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 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 March 31, 2023 was (2.27)% of total assets compared to (5.60)% of total assets at December 31, 2022. 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 March 31, 2023, 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) $ 45,064 $ 27,488 $ 146,793 $ 460,742 Restricted stock, at cost 2,837 — — 1,037 Loans held for sale — — — — Loans 564,562 223,647 869,767 324,870 Other interest-earning assets — 26,184 — — Non-rate-sensitive assets 11,564 — — 107,265 Total assets 624,027 277,319 1,016,560 893,914 Interest-bearing deposits 524,156 408,706 450,542 842,020 Borrowed funds 32,300 — 82 — Non-rate-sensitive liabilities and equity — — — 554,014 Total liabilities and equity 556,456 408,706 450,624 1,396,034 Period gap $ 67,571 $ (131,387) $ 565,936 $ (502,120) Percent of total assets 2.40 % (4.67) % 20.13 % (17.86) % Cumulative gap (current) $ 67,571 $ (63,816) $ 502,120 $ — Percent of total assets 2.40 % (2.27) % 17.86 % — % 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. The Company's most recent simulation model calculates projected impact on net interest income in scenarios where short-term interest rates gradually decrease by two percentage points, gradually decreases by one percentage point, and where short- 73 erm rates gradually increase by two percentage points. The Company's modeling as of March 31, 2023 projects net interest income would be unchanged from stable-rate net interest income if short-term rates affected by Federal Open Market Committee actions fall gradually by two percentage points over the next year, and would increase by approximately 0.2% if short term gradually fall by one percentage point over the next year; net interest income would decrease by approximately 4.6% if rates rise gradually by two percentage points over the next year. Each scenario is 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 higher than that earned in the first year of a stable rate environment by 7.9% in the two percentage point falling-rate scenario, and higher by 9.1% in the one percentage point falling rate scenario; net interest income would be lower than that earned in a stable rate environment by 2.3% in a two percentage point rising rate scenario, when compared to the year-one base scenario. Each year two scenario is well within ALCO's policy limit of a decrease of no more than 20% given a 2.0% move in interest rates, up or down. A summary of the Bank's interest rate risk simulation modeling, as of March 31, 2023 and December 31, 2022 is presented in the following table: Changes in Net Interest Income March 31, 2023 December 31, 2022 Year 1 Projected change if rates decrease by 1.0% 0.2% 0.2% Projected change if rates decrease by 2.0% 0.0% 0.0% Projected change if rates increase by 2.0% (4.6)% (3.8)% Year 2 Projected change if rates decrease by 1.0% 9.1% 6.8% Projected change if rates decrease by 2.0% 7.9% 5.7% Projected change if rates increase by 2.0% (2.3)% (3.4)% 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 March 31, 2023, 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 March 31, 2023, there were no significant differences between the views of the independent consultant and Management regarding the Company's interest rate risk exposure. Management expects interest rates will increase slightly in the next year and believes that the current level of interest risk is acceptable. Cessation of LIBOR The Company is aware that 1) certain tenors of USD denominated LIBOR indices ceased to be published after December 31, 2021, while other tenors are expected to continue being published until June 30, 2023, and 2) no new contracts referencing LIBOR are to be written after December 31, 2021. The Federal Reserve formed the ARRC to guide the transition process in the United States. ARRC has issued a number of recommendations including the adoption of the SOFR as a replacement for LIBOR. The ISDA, the organization that oversees and guides swap and derivatives markets and participants, continues to work on transitions and has issued a voluntary fallback protocol for market participants. The Company has adopted SOFR as its replacement reference rate index for new transactions. Each of the customer loan interest rate swap contracts the Company has 74 in place as of March 31, 2023 is tied to a LIBOR tenor expected to be published until June 2023. The six contracts in place have maturity dates of December 19, 2029, August 21, 2030, April 1, 2031, July 1, 2035, October 1, 2035 and October 1, 2039. It is anticipated that necessary actions to amend these legacy contracts and designate a replacement reference rate index will be undertaken prior to June 30, 2023.