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Interpreting concentration and interest rate risk

Idaho’s financial institution leaders have a responsibility to identify, measure, monitor, and control concentration risks and interest rate risks. These risks have increased in the past few years due to the slow economy, which has brought an increase in loans that carry more risk. Limited consumer loan demand has resulted in a higher percentage of loans in commercial and residential real estate.

This shift in real estate loans combined with historically low interest rates has caused regulators, such as the Idaho Department of Finance, and boards to raise concerns about income when rates rise.

How does management interpret and address concerns on their balance sheets with regard to concentration risk and interest rate risk? Concentration means having significant exposure to any single product or service that exposes the institution to a potential loss which may significantly affect capital, assets, or risk tolerance. Interest rate risk is the risk of financial loss that investors, businesses, and borrowers face when interest rates change.

Management should develop, track, and monitor concentrations in various products, programs, and services to ensure that they remain consistent with strategic plans. These concentrations also should be monitored by the asset liability management committee (ALCO), which should project if any of these conditions could have a significant impact on the future balance sheet and income statement based on projected changes in the marketplace. Policies should be tailored so that risk limits do not trigger a halt in lending but rather warrant high-level reviews (including documentation of continuing risk management rationale) of taking on additional risk.

Concentrations to monitor may include asset classes such as auto loans, unsecured loans, commercial and residential real estate loans, C &I loans, and investments, as well as segments of asset classes such as collateral types, lien positions, nontraditional terms, fixed or variable rates, loan terms, geographic areas, single loans to borrowers, and types of investments. Several of Idaho’s largest banks continue to have large concentrations in their loan portfolios.

Interest rate risk (IRR) goes hand in hand with concentration risk when matching loan and deposit products and rates. Overall, management and the ALCO should develop, track, and monitor IRR, as it affects current and future loan and deposit rates, product marketing, and strategic planning. To address IRR, managers should perform forecasts of the impact of future rate increases and decreases on future profitability, assets, liabilities, and capital. The results of the forecasts can be used to recommend loan and deposit rates and determine if any product lines could lead to losses in certain rate scenarios. Plans can then be developed to address rate scenarios.

Many forms of monitoring can be used to determine IRR and how it impacts the bottom line. Some of the more traditional measures include GAP analysis, income simulation (forecasting), and net economic value models. These models can be developed internally or by third-party providers. Regardless of the method or model used, financial institution leaders need to determine and utilize reasonable assumptions so that reports are useful and meaningful and lead to a path of IRR mitigation and control. It’s best to evaluate the models at implementation and be consistent.

The IRR program adopted must incorporate board oversight, including an understanding of the level and nature of IRR, management oversight of an effective IRR, and annual assessment of the effectiveness of the IRR program.

When establishing limits for concentration or IRR, it’s important to set trigger points that allow management to perform analyses and decide courses of action. The effectiveness of IRR management and the level of IRR exposure are critical factors in regulators’ evaluation of sensitivity to changes in interest rates and capital adequacy.

Scott Klitsch, CPA is a manager with CliftonLarsonAllen LLP in Boise. He can be reached at scott.klitsch@cliftonlarsonallen.com or (208) 387-6440.


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