan out if your top depositors look for a better rate from the bank across the street or an internet bank? With inflation, it is certain that customers are going to be looking for more value.

    IRR is the greatest driver of liquidity risk

    The point with all of this is that it is only by doing some quantitative analysis that you will identify where you have risks now and the risk implications of any decision that the institution takes. Quantify the individual interest rate and liquidity risks. They really do go hand in hand. Most institutions see IRR as the biggest driver of liquidity risk. And then put them together for a forecast and full stress testing, probably monthly, synced up with your ALM testing, but the frequency will vary by institution depending on a number of factors, notably how tight your liquidity position.

    Both your internal management and the regulators will thank you for it!

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