Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Item 7A. Quantitative and Qualitative Disclosures About Market Risk.
Market Risk
Market risk is the risk of loss arising from adverse changes in the fair value of financial instruments due to changes in interest rates, exchange rates, and equity prices. The Company’s market risk is composed primarily of interest rate risk inherent in the normal course of lending and deposit-taking activities. We are also exposed to market risk in our investing activities. We do not have any trading assets or activities.
Interest Rate Risk
Net interest income is our most significant component of earnings and we consider interest rate risk to be our most significant market risk. Our goal is to structure our asset/liability composition to maximize net interest income while managing interest rate risk so as to minimize the adverse impact of changes in interest rates on net interest income and capital in either a rising or declining interest rate environment. Profitability is affected by fluctuations in interest rates. A sudden and substantial change in interest rates may adversely impact our earnings because the interest rates of the underlying assets and liabilities do not change at the same speed, to the same extent or on the same basis.
Interest rate risk is monitored through the use of three complementary modeling tools: static gap analysis, earnings simulation modeling, and economic value simulation (net present value estimation). Each of these models measures changes in a variety of interest rate scenarios. While each of the interest rate risk models has limitations, taken together they represent a reasonably comprehensive view of the magnitude of our interest rate risk, the level of risk through time, and the amount of exposure to changes in certain interest rate relationships. Static gap, which measures aggregate repricing values, is less utilized because it only measures the magnitude of the timing differences and does not address repricing lags, market influences, or management actions. Earnings simulation and economic value models, which more effectively measure the cash flow and optionality impacts, are utilized by management on a regular basis and are discussed further below. From the various model results and our expectations regarding future interest rate movements, the national, regional and local economies, and other financial and business risk factors, we quantify the overall magnitude of interest sensitivity risk and then determine appropriate strategies and practices governing asset growth and pricing, funding sources and pricing, and off-balance sheet commitments.
Earnings Simulation Analysis
We use net interest income simulations which measure the short-term earnings exposure from changes in market rates of interest. The model calculates an earnings estimate based on current and projected balances and rates, incorporating our current financial position with assumptions regarding future business to calculate net interest income under varying hypothetical rate scenarios. This method is subject to the accuracy of the assumptions that underlie the process, but it provides a better analysis of the sensitivity of earnings to changes in interest rates than other analyses, such as the static gap analysis.
Assumptions used in the model are derived from historical trends and management’s outlook. The model assumes a static balance sheet with cash flows reinvested in similar instruments to maintain the balance sheet levels and current composition. Actual cash flows and repricing characteristics for our balance sheet instruments are input to the model. The model incorporates market-based assumptions regarding the impact of changing interest rates on the prepayment rate of certain assets and liabilities. Because these assumptions are inherently uncertain, actual results may differ from simulated results.
Different interest rate scenarios and yield curves are used to measure the sensitivity of earnings to changing interest rates in both a "shocked" instantaneous move and a "ramped" move of rates. Interest rates on different asset and liability accounts move differently when the prime rate changes and such assumptions are reflected in the different rate scenarios. The model does not take into account any future actions that management may take to mitigate the impact of interest rate changes, and it is our strategy is to proactively change the volume and mix of our balance sheet in order to mitigate our interest rate risk.
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The following table presents the estimated net interest income sensitivity over a 12-month horizon for the specified rate change levels presented. This change in interest rates assumes parallel shifts in the yield curve and does not take into account changes in the slope of the yield curve.
Percentage change in Net Interest Income (1)
Change in Interest Rates (in basis points) December 31, 2022 December 31, 2021
+ 400 (1.4)% 8.9%
+ 300 (1.2)% 6.6%
+ 200 (1.0)% 4.3%
+ 100 (0.3)% 2.0%
- 100 (1.5)% (2.5)%
- 200 (5.1)% (5.6)%
- 300 (10.1)% (8.2)%
- 400 (15.1)% (9.6)%
(1) - The percentage change represents the projected net interest income for 12 months on a flat balance sheet in a stable rate environment as compared to the projected net interest income in the various rate scenarios.
From a net interest income perspective, the Company has been fairly neutral historically with no significant change in the short-term (within a 12-month period) and within the lower ranges (+ - 100-200 basis points) of interest rate changes. The Company was more asset sensitive at December 31, 2021 as compared to its position at December 31, 2022. Asset sensitivity generally indicates that in a rising interest rate environment the Company’s net interest income would increase and in a decreasing interest rate environment the Company’s net interest income would decrease. However, the Company's sensitivity position has shifted such that, in the short-term it is projected that net interest income will likely be essentially flat or fall in both a rising and falling rate environment. This shift is due in part to the changing market characteristics of certain loan and deposit products as well as to the shift in the yield curve. Prior to the recent Federal Reserve actions to raise short-term interest rates, the yield curve was very low and rather flat. The rate increases in 2022 resulted in a steepening of the yield curve on the short end (within 1 year), while the longer end of the curve continues to be flat and has actually inverted between 1 and 10 years, meaning that the yield on short-term instruments (1 year) are higher than longer-term instruments (10 years). A flat or inverted interest rate curve is an unfavorable interest rate environment for many financial institutions, including the Bank, as short-term interest rates generally drive our deposit pricing and longer-term interest rates generally drive loan pricing. When these rates converge or invert, the profit spread we realize between loan yields and deposit rates narrows, which pressures our NIM.
As demonstrated in the above table, we would expect net interest income to decline in a decreasing interest rate environment, as interest-earning assets reprice to lower rates and interest-bearing deposits remain at or near their floors. With regard to rising rates with an immediate increase or shock in market rates over the short-term (12-month horizon), we would also expect to realize a decline in net interest income, although not to the extent projected in a declining rate environment. This is due in part to the composition of our loan portfolio which is comprised of 20% variable rate loans which could immediately reprice, thus limiting the magnitude of the impact of rate increases. In addition, the model includes an assumption of a quick repricing up of the funding base in a rising rate environment, and our recent shift to higher-cost brokered deposits and short-term borrowings in our funding mix has lead to a narrowing of the interest rate spread in the projection. As previously noted, these assumptions are inherently uncertain, and actual results may differ from simulated results. Further, the interest rate simulation models do not take into consideration growth, changes in balance sheet mix or composition, or other strategies that management would employee in either a rising or a falling rate scenario.
Economic Value Simulation
Economic value simulation is used to calculate the estimated fair value of assets and liabilities over different interest rate environments. Economic values are calculated based on discounted cash flow analysis. The net economic value of equity is the economic value of all assets minus the economic value of all liabilities. The change in net economic value over different rate environments is an indication of the longer-term earnings capability of the balance sheet. The same assumptions are used in the economic value simulation as in the earnings simulation. The economic value simulation uses instantaneous rate shocks to the balance sheet.
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The following table presents the estimated change in net economic value for the specified change levels presented. This change in interest rates assumes parallel shifts in the yield curve and does not take into account changes in the slope of the yield curve.
Percentage change in Economic Value of Equity (1)
Change in Interest Rates (in basis points) December 31, 2022 December 31, 2021
+ 400 (11.9)% 3.3%
+ 300 (8.9)% 3.5%
+ 200 (6.0)% 3.7%
+ 100 (2.3)% 3.0%
- 100 0.7% (15.4)%
- 200 (2.4)% (32.7)%
- 300 (8.4)% (34.4)%
- 400 (18.2)% (35.5)%
(1) - The percentage change represents our economic value of equity in a stable rate environment as compared to the economic value of equity in the various rate scenarios.
As of December 31, 2022, the Company’s economic value of equity is generally liability sensitive in a rising interest rate environment compared to its position as of December 31, 2021, while the extent of exposure to falling rates has improved from the prior year end. The increase in exposure to rising rates in the current year in primarily due to the composition of the consolidated balance sheets combined with the pricing characteristics and assumptions of certain deposits. Specifically, during 2022, non-maturity deposits, generally with lower betas, have runoff and have been replaced with short-term FHLB advances and short-term brokered deposits. Refer also to the discussion above under Earnings Simulation Analysis.
Impact of Inflation and Changing Prices
Our financial statements included in Item 8 “Financial Statements and Supplementary Data” of this Report have been prepared in accordance with GAAP, which requires the financial position and operating results to be measured principally in terms of historic dollars without considering the change in the relative purchasing power of money over time due to inflation.
Nearly all of the Company’s assets and liabilities are monetary in nature, and as such, changes in interest rates (as discussed above) generally affect the financial condition of the Company to a greater degree than changes in the rate of inflation. Although interest rates are greatly influenced by changes in the inflation rate, they do not necessarily change at the same rate or in the same magnitude as the inflation rate. Inflation affects the Company’s results of operations mainly through increased operating costs, and the impact of inflation on banks in general is normally not as significant as its influence on those businesses that have large investments in plant and inventories. We review pricing of our products and services, as well as our controllable operating and labor costs in light of current and expected costs due to inflation, to mitigate the inflationary impact on financial performance to the extent possible.
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