COMMUNITY FINANCIAL SYSTEM, INC. 10-Q

Item 3. Quantitative and Qualitative Disclosures about Market Risk Market risk is the risk of loss in a financial instrument arising from adverse changes in market rates, prices or credit risk. Credit risk associated with the Company’s loan portfolio has been previously discussed in the asset quality section of the MD&A. Management believes that the tax risk of the Company’s municipal investments associated with potential future changes in statutory, judicial and regulatory actions is minimal. Treasury, agency, mortgage-backed and collateralized mortgage obligation securities issued by government agencies comprise 90.9% of the total portfolio and are currently rated AAA by Moody’s Investor Services and AA+ by Standard & Poor’s. Obligations of state and political subdivisions account for 9.0% of the total portfolio, of which, 96.3% carry a minimum rating of A-. The remaining 0.1% of the portfolio is comprised of other investment grade securities. The Company does not have material foreign currency exchange rate risk exposure. Therefore, almost all the market risk in the investment portfolio is related to interest rates. The ongoing monitoring and management of both interest rate risk and liquidity over the short and long term time horizons is an important component of the Company’s asset/liability management process, which is governed by guidelines established in the policies reviewed and approved annually by the Company’s Board. The Board delegates responsibility for carrying out the policies to the ALCO, which meets each month. The committee is made up of the Company’s senior management as well as regional and line-of-business managers who oversee specific earning asset classes and various funding sources. As the Company does not believe it is possible to reliably predict future interest rate movements, it has maintained an appropriate process and set of measurement tools, which enables it to identify and quantify sources of interest rate risk in varying rate environments. The primary tool used by the Company in managing interest rate risk is income simulation. This begins with the development of a base case scenario, which projects net interest income (“NII”) over the next twelve month period. The base case scenario NII may increase or decrease significantly from quarter to quarter reflective of changes during the most recent quarter in the Company’s: (i) earning assets and liabilities balances, (ii) composition of earning assets and liabilities, (iii) earning asset yields, (iv) cost of funds and (v) model projections, as well as current market interest rates, including the slope of the yield curve and projected changes in the slope of the yield curve over the twelve month period. While a wide variety of strategic balance sheet and treasury yield curve scenarios are tested on an ongoing basis, the following reflects the Company’s estimated NII sensitivity as compared to the base case scenario over the subsequent twelve months based on: ● Balance sheet levels using June 30, 2022 as a starting point. ● The model assumes the Company’s average deposit balances will increase approximately 1.9% over the next twelve months. ● The model assumes the Company’s average earning asset balances will increase approximately 3.0% over the next twelve months. ● Cash flows on earning assets are based on contractual maturity, optionality, and amortization schedules along with applicable prepayments derived from internal historical data and external sources. The model assumes that the majority of remaining PPP loans will be forgiven and repayment of the balances would occur over the remaining two quarters of 2022. All other loan balances are generally projected to increase modestly throughout the forecast period. ● The model assumes no additional investment security purchases over the next twelve months. ● In the rising rates scenarios, the prime rate and federal funds rates are assumed to move up by the amounts listed below over a 12-month period while moving the long end of the treasury curve to spreads over the three month treasury that are more consistent with historical norms based on the last three years (normalized yield curve). Deposit rates are assumed to move in a manner that reflects the historical relationship between deposit rate movement and changes in the federal funds rate. In the -100 basis point model, the prime and federal funds rates are dropped one hundred basis points each, and the treasury curve assumes the same slope as the rising rate scenarios, with all points normalizing off of the three month treasury rate, which is lowered by one hundred basis points from the flat rate scenario. ​ 55 Table of Contents Net Interest Income Sensitivity Model ​ ​ ​ ​ ​ ​ Calculated annualized increase ​ ​ (decrease) in projected net interest ​ ​ income at June 30, 2022 Interest rate scenario (000’s omitted) +200 basis points ​ $6,302 +100 basis points ​ $2,776 -100 basis points ​ ($8,426) ​ Projected NII over the 12-month forecast period increases in the rising rate environments largely due to assumed higher rates on new loans, and assumed higher repricing rates on variable and adjustable rate loans. These increases are partially offset by anticipated increases in deposit and borrowing costs. Over the longer time period, the growth in NII continues to improve in both rising rate environments as the impact from lower yielding assets maturing and being replaced at higher rates is significantly more material than the increase in funding costs. In the -100 basis points scenario, the Company shows interest rate risk exposure to lower rates on all terms. During the first twelve months, net interest income declines largely due to lower assumed rates on loan originations, and certain adjustable and variable rate loans. Modestly lower funding costs associated with deposits and borrowings only partially offset a small proportion of the decrease in interest income. The analysis does not represent a Company forecast and should not be relied upon as being indicative of expected operating results. These hypothetical estimates are based upon numerous assumptions: the nature and timing of interest rate levels (including yield curve shape), prepayments on loans and securities, deposit decay rates, pricing decisions on loans and deposits, reinvestment/replacement of asset and liability cash flows, and other factors. While the assumptions are developed based upon a reasonable outlook for national and local economic and market conditions, the Company cannot make any assurances as to the predictive efficacy of these assumptions, including how customer preferences or competitor influences might change. Furthermore, the sensitivity analysis does not reflect actions that the ALCO might take in responding to or anticipating changes in interest rates and other developments. ​