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, 2021, the Company's net interest income increased by 1%, as a result of balance sheet growth even in the face of compression in the net interest margin. 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/extension risk in its portfolio of mortgage-backed securities should interest rates prove more volatile. Additionally, the Company has limited call risk in its U.S. agency investment portfolio. For the year ended December 31, 2021, the average investment portfolio balances increased by 82% as compared to the average balance at December 31, 2020, in the effort to deploy excess liquidity into higher earning assets in the face of reductions in loan volumes. Cash flows from mortgage backed securities and calls 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 US Treasury bonds. The percentage mix of municipal securities decreased to 5% of total investments at December 31, 2021 from 9% at December 31, 2020, as the focus shifted to shorter duration instruments with more cash flow. The portion of the portfolio invested in mortgage backed securities decreased to 62% at December 31, 2021 from 72% at December 31, 2020 while the portion of the portfolio represented in U.S. agency investments increased from 16% to 24%. Shorter duration floating rate corporate bonds were 2% of total investments at December 31, 2021 and SBA bonds, which are included in agency securities, were 3% of total investments at December 31, 2021. The repricing duration of the investment portfolio was 4.3 years at December 31, 2021 and 3.2 years at December 31, 2020. The higher duration was due to the new purchases made largely in the second half of the year in a higher rate environment where prepayment speeds are excepted to slow.
In the loan portfolio, the repricing duration was 18 months at December 31, 2021 and 21 months at December 31, 2020, with fixed rate loans amounting to 43% of total loans at December 31, 2021 and 45% at December 31, 2020. Variable and adjustable rate loans comprised 57% of total loans at December 31, 2021 and 55% for 2020. Variable rate loans are generally indexed to either the one month London Interbank Offered Rate (“LIBOR”) with fallback language to reference the Secured Overnight Funding Rate ("SOFR") 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 slightly decreased to 41 months at December 31, 2021 from 42 months at December 31, 2020. The Company experienced $792.3 million in total deposit growth for the year ended December 31, 2021 as compared to a total loan decrease of $694.6 million.
While loan growth was impacted in 2021 due to the continuing COVID-19 pandemic and the sale of SBA PPP loans, the Company has continued its emphasis on funding loans in its marketplace, and has continued to achieve disciplined loan pricing, even at the expense of growing new loans. A disciplined approach to loan pricing has resulted in a loan portfolio yield of 4.62% for the year ended December 31, 2021 as compared to 4.66% for the same period in 2020. In the competitive interest rate environment of 2021, the interest rates on new loan originations have been below the rates of loan paydowns and payoffs. Additionally, significant amounts of variable and adjustable rate loans have repriced down to meet market interest rates.
The net unrealized loss before income tax on the investment portfolio was $18.6 million at December 31, 2021 as compared to a net unrealized gain before tax of $22.0 million at December 31, 2020, with $3.0 million of realized net gains recorded during the year ended December 31, 2021. The net unrealized loss on the investment portfolio was due primarily to higher interest rates at year end 2021 as compared to year end 2020. At December 31, 2021, the unrealized gain position represented 0.7% of the portfolio’s book value.
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The Company has credit Risk Participation Agreements ("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 $26.4 million as of December 31, 2021. 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, 2021. 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, 2021, 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 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 an increasing interest rate shock scenario.
As quantified in the table below, the Company’s analysis at December 31, 2021 shows a moderate effect on net interest income over the next 12 months, as well as a modest 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, 2021 is 4.3 years, the loan portfolio 1.5 years, the interest bearing deposit portfolio 2.65 years and the borrowed funds portfolio 5.8 years.
The following table reflects the result of simulation analysis on the December 31, 2021 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 +25.8 +45.2 (5.2)
+300 +18.6 +32.5 (4.3)
+200 +11.2 +19.6 (3.1)
+100 +4.7 +8.1 (1.2)
— — — —
(100) (3.2) (5.6) (4.7)
(200) (5.1) (9.0) (19.5)
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, 2021, 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,
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2021 are not considered to be excessive. The positive impact of +4.7% in net interest income and +8.1% in net income given a 100 basis point increase in market interest rates at December 31, 2021 compares to +1.6% in net interest income and +2.8% in net income for the same period in 2020 and reflects in large measure the repricing of cash on hand and tempered by the impact of variable and adjustable rate loans that are at floor rates at December 31, 2021 and won’t reprice above floors without more significant rate movements.
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. Recent increases in deposit decay rates, however, have lowered the modeled valuation of core deposits. As a result, the model shows that the value increase of more rate sensitive core deposits in a rising rate environment does not rise fast enough to overcome the valuation decline in assets. If decay rates return to more normal historical speeds, the normal pattern of increasing income correlating with an increasing EVE (Economic Value of Equity) would return. The Company believes its balance sheet is well positioned in the current interest rate environment.
During 2021, largely as a result of the COVID-19 pandemic, the Company continued to experience higher levels of deposit growth as compared to loan growth. This resulted in extraordinary levels of liquidity which management was able to invest in overnight funds and marketable securities. 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. The interest rate risk position at December 31, 2021 was dissimilar to the interest rate risk position at December 31, 2020, in that there was more expected net interest income in rising rates as a percentage. This is partly a mathematical consequence of starting from a low level for the Net Interest Margin at the end of 2021. As compared to December 31, 2020, the sum of federal funds sold, interest bearing deposits with banks and other short-term investments and loans held for sale decreased by $120 million at December 31, 2020, and as noted above, there is still a significant amount of variable rate loans that are below floor levels at December 31, 2021.
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.
During 2021, average market interest rates were mixed , and resulted in a steepening of the yield curve. As compared to the year 2020, the average two year U.S. Treasury rate in 2021 decreased by 13 basis points from 0.39% to 0.26%. The average five year U.S. Treasury rate increased by 32 basis points from 0.54% to 0.86% while the average ten year U.S. Treasury rate increased by 55 basis points from 0.88% to 1.43%. In that environment, the Company was able to achieve a net interest spread for 2021 of 2.59% compared to 2.81% for the year of 2020. 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 2021 has been consistent with its risk analysis at December 31, 2020. 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 89% and 88% of the Company’s revenue for the years ended December 31, 2021 and December 31, 2020, respectively. The Company’s net interest margin was 2.81% for the year ended December 31, 2021, as compared to 3.19% for the year ended December 31, 2020. The decline in net interest margin for the year ended December 31, 2021 as compared to the year ended December 31, 2020, was due to decreasing average loan balances and the balance sheet asset mix skewing towards lower yielding marketable securities, as the Bank continued to experience 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.
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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, 2021, the Company had a negative gap position of approximately $267 million or 2% of total assets out to three months and a positive cumulative gap position of $102 million or 0.86% of total assets out to 12 months; as compared to a positive gap position of approximately $464 million or 4% of total assets out to three months and a positive cumulative gap position of approximately $352 million or 3% of total assets out to 12 months at December 31, 2020. The change in the positive gap position at December 31, 2021, as compared to December 2020, was due to the increase in savings and money market accounts and moving those balances into the securities portfolio rather than holding them all in short term cash accounts. The change in the gap position at December 31, 2021 as compared to December 31, 2020 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 due to the repricing of variable rate assets and the assumption of an increase in money market interest rates by 50% 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, 2021
(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 $ 175,592 $ 282,605 $ 584,996 $ 571,101 $ 1,009,114 $ 2,623,408
Loans (1)(2)
3,668,220 762,802 1,509,019 692,713 480,061 7,112,815
Fed funds and other short-term investments 1,701,337 — — — — 1,701,337
Other earning assets 108,789 — — — — 108,789
Total $ 5,653,938 $ 1,045,407 $ 2,094,015 $ 1,263,814 $ 1,489,175 $ 11,546,349 300,961 $ 11,847,310
RATE SENSITIVE LIABILITIES:
Noninterest bearing demand (3)
$ 117,696 $ 327,398 $ 710,692 $ 524,335 $ 1,597,834 $ 3,277,955
Interest bearing transaction 777,255 — — — — 777,255
Savings and money market 4,872,248 — 225,000 100,000 5,197,248
Time deposits 129,459 349,102 226,683 20,708 3,130 729,082
Customer repurchase agreements and fed funds purchased 23,918 — — — — 23,918
Other borrowings — 69,670 — 300,000 369,670
Total $ 5,920,576 $ 676,500 $ 1,232,045 $ 645,043 $ 1,900,964 $ 10,375,128 121,407 $ 10,496,535
Gap $ (266,638) $ 368,907 $ 861,970 $ 618,771 $ (411,789) $ 1,171,221
Cumulative Gap $ (266,638) $ 102,269 $ 964,239 $ 1,583,010 $ 1,171,221
Cumulative gap as percent of total assets (2.25) % 0.86 % 8.14 % 13.36 % 9.89 %
OFF BALANCE-SHEET:
Interest Rate Swaps - Fed Funds based — — — — — $ —
Total $ — $ — $ — $ — $ — $ — $ — $ —
Gap $ (266,638) $ 368,907 $ 861,970 $ 618,771 $ (411,789) $ 1,171,221
Cumulative Gap $ (266,638) $ 102,269 $ 964,239 $ 1,583,010 $ 1,171,221
Cumulative gap as percent of total assets (2.25) % 0.86 % 8.14 % 13.36 % 9.89 %
(1) Includes loans held for sale
(2) Nonaccrual loans are included in the over 60 months category
(3) Non-Interest Bearing demand, while assumed to be non-rate sensitive, are displayed based on the expected deposit decay period
The sum of federal funds sold, interest bearing deposits with banks and other short-term investments decreased by $80 million at December 31, 2021 as compared to December 31, 2020.
Although NOW and money market accounts are subject to immediate repricing, the Bank generally expects there to be a lag in rate changes based on our experience that could change the actual results from what is modeled here.