Sensitivity Training for Asset-Liability Managers
By: Brad Spears, Vice President, Member Services, FHLB Des Moines

Since September of 2007, the Federal Reserve Open Market Committee (FOMC) has lowered the fed funds rate 325 basis points (bp) including an extremely rare 75 bp inter-meeting cut. These FOMC mandated declines have resulted in a reduction of similar magnitude in the Prime rate. However, recent remarks from Fed Chairman Ben Bernanke have signaled that the FOMC easing policy may have come to an end. A weakening dollar and rising energy prices may force the FOMC’s hand into raising rates to decrease inflationary pressures. Some traders anticipate the FOMC could begin increasing rates sometime before the end of the year. It is important for asset-liability managers to understand the ramifications of this potential FOMC policy shift.

The primary impetus behind the FOMC’s easing policy was the continued decline in financial markets resulting from the issues with the sub-prime mortgage market and the overall decline in economic fundamentals. The resulting “credit crunch” has dramatically slowed lending activity and has placed a renewed emphasis on stabilizing and preserving net interest margin for many financial institutions.

Institutions with large volumes of adjustable-rate assets continue to experience the persistent pressure of compressing margins as these assets reprice at much lower levels which can be extremely punitive if these institutions do not have sufficient interest rate floors in place. Additionally, this decline in rates has led to an increased customer desire for longer-term fixed-rate loans. On the deposit side of the balance sheet, many depositories have been reluctant to decrease offered rates in order to preserve liquidity which has increased pressure on net interest margins.

The concept of sensitivity in interest rate risk management is one that asset-liability managers have been dealing with for many years. The sensitivity of a financial institution’s balance sheet deals directly with the inherent mismatch between the repricing intervals and magnitudes of the institution’s asset and liability cash flows. In particular, we can break this down into two categories: asset sensitive and liability sensitive.

Asset Sensitive

If a financial institution’s balance sheet cash flow position is asset sensitive, the institution’s asset cash flows reprice or are reinvested at a faster rate or in a larger magnitude than liability cash flows. This creates a situation where interest income is more sensitive than interest expense to movement in interest rates. If rates ascend, the appreciation in asset yields leads to an increase in interest income and an expansion in net interest margin. The reverse occurs if rates descend as asset cash flows are reinvested at lower rates and net interest margins are compressed.

Asset sensitive cash flow positions are typical of financial institutions with large volumes of adjustable-rate assets with short repricing intervals. Generally, to prevent financial underperformance in declining rate environments, the institution can extend asset duration by purchasing or originating non-optionable bullet instruments or shorten liability side duration.

Liability Sensitive

A liability sensitive balance sheet position implies that a financial institution’s liability cash flows reprice or are reinvested at a faster rate or larger magnitude than asset cash flows. This balance sheet profile creates a situation where interest expense is more sensitive than interest income to movements in interest rates. If market rates move upward, a larger increase in interest expense creates spread compression. If market rates decline, interest expense declines as certificate and deposit rates are lowered and net interest margin slowly expands.

It is natural for a financial institution to purport a liability sensitive interest rate risk profile due to the short-term nature of the funding base. Typically, a liability sensitive institution can either extend the liability base duration or shorten the asset base to prevent financial underperformance in rising rate environments.

FHLB Des Moines Resources

Proper funds management policies and procedures are and should always be an integral part of any financial institution’s business strategy. The Federal Home Loan Bank of Des Moines (FHLB Des Moines) has a wide range of products and services that can assist members in the funds management process.

If your institution displays an asset sensitive interest rate risk profile, the member could utilize short-term repo advances to shorten the liability base repricing interval and limit spread compression in declining rate environments. These short-term repo products are highly correlated to Prime (99% over the past seven years) and are priced at a significant spread below Prime. Over the past seven years (on average), the one-week repo has been priced at Prime-280 bp, the one-month repo has been Prime-277 bp and the 3-month repo has been Prime-272 bp. All of these can be used to mitigate basis risk and prevent spread compression on Prime-based assets should rates decline.

Members can utilize the LIBOR or Prime-based advances to combat an asset sensitive profile in declining rate environments. FHLB Des Moines also has many long-term, non-amortizing advances that could be used to compensate for a liability sensitive profile if rates increase. If the member cannot extend liability side duration through retail deposits, FHLB Des Moines advances are a cost effective and efficient alternative.

FHLB Des Moines members have many tools at their disposure to mitigate asset and liability cash flow imbalances that can result from shifts in interest rates. The key is actively measuring and monitoring asset and liability cash flows so whatever funding decision is made augments financial performance and net interest margin management.

Please contact your local calling officer with questions or for more information.