Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Item 7A Quantitative and Qualitative Disclosures About Market Risk
Market Risk. Market risk represents the risk of loss due to changes in market values of assets and liabilities. We incur market risk in the normal course of business through exposures to market interest rates, equity prices, and credit spreads. We have identified two primary sources of market risk: interest rate risk and price risk.
Interest Rate Risk. Interest rate risk is the risk to earnings and values arising from changes in market interest rates. Interest rate risk arises from timing differences in the repricing and maturities of interest earning assets and interest bearing liabilities (reprice risk), changes in the expected maturities of assets and liabilities arising from embedded options, such as borrowers’ ability to prepay residential mortgage loans at any time and depositors’ ability to redeem certificates of deposit before maturity (option risk), changes in the shape of the yield curve where interest rates increase or decrease in a nonparallel fashion (yield curve risk), and changes in spread relationships between different yield curves, such as U.S. Treasuries and SOFR (basis risk).
The Asset Liability Committee of our Board of Directors (“ALCO”) establishes broad policy limits with respect to interest rate risk. ALCO establishes specific operating guidelines within the parameters of the Board of Directors’ policies. In general, we seek to minimize the impact of changing interest rates on net interest income and the economic
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values of assets and liabilities. Our ALCO meets quarterly to monitor the level of interest rate risk sensitivity to ensure compliance with the Board of Directors’ approved risk limits.
Interest rate risk management is an active process that encompasses monitoring loan and deposit flows complemented by investment and funding activities. Effective management of interest rate risk begins with understanding the dynamic characteristics of assets and liabilities and determining the appropriate interest rate risk posture given business forecasts, management objectives, market expectations, and policy constraints.
An asset sensitive position refers to a balance sheet position in which an increase in short-term interest rates is expected to generate higher net interest income, as rates earned on our interest earning assets would reprice upward more quickly than rates paid on our interest bearing liabilities, thus expanding our net interest margin. Conversely, a liability sensitive position refers to a balance sheet position in which an increase in short-term interest rates is expected to generate lower net interest income, as rates paid on our interest bearing liabilities would reprice upward more quickly than rates earned on our interest earning assets, thus compressing our net interest margin.
Income simulation analysis. Interest rate risk measurement is calculated and reported to the ALCO at least quarterly. The information reported includes period-end results and identifies any policy limits exceeded, along with an assessment of the policy limit breach and the action plan and timeline for resolution, mitigation, or assumption of the risk.
Our primary approach to model interest rate risk is Net Interest Income at Risk (“NII at Risk”). Under NII at Risk, net interest income is modeled utilizing various assumptions for assets, liabilities, and derivatives.
We report NII at Risk to isolate the change in income related solely to interest earning assets and interest bearing liabilities. The NII at Risk results reflect the analysis used quarterly by management. It models gradual parallel shifts in market interest rates based on the indicated interest rate environments implied by the forward yield curve over a two-year period. No rates in the model are allowed to go below zero.
The following table sets forth the estimated changes in the Company’s annual net interest income that would result from the designated instantaneous parallel shift in interest rates noted, as of the dates indicated. Computations of prospective effects of hypothetical interest rate changes are based on numerous assumptions including relative levels of market interest rates, loan prepayments and deposit decay, and should not be relied upon as indicative of actual results.
Net Interest Income Sensitivity Immediate Changes in Rates (1)
-300
-200
-100
+100
+200
+300
(Dollars in thousands)
December 31, 2024
Dollar change
$
(24,725)
$
(15,384)
$
(6,089)
$
3,559
$
6,284
$
8,289
Percent change
(12)
%
(7)
%
(3)
%
2
%
3
%
4
%
December 31, 2023
Dollar change
$
(24,515)
$
(13,747)
$
(4,176)
$
(2,007)
$
(2,449)
$
(3,424)
Percent change
(12)
%
(6)
%
(2)
%
(1)
%
(1)
%
(2)
%
(1) This data does not reflect any actions that we may undertake in response to changes in interest rates such as changes in rates paid on certain deposit accounts based on local competitive factors, which could reduce the actual impact on net interest income, if any.
As with any method used to assess interest rate risk, there are inherent limitations in the methodology described above. The model operates on the assumption that interest rate changes occur as instantaneous parallel shifts in the yield curve. However, in reality, rate adjustments seldom happen instantly. The simplifying assumption that short-term and long-term rates change uniformly may not accurately represent historical rate patterns, which often exhibit non-parallel yield curve shifts. Moreover, the model assumes that assets and liabilities with similar maturity or repricing periods will respond uniformly to rate changes. In practice, certain financial instruments may react in anticipation of market rate changes, while others may lag behind. Additionally, the methodology does not fully consider the impact of annual and lifetime restrictions on rate changes for specific assets, such as adjustable-rate loans. Actual loan prepayments and early
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withdrawals from certificates may significantly differ from the assumptions made in the model when interest rates change. Lastly, the methodology does not evaluate the potential impact of higher rates on the ability of adjustable-rate loan borrowers to manage their debt. The Company takes all these factors into account when monitoring its exposure to interest rate risk.
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