Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Management of Interest Rate Risk (“IRR”)
Market risk is the risk of loss from adverse changes in market prices and rates. The Company’s market risk arises primarily from the IRR inherent in its lending, investment, deposit-taking, and funding activities. The Company’s profitability is affected by fluctuations in interest rates. Changes in interest rates may negatively or positively impact the Company’s earnings to the extent that the interest rates borne by assets and liabilities do not change at the same speed, to the same extent or on the same basis. To that end, management actively monitors and manages IRR. The extent of the movement of interest rates, higher or lower, is an uncertainty that could have a substantial impact on the earnings of the Company.
The principal objectives of the IRR management function are to evaluate the IRR inherent in the Company’s business; determine the level of risk appropriate given the Company’s business focus, operating environment, capital, and liquidity requirements and performance objectives; and manage the risk consistent with Board approved guidelines. The Company’s Board has established an Asset Liability Committee (“ALCO”) consisting of members of management, responsible for reviewing asset liability policies and the IRR position. ALCO meets monthly and reports the Company’s IRR position and trends to the Board on a regular basis.
53
The Company utilizes a number of strategies to manage IRR including, but not limited to: (1) managing the origination, purchase, sale, and retention of various types of loans with differing IRR profiles; (2) attempting to reduce the overall interest rate sensitivity of liabilities by emphasizing core and longer-term deposits; (3) selectively purchasing interest rate swaps converting the rates for customer loans to manage individual loans and the Bank’s overall IRR profile; (4) managing the investment portfolio IRR profile; and (5) managing the maturities and rate structures of borrowings. During 2021, the Company generally retained newly originated mortgage loans in its portfolio. However, in 2020, the Company sold most of its 30-year fixed-rate residential real estate loan originations in the secondary market. The Company currently does not participate in financial futures contracts, interest rate swaps (other than for commercial loans for customers), or other activities involving the use of off-balance-sheet derivative financial instruments, but may do so in the future to manage IRR.
The matching of assets and liabilities may be analyzed by examining the extent to which such assets and liabilities are “interest rate sensitive” and by monitoring an institution’s interest rate sensitivity “gap.” An asset or liability is said to be interest rate sensitive within a specific time period if it will mature or reprice within that time period. The interest rate sensitivity gap is defined as 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 same time period. A gap is considered positive when the amount of interest rate sensitive assets exceeds the amount of interest rate sensitive liabilities. A gap is considered negative when the amount of interest rate sensitive liabilities exceeds the amount of interest rate sensitive assets. Accordingly, during a period of rising interest rates, an institution with a negative gap position theoretically would not be in as favorable a position, compared to an institution with a positive gap, to invest in higher-yielding assets. This may result in the yield on the institution’s assets increasing at a slower rate than the increase in its cost of interest-bearing liabilities. Conversely, during a period of falling interest rates, an institution with a negative gap might experience a repricing of its assets at a slower rate than its interest-bearing liabilities, which, consequently, may result in its net interest income growing at a faster rate than an institution with a positive gap position.
Interest rate sensitivity is monitored through the use of an IRR model. Prepayment, rate sensitivity, and average life assumptions can have a significant impact on the IRR model results. There can be no assurance that those assumptions will be realized.
The following table sets forth the amounts of interest-earning assets and interest-bearing liabilities outstanding at December 31, 2021, which were estimated by the Company, based upon certain assumptions, to reprice or mature in each of the future time periods shown. At December 31, 2021, the Company’s one-year gap was positive 14.15%, as compared to positive 18.05% at December 31, 2020. The decrease was primarily due to deployment of cash into loans and debt and equity securities. The table is intended to provide an approximation of the projected repricing of assets and liabilities at December 31, 2021 on the basis of contractual maturities, anticipated prepayments, scheduled rate adjustments, and the rate sensitivity of non-maturity deposits within a three month period and subsequent selected time intervals.
54
At December 31, 2021 3 Months
or Less More than
3 Months
to 1 Year More than
1 Year to
3 Years More than
3 Years to
5 Years More than
5 Years Total
(dollars in thousands)
Interest-earning assets:
Interest-earning deposits and short-term investments $ 51,454 $ 1,430 $ 1,730 $ — $ — $ 54,614
Debt securities 457,897 204,791 332,641 273,661 444,432 1,713,422
Equity investments — 250 30,241 34,817 35,847 101,155
Restricted equity investments — — — — 53,195 53,195
Loans receivable (1)
2,305,614 1,303,970 2,208,622 1,462,527 1,342,137 8,622,870
Total interest-earning assets 2,814,965 1,510,441 2,573,234 1,771,005 1,875,611 10,545,256
Interest-bearing liabilities:
Interest-bearing checking accounts 1,514,309 204,188 471,815 382,170 1,629,254 4,201,736
Money market deposit accounts 70,139 48,349 112,434 91,943 413,225 736,090
Savings accounts 85,891 134,368 300,813 235,604 851,257 1,607,933
Time deposits 170,811 381,855 178,053 29,956 14,326 775,001
Securities sold under agreements to repurchase and other borrowings 223,068 156 450 123,493 743 347,910
Total interest-bearing liabilities 2,064,218 768,916 1,063,565 863,166 2,908,805 7,668,670
Interest sensitivity gap (2)
$ 750,747 $ 741,525 $ 1,509,669 $ 907,839 $ (1,033,194) $ 2,876,586
Cumulative interest sensitivity gap $ 750,747 $ 1,492,272 $ 3,001,941 $ 3,909,780 $ 2,876,586 $ 2,876,586
Cumulative interest sensitivity gap as a percent of total interest-earning assets 7.12 % 14.15 % 28.47 % 37.08 % 27.28 % 27.28 %
(1) For purposes of the gap analysis, loans receivable includes loans held-for-sale and non-performing loans gross of the allowance for loan credit losses for loans, unamortized discounts, and deferred loan fees.
(2) Interest sensitivity gap represents the difference between interest-earning assets and interest-bearing liabilities.
Certain shortcomings are inherent in gap analysis. For example, although certain assets and liabilities may have similar maturities or periods to repricing, they may react in different degrees to changes in market interest rates. Also, the 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 interest rates. Additionally, certain assets, such as adjustable-rate loans, have features which restrict changes in interest rates both on a short-term basis and over the life of the asset. Further, in the event of a change in interest rates, loan prepayment rates and average lives of deposits would likely deviate significantly from those assumed in the calculation. Finally, the ability of many borrowers to service their adjustable-rate loans may be impaired in the event of an interest rate increase.
Another method of analyzing an institution’s exposure to IRR is by measuring the change in the institution’s economic value of equity (“EVE”) and net interest income under various interest rate scenarios. EVE is the difference between the net present value of assets, liabilities and off-balance-sheet contracts. The EVE ratio, in any interest rate scenario, is defined as the EVE in that scenario divided by the fair value of assets in the same scenario. Interest rate sensitivity is monitored by management through the use of a model which measures IRR by modeling the change in EVE and net interest income over a range of interest rate scenarios.
55
The following table sets forth the Company’s EVE and net interest income projections as of December 31, 2021 and 2020 (dollars in thousands).
December 31, 2021 December 31, 2020
Change in
Interest Rates
in Basis Points Economic Value of Equity Net Interest Income Economic Value of Equity Net Interest Income
(Rate Shock) Amount %
Change EVE
Ratio Amount %
Change Amount %
Change EVE
Ratio Amount %
Change
300 $ 1,817,134 24.5 % 16.7 % $ 346,723 10.3 % $ 1,890,335 38.5 % 17.3 % $ 340,098 16.2 %
200 1,738,602 19.1 15.6 336,816 7.1 1,752,255 28.4 15.7 325,436 11.2
100 1,621,984 11.1 14.2 325,960 3.7 1,578,917 15.7 13.9 309,644 5.8
Static 1,459,706 — 12.5 314,395 — 1,365,119 — 11.8 292,572 —
(100) 1,230,947 (15.7) 10.3 299,994 (4.6) 1,074,346 (21.3) 9.2 284,763 (2.7)
The change in interest rate sensitivity year over year was impacted by the deployment of cash into loans and investments.
As is the case with the gap calculation, certain shortcomings are inherent in the methodology used in the EVE and net interest income IRR measurements. The model requires the making of certain assumptions which may tend to oversimplify the manner in which actual yields and costs respond to changes in market interest rates. First, the model assumes that the composition of the Company’s interest sensitive assets and liabilities existing at the beginning of a period remains constant over the period being measured. Second, the model assumes that a particular change in interest rates is reflected uniformly across the yield curve regardless of the duration to maturity or repricing of specific assets and liabilities. Third, the model does not take into account the Company’s business or strategic plans. Accordingly, although the above measurements provide an indication of the Company’s IRR exposure at a particular point in time, such measurements are not intended to provide a precise forecast of the effect of changes in market interest rates on the Company’s EVE and net interest income and can be expected to differ from actual results.
56