Just like your car, your interest rate risk model gets you from point A to point B.  With IRR models, the journey is from your core system data to your rate sensitivity measurements and reporting. That gets bank management, and your examiner, where you want to go.

But just like your car, without enough fuel, or without the right fuel, completing your journey can be problematic. We know what fuel to put in our car, but what’s the fuel for your IRR model?

Bank-specific assumptions are the fuel for your IRR model.

Bank-specific assumptions include the average life and rate sensitivity beta for your nonmaturity deposit accounts (NMDAs) as well as the prepay rates for your loans, and they’re critically important to an accurate IRR model result. They’re so important because they represent the biggest unknowns in your entire asset liability process.

Interest rate risk models work by modeling the institution’s cash flow changes associated with changes in market rates.  And like all models, they work best when the inputs accurately reflect reality.

Consider your balance sheet.  Every asset and liability on a financial institution’s balance sheet has both a stated maturity and a rate set or formula except your NMDAs.  Similarly, your loans have a stated maturity and amortization but they’re subject to prepaying early.

Unless you accurately estimate the average life and rate sensitivity of your NMDAs and the prepayment behavior of your assets, your IRR projections will suffer. In fact, these 2 sets of assumptions by themselves are sufficient to completely change your reported interest rate sensitivity from asset-sensitive to liability-sensitive, or vice versa.

Because these bank-specific assumptions are so important to a robust IRR process, the regulators specifically called them out in the landmark 2010 Advisory on Interest Rate Risk.  They said…

“The regulators remind institutions to document, monitor, and regularly update key assumptions used in IRR measurement models. At a minimum, institutions should ensure the reasonableness of asset prepayments, non-maturity deposit price sensitivity and decay rates, and key rate drivers for each interest rate shock scenario.”
Our regulators then specifically followed up with the 2012 Interagency Advisory on Interest Rate Risk Management Frequently Asked Questions…

“Can an institution use industry estimates for non-maturity-deposit (NMD) decay rates?
Answer: Institutions should use assumptions that reflect the institution’s profile and activities and generally avoid reliance on industry estimates or default vendor assumptions….An institution can contract with an outside vendor to assist with this process if necessary….Similar considerations should be given to other key rate drivers and prepayment assumptions used in the IRR model.”
Since then, examiners have been on the lookout for bank-specific assumptions along with appropriate documentation. It’s not a matter of if your examiner will question your bank-specific assumptions, but when.

Kinective can help you meet this regulatory requirement by performing, delivering, and documenting a statistically valid deposit study and loan prepay study. All at a surprisingly affordable price.
Contact our experts at Kinective today.
Article updated March 22, 2024