First Bancorp, Inc /ME/ 10-Q

Item 3 – Quantitative and Qualitative Disclosures About Market Risk Market-Risk Management Market risk is the risk of loss arising from adverse changes in the fair value of financial instruments due to changes in interest rates. The First Bancorp, Inc.'s market risk is composed primarily of interest rate risk. The Bank's Asset/Liability Committee (ALCO) is responsible for reviewing the interest rate sensitivity position of the Company and establishing policies to monitor and limit exposure to interest rate risk. All guidelines and policies established by ALCO have been approved by the Board of Directors. Asset/Liability Management The primary goal of asset/liability management is to maximize net interest income within the interest rate risk limits set by ALCO. Interest rate risk is monitored through the use of two complementary measures: static gap analysis and earnings simulation modeling. While each measurement has limitations, taken together they represent a reasonably comprehensive view of the magnitude of interest rate risk in the Company, the level of risk through time, and the amount of exposure to changes in certain interest rate relationships. Static gap analysis measures the amount of repricing risk embedded in the balance sheet at a point in time. It does so by comparing the differences in the repricing characteristics of assets and liabilities. A gap is defined as the difference between the principal amount of assets and liabilities that reprice within a specified time period. The Company's cumulative one-year gap at June 30, 2020 was 1.08% of total assets compared to -5.96% of total assets at December 31, 2019. Core deposits with non-contractual maturities are presented based upon historical patterns of balance attrition and pricing behavior, which are reviewed at least annually. The gap repricing distributions include principal cash flows from residential mortgage loans and mortgage-backed securities in the time frames in which they are expected to be received. Mortgage prepayments are estimated by applying industry median projections of prepayment speeds to portfolio segments based on coupon range and loan age. A summary of the Company's static gap, as of June 30, 2020, is presented in the following table: 0-90 90-365 1-5 5+ Dollars in thousands Days Days Years Years Investment securities at amortized cost (HTM) and fair value (AFS) $ 88,203 $ 164,188 $ 230,886 $ 170,185 Restricted stock, at cost 9,508 — — 1,037 Loans held for sale — — — 4,950 Loans 465,720 266,976 535,575 183,352 Other interest-earning assets 3,288 24,431 — — Non-rate-sensitive assets 26,447 — — 92,378 Total assets 593,166 455,595 766,461 451,902 Interest-bearing deposits 546,165 253,950 200,049 584,761 Borrowed funds 140,000 22,600 55,101 — Non-rate-sensitive liabilities and equity 33,822 27,825 34,100 368,751 Total liabilities and equity 719,987 304,375 289,250 953,512 Period gap $ (126,821) $ 151,220 $ 477,211 $ (501,610) Percent of total assets (5.59) % 6.67 % 21.05 % (22.13) % Cumulative gap (current) $ (126,821) $ 24,399 $ 501,610 $ — Percent of total assets (5.59) % 1.08 % 22.13 % — % The earnings simulation model forecasts capture the impact of changing interest rates on one-year and two-year net interest income. The modeling process calculates changes in interest income received and interest expense paid on all interest-earning assets and interest-bearing liabilities reflected on the Company's balance sheet. None of the assets used in the simulation are held for trading purposes. The modeling is done for a variety of scenarios that incorporate changes in the absolute level of interest rates as well as basis risk, as represented by changes in the shape of the yield curve and changes in interest rate relationships. Management evaluates the effects on income of alternative interest rate scenarios against earnings in a stable interest rate environment. This analysis is also most useful in determining the short-run earnings exposures to changes in customer behavior involving loan payments and deposit additions and withdrawals. 74 The Company's most recent simulation model projects net interest income would decrease by approximately 0.1% of stable-rate net interest income if short-term rates affected by Federal Open Market Committee actions fall gradually by one percentage point over the next year, and decrease by approximately 0.1% if rates rise gradually by two percentage points. Both scenarios are well within ALCO's policy limit of a decrease in net interest income of no more than 10.0% given a 2.0% move in interest rates, up or down. Management believes this reflects a reasonable interest rate risk position. In year two, and assuming no additional movement in rates, the model forecasts that net interest income would be lower than that earned in a stable rate environment by 3.2% in a falling-rate scenario, and lower than that earned in a stable rate environment by 2.8% in a rising rate scenario, when compared to the year-one base scenario. A summary of the Bank's interest rate risk simulation modeling, as of June 30, 2020 and December 31, 2019 is presented in the following table: Changes in Net Interest Income June 30, 2020 December 31, 2019 Year 1 Projected change if rates decrease by 1.0% -0.1% 0.2% Projected change if rates increase by 2.0% -0.1% -4.3% Year 2 Projected change if rates decrease by 1.0% -3.2% -0.9% Projected change if rates increase by 2.0% -2.8% -10.1% This dynamic simulation model includes assumptions about how the balance sheet is likely to evolve through time and in different interest rate environments. Loans and deposits are projected to maintain stable balances. All maturities, calls and prepayments in the securities portfolio are assumed to be reinvested in similar assets. Mortgage loan prepayment assumptions are developed from industry median estimates of prepayment speeds for portfolios with similar coupon ranges and seasoning. Non-contractual deposit volatility and pricing are assumed to follow historical patterns. The sensitivities of key assumptions are analyzed annually and reviewed by ALCO. This sensitivity analysis does not represent a Company forecast and should not be relied upon as being indicative of expected operating results. These hypothetical estimates are based upon numerous assumptions including, among others, the nature and timing of interest rate levels, yield curve shape, prepayments on loans and securities, pricing decisions on loans and deposits, and reinvestment/ replacement of asset and liability cash flows. While assumptions are developed based upon current economic and local market conditions, the Company cannot make any assurances as to the predictive ability of these assumptions, including how customer preferences or competitor influences might change. Interest Rate Risk Management A variety of financial instruments can be used to manage interest rate sensitivity. These may include investment securities, interest rate swaps, and interest rate caps and floors. Frequently called interest rate derivatives, interest rate swaps, caps and floors have characteristics similar to securities but possess the advantages of customization of the risk-reward profile of the instrument, minimization of balance sheet leverage and improvement of liquidity. As of June 30, 2020, the Company was using interest rate swaps for interest rate risk management. The Company engages an independent consultant to periodically review its interest rate risk position, as well as the effectiveness of simulation modeling and reasonableness of assumptions used. As of June 30, 2020, there were no significant differences between the views of the independent consultant and Management regarding the Company's interest rate risk exposure. In response the the COVID-19 pandemic, the Federal Open Market Committee in March 2020 lowered its short-term benchmark interest rate by 150 basis points to a range of 0.00% to 0.25%. Management expects that short-term interest rates are likely to remain in this range for at least the next several quarters, and believes that the current level of interest rate risk is acceptable. Cessation of LIBOR The Company is aware that LIBOR may no longer be published after December 31, 2021. The Federal Reserve formed the Alternative Reference Rates Committee (ARRC) to guide the transition process in the United States. ARRC has issued a number of recommendations including the adoption of the Secured Overnight Financing Rate (SOFR) as a replacement for LIBOR. The International Swap and Derivatives Association (ISDA), the organization that oversees and guides swap and derivatives markets and participants, continues to work on transitions and replacement rates, including having replacement rates in place before the possible cessation of LIBOR at the end of 2021, and has committed to providing more definitive recommendations later in 2020. The Company has formed a working group to address the change away from LIBOR. Management intends to continue to monitor developments from ARRC and ISDA closely, and expects to pursue the steps ultimately recommended to provide for an orderly transition to a post-LIBOR environment. Of the interest rate swap contracts the Bank has in place as of June 30, 2020, two contracts carrying a total notional amount of $50 million are set to mature prior 75 to December 31, 2021; nine contracts with a total notional amount of $210 million have maturity dates beyond December 31, 2021. The three customer loan swap contracts have maturity dates of December 19, 2029, July 1, 2035 and October 1, 2039.