Item 7A. Quantitative and Qualitative Disclosures About Market Risk
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Asset/Liability Management of Interest Rate Risk
A fundamental risk in banking is exposure to market risk, or interest rate risk, since a bank’s net income is largely dependent on net interest income. The Bank’s ALCO formulates and monitors the management of interest rate risk through policies and guidelines established by it and the full Board of Directors and through review of detailed reports discussed quarterly. In its consideration of risk limits, the ALCO considers the impact on earnings and capital, the level and direction of interest rates, liquidity, local economic conditions, outside threats and other factors. Banking is generally a business of managing the maturity and repricing mismatch inherent in its asset and liability cash flows and to provide net interest income growth consistent with the Company’s profit objectives.
During the year ended December 31, 2020, the Company's net interest income decreased by 1%, as a result of compression in the net interest margin largely offset by growth in average earnings assets. The Company believes it is able to continue to manage its overall interest rate risk position to a moderate level.
The Company, through its ALCO and ongoing financial management practices, monitors the interest rate environment in which it operates and adjusts the rates and maturities of its assets and liabilities to remain competitive and to achieve its overall financial objectives subject to established risk limits. In the current and expected future interest rate environment, the Company has been maintaining its investment portfolio to manage the balance between yield and prepayment risk in its portfolio of mortgage-backed securities should interest rates remain at current levels. Further, the Company has been managing the investment portfolio to mitigate extension risk and related declines in market values in that same portfolio should interest rates increase. Additionally, the Company has limited call risk in its U.S. agency investment portfolio. During the year ended December 31, 2020, the average investment portfolio balances increased by 17% as compared to balances at December 31, 2019, in the effort to maintain the overall proportion of AFS securities to total assets, while also prudently managing significant deposit growth that outpaced loan growth. Cash flows from mortgage backed securities and sales of U.S. agency securities were reinvested primarily into a similar combination of mortgage backed securities and agencies. Additional investments have been made in community bank sub-debt and SBA bonds. The percentage mix of municipal securities increased to 9% of total investments at December 31, 2020 from 8% at December 31, 2019, as the focus shifted to shorter duration instruments with more cash flow. The portion of the portfolio invested in mortgage backed securities increased to 72% at December 31, 2020 from 65% at December 31, 2019 while the portion of the portfolio represented in U.S. agency investments decreased from 22% to 16%. Shorter duration floating rate corporate bonds were 3% of total investments at December 31, 2020 and SBA bonds, which are included in mortgage backed securities, were 6% of total investments at December 31, 2020. The duration of the investment portfolio was 3.2 years at December 31, 2020 and 3.4 at December 31, 2019. The lower duration was due to the passage of time and maturity of the bond portfolio and the faster mortgage prepayment environment, mitigated by purchases of a higher mix and dollar amount of longer duration mortgage backed securities and municipal bonds.
In the loan portfolio, the repricing duration was 21 months at December 31, 2020 and 20 months at December 31, 2019, with fixed rate loans amounting to 45% of total loans at December 31, 2020 and 41% at December 31, 2019. Variable and adjustable rate loans comprised 55% of total loans at December 31, 2020 and 59% for 2019. Variable rate loans are generally indexed to either the one month London Interbank Offered Rate (“LIBOR”) or the Wall Street Journal prime interest rate, while adjustable rate loans are indexed primarily to the five year U.S. Treasury interest rate.
The duration of the deposit portfolio lengthened to 42 months at December 31, 2020 from 27 months at December 31, 2019. The change since December 31, 2019 was due to measured nonmaturity deposit decay rates extending due to an economic slowdown and a resulting lack of deposit competition as rates fell. The Company experienced $2.0 billion in total deposit growth for the year ended December 31, 2020 as compared to total loan growth of $214.5 million.
While loan growth was impacted in 2020 due to the COVID-19 pandemic, the Company has continued its emphasis on funding loans in its marketplace, and has continued to achieve discplined loan pricing, even at the expense of growing new loans. A disciplined approach to loan pricing has resulted in a loan portfolio yield of 4.66% for the year ended December 31, 2020 as compared to 5.45% for the same period in 2019. In the competitive interest rate environment of 2020, the interest rates on new loan originations have been well below the rates of loan paydowns and payoffs. Additionally, significant amounts of variable and adjustable rate loans have repriced down as market interest rates decreased.
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The net unrealized gain before income tax on the investment portfolio was $22.0 million at December 31, 2020 as compared to a net unrealized gain before tax of $4.2 million at December 31, 2019, with $1.8 million of realized net gains recorded during the year ended December 31, 2020. The higher net unrealized gain on the investment portfolio was due primarily to lower interest rates at year end 2020 as compared to year end 2019. At December 31, 2020, the unrealized gain position represented 2% of the portfolio’s book value.
The Company is a party to interest rate swaps as part of its interest rate risk management strategy intended to mitigate the potential risk of rising interest rates on the Bank’s cost of funds. As of both December 31, 2020 and 2019, the Company had one interest rate swap transaction outstanding that had a notional amount of $100.0 million associated with the Company’s variable rate deposits. The interest rate swap is designated as a cash flow hedge and involves the receipt of variable rate amounts from a counterparty in exchange for the Company making fixed payments that began in April 2016. The net unrealized loss before income tax on the interest rate swap was $516 thousand at December 31, 2020 as compared to a net unrealized loss before income tax of $202 thousand at December 31, 2019, and is included in accumulated other comprehensive income (net of taxes) on the Consolidated Balance Sheet. The increased unrealized gain in value since year end 2019 was due to the declines in market interest rates.
During the third quarter of 2018, the Company entered into credit RPAs with institutional counterparties, under which the Company assumes its pro-rata share of the credit exposure associated with a borrower’s performance related to interest rate derivative contracts. The fair value of RPAs is calculated by determining the total expected asset or liability exposure of the derivatives to the borrowers and applying the borrowers’ credit spread to that exposure. Total expected exposure incorporates both the current and potential future exposure of the derivatives, derived from using observable inputs, such as yield curves and volatilities. These derivatives are not designated as hedges, are not speculative, and have a notional value of $26.9 million as of December 31, 2020. The changes in fair value for these contracts are recognized directly in earnings.
There can be no assurance that the Company will be able to successfully achieve its optimal asset liability mix, as a result of competitive pressures, customer preferences and the inability to perfectly forecast future interest rates and movements.
One of the tools used by the Company to manage its interest rate risk is a static gap analysis presented below. The Company also employs an earnings simulation model on a quarterly basis to monitor its interest rate sensitivity and risk and to model its balance sheet cash flows and the related income statement effects in different interest rate scenarios. The model utilizes current balance sheet data and attributes and is adjusted for assumptions as to investment maturities (including prepayments), loan prepayments, interest rates, and the level of noninterest income and noninterest expense. The data is then subjected to a “shock test” which assumes a simultaneous change in interest rates up 100, 200, 300, and 400 basis points or down 100 and 200 basis points, along the entire yield curve, but not below zero. The results are analyzed as to the impact on net interest income, net income and the market equity over the next twelve and twenty-four month periods from December 31, 2020. In addition to analysis of simultaneous changes in interest rates along the yield curve, changes based on interest rate “ramps” is also performed and reviewed by ALCO, but is not herein disclosed. Such analysis represents the impact of a more gradual change in interest rates, as well as yield curve shape changes.
For the analysis presented below, at December 31, 2020, the simulation assumes a 50 basis point change in interest rates on money market and interest bearing transaction deposits for each 100 basis point change in market interest rates in a decreasing interest rate shock scenario with a floor of 10 basis points, and assumes a 70 basis point change in interest rates on money market and interest bearing transaction deposits for each 100 basis point change in market interest rates in an increasing interest rate shock scenario.
As quantified in the table below, the Company’s analysis at December 31, 2020 shows a moderate effect on net interest income over the next 12 months, as well as a moderate effect on the economic value of equity when interest rates are shocked both down 100 and 200 basis points and up 100, 200, 300, and 400 basis points. This moderate impact is due substantially to the significant level of variable rate and repriceable assets and liabilities and related shorter asset and liability durations. The repricing duration of the investment portfolio at December 31, 2020 is 3.2 years, the loan portfolio 1.7 years, the interest bearing deposit portfolio 2.65 years and the borrowed funds portfolio 5.8 years.
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The following table reflects the result of simulation analysis on the December 31, 2020 asset and liability balances:
Change in interest
rates (basis points) Percentage change in net
interest income Percentage change in
net income Percentage change in
market value of portfolio
equity
+400 +14.0 +23.8 +8.1
+300 +9.4 +16.0 +6.4
+200 +5.0 +8.5 +4.7
+100 +1.6 +2.8 +2.8
— — — —
(100) (1.6) (2.6) (11.3)
(200) (1.9) (3.2) (23.6)
The results of simulation analysis are within the relevant policy limits adopted by the Company except for the negative 200 basis point scenario for the market value of portfolio equity, which becomes harder to interpret as assets and liabilities go down to the zero lower bound in the simulation. For net interest income, the Company has adopted a policy limit of 10% for a 100 basis point change, 12% for a 200 basis point change, 18% for a 300 basis point change and 24% for a 400 basis point change. For the market value of equity, the Company has adopted a policy limit of 12% for a 100 basis point change, 15% for a 200 basis point change, 25% for a 300 basis point change and 30% for a 400 basis point change. Due to the level of market rates at December 31, 2020, all down interest rate shocks (-100, -200, -300 and -400 basis points) leave the Bank with zero and negative rate instruments and are not considered practical or informative. The changes in net interest income, net income and the economic value of equity in both a higher and lower interest rate shock scenario at December 31, 2020 are not considered to be excessive. The positive impact of +1.6% in net interest income and +2.8% in net income given a 100 basis point increase in market interest rates at December 31, 2020 compares to +5.1% in net interest income and +8.8 in net income for the same period in 2019 and reflects in large measure the impact of variable and adjustable rate loans that are at floor rates at December 31, 2020 and won’t reprice above floors without more significant rate movements as compared to December 31, 2019.
Generally speaking, the loss of economic value of portfolio equity in a lower interest rate environment is due to lower values of core deposits more than offsetting the gains in loan and investment values; while the gain of economic value of portfolio equity in a higher interest rate environment is due to higher value of core deposits more than offsetting lower values of fixed rate loans and investments. The Company believes its balance sheet is well positioned in the current interest rate environment.
During 2020, largely as a result of the COVID-19 pandemic, the Company experienced sharply lower market interest rates together with significantly higher levels of deposit growth as compared to loan growth. This resulted in extraordinary levels of liquidity which was able to be invested in overnight funds which yielded a weighted average rate over the course of the year of just 0.22%. This event resulted in a decline in the net interest spread. Additionally, while a significant mix of the deposit growth was in noninterest bearing funds, the value of these interest free funds decreased in the lower market rate environment. In this challenging interest rate environment in 2020, the Company continued to manage its interest rate sensitivity position to moderate levels of risk, as indicated in the simulation results above. The interest rate risk position at December 31, 2020 was dissimilar to the interest rate risk position at December 31, 2019. As compared to December 31, 2019, the sum of federal funds sold, interest bearing deposits with banks and other short-term investments and loans held for sale increased by $1.5 billion at December 31, 2020, and as noted above, significant amounts of variable rate loans were below floor levels at December 31, 2020.
Certain shortcomings are inherent in the method of analysis presented in the foregoing table. For example, although certain assets and liabilities may have similar maturities or repricing periods, they may react in different degrees to changes in market interest rates. Also, the interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types may lag behind changes in market rates. Additionally, certain assets, such as adjustable-rate mortgage loans, have features that limit changes in interest rates on a short-term basis and over the life of the loan. Further, in the event of a change in interest rates, prepayment and early withdrawal levels could deviate significantly from those assumed in calculating the tables. Finally, the ability of many borrowers to service their debt may decrease in the event of a significant interest rate increase.
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During 2020, average market interest rates declined sharply, and resulted in a flattening of the yield curve. As compared to the year 2019, the average two year U.S. Treasury rate in 2020 decreased by 159 basis points from 1.98% to 0.39%. The average five year U.S. Treasury rate decreased by 142 basis points from 1.96% to 0.53% while the average ten year U.S. Treasury rate decreased by 127 basis points from 2.15% to 0.88%. In that environment, the Company was able to achieve a net interest spread for 2020 of 2.81% compared to 3.05% for the year of 2019. The decline was due primarily to a decrease in the yield on earnings assets, of which higher average liquidity was a significant factor. The Company believes that the change in the net interest spread for the full year 2020 has been consistent with its risk analysis at December 31, 2019. On an annual basis, the Company back-tests the actual change in its net interest spread against expected change and actual market interest rate movements and other factors impacting actual as compared to projected results.
Gap Analysis
Banks and other financial institutions earnings are significantly dependent upon net interest income, which is the difference between interest earned on earning assets and interest expense on interest bearing liabilities. Net interest income represented 88% and 92% of the Company’s revenue for the years ended December 31, 2020 and December 31, 2019, respectively. The Company’s net interest margin was 3.19% for the year ended December 31, 2020, as compared to 3.77% for the year ended December 31, 2019. The decline in net interest margin for the year ended December 31, 2020 as compared to the year ended December 31, 2019, was due to increased funding costs from term deposits gathered early in the year, new loan and variable rate loans adjusting downward as market rates fell, exacerbated by a decrease in the average loan to deposit ratio, as the Bank experienced high levels of on balance sheet liquidity.
In falling interest rate environments, net interest income is maximized with longer term, higher yielding assets being funded by lower yielding short-term funds, or what is referred to as a negative mismatch or negative gap. Conversely, in a rising interest rate environment, net interest income is maximized with shorter term, higher yielding assets being funded by longer-term liabilities or what is referred to as a positive mismatch or positive gap.
The gap position, which is a measure of the difference in maturity and repricing volume between assets and liabilities, is a means of monitoring the sensitivity of a financial institution to changes in interest rates. The chart below provides an indication of the sensitivity of the Company to changes in interest rates. A negative gap indicates the degree to which the volume of repriceable liabilities exceeds repriceable assets in given time periods.
At December 31, 2020, the Company had a positive gap position of approximately $464 million or 4.2% of total assets out to three months and a positive cumulative gap position of $352 million or 3% of total assets out to 12 months; as compared to a positive gap position of approximately $295 million or 3% of total assets out to three months and a positive cumulative gap position of approximately $243 million or 3% of total assets out to 12 months at December 31, 2019. The change in the positive gap position at December 31, 2020, as compared to December 2019, was minimal and contributed to the neutral interest rate risk position of the Company. The change in the gap position at December 31, 2020 as compared to December 31, 2019 is not deemed material to the Company’s overall interest rate risk position. The overall interest rate risk position relies more heavily on simulation analysis, which captures the full optionality within the balance sheet. The current position is within guideline limits established by the ALCO. While management believes that this overall position creates a reasonable balance in managing its interest rate risk and maximizing its net interest margin within plan objectives, there can be no assurance as to actual results.
Management has carefully considered its strategy to maximize interest income by reviewing interest rate levels, economic indicators and call features within its investment portfolio. These factors have been discussed with the ALCO and management believes that current strategies are appropriate to current economic and interest rate trends.
If interest rates increase by 100 basis points, the Company’s net interest income and net interest margin are expected to increase modestly due to the repricing of variable rate assets and the assumption of an increase in money market interest rates by 70% of the change in market interest rates.
If interest rates decline by 100 basis points, the Company’s net interest income and margin are expected to decline modestly as the impact of lower market rates on a large amount of liquid assets more than offsets the ability to lower interest rates on interest bearing liabilities.
Because competitive market behavior does not necessarily track the trend of interest rates but at times moves ahead of financial market influences, the change in the cost of liabilities may be different than anticipated by the gap model. If this were to occur, the effects of a declining interest rate environment may not be in accordance with management’s expectations.
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Gap Analysis
December 31, 2020
(dollars in thousands)
Repricible in: 0-3 months 4-12 months 13-36 months 37-60 months Over 60 months Total Rate
Sensitive Non Sensitive Total
RATE SENSITIVE ASSETS:
Investment securities $ 129,321 $ 146,042 $ 271,885 $ 183,583 $ 420,252 $ 1,151,083
Loans (1)(2)
3,805,449 588,026 1,873,182 739,945 841,815 $ 7,848,417
Fed funds and other short-term investments 1,780,619 — — — — $ 1,780,619
Other earning assets 76,729 — — — — $ 76,729
Total $ 5,792,118 $ 734,068 $ 2,145,067 $ 923,528 $ 1,262,067 $ 10,856,848 260,954 $ 11,117,802
RATE SENSITIVE LIABILITIES:
Noninterest bearing demand $ 97,582 $ 272,338 $ 596,428 $ 445,919 $ 1,402,067 $ 2,814,334
Interest bearing transaction 751,923 — — — — $ 751,923
Savings and money market 4,320,186 — — — 325,000 $ 4,645,186
Time deposits 201,312 325,329 376,825 71,164 3,130 $ 977,760
Customer repurchase agreements and fed funds purchased 26,726 — — — — $ 26,726
Other borrowings — 148,531 — 69,546 350,000 $ 568,077
Total $ 5,397,729 $ 746,198 $ 973,253 $ 586,629 $ 2,080,197 $ 9,784,006 92,904 $ 9,876,910
Gap $ 394,389 $ (12,130) $ 1,171,814 $ 336,899 $ (818,130) $ 1,072,842
Cumulative Gap $ 364,389 $ 352,259 $ 1,524,073 $ 1,860,972 $ 1,042,842
Cumulative gap as percent of total assets 3.55 % 3.44 % 13.98 % 17.01 % 9.65 %
OFF BALANCE-SHEET:
Interest Rate Swaps - Fed Funds based 100,000 (100,000) $ —
Total $ 100,000 $ (100,000) $ — $ — $ — $ — $ — $ —
Gap $ 494,389 $ (112,130) $ 1,171,814 $ 336,899 $ (818,130) $ 1,072,842
Cumulative Gap $ 464,389 $ 352,259 $ 1,524,073 $ 1,860,972 $ 1,042,842
Cumulative gap as percent of total assets 4.45 % 3.44 % 13.98 % 17.01 % 9.65 %
(1) Includes loans held for sale
(2) Nonaccrual loans are included in the over 60 months category
The sum of federal funds sold, interest bearing deposits with banks and other short-term investments increased by $1.6 billion at December 31, 2020 as compared to December 31, 2019. The Company was able to curtail some short term liabilities at year end 2020 as compared to 2019, but was holding more time deposits that are due to mature and reprice in the 4-12 month time horizon. This change resulted in the cumulative gap position within 12 months decreasing to 3.2% of total assets at December 31, 2020 from 3% of total assets at December 31, 2019.
Although NOW and money market accounts are subject to immediate repricing, the Bank’s gap model has incorporated a repricing schedule to account for a lag in rate changes based on our experience, as measured by the amount of those deposit rate changes relative to the amount of rate change in assets.
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