Setting Risk Limits for your Interest Rate Risk Earnings Simulation
Have you been in this situation before? The examiners recently came in for a review and left you with some recommendation that says that you should set reasonable policy limits on your income simulation results calculated by your interest rate risk model. However, when you ask them for guidance on what is reasonable, they say that it is for the Board to decide on what is reasonable. They also mention that you need a limit on the percent change of net income in addition to net interest income. So, now where do you start?
The way most banks have been setting their policy parameters has been using a 5 or 10 percent change for every 100 bps change in rates. This parameter, for most, has been based on an industry norm or rule of thumb. Examiners are now coming in and asking if the Board is aware of what impact that level of change in net interest income has on pre-tax net income. This is when most bankers start to scramble. Here is an example of how an examiner now views your 10 percent policy parameter on the percent change in net interest income.
Current 100 bps change
Net Interest Income (NII) $4,000,000 $4,000,000(-10%) = $3,600,000
Net Non-Interest Expense $3,000,000 $3,000,000
Pretax Net Income $1,000,000 $600,000
Regardless of your current position of your interest rate risk, your policy parameter tells examiners that you are willing to let the position change a certain amount before making any changes in your strategy. In this example, if you have the national average efficiency ratio of 69 percent for all banks, then your 10 percent NII policy parameter in a 100 bps rate change creates the situation that your pretax net income will change by 40 percent. When examiners make the recommendation for setting reasonable policy limits, it is because they may see something like this with your current limit or they think the Board isn’t aware of this exposure to pretax net income.
The best way to set your limits (and easiest in my opinion) is to back into the net interest income parameter by starting with the net income position. If you figure out the amount of change in net income the Board is willing to accept given a certain amount of change in interest rates, then you can easily calculate the percent change in net interest income. Here is an example to illustrate this thought process.
Current 100 bps change
Pretax Net Income $1,000,000 $1,000,000(-15%) = $850,000
Net Non-Interest Expense $3,000,000 $3,000,000
Net Interest Income (NII) $4,000,000 $3,850,000
If the Board is comfortable with a 15% change in net income when rates move 100 bps, then the corresponding NII dollars would be net income plus the net non-interest expense, or $850,000 + $3,000,000 = $3,850,000. The resulting percent change in NII is 3.75%. So, if the Board is comfortable with a 15% change in pre-tax net income, then a policy limit on the percent change of NII at 3.75% makes sense and is reasonable. In this example, a 25% change in NII would result in pre-tax net income to be $0, or a 100% change.
A few things to keep in mind as it relates to the policy limits in your reports.
1. Unless pre-tax net income is already negative or very close to being negative, a policy limit on the change of NII that causes net income to become negative is generally frowned upon, unless it takes an extreme change in interest rates to make net income negative.
2. The policy limits should be re-assessed annually and updated, especially if there have been some material changes to ROA.
3. When setting policy limits on both NII and Net income, they should be linked. If your policy limit on NII is 10%, but your policy limit on net income is 20%, then in the above example, you will violate your net income parameter well before you are in range of your NII parameter.
4. The higher the efficiency ratio of the bank, the bigger the impact a change in NII will have on net income.
Knowing what the ultimate impact of changing interest rates have on the bottom line makes the policy parameters used within your reports more meaningful.