Everyone knows interest rate risk (IRR) is one of the two largest risks to a financial institution along with credit. What people often don’t realize is that much of an institution’s IRR is self-induced. That means institutions create IRR through a haphazard approach to pricing assets and liabilities. The Kohl Strategic Pricing Framework (SPF) corrects this through strategic pricing assets and liabilities in concert to eliminate most of an institution’s interest rate risk.
The initial step towards addressing this issue involves distinguishing between what the institution can control and what it does not. Except for a few exceptions, the loan and investment rates are either fixed or linked to an external benchmark such as the Prime Rate or Treasury yields. However, this lack of control over pricing does not apply as strongly to liabilities, where there is a greater degree of flexibility. Most liabilities on the books are non-maturity, administered rate instruments. Administer rate means that the institution has full control of the rate and can change those rates at its discretion. This is where most of the mistakes are made, and opportunity exists.
A lot of financial institutions use their internal cost of funds as the cost of funds to price loans. One of the major problems with this method of pricing is that fixed rate loans are being priced with variable cost funds. That is the very definition of interest rate risk yet it’s a common practice in banking. Institutions literally create most of their interest rate risk here,
The impact of this mistake is becoming painful to many organizations. As of today in early 2024, numerous institutions are seeing interest margins getting crushed as loan rates have topped and deposit rates are rising. This situation compresses interest margins to the extent that institutions are losing capital, with about 20% receiving a CAMELS rating of 3 or higher. The issue is expected to deteriorate with each net quarterly reporting cycle. So, what actions can be taken to address this?
First and foremost, one must stop using the interest cost of funds (iCOF) as an input to pricing loans. Using iCOF does not inject the cost of interest rate risk into the loan price. It says we’re going to price out loans based on historical costs and not today’s costs plus we’re going to ignore interest rate risk. In addition, we’re going to expose our institution to margin compression the minute we raise the price of our existing deposits.
The long-known solution to this is to use Funds Transfer Pricing (FTP.) Using FTP injects an IRR cost into new loan pricing and investment yields. This means that the FTP rate prices loans and investment in ANTICIPATION OF RISING INTEREST RATES. It builds a buffer so that when deposit rates do increase the institution can absorb the blow without endangering capital. For those inclined to hedge their IRR, FTP provides the funding margin to pay for the hedge.
Using FTP is the first and most critical step in the Strategic Pricing Framework. Once your loans and investments have interest rate risk accounted for in the price you are now set to absorb changes in interest rates. Without this, the entire SPF concept falls apart and can be more harmful than helpful.
Now that the new loans and investments are coming on the balance sheet with IRR accounted for, we can start to price liabilities in concert with all interest earning assets to virtually eliminate interest rate risk. It is essential to determine the full cost for servicing your interest earning assets and liabilities. With that information, you can set your administered rate deposits at rates that mirror the changes in the rates on your existing asset portfolio.
It is essential to understand the total cost associated with servicing both your assets and liabilities. Armed with this information, you can adjust the interest rates on deposits to reflect changes in the interest rates of your existing loan portfolio.
Total Asset Revenue including non-interest income.
Less Total cost to service assets excluding the cost of funds as that’s being calculated.
Less Total cost to service the specific deposit you are attempting to price.
Less your desired ROA.
Leaves you with the rate of the administered rate deposit.
This simply suggests pricing the specific deposit so that all costs (and desired return) are covered by the resulting net interest margin. It’s not overly complex, just basic banking.
The second critical element is knowing the cost of delivering the specific deposit being analyzed. All deposits have different costs and that needs to be recognized. For example, non-interest checking accounts commonly have interchange and other revenues that more than cover the servicing costs to the point they make money. In contrast, money market accounts tend to have very low servicing costs and pay high rates so it’s very important to understand those costs so not to price those accounts too low or high.
The ability to price non-maturity deposits to mirror the changes in the asset portfolio yield substantially reduces interest rate risk. There is no interest rate risk associated with many non-interest checking accounts as they make money on their own. One could leave the money in a vault and never endanger capital.
At the other end of the spectrum are CDs. There is interest rate risk with these, but they are usually a very small part of the funding pool. Plus, they are typically of shorter terms and do not contribute a lot to asset liability duration mismatches.
That leaves just the non-maturity products with administered rates. It should be clear that if they are priced to mirror interest income, IRR will be significantly reduced. The bottom-line is don’t price loans based on deposit rates. price deposits based on loan rates. It’s the opposite of what most institutions do.