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Item 3. Quantitative and Qualitative Disclosures About Market Risk

2023-05-09 compared with 2022-11-07 · 55 added, 39 removed, 3 unchanged (97% of the section changed)

Item 3 – Quantitative and Qualitative Disclosures About Market Risk

INTEREST RATE RISK (INCLUDING QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT 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.

In addition to changes in volumes of loans and deposits, our level of net interest income is continually at risk due to the effect that changes in general market interest rate trends have on interest yields earned and paid with respect to our various categories of earning assets and interest-bearing liabilities.

It is our policy to maintain portfolios of earning assets and interest-bearing liabilities with maturities and repricing opportunities that will afford protection, to the extent practical, against wide interest rate fluctuations.

Our exposure to interest rate risk is analyzed on a regular basis by management using standard "gap" reports (which measure the difference between the amount of interest-earning assets maturing or repricing within a specific time period and the amount of interest-bearing liabilities maturing or repricing within that time period), maturity reports, and an asset/liability software model that simulates future levels of interest income and expense based on current interest rates, expected future interest rates, and various intervals of “shock” or "ramped" interest rate scenarios.

Over the years, we have been able to maintain a fairly consistent yield on average earning assets (our NIM), even during periods of changing interest rates.

Over the past five calendar years, our NIM has ranged from a low of 3.16% (realized in 2021) to a high of 4.09% (realized in 2018).

The 93 basis point fluctuation in NIM between the high and low point during this period was a direct result of the Federal Reserve monetary policy enacted at the beginning of the COVID-19 pandemic resulting in a reduction in short-term market interest rates totaling 150 basis points in March 2020.

During the first nine months of 2022, the Federal Reserve implemented monetary policy to combat inflationary conditions and increased short-term rates 300 basis points, with the anticipation of additional rate increases to occur throughout 2022.

There has be no significant change in the Company-estimated net interest income sensitivity from December 31, 2021.

Using stated maturities for all fixed rate instruments except mortgage-backed securities (which are allocated in the periods of their expected payback) and securities and borrowings with call features that are expected to be called (which are shown in the period of their expected call), at September 30, 2022, we had approximate ly $3.5 billion more in interest-bearing liabilities that are subject to interest rate changes within one year than earning assets.

This generally would indicate that net interest income would experience downward pressure in a rising interest rate environment and would benefit from a declining interest rate environment.

However, this method of analyzing interest sensitivity only measures the magnitude of the timing differences and does not address earnings, market value, or management actions.

Also, 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.

In addition to the effects of “when” various rate-sensitive products reprice, market rate changes may not result in uniform changes in rates among all products.

For example, included in interest-bearing liabilities subject to interest rate changes within one year as of September 30, 2022 were deposits tota ling $4.7 billion c omprised of checking, savings, and certain types of money market deposits with interest rates set by management.

These types of deposits historically have not repriced with, or in the same proportion, as general market indicators.

Generally, when rates change, our interest-sensitive assets that are subject to adjustment reprice immediately at the full amount of the change, while our interest-sensitive liabilities that are subject to adjustment reprice at a lag to the rate change and typically not to the full extent of the rate change.

In the short-term (less than twelve months), this generally results in us being asset-sensitive, meaning that our net interest income benefits from an increase in interest rates and is negatively impacted by a decrease in interest rates.

The increase in our NIM during the third quarter of 2022 demonstrated this concept.

In the twelve-month and longer horizon, the impact of having a higher level of interest-sensitive liabilities generally lessens the short-term effects of changes in interest rates.

Overall we believe that in the near-term (twelve months), net interest income will not likely experience significant pressure from fluctuations in interest rates, and we may continue to benefit from the anticipated rise in interest rates.

Because of the static nature and limitations as discussed above of the gap report, we also employ an earnings simulation model to analyze the sensitivity of net interest income to movements in interest rates.

The model is based on actual cash flows and repricing characteristics for on- and off-balance sheet instruments and incorporates market-based assumptions regarding the impact of changing interest rates on the prepayment rate of certain assets and liabilities.

Earnings-simulation analysis captures not only the potential of these interest sensitive assets and liabilities to mature or reprice, but also the probability that they will do so.

Moreover, earnings-simulation analysis considers the relative sensitivities of these balance sheet items and projects their behavior over an extended period of time.

The general discussion in the foregoing paragraph applies most directly in a “normal” interest rate environment in which longer-term maturity instruments carry higher interest rates than short-term maturity instruments, and is less applicable in periods in which there is a “flat” interest rate curve.

A “flat yield curve” means that short-term interest rates are substantially the same as long-term interest rates.

Actions taken by the Federal Reserve at the beginning of the pandemic resulted in a very low and flat interest rate curve environment.

Recent actions to raise short-term interest rates have resulted in a some steepening of the yield curve on the short end (within 1 year).

However, the longer end of the curve continues to be flat and has actually inverted recently (between 1 and 10 years) meaning that the yield on short-term instruments (1 year) are higher than longer-term instruments (10 years).

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 to proactively change the volume and mix of our balance sheet in order to mitigate our interest rate risk.

There has been no significant change in the Company's estimated net interest income sensitivity position from December 31, 2022.

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.

Starting in 2022, the Company's sensitivity position shifted somewhat 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 position 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.

The rapid 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 has inverted between 1 and 10 years, meaning that the yield on short-term instruments (less than 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 net interest margin.

Assuming that short term rates continue to rise over the next 12 months, we may see some benefit to our net interest margin from raising rates if we are able to maintain stable funding costs.

Our experience historically has been that our demand deposit accounts have lagged the timing and amount of general market increases.

However, we expect continued pressure on net interest margin from market competition for quality loans and the current mix of out earning assets in lower yielding investment securities.

Because the assets and liabilities of a bank are primarily monetary in nature (payable in fixed, determinable amounts), the performance of a bank is affected more by changes in interest rates than by inflation as discussed above under Interest Rate Risk.

Interest rates generally increase as the rate of inflation increases, but the magnitude of the change in rates may not be the same.

The effect of inflation on banks is normally not as significant as its influence on those businesses that have large investments in plant and inventories.

During periods of high inflation as we have recently experienced, there are normally corresponding increases in the money supply, and banks will normally experience above average growth in assets, loans, and deposits.

Also, general increases in the price of goods and services will generally result in increased operating expenses.

When these rates converge or invert, the profit spread we realize between loan yields and deposit rates narrows, which pressures our NIM.

With regard to rising rates, with an immediate increase or shock in market rates over the short-term (12-month horizon), we would 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 given that the majority of our portfolio is at fixed rates.

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.

While we believe rates may continue to increase in 2023 at a slower pace than in the prior year, there is a possibility that the Federal Reserve may start to reduce rates later in the year or in 2024.

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 repricing may lag given continued market competition for deposits.

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.

As of December 31, 2022, the Company’s economic value of equity ("EVE") was generally liability sensitive in a rising interest rate environment and there has been no significant change in our EVE position from year end.

The increase in EVE exposure to rising rates which occurred starting in 2022 is primarily due to the composition of the consolidated balance sheets combined with the pricing characteristics and assumptions of certain deposits.

Specifically, starting in 2022, non-maturity deposits, generally with lower betas, have decreased and were replaced with short-term FHLB advances and short-term brokered deposits.

Our financial statements 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.

Compared sentence by sentence after normalising whitespace, quotation marks, case and digits, so re-formatting and restated figures do not read as changed language. Wording changes appear as one removal and one addition. The current filing and the prior one are authoritative.

What changed 10-Q

Item 3. Quantitative and Qualitative Disclosures About Market Risk