"Which measurements would you put highest priority on in 2024?"

I’d say that Net Interest Margin (NIM) changes and Economic Value of Equity (EVE) should continue to be the primary focus of IRR management in 2024. Gap calculations rarely give the full picture (focused on timing of reprice, and not magnitude), and Duration measurements can be difficult to understand. Given the extreme rate increases in the past two years and the bank failures in 2023, all financial institution managers and directors should have a clear understanding of how future market rate changes could impact both shorter-term earnings (aka the NIM in the next one and two years) and longer-term capital values (aka the EVE).

As market rates jumped dramatically in 2022, most financial institutions saw nice increases in their NIMs. Balance sheets were filled with shorter-term assets like Fed Funds sold, short-term securities, and variable rate loans. When market rates increased, income on these assets skyrocketed. At the same time, the liquidity in the banking system was still quite strong from the previous Pandemic-related stimulus programs and curtailed consumer spending. As a result, banks and credit unions were slow to increase deposit rates, which in turn, led to widening margins and strong earnings for the better part of 2022.

However, that all dramatically reversed in 2023. Market liquidity seemed to evaporate in an instant as rates continued to rise (causing massive depreciation in investment portfolios), inflation took hold demanding increased commercial and consumer spending, and depositors “woke up” and began to discover alternatives to earn greater returns both inside and outside of the banking system. In simple economic terms, the demand for money exceeded the supply of money, causing a quick and material increase in the cost of money (i.e. deposit rates) and materially lower NIMs. Moreover, the now two-year run-up in market rates has wreaked havoc on investment values, causing big drops in EVE calculations, both in the “base-case” and in the rising rate scenarios.

So, what now, and what can we expect to happen if market rates stay where they’re at for another year, go down, or even continue to climb? We’d like to think that with the increases in deposit rates we’ve seen in 2023, that NIMs are back to more “normal” levels (after the jump in 2022, and the fall back in 2023), and should hold in flat or rising rate scenarios, but what if the Fed begins to drop market rates? And what if, at the same time, market liquidity stays tight? While falling rates should at least cause a rebound in security values (and EVE), that could have a really severe impact on NIMs as asset yields would drop, and deposit rates would likely stay elevated – a scenario no CFO wants to see.

None of us have the crystal ball to tell us what rates will do in 2024, but it’s safe to say that we all need to be sure that we’re closely monitoring both projected NIM shocks and EVE changes, and that we can trust the results of our IRR models.

I can’t remember another time in my 30+ year banking career that we’ve seen this much attention on IRR, and certainly not this much emphasis from Regulators, and rightly so. Examiners are looking closely at those underlying assumptions that drive the model; particularly things like deposit pricing, decay rates, deposit trends, and the impact of those previous Pandemic-related surge deposits. They want to see that IRR models are regularly backtested, and the key model assumptions are stress tested (aka “sensitivity” tested).

If you don’t have complete confidence in your IRR model, or if you’re not sure that you’ve been checking all the Regulatory “boxes,” reach out to us, and we can help you identify any areas where your model and your management practices may be coming up short, before the examiners do.

Give us a call or email us at advisory@plansmith.com to discuss your organization’s individual needs.

Dave Wicklund
Director of ALM Advisory Services