Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Our primary market risk is interest rate risk, which is defined as the risk of loss of net interest income or net interest margin because of changes in interest rates.
Asset/Liability Management
As a financial institution, one of our primary market risks is interest rate volatility. Changes in market interest rates, whether they are increases or decreases, can trigger repricing and changes in the pace of payments for both assets and liabilities (prepayment risk), which individually or in combination may affect our net income, net interest income and net interest margin, either positively or negatively. In recognition of this, we actively manage our assets and liabilities to minimize the impact of changing interest rates on our net interest margin and maximize our net interest income and the return on equity, while maintaining adequate liquidity and capital.
Our board of directors has established a Board Risk Committee that, among other duties, sets broad asset and liability management policy (“ALM” policy) and directives for asset/liability management, as well as establishes review and control procedures to ensure adherence to this policy. The board of directors has delegated authority for the development and implementation of all asset and liability management policies, procedures, and strategies to the Asset/Liability Committee (“ALCO”). ALCO is comprised of various members of senior management responsible for interpreting the longer range objectives established by the board of directors. As such ALCO sets basic direction for the Corporation’s sources and uses of funds, establishes numerical ranges for primary and secondary objectives, monitors risk and the delivery of services, establishes subs to manage specific ALM activities, and monitors the counterparties engaged in ALM activities. Our ALM policy is reviewed by ALCO and the board of directors at least annually, which includes an evaluation of the ALM policy limits and guidelines in light of our risk profile, business strategies, regulatory guidelines and overall market conditions.
As part of our management of interest rate risk, we utilize the following modeling techniques that simulate the effects of variations in interest rates: (1) repricing gap analysis; (2) net interest income simulation; and (3) economic value of equity simulation. These models require that we use various assumptions, including asset and liability pricing responses, asset and liability new business, repayment and redemption responses, behavior of imbedded options and sensitivity of relationships across different rate indexes and product types. These assumptions are inherently uncertain and, as a result, the models cannot precisely predict the fluctuations in market interest rates or precisely measure the impact of future changes in interest rates. Actual results will differ from the model’s simulated results due to timing, magnitude and frequency of interest rate changes as well as changes in market conditions and the application and timing of various management strategies.
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Gap analysis. Management measures and evaluates the potential effects of interest rate movements on earnings through an interest rate sensitivity “gap” analysis. Given the size and turnover rate of the originated mortgage loans held for sale, loans held for sale are treated as having a maturity of 12 months or less. Interest rate sensitivity reflects the potential effect on net interest income when there is movement in interest rates. An institution is considered to be asset sensitive, or having a positive gap, when the amount of its interest-earning assets reprices within a given period exceeds the amount of its interest-bearing liabilities also repricing within that time period. Conversely, an institution is considered to be liability sensitive, or having a negative gap, when the amount of its interest-bearing liabilities reprices within a given period exceeds the amount of its interest-earning assets also within that time period. During a period of rising interest rates, a negative gap would tend to decrease net interest income, while a positive gap would tend to increase net interest income. During a period of falling interest rates, a negative gap would tend to result in an increase in net interest income, while a positive gap would tend to decrease net interest income.
The following table presents the interest rate gap analysis of our assets and liabilities as of December 31, 2021.
Greater
Than
5 years and
As of December 31, 2021
12 Months
Not Rate
(dollars in thousands)
or Less
1-2 Years
2-5 Years
Sensitive
Total
Cash and investments
$
48,861
4,246
31,144
107,257
191,508
Loans (1)
920,570
155,542
332,792
39,677
1,448,581
Other Assets
—
—
—
73,354
73,354
Total Assets
$
969,431
159,788
363,936
220,288
1,713,443
Non-interest bearing deposits
9,232
8,946
25,977
230,373
274,528
Interest bearing deposits
965,876
—
—
—
965,876
Time deposits
126,719
18,106
61,184
—
206,009
Borrowings
41,344
—
—
—
41,344
Other Liabilities
—
—
—
60,326
60,326
Total stockholders' equity
—
—
—
165,360
165,360
Total liabilities and stockholders' equity
$
1,143,171
27,052
87,161
456,059
1,713,443
Repricing gap:
Positive (negative)
$
(173,740)
132,736
276,775
(235,771)
—
Cumulative repricing gap: Dollar amount
$
(173,740)
(41,004)
235,771
—
—
Percent of total assets
(10.1)%
(2.4)%
13.8%
—
(1) Loans include portfolio loans and loans held-for-sale
Under the static repricing gap analysis for the fiscal year ended December 31, 2021, we model as slightly liability-sensitive through two years. This result is mainly due to core-deposit growth from our strategy of increasing the concentration of relationship-based transaction accounts through the efforts of our business developers. Core customer preference, in the current economic environment, is for short term or liquid deposits. In addition, excess cash from PPP loan forgiveness and sale of loans held for sale were used to pay down borrowings at the end of the year to manage the margin.
Simulations of net interest income. We use a simulation model on a quarterly basis to measure and evaluate potential changes in our net interest income resulting from various hypothetical interest rate scenarios. Our model incorporates various assumptions that management believes to be reasonable, but which may have a significant impact on results such as:
● The timing of changes in interest rates;
● Shifts or rotations in the yield curve;
● Repricing characteristics for market rate sensitive instruments on the balance sheet;
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● Differing sensitivities of financial instruments due to differing underlying rate indices;
● Varying timing of loan prepayments for different interest rate scenarios;
● The effect of interest rate floors, periodic loan caps and lifetime loan caps;
● Overall growth rates and product mix of interest-earning assets and interest-bearing liabilities.
Because of the limitations inherent in any approach used to measure interest rate risk, simulated results are not intended to be used as a forecast of the actual effect of a change in market interest rates on our results, but rather as a means to better plan and execute appropriate Asset / Liability Management (“ALM”) strategies.
Potential changes to our net interest income between a flat interest rate scenario and hypothetical rising and declining interest rate scenarios, measured over a one-year period as of December 31, 2021 and 2020 are presented in the following table. The simulation assumes rate shifts occur upward and downward on the yield curve in even increments over the first twelve months (ramp), followed by rates held constant thereafter.
Rate Ramp:
Estimated increase
(decrease) in Net Interest
Income
For the year ending
December 31,
Changes in Market Interest Rates
2021
2020
+300 basis points over next 12 months
0.21
%
1.87
%
+200 basis points over next 12 months
(0.18)
%
1.02
%
+100 basis points over next 12 months
(0.31)
%
0.50
%
No Change
-100 basis points over next 12 months
(0.22)
%
(1.73)
%
-200 basis points over next 12 months
(2.34)
%
(5.21)
%
The above interest rate simulation suggests that the Corporation’s balance sheet is narrowly liability sensitive as of December 31, 2021. In its current position, the table indicates that a 100 or 200 basis point increase in interest rates would have a modestly negative impact from rising rates on net interest income over the next 12 months and a modestly positive impact in a 300 basis point increase. The simulated exposure to a change in interest rates is contained, manageable and well within policy guidelines. The results continue to drive our funding strategy of increasing relationship-based accounts (core deposits).
Simulation of economic value of equity . To quantify the amount of capital required to absorb potential losses in value of our interest-earning assets and interest-bearing liabilities resulting from adverse market movements, we calculate economic value of equity on a quarterly basis. We define economic value of equity as the net present value of our balance sheet’s cash flow, and we calculate economic value of equity by discounting anticipated principal and interest cash flows under the prevailing and hypothetical interest rate environments. Potential changes to our economic value of equity between a flat rate scenario and hypothetical rising and declining rate scenarios, measured as of December 31, 2021 and 2020, are presented in the following table. The projections assume shifts upward and downward in the yield curve of 100, 200 and 300 basis points occurring immediately. We would note that starting in the first quarter of 2020 that our simulations in a downward parallel shift of the yield curve, interest and discount rates at the short-end of the yield curve are allowed to decline below 0%. Management has and continues to employ strategies to mitigate risk in these scenarios.
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Strategies include actively lowering deposit and funding rates as well as adding and maintaining the use of interest rate floors on floating rate loans.
Estimated increase (decrease) in Net
Economic Value at December 31,
Changes in Market Interest Rates
2021
2020
+300 basis points
60
%
103
%
+200 basis points
45
%
78
%
+100 basis points
26
%
45
%
No Change
-100 basis points
(37)
%
(67)
%
-200 basis points
(97)
%
(175)
%
This economic value of equity profile at December 31, 2021 suggests that we would experience a positive effect from an increase in rates, and that the impact would become greater as rates continue to rise due to the duration of our interest-earning assets. Conversely, we would experience a negative effect from a decrease in rates. While an instantaneous shift in interest rates is used in this analysis to provide an estimate of exposure, we believe that a gradual shift in interest rates would have a much more modest impact. Since economic value of equity measures the discounted present value of cash flows over the estimated lives of instruments, the change in economic value of equity does not directly correlate to the degree that earnings would be impacted over a shorter time horizon.
The results of our net interest income and economic value of equity simulation analysis are purely hypothetical, and a variety of factors might cause actual results to differ substantially from what is depicted. For example, if the timing and magnitude of interest rate changes differ from that projected, our net interest income might vary significantly. Non-parallel yield curve shifts or changes in interest rate spreads would also cause our net interest income to be different from that projected. An increasing interest rate environment could reduce projected net interest income if deposits and other short-term interest-bearing liabilities reprice faster than expected or faster than our interest-earning assets. Actual results could differ from those projected if we grow interest-earning assets and interest-bearing liabilities faster or slower than estimated, or otherwise change its mix of products. Actual results could also differ from those projected if we experience substantially different repayment speeds in our loan portfolio than those assumed in the simulation model. Furthermore, the results do not take into account the impact of changes in loan prepayment rates on loan discount accretion. If prepayment rates were to increase on our loans, we would recognize any remaining loan discounts into interest income. This would result in a current period offset to declining net interest income caused by higher rate loans prepaying. Finally, these simulation results do not contemplate all the actions that we may undertake in response to changes in interest rates, such as changes to our loan, investment, deposit, funding or other strategies.