Item 7A. Quantitative and Qualitative Disclosures About Market Risk
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Many assumptions are used to calculate the impact of interest rate fluctuations on our net interest income, such as asset prepayments, non-maturity deposit price sensitivity and decay rates, and key rate drivers. Because of the inherent use of these estimates and assumptions in the model, our actual results may, and very likely will, differ from our static earnings at risk (“EAR”) results. In addition, static EAR results do not include actions that our management may undertake to manage the risks in response to anticipated changes in interest rates or client behavior. For example, as part of our asset/liability management strategy, management has the ability to increase asset duration and decrease liability duration in order to reduce asset sensitivity, or to decrease asset duration and increase liability duration in order to increase asset sensitivity.
The following table summarizes the results of our EAR analysis in simulating the change in net interest income and fair value of equity over a 12-month horizon as of December 31, 2023:
IMPACT ON NET INTEREST INCOME UNDER A STATIC BALANCE SHEET, PARALLEL INTEREST RATE SHOCK
Earnings at Risk -400 bps -300 bps -200 bps -100 bps Flat +100 bps +200 bps +300 bps +400 bps
December 31, 2023 0.7 % (1.4) % (2.2) % (1.4) % 0.0 % 1.3 % 2.5 % 3.7 % 4.9 %
Utilizing an economic value of equity (“EVE”) approach, we analyze the risk to capital from the effects of various interest rate scenarios through a long-term discounted cash flow model. This measures the difference between the economic value of our assets and the economic value of our liabilities, which is a proxy for our liquidation value. While this provides some value as a risk measurement tool, management believes EAR is more appropriate in accordance with the going concern principle.
The following table illustrates the results of our EVE analysis as of December 31, 2023.
ECONOMIC VALUE OF EQUITY ANALYSIS UNDER A STATIC BALANCE SHEET, PARALLEL INTEREST RATE SHOCK
Economic Value of Equity -400 bps -300 bps -200 bps -100 bps Flat +100 bps +200 bps +300 bps +400 bps
December 31, 2023 (9.8) % (4.5) % (1.1) % (0.1) % 0.0 % (0.7) % (2.0) % (2.8) % (4.0) %
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Interest Rate Sensitivity and Market Risk
As a financial institution, our primary component of market risk is interest rate volatility. Our asset liability and funds management policy provides management with the guidelines for funds management, and we have established a measurement system for monitoring our net interest rate sensitivity position . We endeavor to manage our sensitivity position within our established guidelines.
Fluctuations in interest rates will ultimately impact both the level of income and the market value of all interest earning assets and interest-bearing liabilities, other than those that have a short term to maturity. Interest rate risk is the potential of economic losses due to future interest rate changes. These economic losses can be reflected as a loss of future net interest income and/or a loss of current fair market values. The objective is to measure the effect on net interest income and to adjust the balance sheet to minimize the inherent risk while at the same time maximizing income.
We endeavor to manage our exposure to interest rates by structuring our balance sheet in the ordinary course of business. We do not enter into instruments such as leveraged derivatives, financial options or financial futures contracts for the purpose of reducing interest rate risk. We endeavor to hedge the interest rate risks of our available for sale mortgage pipeline by using MBS, and short positions. Based on the nature of our operations, we are not subject to foreign exchange or commodity price risk. We do not own any trading assets.
Our exposure to interest rate risk is managed by the Bank’s Asset/Liability Management Committee (“ALCO”) in accordance with policies approved by our board of directors. The ALCO formulates strategies based on perceived levels of interest rate risk. In determining the appropriate level of interest rate risk, the committee considers the impact on earnings and capital of the current outlook for interest rates, potential changes in interest rates, regional economies, liquidity, business strategies and other factors. The ALCO meets regularly to review, among other things, the sensitivity of assets and liabilities to interest rate changes, the book and market values of assets and liabilities, unrealized gains and losses, purchase and sale activities, commitments to originate loans and the maturities of investments and borrowings. Additionally, the ALCO reviews liquidity, capital planning, cash flow flexibility, maturities of deposits and consumer and commercial deposit activity. Management employs methodologies to manage interest rate risk, which include an analysis of relationships between interest earning assets and interest-bearing liabilities and an interest rate shock simulation model.
The following table indicates that, for periods less than one year, rate-sensitive assets exceeded rate-sensitive liabilities, resulting in an asset-sensitive position. For a bank with an asset-sensitive position, or positive gap, rising interest rates would generally be expected to have a positive effect on net interest income, and falling interest rates would generally be expected to have the opposite effect.
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INTEREST SENSITIVITY GAP
December 31, 2023 Within One Month After One Month Through Three Months After Three Through Twelve Months Within One Year Greater Than One Year or Non-Sensitive Total
(in thousands)
Assets
Interest earning assets
Loans (1)
$ 351,769 $ 471,678 $ 319,530 $ 1,142,977 $ 767,792 $ 1,910,769
Securities
3,756 21,571 28,444 53,771 158,911 212,682
Interest-bearing deposits at other financial institutions 39,044 — — 39,044 — 39,044
Federal funds sold
407 — — 407 — 407
Total earning assets
$ 394,976 $ 493,249 $ 347,974 $ 1,236,199 $ 926,703 $ 2,162,902
Liabilities
Interest-bearing liabilities
Interest-bearing deposits $ 13,138 $ 26,277 $ 116,536 $ 155,951 $ 711,697 $ 867,648
Time deposits
69,921 50,844 229,894 350,659 60,316 410,975
Total Interest-bearing deposits 83,059 77,121 346,430 506,610 772,013 1,278,623
FHLB Advances
15,000 — — 15,000 7,000 22,000
Other borrowed funds
— — — — 27,062 27,062
Total Interest-bearing liabilities $ 98,059 $ 77,121 $ 346,430 $ 521,610 $ 806,075 $ 1,327,685
Period gap
$ 296,917 $ 416,128 $ 1,544 $ 714,589 $ 120,628 $ 835,217
Cumulative gap $ 296,917 $ 713,045 $ 714,589 $ 714,589 $ 835,217
Ratio of cumulative gap to total earning assets
13.73 % 32.97 % 33.04 % 33.04 % 38.62 %
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(1) Includes loans held for sale and loans made under the SBA-PPP loan program.
We use quarterly EAR simulations to assess the impact of changing interest rates on our earnings under a variety of scenarios and time horizons. These simulations utilize both instantaneous and parallel changes in the level of interest rates, as well as non-parallel changes such as changing slopes and twists of the yield curve. Static simulation models are based on current exposures and assume a constant balance sheet with no new growth. Dynamic simulation models are also utilized that rely on assumptions regarding changes in existing lines of business, new business, and changes in management and client behavior.
We also use economic value-based methodologies to estimate the degree to which the economic values of the Bank’s positions change under different interest rate scenarios. The economic-value approach focuses on a longer-term time horizon and endeavors to capture all future cash flows expected from existing assets and liabilities. The economic value model utilizes a static approach in that the analysis does not incorporate new business; rather, the analysis shows a snapshot in time of the risk inherent in the balance sheet.
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