Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Item 7A. Quantitative and Qualitative Disclosures about Market Risk
Quantitative Aspects of Market Risk. The Corporation does not maintain a trading account for any class of financial instrument nor does it purchase high-risk derivative financial instruments. Furthermore, the Corporation is not subject to foreign currency exchange rate risk or commodity price risk. The primary market risk that the Corporation faces is interest rate risk. For information regarding the sensitivity to interest rate risk of the Corporation's interest-earning assets and interest-bearing liabilities, see “Interest Rate Risk” below and Item 1, “Business - Lending Activities - Maturity of Loans Held for Investment,” “- Investment Securities Activities,” and “- Deposit Activities and Other Sources of Funds - Time Deposits by Maturities” in this Form 10-K.
Interest Rate Risk. One of the Corporation's principal financial objectives is to achieve long-term profitability while reducing its exposure to fluctuating interest rates. The Corporation, through the Corporation's Asset-Liability Committee, has sought to reduce the exposure of its earnings to changes in interest rates by attempting to manage the repricing mismatch between interest-earning assets and interest-bearing liabilities. The principal element in achieving this objective is to increase the interest rate sensitivity of the Corporation's interest-earning assets by retaining for its portfolio new loan originations with interest rates subject to periodic adjustment to market conditions. In addition, the Corporation maintains an investment portfolio, which is largely comprised of U.S. government agency MBS and U.S. government sponsored enterprise MBS and CMOs with contractual maturities of up to 30 years that reprice frequently or have a relatively short-average life. The Corporation relies on retail deposits as its primary source of funds while utilizing FHLB - San Francisco
62
Table of Contents
advances as a secondary source of funding. Management believes retail deposits, unlike brokered deposits, reduce the effects of interest rate fluctuations because they generally represent a more stable source of funds. As part of its interest rate risk management strategy, the Corporation promotes transaction accounts and time deposits with terms up to seven years. For additional information, see Item 7, “Management's Discussion and Analysis of Financial Condition and Results of Operations” in this Form 10-K.
Through the use of an internal interest rate risk model, the Corporation is able to analyze its interest rate risk exposure by measuring the change in net portfolio value (“NPV”) over a variety of interest rate scenarios. NPV is defined as the net present value of expected future cash flows from assets, liabilities and off-balance sheet contracts. The calculation is intended to illustrate the change in NPV that would occur in the event of an immediate change in interest rates of -100, +100, +200 and +300 basis points (“bp”) with no effect given to steps that management might take to counter the effect of the interest rate movement. As of June 30, 2022, the targeted federal funds rate range was 1.50% to 1.75%, making an immediate change of minus 300 basis points or more unlikely.
The following table sets forth as of June 30, 2022 the estimated changes in NPV based on the indicated interest rate environment (dollars in thousands):
Net
Portfolio
NPV as Percentage
Basis Points ("bp")
Portfolio
NPV
Value of
of Portfolio Value
Sensitivity
Change in Rates
Value
Change (1)
Assets
Assets (2)
Measure (3)
+300 bp
$
197,876
$
94,639
$
1,251,834
15.81
%
+694
bp
+200 bp
$
171,305
$
68,068
$
1,227,494
13.96
%
+509
bp
+100 bp
$
140,221
$
36,984
$
1,198,690
11.70
%
+283
bp
-
$
103,237
$
—
$
1,164,038
8.87
%
—
-100 bp
$
99,176
$
(4,061)
$
1,161,691
8.54
%
(33)
bp
-200 bp
$
124,158
$
20,921
$
1,189,093
10.44
%
157
bp
(1) Represents the increase (decrease) of the NPV at the indicated interest rate change in comparison to the NPV at June 30, 2022 (“base case”).
(2) Calculated as the NPV divided by the portfolio value of total assets.
(3) Calculated as the change in the NPV ratio (NPV as a Percentage of Portfolio Value Assets) from the base case amount assuming the indicated change in interest rates (expressed in basis points).
The following table is derived from the internal interest rate risk model and represents the change in the NPV at a -100 basis point rate shock at June 30, 2022 and 2021:
At June 30, 2022
At June 30, 2021
(-100 bp rate shock)
(-100 bp rate shock)
Pre-Shock NPV Ratio: NPV as a % of PV Assets
8.87
%
12.54
%
Post-Shock NPV Ratio: NPV as a % of PV Assets
8.54
%
11.25
%
Sensitivity Measure: Change in NPV Ratio
-33
bp
-129
bp
The pre-shock NPV ratio decreased 367 basis points to 8.87 percent at June 30, 2022 from 12.54 percent at June 30, 2021 and the post-shock NPV ratio decreased 271 basis points to 8.54 percent at June 30, 2022 from 11.25 percent at June 30, 2021. The decrease of the NPV ratios was primarily attributable to increases in market interest rates and a $7.5 million cash dividend distribution from the Bank to the Corporation in September 2021, partly offset by the net income in fiscal 2022 and amortization of stock-based compensation expense.
As with any method of measuring interest rate risk, certain shortcomings are inherent in the method of analysis presented in the foregoing tables. 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 of assets and liabilities may lag behind changes in market interest rates. Additionally, certain assets, such as ARM loans, have features that restrict changes in interest rates on a short-term basis and over the life of the asset. Further, in the event of a change in interest rates, expected rates of prepayments on loans and early withdrawals from time deposits could likely deviate significantly from those assumed when calculating the results described in the tables above. It is also possible that,
63
Table of Contents
as a result of an interest rate increase, the higher mortgage payments required from ARM borrowers could result in an increase in delinquencies and defaults. Accordingly, the data presented in the tables in this section should not be relied upon as indicative of actual results in the event of changes in interest rates. Furthermore, the NPV presented in the foregoing tables is not intended to present the fair market value of the Corporation, nor does it represent amounts that would be available for distribution to shareholders in the event of the liquidation of the Corporation.
The Corporation measures and evaluates the potential effects of interest rate movements through an interest rate sensitivity "gap" analysis. Interest rate sensitivity reflects the potential effect on net interest income when there is movement in interest rates. For loans, securities and liabilities with contractual maturities, the table presents contractual repricing or scheduled maturity. For transaction accounts (checking, money market and savings deposits) that have no contractual maturity, the table presents estimated principal cash flows and, as applicable, the Corporation's historical experience, management's judgment and statistical analysis concerning their most likely withdrawal behaviors.
The following table represents the interest rate gap analysis of the Corporation's assets and liabilities as of June 30, 2022:
Term to Contractual Repricing, Estimated Repricing, or Contractual
Maturity (1)
As of June 30, 2022
Greater than
Greater than
Greater than
12 months or
1 year to 3
3 years to
5 years or
(Dollars In Thousands)
less
years
5 years
non-sensitive
Total
Repricing Assets:
Cash and cash equivalents
$
15,567
$
—
$
—
$
7,847
$
23,414
Investment securities
11,657
—
—
176,764
188,421
Loans held for investment
234,257
177,477
203,393
324,865
939,992
FHLB - San Francisco stock
8,239
—
—
—
8,239
Other assets
2,966
—
—
24,006
26,972
Total assets
272,686
177,477
203,393
533,482
1,187,038
Repricing Liabilities and Equity:
Checking deposits - non interest-bearing
—
—
—
125,089
125,089
Checking deposits - interest bearing
50,368
100,736
100,736
83,948
335,788
Savings deposits
66,716
133,432
133,433
—
333,581
Money market deposits
19,949
19,948
—
—
39,897
Time deposits
78,644
34,490
6,738
1,277
121,149
Borrowings
35,000
50,000
—
—
85,000
Other liabilities
211
—
—
17,673
17,884
Stockholders' equity
—
—
—
128,650
128,650
Total liabilities and stockholders' equity
250,888
338,606
240,907
356,637
1,187,038
Repricing gap positive (negative)
$
21,798
$
(161,129)
$
(37,514)
$
176,845
$
—
Cumulative repricing gap:
Dollar amount
$
21,798
$
(139,331)
$
(176,845)
$
—
$
—
Percent of total assets
2
%
(12)
%
(15)
%
—
%
—
%
(1) Cash and cash equivalents are presented as estimated repricing; investment securities and loans held for investment are presented as contractual maturities or contractual repricing (without consideration for prepayments); FHLB - San Francisco stock is presented as contractual repricing; transaction accounts (checking, savings and money market deposits) are presented as estimated repricing; while time deposits (without consideration for early withdrawals) and borrowings are presented as contractual maturities.
64
Table of Contents
The static gap analysis under 12 months or less duration shows a positive position in the "Cumulative repricing gap - dollar amount" category, indicating more assets are sensitive to repricing than liabilities in the short term. Management views non interest-bearing deposits to be the least sensitive to changes in market interest rates and these accounts are therefore characterized as long-term funding. Interest-bearing checking deposits are considered more sensitive, followed by increased sensitivity for savings and money market deposits. For the purpose of calculating gap, a portion of these interest-bearing deposit balances are assumed to be subject to estimated repricing as follows: interest-bearing checking deposits at 15% per year, savings deposits at 20% per year and money market deposits at 50% in the first and second years.
The gap results presented above could vary substantially if different assumptions are used or if actual experience differs from the assumptions used in the preparation of the gap analysis. Furthermore, the gap analysis provides a static view of interest rate risk exposure at a specific point in time without taking into account redirection of cash flows activity and deposit fluctuations.
The extent to which the net interest margin will be impacted by changes in prevailing interest rates will depend on a number of factors, including how quickly interest-earning assets and interest-bearing liabilities react to interest rate changes. It is not uncommon for rates on certain assets or liabilities to lag behind changes in the market rates of interest. Additionally, prepayments of loans and early withdrawals of certificates of deposit could cause interest sensitivities to vary. As a result, the relationship between interest-earning assets and interest-bearing liabilities, as shown in the previous table, is only a general indicator of interest rate sensitivity and the effect of changing interest rates on net interest income is likely to be different from that predicted solely on the basis of the interest rate sensitivity analysis set forth in the previous table.
The Corporation also models the sensitivity of net interest income for the 12-month period subsequent to any given month-end assuming a dynamic balance sheet accounting for, among other items:
● The Corporation’s current balance sheet and repricing characteristics;
● Forecasted balance sheet growth consistent with the business plan;
● Current interest rates and yield curves and management estimates of projected interest rates;
● Embedded options, interest rate floors, periodic caps and lifetime caps;
● Repricing characteristics for market rate sensitive instruments;
● Loan, investment, deposit and borrowing cash flows;
● Loan prepayment estimates for each type of loan; and
● Immediate, permanent and parallel movements in interest rates of plus 300, 200 and 100, minus 100 and minus 200 basis points.
The following table describes the results of the analysis at June 30, 2022 and 2021:
At June 30, 2022
At June 30, 2021
Basis Point (bp)
Change in
Basis Point (bp)
Change in
Change in Rates
Net Interest Income
Change in Rates
Net Interest Income
+300 bp
3.32%
+300 bp
4.55%
+200 bp
2.14%
+200 bp
2.06%
+100 bp
1.05%
+100 bp
0.23%
-100 bp
-0.09%
-100 bp
0.22%
-200 bp
-3.28%
-200 bp
0.15%
At June 30, 2022 and 2021, the Corporation was asset sensitive as its interest-earning assets at those dates are expected to reprice more quickly than its interest-bearing liabilities during the subsequent 12-month period. Therefore, in a rising interest rate environment, the model projects an increase in net interest income over the subsequent 12-month period. In a falling interest rate environment, the results project a decrease in net interest income over the subsequent 12-month period, except for the -100 and -200 basis point scenarios at June 30, 2021.
Management believes that the assumptions used to complete the analysis described in the table above are reasonable. However, past experience has shown that immediate, permanent and parallel movements in interest rates will not
65
Table of Contents
necessarily occur. Additionally, while the analysis provides a tool to evaluate the projected net interest income to changes in interest rates, actual results may be substantially different if actual experience differs from the assumptions used to complete the analysis, particularly with respect to the 12-month business plan when asset growth is forecast. Therefore, the model results that the Corporation discloses should be thought of as a risk management tool to compare the trends of the Corporation’s current disclosure to previous disclosures, over time, within the context of the actual performance of the treasury yield curve.
Item 8. Financial Statements and Supplementary Data
Please refer to the Consolidated Financial Statements and Notes to Consolidated Financial Statements in this Form 10-K and incorporated into this Item 8 by reference.
Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure
None.