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 monthly by ALCO and quarterly by the Board. 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 providing net interest income growth consistent with the Company’s profit objectives.
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.
During 2022, average market interest rates were markedly higher and resulted in an inverted yield curve. As compared to the year 2021, the average two year U.S. Treasury rate in 2022 increased by 273 basis points from 0.26% to 2.99%. The average five year U.S. Treasury rate increased by 214 basis points from 0.86% to 3.00% while the average ten year U.S. Treasury rate increased by 152 basis points from 1.43% to 2.95%. In that environment, the Company's result for net interest spread in 2022 was 2.33% compared to 2.59% for the year of 2021. The decline was due primarily to an increase in the rate on funding costs, of which lower average liquidity was a factor in ultimately reducing the net interest spread. The Company believes that the change in the net interest spread for the full year 2022 has been consistent with its risk analysis at December 31, 2021 when accounting for balance sheet volume and mix changes. 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.
The loan portfolio increased, most significantly, towards the end of 2022. The repricing duration on loans was 13 months at December 31, 2022 and 18 months at December 31, 2021, with fixed-rate loans amounting to 38% of total loans at December 31, 2022 and 43% at December 31, 2021. Variable and adjustable rate loans comprised 62% of total loans at December 31, 2022 and 57% for 2021. 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.
Interest rate floors on certain of the Company's variable and adjustable rate loans may provide asset yield protection in a low-interest rate environment; however, they are also expected to delay the impact of increases to market rates on interest income until such floors have been exceeded. The majority of loans with floors repriced above those floor levels in 2022, increasing the impact of rising rates on interest income when modeling positive interest rate shocks at December 31, 2022. This is what the Bank experienced in the first half of 2022 when the first 150 basis points of rate hikes earlier in the year did not exceed the majority of loans' floor rates. This is why the weighted average rate of the Company's variable rate loans increased by approximately 293 basis points from December 31, 2021 to December 31, 2022 in connection with the 425 basis points in Fed Funds rate hikes caused by actions taken by the FRB. At December 31, 2022, the Company had a portfolio of 3.1 billion of variable and adjustable rate loans that were subject to interest rate floors with a weighted average rate of 7.08%. At December 31, 2022, only $241 million of loans held by the Company were earning interest at their floor rate, largely because these loans have not reached their initial adjustment date yet.
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 $25.9 million as of December 31, 2022. The changes in fair value for these contracts are recognized directly in earnings.
The duration of the deposit portfolio decreased to 29 months at December 31, 2022 from 41 months at December 31, 2021. The Company experienced a total deposit decrease of $1.3 billion for the year ended December 31, 2022 as compared to a total loan increase of $570.0 million for the same period. This decrease in deposits was primarily the result of rate increases from the Federal Reserve and the related deposit disintermediation associated with those higher rates. Additionally, the Company’s cost of interest increased by 91 basis points across its interest-bearing deposits, which comprise 63.84% of its total deposits, at December 31, 2022.
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Management relies on the use of models in order to measure the expected future impact on interest income of various interest rate environments, as described above. Through its modeling, the Company makes certain estimates that may vary from actual results. There can be no assurance that the Company will be able to successfully achieve its optimal asset liability mix, given competitive pressures, customer preferences and the inability to forecast future interest rates and movements with complete accuracy.
The Company employs an earnings simulation model (immediate parallel shifts along the yield curve) 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. Further discussion of the limitations of this analysis are listed below and in Item 1A. Risk Factors. 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, 200 and 300 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, 2022. In addition to analysis of immediate parallel shifts 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, 2022, the simulation assumes a 70 basis point change in interest rates on interest bearing 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 interest bearing deposits for each 100 basis point change in market interest rates in an increasing interest rate shock scenario.
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 interest rate risk model. If this were to occur, the effects of a rising or declining interest rate environment may not be in accordance with management’s expectations.
As quantified in the table below, the Company’s analysis at December 31, 2022 shows an increasingly significant effect on net interest income over the next 12 months, as well as an increasingly significant effect on the economic value of equity when interest rates are shocked down 100, 200 and 300 basis points and up 100, 200, 300 and 400 basis points. This impact is due substantially to the significant level of variable rate and repriceable assets and liabilities and related shorter asset and liability durations. In a normal rising interest rate environment, the Company expects its interest income on variable and adjustable rate loans to increase and the interest expense on its deposit liabilities to increase based on our funding needs, market conditions and certain contractual obligations.
The following table reflects the result of the simulation analysis on the December 31, 2022 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 33.6 57.0 6.7
+300 25.7 43.0 5.6
+200 17.8 29.2 4.2
+100 9.9 16.4 2.5
— — — —
(100) (4.7) (7.3) (3.5)
(200) (11.4) (18.1) (8.9)
(300) (17.7) (28.0) (17.2)
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The results of the simulation are within the relevant policy limits adopted by the Company for percentage change in net interest income. 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. The impact of +9.9% in net interest income and +16.4% in net income given a 100 basis point increase in market interest rates at December 31, 2022 compares to +4.7% in net interest income and +8.1% in net income for the same period in 2021 and reflects in large measure the floor rate discussion above. At the end of 2022, the variable rate loans with floors do not have to overcome their floor rate before their yield adjusts and the income increase is immediate, as opposed to the end of 2021, where a 100 basis point increase would not have moved that subset of loans off their floors, muting the impact of the rate increase on income.
Generally speaking, the loss of Economic Value of Equity ("EVE") 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.
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.
While an instantaneous parallel shift in interest rates was used in this analysis to provide an estimate of exposure under these scenarios, we believe that a non-immediate parallel shifts in interest rates would have a more modest impact. Further, the earnings simulation model does not take into account factors such as future balance sheet growth, changes in product mix, changes in yield curve relationships, the various rate indexes do not move in parallel (e.g. SOFR, LIBOR, Fed Funds), hedging activities we might take and changing product spreads that could mitigate any potential beneficial or adverse impact of changes in interest rates.
Another key factor to consider is the behavior of our deposit portfolio in the baseline forecast and in alternate interest rate scenarios set out in the table above is a key assumption in our projected estimates of net interest income. The projected impact on net interest income in the table above assumes no change in deposit portfolio size or mix from the baseline forecast in alternative rate environments. In higher rate scenarios, any customer activity resulting in the replacement of low-cost or noninterest-bearing deposits with higher-yielding deposits or market-based funding would reduce the assumed benefit of those deposits. The projected impact on net interest income in the table above also assumes a "through-the-cycle" non-maturity deposit beta which may not be an accurate predictor of actual deposit rate changes realized in scenarios of smaller and/or non-parallel interest rate movements.
Each of the above analyses may not, on its own, be an accurate indicator of how our net interest income will be affected by changes in interest rates. Income associated with interest-earning assets and costs associated with interest-bearing liabilities may not be affected uniformly by changes in interest rates. In addition, the magnitude and duration of changes in interest rates may have a significant impact on net interest income. For example, although certain assets and liabilities may have similar maturities or periods of repricing, they may react to different degrees to changes in market interest rates. Interest rates on certain types of assets and liabilities fluctuate in advance of changes in general market rates, while interest rates on other types may lag behind changes in general market rates. In addition, certain assets, such as adjustable-rate mortgage loans, have features (generally referred to as interest rate caps and floors) that limit changes in interest rates. Prepayment and early withdrawal levels also could deviate significantly from those assumed in calculating the maturity of certain instruments. The ability of many borrowers to service their debts also may decrease during periods of rising interest rates. ALCO reviews each of the above interest rate sensitivity analyses along with several different interest rate scenarios as part of its responsibility to provide a satisfactory, consistent level of profitability within the framework of established liquidity, loan, investment, borrowing and capital policies.
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