Pub. 3 2015 Issue 3

www.uba.org 14 Interest Rate Risk: How an Increase in Rates May Hurt Your Institution—and the Economy E veryone is waiting with bated breath for interest rates to rise. When will they rise? How much will they rise? Bankers are out doing a net interest rate margin dance, praying the gods that make these changes (the Federal Reserve) will increase rates so they can have improved net income. The assumption is that net interest rate margins will improve with an increase in interest rates since many financial institutions are currently asset sensitive. But what if rises in interest rates mean de- posits reprice more quickly than expected and more quickly than your loan portfo- lio? What if a rise in interest rates will actually harm borrowers, which in turn hurts credit quality? I am talking of course about variable rate loans. Many financial institutions still have a large portion of their portfolio tied to an index, and many of those loans are sitting on interest rate floors. You still may not be able to change rates on your loan portfolio as rates begin to rise—and this could be compounded if rates rise slowly. Even if rates do rise at a slow pace, financial institutions at some point will feel the pressure to increase deposit interest rates, which will have a negative impact on already compressed net interest margins. If rates rise more quickly, this negative impact may be alleviated by moving loans off their interest rate floors. However, there are other risks associated with variable rate loans in this economic environment. Loans will begin to reprice, be it quickly or slowly, as interest rates rise. As loans reprice, borrowers may have debt service coverage ratios in excess of the amount needed to service the debt. However, how many of those borrowers can sustain an increase of 100 basis points? And will you still being able to meet your underwriting criteria with a 200 basis point increase? While our economy is still in recovery mode, many borrowers haven’t had a full return to pre-recession profit and may still struggle if anything significant were to im- pact income. On a $1 million interest-only loan, a 200 basis point increase is $1,667 per month, or $20,000 per year. This may not be that big of a deal for many borrowers, but consider the following: A borrower has $100,000 of cash available to service debt. On an interest-only line of credit of $1 million and 5 percent inter- est, this gives the borrower a debt service coverage ratio of 2.0 to 1.0. Now, using the same scenario above, assume rates rise by 100 basis points and 200 basis points. The debt service coverage ratio drops to 1.67 and 1.43, respectively. These are still acceptable coverage ratios. What if we take a scenario where a borrower is at 1.30 for their debt service coverage, meaning in the above example they generate $65,000 of cash available to service debt. Then, a 100 basis point increase drops the debt service coverage ratio to 1.08. While above 1.0, it’s below what most financial institutions would desire because it leaves little cushion for anything to go wrong. At 200 basis points, the debt service coverage ratio drops to 0.93 to 1.0, which means the borrower will be unable to service the debt and runs the risk of default. How many acceptable credits do you have today that will be troubled debt restructuring candidates after a 200 basis point increase? Similarly, if we use an example where a borrower has a $1 million term loan with a five-year maturity based on a 30-year amortiza- tion with $100,000 of cash available to By Katherine Hart, CPA, Senior Manager, Moss Adams LLP service debt, then the borrower maintains a positive debt service coverage ratio, even with a 200 basis point increase. However, when the debt service coverage ratio starts at 1.25 in the base case and at a 200 basis point increase in interest rates, the debt service coverage ratio falls to 1.01 to 1.0 with less than $700 of cushion. Granted, most term loans aren’t going to reprice immediately, but as these loans mature they may no longer qualify for financing at many institutions. So what can your institution do? First: Institutions need to analyze their balance sheets to determine if they have this type of interest rate exposure and the extent of the exposure they have. Second: Begin performing stress testing or scenario testing of your assumptions. Include stress testing on borrowers’ debt service coverage ratios, to determine at what level your borrowers’ begin to face an economic hardship because of an increase in rates. Run scenarios—such as not repricing the portion of your loan portfolio with relatively low (1.25 or less) debt service coverage ratios, because they will be unable to reprice without a rate modification—as rates increase. Or a scenario with loan runoff due to charge- offs for customers being unable to meet their debt obligations. Determine which have the greatest potential impact on your institution and spend more time ensuring those assumptions are valid or safeguards are put in place to minimize the impact. Third: Institutions may want to revisit their lending practices to determine which have a greater impact on your interest rate risk and whether it’s at an acceptable level based on the institution’s risk profile and loan mix. We may not be able to determine when or how much interest rates will increase, but you can and should know the impact of rate increases on the ability of your borrowers to continue servicing their debt, and evaluate this in the context of your institution’s risk appetite. n Katherine Hart worked in the banking industry for 10 years prior to joining Moss Adams in 2005. She provides internal audit, consulting, auditing, accounting, regulatory compliance, and SEC reporting services to financial institu- tions. You can reach her at (503) 478-2257 or katherine.hart@mossadams.com .