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when rates decline, although rate floors on some of our variable-rate loans partially offset other negative pressures.
While we view declining interest rates as highly unlikely, the potential percentage reduction in net interest income
exceeds our internal policy guidelines in declining interest rate scenarios and we will continue to monitor our interest
rate risk profile and take corrective action as deemed appropriate.
Net interest income would likely improve by $918,000, or 1.61%, if interest rates were to increase by 100 basis
points relative to a stable interest rate scenario, with the favorable variance expanding the higher interest rates rise.
The initial increase in rising rate scenarios will be limited to some extent by the fact that many of our variable-rate
loans are currently at rate floors, resulting in a re-pricing lag while variable rates are increasing to floored levels, but
the Company still appears well-positioned to benefit from an upward shift in the yield curve.
In recent periods we have added scenarios to our net interest income simulations to model the possibility of no
growth, the potential runoff of “surge” core deposits which flowed into the Bank in the most recent economic cycle,
and potential unfavorable shifts in deposit rates. Even though net interest income will naturally be lower under static
growth assumptions, the changes under declining and rising rates relative to a base case of flat rates are similar to the
changes noted above for our standard projections. If a certain level of deposit runoff is assumed, projected net
interest income in declining rate and flat rate scenarios does not change materially relative to standard growth
projections, but the benefit we would otherwise experience in rising rate scenarios is muted. When unfavorable rate
changes on deposits are factored into the model, net interest income remains relatively flat even in rising interest rate
scenarios.
The economic value (or “fair value”) of financial instruments on the Company’s balance sheet will also vary under
the interest rate scenarios previously discussed, and potential variances are modeled using the same software that is
utilized for net interest income simulations. The difference between the projected fair value of the Company’s
financial assets and the fair value of its financial liabilities is referred to as the economic value of equity (“EVE”),
and changes in EVE under different interest rate scenarios are effectively a gauge of the Company’s longer-term
exposure to interest rate risk. Fair values for financial instruments are estimated by discounting projected cash flows
(principal and interest) at projected replacement interest rates for each account type, while the fair value of non-
financial accounts is assumed to equal their book value for all rate scenarios. An economic value simulation is a
static measure utilizing balance sheet accounts at a given point in time, and the measurement can change substantially
over time as the characteristics of the Company’s balance sheet evolve and interest rate and yield curve assumptions
are updated.
The change in economic value under different interest rate scenarios depends on the characteristics of each class of
financial instrument, including stated interest rates or spreads relative to current or projected market-level interest
rates or spreads, the likelihood of principal prepayments, whether contractual interest rates are fixed or floating, and
the average remaining time to maturity. As a general rule, fixed-rate financial assets become more valuable in
declining rate scenarios and less valuable in rising rate scenarios, while fixed-rate financial liabilities gain in value as
interest rates rise and lose value as interest rates decline. The longer the duration of the financial instrument, the
greater the impact a rate change will have on its value. In our economic value simulations, estimated prepayments
are factored in for financial instruments with stated maturity dates, and decay rates for non-maturity deposits are
projected based on historical patterns and management’s best estimates. We have found that model results are highly
sensitive to changes in assumed decay rates for non-maturity deposits, in particular. The table below shows
estimated changes in the Company’s EVE as of December 31, 2014, under different interest rate scenarios relative to
a base case of current interest rates:
Immediate Change in Rate
-300 bp
-200 bp
-100 bp
+100 bp
+200 bp
+300 bp
Change in EVE (in $000’s)
-$62,271
-$84,444
-$39,600
+$68,093
+$105,899
+$138,036
% Change
-17.71%
-24.01%
-11.26%
+19.36%
+30.11%
+39.25%
The table shows that our EVE will generally deteriorate in declining rate scenarios, but should benefit from a parallel
shift upward in the yield curve. While still negative relative to the base case, we see a favorable swing in EVE as
interest rates drop more than 200 basis points. This is due to the relative durations of our fixed-rate assets and
liabilities, combined with the optionality inherent in our balance sheet. As noted previously, however, management
is of the opinion that the potential for a significant rate decline is low.
