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effect is exacerbated by accelerated prepayments on fixed-rate loans and mortgage-backed securities when rates decline,
although rate floors on some of our variable-rate loans partially offset other negative pressures. While we view further
interest rate reductions as highly unlikely, the potential percentage drop 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 $1.409 million, or 2.12%, 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 addition to the net interest income simulations shown above, we run stress scenarios modeling the possibility of no
balance sheet growth, the potential runoff of “surge” core deposits which flowed into the Company in the most recent
economic cycle, and potential unfavorable movement in deposit rates relative to yields on earning assets. 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 non-maturity 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 minimized. 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. 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. The table below shows estimated changes in the Company’s EVE
as of December 31, 2015, 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)
-$90,683
-$108,499
-$68,466
+$36,954
+$63,855
+$84,663
% Change
-23.43%
-28.03%
-17.69%
+9.55%
+16.50%
+21.87%
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. We also run stress scenarios for EVE to simulate the
possibility of higher loan prepayment rates, unfavorable changes in deposit rates, and higher deposit decay rates. Model
results are highly sensitive to changes in assumed decay rates for non-maturity deposits, in particular.