The importance of stress scenarios in budgeting
Most financial institutions take an iterative approach to their budgeting process – running through multiple passes and scenarios before finalizing. We have seen the most progressive institutions take their budgeting practices to the next level by running stress scenarios as part of this iterative process. Given the risks facing financial institutions due to anticipated rate increases, which requires a much broader view than traditional interest rate risk, it is now more imperative than ever to include scenario analysis in your budgeting process.
Most in the banking industry expect higher interest rates to improve net interest margins over the long term. However, given the extended low rate environment over the past six years combined with mediocre economic conditions, the expected rise in interest rates could pose numerous short-term threats to financial institutions, including interest rate risk, liquidity risk, credit risk and overall performance risk. What is the quickest way to assess the impacts of these risks on your institution? Create a stress scenario to forecast the potential impacts of these events and run that stress scenario against your budget.
Admittedly, the interest rate prognosis courtesy of the Federal Reserve remains murky. My own view is that it does not really matter exactly when interest rates rise. What does matter is that your institution has modeled different forecast variables that could be affected by rising rates (as opposed to just an increase in market rates) and has a solid plan in place for that eventuality. Here’s why: most institutions will see a direct impact to their earnings, capital and other key financial metrics as rates begin to rise.
This goes well beyond traditional interest rate risk, where short-term deposit costs increase more rapidly than longer term asset yields. Given the current market conditions, a string of rate increases may change the structure of your balance sheet, your pricing practices and, ultimately, your bottom line earnings, capital and liquidity targets. Let’s look at an example of how this could very easily transpire:
Deposit impact. Conventional wisdom holds that consumers have been rate starved for so long that they will “chase” rates as they begin to rise. However, your traditional assumptions around core deposits are most likely not going to hold true in this rate cycle. In addition to impacting your non-maturity deposits, a rate increase may also affect your certificates of deposit (CDs) balances and expenses. While early withdrawal penalties are common on time deposits, a rapid rise in rates would provide enough incentive for your customers to withdraw funds early and pay the penalty in order to earn higher levels of interest return. So what does all of this mean?
You should either expect a significant runoff of your deposit balances if you don’t take an aggressive deposit pricing approach, generally staying in line with market rate changes, or you should expect a more pronounced rise in your cost of funds if you do take an aggressive approach. With these potential impacts on all of your interest-bearing deposits, you either have a potential liquidity issue or you encounter a negative impact to earnings due to increased interest expenses.
Loan impact. The impact on long-term rates as short-term rates begin to rise is debatable. I have two mortgage broker friends who both strongly believe that the bond market won’t support an increase in long-term rates in the near term, while others look back to 2013 as an indication that long-term rates are ready to move once there is proof that the Fed will, in fact, increase short-term rates. Unfortunately, both scenarios may create an issue for your institution.
If long-term rates do in fact remain lower (or at least don’t increase as rapidly as short-term rates), then this flattening of the yield curve will continue to apply downward pressures on margins, resulting in a risk to your earnings. However, if rates do increase at the longer end of the curve, you may see a significant decrease in your mortgage loan business, very similar to 2013, when the loan origination and refi business all but dried up, which will also impact your bottom line performance.
Credit impact. As rates start to increase, the cost associated with your customers’ floating rate debt will also increase. The resulting increases in payments may cause both delinquencies and defaults to rise, both of which will have a negative impact to earnings and your capital positions.
My point here is not to depress you, or to run around declaring, like Chicken Little, that the “the sky is falling.” Rather, I want to encourage you to utilize the data, processes and tools available to you to plan for these types of scenarios. Just about every financial institution develops an annual budget in some form or another. My recommendation is to create multiple scenarios of your budget that account for the changes indicated above in order to understand the financial impacts to your institution.
Using your baseline budget as a starting point and stressing your input assumptions for interest rates, deposit runoff, early withdrawals on CDs, deposit pricing, new loan business, delinquencies and charge-offs will allow your institution to project the impact of these various events individually and in combination. Ultimately, you can assess the potential impacts of these stressed scenarios and develop plans to implement in case you start to see them occur.
Running stress scenarios as part of your budget process enables your institution to assess the impacts of the stress scenario before you finalize your budget, and allows you to assess these impacts at a more granular level. Budgeting is typically performed at a more detailed organizational level than your asset liability management (ALM) process, enabling targets to be set for line-of-business managers for different regions, centers and products. By assessing impacts and possibly modifying your budget based on these stressed scenarios, you are able to establish appropriate targets and mitigation plans at each of these segmented levels, as opposed to just at the institution level.
Mr. Ridgway is senior solutions engineer for Portland, Ore.-based Axiom EPM, which provides financial planning and performance management software for financial institutions. He can be reached at [email protected].