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Item 3. Quantitative and Qualitative Disclosures About Market Risk

2024-05-03 compared with 2023-10-27 · 51 added, 33 removed, 16 unchanged (84% of the section changed)

1 unchanged sentence

Market risk is defined as the degree to which changes in interest rates, foreign exchange rates, commodity prices, or equity prices can adversely affect a financial institution’s earnings or capital.

For financial institutions, market risk primarily reflects exposures to changes in interest rates.

For financial institutions, market risk arises primarily from interest rate risk inherent in lending, investment, and deposit-taking activities.

Interest rate risk can arise from timing differences in the repricing and maturities of interest-earning assets and interest-bearing liabilities (repricing risk), changes in the expected maturities of assets and liabilities arising from embedded options, such as borrowers’ ability to prepay home mortgage loans at any time, depositors’ ability to redeem certificates of deposit before maturity (option risk), changes in the

CARTER BANKSHARES, INC.

shape of the yield curve, where interest rates increase or decrease in a non-parallel fashion (yield curve risk), and changes in spread relationships between different yield curves, such as U.S.

Treasuries and SOFR (basis risk).

Interest rate fluctuations affect earnings by changing net interest income and other interest-sensitive income and expense levels.

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However, excessive interest rate risk can threaten a financial institution’s earnings, capital, liquidity, and solvency.

Our sensitivity to changes in interest rate movements is continually monitored by the ALCO.

The ALCO utilizes an asset liability model (“ALM”) to monitor and manage market risk by simulating various rate shock scenarios and analyzing the results of the rate shocks on the Company’s projected net interest income (“NII”) and economic value of equity (“EVE”).

The rate shock scenarios used in the ALM span over multiple time horizons and yield curve shapes and include parallel and non-parallel shifts to ensure the ALCO can mitigate future earnings and market value fluctuations due to changes in market interest rates.

Within the context of the ALM, NII rate shock simulations explicitly measure the exposure to earnings from changes in market rates of interest over a defined time horizon.

These robust simulations include assumptions of how the balance sheet will react in different rate environments including loan prepayment speeds, the average life of non-maturing deposits, and how sensitive each interest-earning asset and interest-bearing liability is to changes in the market rates (betas).

Under simulation analysis, our current financial position is combined with assumptions regarding future business to calculate net interest income under various hypothetical rate scenarios.

Reviewing these various measures provides us with a more comprehensive view of our interest rate risk profile.

NII rate shock simulation results are compared to a base case NII result to provide an estimate of the impact that simulated market rate changes may have on 12 months and 24 months of pretax NII.

The base case earnings scenario together with various rate shock earning scenarios are modeled utilizing both a static and growth balance sheet.

A static balance sheet is a no-growth balance sheet in which all maturing and/or repricing cash flows are reinvested in the same product at the existing product spread over a prescribed index.

Parallel rate shock analyses assume an immediate parallel shift in market interest rates across all horizons of the yield curve and also include management’s assumptions regarding the impact of interest rate changes on non-maturity deposit products (noninterest-bearing demand, interest-bearing demand, money market, and savings) and changes in the prepayment behavior of loans and securities with embedded optionality.

Our policy guidelines limit the change in pretax NII over a 12-month horizon using rate shocks of +/- 100, 200, 300, and 400 basis points.

We have temporarily suspended the + 300 and + 400 basis point rate shock analyses.

Due to Federal Open Market Committee’s slowing future rate increase projections coupled with the recent increase in the Fed Funds Target Rate of 5.00% since March 17, 2022, we believe the impact to NII income when evaluating the + 300 and +400 basis point rate shock scenarios do not provide meaningful insight into our interest rate risk position nor does it project a probably interest rate environment for the foreseeable future.

To monitor interest rate risk beyond the 24-month time horizon of rate shocks, we also perform EVE rate shock simulations using the same assumptions used in the NII rate shock simulations discussed above.

EVE represents the present value of all asset cash flows discounted with related market interest rates minus the present value of all liability cash flows which are also discounted with related market interest rates.

The impact of a changing interest rate environment on the Company’s projected EVE is analyzed by shocking market interest rates, then modeling the impact of the rate shock on both the cash flow of assets and liabilities, and the underlying discount rate utilized in the present value calculation of the assets and liabilities.

Market rate shock results are then compared to base case simulation results to determine the impact that market rate changes may have on our EVE.

As with NII rate shock analyses, EVE rate shock analyses incorporate management’s assumptions regarding prepayment behavior of fixed rate loans and securities with embedded optionality and the behavior and value of non-maturity deposit products.

Our policy guidelines limit the change in EVE given changes in rates of +/- 100, 200, 300, and 400 basis points.

The Company’s ALCO is responsible for the reviewing the interest rate sensitivity position of the institution, establishing policies to monitor and limit exposure to this type of risk, and employing strategies to ensure our asset-liability structure produces the maximum yield-cost spread available based on current market conditions.

The Company’s Investment / Interest Rate Risk Committee, a committee of the Board of Directors, reviews and approves the policies established by ALCO.

Earnings Simulation Modeling

The ALCO uses an asset liability model (“ALM”) to forecast earning simulations that measure the sensitivity of net interest income to changes in interest rates.

The ALM calculates an earnings estimate based on current and projected balances and rates.

This method is subject to the accuracy of the assumptions that support the ALM process.

The ALCO derives the assumptions used in the ALM from historical trends and management’s outlook, including expected loan growth, loan prepayment rates, deposit growth rates, changes to deposit product betas and non-maturity deposit decay rates, and projected yields and rates.

The ALM assumes that all maturities, calls, and prepayments in the securities portfolio are reinvested in like instruments.

These assumptions may not be realized and unanticipated events and circumstances may also occur that cause the assumptions to be inaccurate.

The ALM also does not take into account any future actions management may take to mitigate the impact of unforeseen interest rate changes.

A sensitivity analysis for deposit betas, deposit decay rates and loan prepayment speeds is performed at least annually within the ALM to help ALCO better understand the impact of these critical assumptions on the ALM results.

The ALCO reviews the assumptions of the ALM at least quarterly and periodically adjusts them when deemed appropriate.

The ALCO also uses different interest rate scenarios and shifts in yield curve shapes to measure the sensitivity of earnings to various interest rate environments.

Interest rates on unique asset and liability accounts move differently when the short-term market rate changes.

These differences are reflected in the different rate scenarios utilized by the ALM.

For earning simulations, our policy guidelines limit the change in net interest income over a 12-month and 24-month horizon using rate shocks of +/- 100, 200, 300, 400 basis points and for non-parallel yield curve shift scenarios.

We have temporarily suspended the + 300 and + 400 basis point rate shock analyses.

Due to Federal Open Market Committee’s slowing future rate increase projections coupled with the recent increase in the Fed Funds Target Rate of 5.25% since March 17, 2022.

We believe the impact to NII income when evaluating the + 300 and +400 basis point rate shock scenarios do not provide meaningful insight into our interest rate risk position nor does it project a probably interest rate environment for the foreseeable future.

Due to FOMC’s current pause in overnight rate increase projections coupled with current rate forecasts that imply that the FOMC will likely begin reducing the Fed Funds Target Rate before the end of the year, we believe the impact to net interest income when evaluating the + 300 and +400 basis point rate shock scenarios do not provide meaningful insight into our interest rate risk position nor does it project a probable interest rate environment for the foreseeable future.

The following tables reflect the earnings simulation results for the periods presented utilizing a forecasted static balance sheet over the next twelve months.

All percentage changes presented are within prescribed ranges set by ALCO.

March 31, 2024 December 31, 2023

Change in Interest Rate (basis points) % Change in Pretax Net Interest Income % Change in Pretax Net Interest Income

200 1.5% (1.1)%

100 1.1% (0.3)%

-100 1.3% 2.4%

-200 2.2% 4.4%

-300 3.0% 5.6%

-400 4.0% 6.7%

The results from the earnings simulation imply that the Company’s balance sheet is slightly liability sensitive balance sheet at March 31, 2024 and December 31, 2023.

The above table indicates that, in a rising interest rate environment, the Company is positioned to have a minimum increase in net interest income for the same asset and liability mix due to the balance sheet composition, related maturity structures, and repricing correlations to market interest rates for assets and liabilities.

However, in a declining interest rate environment, we are positioned to have a slightly more advantageous increase in net interest income for

CARTER BANKSHARES, INC.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK (continued)

The following tables reflect the NII rate shock analyses and EVE analyses results for the periods presented utilizing a forecasted static balance sheet over the next twelve months.

the same reasons discussed above.

The liability sensitivity is due to a variety of factors which include 1) lower yielding, floating rate excess cash positions held in federal reserve bank and interest-bearing deposits in other financial institutions, that are more sensitive to future market interest rate changes which were deployed into higher yielding, fixed and variable rate securities and portfolio loans that are less sensitive to future market interest rate changes, 2) shortening maturities of the time deposit portfolio due to shorter term time deposit promotional campaigns related to the inverted yield curve, and 3) the recent shifts in the shape of the yield curve between the two periods presented above.

Economic Value of Equity Modeling

Economic value of equity simulation is used to calculate the estimated fair value of assets and liabilities over different interest rate environments.

The ALM calculates the economic value of equity based on discounted cash flow analysis.

The net economic value of equity is the economic value of all assets minus the economic value of all liabilities.

The change in net economic value of equity over different rate environments is an indication of the longer-term earnings capability of the balance sheet.

The Company uses the same assumptions in the economic value of equity simulation model as in the earnings simulation model.

The economic value of equity simulation model uses instantaneous rate shocks to the balance sheet.

For economic value of equity simulation, our policy guidelines limit the change in economic value of equity given changes in rates of +/- 100, 200, 300, 400 basis points and for non-parallel yield curve shift scenarios.

We have temporarily suspended the + 300 and + 400 basis point rate shock analyses.

Results for the economic value of equity modeling are driven primarily by the shape of the underlying yield curves and option-adjusted spreads used to discount the projected cash flows of assets and liabilities, and the assumed life span of the assets and liabilities being discounted.

The following tables reflect the economic value of equity analyses results for the periods presented.

All percentage changes presented are within prescribed ranges set by management.

September 30, 2023 December 31, 2022

Change in Interest Rate (basis points) % Change in Pretax Net Interest Income % Change in Economic Value of Equity % Change in Pretax Net Interest Income % Change in Economic Value of Equity

March 31, 2024 December 31, 2023

Change in Interest Rate (basis points) % Change in Economic Value of Equity % Change in Economic Value of Equity

200 (5.7)% (4.7)%

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-400 (6.9)% (10.9)%

The results from the net interest income rate shock analysis imply that Company’s balance sheet has shifted from an asset sensitive balance sheet when adjusted for repricing correlations (betas) at December 31, 2022 to a slightly liability sensitive balance sheet when adjusted for repricing correlations (betas) at September 30, 2023.

The above table indicates that in a rising interest rate environment, the Company is positioned to have a minimum increase in pretax net interest income for the same asset base due to the balance sheet composition, related maturity structures, and repricing correlations to market interest rates for assets and liabilities.

However, in a declining interest rate environment, we are positioned to have slightly more advantageous increased pretax net interest income for the same reasons discussed above.

Based on the ALM results presented above for the quarters ending September 30, 2023 and December 31, 2022, the Company’s balance sheet is slightly liability sensitive at September 30, 2023 versus assets sensitive at December 31, 2022.

This migration in asset sensitivity to liability sensitive is due to 1) lower yielding, floating rate excess cash positions held in federal reserve bank and interest-bearing deposits in other financial institutions that are more sensitive to future market interest rate changes which were deployed into higher yielding, fixed and floating rate securities and portfolio loans that are less sensitive to future market interest rate changes, 2) the addition of the Company’s largest lending relationship with an aggregate principal amount of $301.9 million being placed on nonaccrual status as of September 30, 2023, 3) shortening maturities of the time deposit portfolio due to shorter term time deposit promotional campaigns related to the inverted yield curve, and 4) the recent shifts in the shape of the yield curve between the two periods presented above.

In addition to rate shocks and EVE analyses, sensitivity analyses are performed to help us identify which model assumptions are critical and cause the greatest impact on pretax NII.

Sensitivity analyses include changing prepayment behavior of loans and securities with optionality, repricing correlations, and the impact of interest rate changes on non-maturity deposit products (decay rates).

Compared sentence by sentence after normalising whitespace, quotation marks, case and digits, so re-formatting and restated figures do not read as changed language. Wording changes appear as one removal and one addition. The current filing and the prior one are authoritative.

What changed 10-Q

Item 3. Quantitative and Qualitative Disclosures About Market Risk