Mechanics Bancorp 10-Q

ITEM 3 QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Market Risk Management Market risk is defined as the sensitivity of income, fair value measurements and capital to changes in interest rates, foreign currency exchange rates, commodity prices and other relevant market rates or prices. The primary market risks that we are exposed to are price and interest rate risks. Price risk is defined as the risk to current or anticipated earnings or capital arising from changes in the value of either assets or liabilities that are entered into as part of distributing or managing risk. Interest rate risk is defined as risk to current or anticipated earnings or capital arising from movements in interest rates. For the Company, price and interest rate risks arise from the financial instruments and positions we hold. This includes loans, MSRs, investment securities, deposits, borrowings, long-term debt and derivative financial instruments. Due to the nature of our current operations, we are not subject to foreign currency exchange or commodity price risk. Our real estate loan portfolio is subject to risks associated with the local economies of our various markets, in particular, the regional economy of the western United States, including Hawaii. The spread between the yield on interest-earning assets and the cost of interest-bearing liabilities and the relative dollar amounts of these assets and liabilities are the principal items affecting net interest income. Changes in net interest rates (interest rate risk) are influenced to a significant degree by the repricing characteristics of assets and liabilities (timing risk), the relationship between various rates (basis risk), customer options (option risk) and changes in the shape of the yield curve (time-sensitive risk). We manage the available-for-sale investment securities portfolio while maintaining a balance between risk and return. The Company's funding strategy is to grow deposits while we efficiently supplement using wholesale borrowings. We estimate the sensitivity of our net interest income to changes in market interest rates using an interest rate simulation model that includes assumptions related to the level of balance sheet growth, deposit repricing characteristics and the rate of prepayments for multiple interest rate change scenarios. Interest rate sensitivity depends on certain repricing characteristics in our interest-earnings assets and interest-bearing liabilities, including the maturity structure of assets and liabilities and their repricing characteristics during the periods of changes in market interest rates. Effective interest rate risk management seeks to ensure both assets and liabilities respond to changes in interest rates within an acceptable timeframe, minimizing the impact of interest rate changes on net interest income and capital. Interest rate sensitivity is measured as the difference between the volume of assets and liabilities, at a point in time, which are subject to repricing at various time horizons, known as interest rate sensitivity gaps. 57 The following table presents sensitivity gaps for these different intervals: At March 31, 2024 (in thousands) 3 Mos. or Less More Than 3 Mos. to 6 Mos. More Than 6 Mos. to 12 Mos. More Than 12 Mos. to 3 Yrs. More Than 3 Yrs. to 5 Yrs. More Than 5 to 15 Yrs. More Than 15 Yrs. Non-Rate- Sensitive Total Interest-earning assets: Cash & cash equivalents $ 320,327 $ — $ — $ — $ — $ — $ — $ — $ 320,327 FHLB Stock 68,095 — — — — — 5,627 — 73,722 Investment securities (1) 134,352 116,717 45,647 157,813 152,955 548,218 35,406 — 1,191,108 LHFS 21,102 — — — — — — — 21,102 LHFI (1) 1,301,538 418,824 552,931 1,944,290 1,915,452 1,234,902 76,792 — 7,444,729 Total 1,845,414 535,541 598,578 2,102,103 2,068,407 1,783,120 117,825 — 9,050,988 Non-interest-earning assets — — — — — — — 404,194 404,194 Total assets $ 1,845,414 $ 535,541 $ 598,578 $ 2,102,103 $ 2,068,407 $ 1,783,120 $ 117,825 $ 404,194 $ 9,455,182 Interest-bearing liabilities: Demand deposit accounts (2) $ 330,301 $ — $ — $ — $ — $ — $ — $ — $ 330,301 Savings accounts (2) 256,383 — — — — — — — 256,383 Money market accounts (2 ) 1,536,341 — — — — — — — 1,536,341 Certificates of deposit 1,373,216 1,089,329 320,049 265,129 8,680 45 70 — 3,056,518 FHLB advances 284,000 — 225,000 800,000 200,000 — — — 1,509,000 FRB borrowings 300,000 — 285,000 — — — — — 585,000 Long-term debt (3) 59,857 — — 165,000 — — — — 224,857 Total 4,140,098 1,089,329 830,049 1,230,129 208,680 45 70 — 7,498,400 Non-interest bearing liabilities — — — — — — — 1,429,449 1,429,449 Shareholders' Equity — — — — — — — 527,333 527,333 Total liabilities and shareholders' equity $ 4,140,098 $ 1,089,329 $ 830,049 $ 1,230,129 $ 208,680 $ 45 $ 70 $ 1,956,782 $ 9,455,182 Interest sensitivity gap $ (2,294,684) $ (553,788) $ (231,471) $ 871,974 $ 1,859,727 $ 1,783,075 $ 117,755 Cumulative interest sensitivity gap Total $ (2,294,684) $ (2,848,472) $ (3,079,943) $ (2,207,969) $ (348,242) $ 1,434,833 $ 1,552,588 As a % of total assets (24) % (30) % (33) % (23) % (4) % 15 % 16 % As a % of cumulative interest-bearing liabilities 45 % 46 % 49 % 70 % 95 % 119 % 121 % (1) Based on contractual maturities, repricing dates and forecasted principal payments assuming normal amortization and, where applicable, prepayments. (2) Assumes 100% of interest-bearing non-maturity deposits are subject to repricing in three months or less. (3) Based on contractual maturity. As of March 31, 2024, the Company is considered liability-sensitive as exhibited by the gap table. To reduce our net interest income sensitivity the Company has taken actions to extend the duration of its liabilities, both through increased levels of term certificates of deposit and the utilization of fixed-rate term borrowings. Changes in the mix of interest-earning assets or interest-bearing liabilities can either increase or decrease the net interest margin, without affecting interest rate sensitivity. In addition, the interest rate spread between an earning asset and its funding liability can vary significantly, while the timing of repricing for both the asset and the liability remains the same, thereby impacting net interest income. This characteristic is referred to as basis risk. Varying interest rate environments can create unexpected changes in 58 prepayment levels of assets and liabilities that are not reflected in the interest rate sensitivity analysis. These prepayments may have a significant impact on our net interest margin. Because of these factors, an interest sensitivity gap analysis may not provide an accurate assessment of our actual exposure to changes in interest rates. The estimated impact on our net interest income over a time horizon of one year and the change in net portfolio value as of March 31, 2024 and December 31, 2023 are provided in the table below. For the scenarios shown, the interest rate simulation assumes an instantaneous and sustained shift in market interest rates and no change in the composition or size of the balance sheet. At March 31, 2024 At December 31, 2023 Change in Interest Rates (basis points) (1) Percentage Change Net Interest Income (2) Net Portfolio Value (3) Net Interest Income (2) Net Portfolio Value (3) +300 (16.5) % (25.1) % (15.4) % (23.8) % +200 (10.1) % (14.7) % (9.4) % (13.9) % +100 (4.5) % (6.2) % (4.2) % (5.9) % -100 3.8 % 2.6 % 3.5 % 1.9 % -200 7.2 % 1.6 % 6.6 % 1.0 % -300 11.0 % (3.0) % 10.9 % (6.7) % (1) For purposes of our model, we assume interest rates will not go below zero. This "floor" limits the effect of a potential negative interest rate shock in a low rate environment. (2) This percentage change represents the impact to net interest income for a one-year period, assuming there is no change in the structure of the balance sheet. (3) This percentage change represents the impact to the net present value of equity, assuming there is no change in the structure of the balance sheet. The changes in interest rate sensitivity between December 31, 2023 and March 31, 2024 reflected the impact of higher market interest rates, a flat to inverted yield curve and changes to overall balance sheet composition. Some of the assumptions made in the simulation model may not materialize and unanticipated events and circumstances will occur. In addition, the simulation model does not take into account any future actions that we could undertake to mitigate an adverse impact due to changes in interest rates from those expected, in the actual level of market interest rates or competitive influences on our deposits. Current Banking Environment Industry events, including bank failures, have led to uncertainty and concerns regarding the liquidity positions of the banking sector. These failures underscore the importance of maintaining access to diverse sources of funding. Market conditions and external factors may unpredictably impact the competitive landscape for deposits in the banking industry. Additionally, the higher interest rate environment has increased competition for liquidity and the premium at which liquidity is available to meet funding needs. Reliance on secondary funding sources could increase the Company's overall cost of funding and reduce net interest income. As of March 31, 2024, the Company had available contingent liquidity of $5.1 billion which is equal to 78% of its total deposits and the level of uninsured deposits was 8% of total deposits. The Company believes it has sufficient liquidity to meet its current needs. 59