Outlook
 

SPRING 2005 

In Focus This Quarter: 


Interest Rate Risk and Funds Management
 

Starting in mid-year 2004, the Federal Reserve began raising the target federal funds rate from historical lows. As a result, the 

shape of the yield curve flattened substantially during the second half of 2004. These changes in the interest rate environment 

have prompted some industry observers to express concerns about interest rate risk at FDIC-insured institutions. This issue of 

FDIC Outlook assesses the extent of interest rate risk and emerging issues in liquidity and funds management of FDIC-insured 

institutions. 

FDIC Chief Economist Richard A. Brown (far right) leads the discussion at the Interest Rate Risk Roundtable. Panelists are (l to r): William A. Stark, FDIC; 

Tanya S. Azarchs, Standard & Poor’s; and Hal S. Johnson, BB&T. 

Perspectives on Interest Rate Risk Management in the U.S. Banking Industry 

The FDIC hosted a roundtable discussion with industry experts on January 13, 2005, to identify major issues in interest rate 

risk management for FDIC-insured financial institutions. FDIC Chief Economist Richard A. Brown moderated the roundtable, 

which consisted of Tanya S. Azarchs, Managing Director of Financial Services Ratings at Standard & Poor’s; Hal S. Johnson, 

Executive Vice President of Funds Management at BB&T; and William A. Stark, Associate Director of Capital Markets in the 

FDIC Division of Supervision and Consumer Protection. See page 3. 

Profiles of Depositories Exposed to Interest Rate Risk 

Recent increases in short-term interest rates have some market participants concerned about how bank and thrift earnings would 

respond to an increase in longer-term assets at many institutions. A related concern is the indirect effect of interest rate increases 

on borrowers’ credit quality. This article describes some general profiles of depositories that may be vulnerable to rising interest 

rates and why rising interest rates appear to pose less of a concern today than during the 1970s and early 1980s. See page 14. 

Rate/Volume Analysis: An Off-Site Approach to Measuring Interest Rate Risk 

A rising interest rate environment can have varying effects on an institution’s earnings, depending on its asset/liability structure. 

Assessing the amount of interest rate risk prevalent using off-site data is challenging. An alternative method of assessing interest 

rate risk for a particular period is through rate/volume analysis. The article uses this technique to assess how rate-sensitive 

earnings were at community banks during the past 12-month period. See page 21. 

Funding Asset Growth in a Rising Rate Environment: National and Regional Perspectives 

During the past decade, greater competition for traditional deposits among industry participants, credit unions, and other financial 

intermediaries has led to funding challenges for many FDIC-insured institutions. This article analyzes liquidity and funding issues 

from both a national and regional perspective. See page 25. 

FEDERAL DEPOSIT INSURANCE CORPORATION 
The FDIC Outlook is published quarterly by the Division of Insurance and Research of the Federal Deposit 

Insurance Corporation as an information source on banking and economic issues for insured financial 

institutions and financial institution regulators. It is produced for the following six geographic regions: 

Atlanta Region (AL, FL, GA, NC, SC, VA, WV) 

Jack M. Phelps, Regional Manager, 678-916-2295 

Chicago Region (IL, IN, KY, MI, OH, WI) 

David Van Vickle, Regional Manager, 312-382-7551 

Dallas Region 

Midsouth (AR, LA, MS, TN): Gary Beasley, Regional Manager, 901-821-5234 

Southwest (CO, NM, OK, TX): Alan Bush, Regional Manager, 972-761-2072 

Kansas City Region (IA, KS, MN, MO, ND, NE, SD) 

John Anderlik, Regional Manager, 816-234-8198 

New York Region 

Mid-Atlantic (DC, DE, MD, NJ, NY, PA, PR, VI): Kathy Kalser, Regional Manager, 917-320-2650 

New England (CT, MA, ME, NH, RI, VT): Paul Driscoll, Regional Manager, 781-794-5502 

San Francisco Region (AK, AS, AZ, CA, FM, GU, HI, ID, MT, NV, OR, UT, WA, WY) 

Catherine Phillips-Olsen, Regional Manager, 415-808-8158 

The FDIC Outlook provides an overview of economic and banking risks and discusses how these risks relate 

to insured institutions nationally and in each FDIC region. 

Single copy subscriptions of the FDIC Outlook can be obtained by sending the subscription form found on 

the back cover to the FDIC Public Information Center. 

The FDIC Outlook is available online by visiting the FDIC’s Web site at www.fdic.gov. For more information 

or to provide comments or suggestions about FDIC Outlook, please call Jack M. Phelps at 678-916-2295 or 

send an e-mail to jphelps@fdic.gov. 

The views expressed in the FDIC Outlook are those of the authors and do not necessarily reflect official 

positions of the Federal Deposit Insurance Corporation. Some of the information used in the preparation 

of this publication was obtained from publicly available sources that are considered reliable. However, the 

use of this information does not constitute an endorsement of its accuracy by the Federal Deposit Insurance 

Corporation. 

Chairman Donald E. Powell 

Director, Division of Insurance 

and Research 

Arthur J. Murton 

Executive Editor Maureen E. Sweeney 

Managing Editor Mary Ledwin Bean 

Editors Jack M. Phelps 

Kathy Kalser 

Ronald L. Spieker 

Richard A. Brown 

Norman Williams 

Publications Managers Elena Johnson 

Geri Bonebrake 

FDIC OUTLOOK 2 SPRING 2005 
Roundtable panelists are (l to r): William A. Stark, FDIC; Hal S. Johnson, BB&T; and Tanya S. Azarchs, Standard & Poor’s. 

Perspectives on Interest Rate Risk Management 

in the U.S. Banking Industry 

Changes in the level and shape of the interest rate yield 

curve pose challenges for interest rate risk management 

in the U.S. banking sector. Based on a number of recent 

studies and analysis, there is general agreement that interest 

rate risk at institutions insured by the Federal Deposit 

Insurance Corporation (FDIC) is, for the most part, well 

managed. However, in spite of this general conclusion, 

there are a variety of approaches that individual financial 

institutions can take to manage this risk. Ultimately, the 

appropriateness of the techniques used by each institution 

to manage its interest rate exposures can only be evaluated 

on a case-by-case basis. But given that all institutions are 

subject to the same market forces and have to make similar 

types of choices among analytical techniques and mitigation 

strategies, it is also useful to discuss interest rate risk from 

a macro perspective. 

It was with this goal in mind that the FDIC convened a 

January 13, 2005, interest rate risk roundtable to discuss 

macro trends and techniques with leading industry experts. 

The panel of discussants included Tanya S. Azarchs, 

Managing Director, Financial Services Ratings, Standard 

& Poor’s; Hal S. Johnson, Executive Vice President, 

Funds Management Department, BB&T; and William A. 

Stark, Associate Director of Capital Markets, Division of 

Supervision and Consumer Protection, FDIC. The roundtable was moderated by Richard A. Brown, the FDIC’s 

Chief Economist. 

The following is a summary of the roundtable discussion. 

MR. BROWN: Good afternoon, and welcome to 

today’s interest rate risk roundtable. Interest rates 

are a topic that economists know a lot about, but 

interest rate risk is another matter. This is a highly 

institutional area, involving a complex interaction 

between interest rate and yield curve trends and the 

unique financial positions held by each depository 

institution. A great deal of institutional and technical information is required to understand this issue, 

and so we are very fortunate to have with us today a 

panel of experts who are accustomed to assembling 

this information into useful analyses. 

I would like to start out by asking each panelist to 

give a little of his or her own institutional perspective 

on interest rate risk, coming from a rating agency, a 

bank, and a regulatory perspective. 

MS. AZARCHS: As a rating agency, I think our interests are rather well aligned with the interests of regulators in the sense that we care first and foremost about 

what regulators call safety and soundness, or what we 

call relative imperviousness to default. But the difference that we have as a rating agency is that we do not 

spend as long examining or analyzing each institution. 

We leverage off the examination work the regulators do. 

FDIC OUTLOOK 3 SPRING 2005 
In Focus This Quarter: Interest Rate Risk and Funds Management 

That being said, we look into the issue of interest rate 

risk in the context of a broader initiative, which is to 

look at enterprise-wide risk management. We have a 

fairly intensive effort under way to do that. We look at 

market risk as it is expressed in trading risk. We think 

that is a larger risk than structural interest rate risktaking for the institutions that are major trading 

houses, and even not-so-major trading houses. Credit 

risk continues to be of paramount importance to us. We 

still think that when banks fail, they typically fail the 

good, old-fashioned way, which is by making a mistake 

on credit risk. If I were to rank-order interest rate risk, 

I would put it third on our list, coming after market risk 

and credit risk. 

When we look at interest rate risk, we are looking at 

very much the same things that the regulators look at. 

We look at corporate governance—that is, the policies, 

the procedures, and the communication that goes on 

amongst the various constituents at a bank. We also 

look at the methodology and the measurement of the 

risks. It is very difficult for us to communicate back to 

the outside world how we get comfortable with the 

interest rate risk-taking, because interest rate risk 

management is an art and not a science. We are fully 

cognizant of the assumption-driven, methodologydriven conclusions that one reaches from it. 

Broadly speaking, we think that banks have done a 

fairly good job of managing interest rate risk over the 

years, during which the net interest margin, for example, has been fairly solid and uncorrelated to rate movements in the industry. But, we look into interest rate 

risk just to make sure the regulators do not miss 

anything. 

“We still think that when banks 

fail, they typically fail the good, 

old-fashioned way, which is by 

making a mistake on credit risk. 

If I were to rank-order interest 

rate risk, I would put it third on 

our list, coming after market risk 

and credit risk.” 

Tanya Azarchs 

MR. JOHNSON: I would concur with Tanya that 

interest rate risk probably would not be “Job One” at 

our institution. Credit risk holds that top spot. We look 

at a broader definition than interest rate risk; we call it 

market risk, and we do pay very close attention to it. 

We do not have a tremendous amount of interest rate 

exposure on our balance sheet. However, from a market 

perspective, we have a significant exposure to those 

things that we cannot necessarily control, and those are 

the things that we spend a lot of time with our team 

trying to figure out. We try to gauge what the next 

thing coming down the track is and what we can do to 

help either mitigate the effect or somehow offset it. 

Right now, for instance, competitive loan pricing is a 

big factor in our marketplace as the rates on loans relative to the traditional indexes have fallen. We have 

seen that particularly in the mortgage market. Additionally, the supply of loans is not very robust right 

now, so that obviously is reflected in the pricing. 

It is a real challenge trying to model interest rate 

risk. You model what you believe your balance sheet 

growth is going to look like, and as that growth 

changes or becomes different from what your expectations are, that also has an impact on your interest 

rate risk profile. 

We are still a heavily margin-reliant institution, and 

so the interest rate risk management process is very 

important to us. Maintaining that margin and making 

sure that we use appropriate hedges to try to minimize 

our exposure to extreme interest rate events is important to us. 

MR. STARK: It is always enjoyable to talk about 

interest rate risk, because it is a challenging area and 

hard to describe. When you make a loan and somebody 

does not pay you back, you know what your loss is. 

However, if interest rates move against your balance 

sheet position, it is not as straightforward a process to 

measure your loss. 

Looking at interest rate risk from a supervisory viewpoint, I try to keep track of two things. First, I keep 

track of the type of assets banks are buying. Second, 

I watch management’s behavior in periods of volatile 

interest rates in order to assess how they are managing 

their risks during these periods, to see if they have 

adequate controls, hedges, or mitigants in place and 

how those controls perform. 

FDIC OUTLOOK 4 SPRING 2005 
Perspectives on Interest Rate Risk Management 

Regarding the type of assets that can present interest 

rate risk, exposure to mortgage-related assets is an obvious starting point. The mortgage loan is not a perfect 

instrument. From an investor’s perspective, there is a 

“flaw” in the basic mortgage that is used here in the 

United States: it has an option in it. 

When you invest in a mortgage, there are three things 

that can happen—and two of them are bad. One event 

is that rates go up and the value of the loan goes down. 

A second event is that rates go down and the customer 

pays off the loan. A third event is that rates stay 

exactly the same and you earn exactly what you 

thought you were going to earn. 

“When you invest in a mortgage, 

there are three things that can 

happen—and two of them are 

bad.” 

William Stark 

As a result, this is an interesting category of assets to 

watch, because we know it creates unique challenges for 

the bank managers who are trying to manage the interest rate risk associated with these option instruments. 

Finally, in an overall sense, I reach the same general 

conclusions as my fellow panel members that interest 

rate risk ranks secondary in a ranking of risks; it does 

not share the same level of concern as credit risk. 

Historically, we have found that credit risk is the 

primary cause of bank insolvencies, with rate volatility 

and related impacts to earnings and capital being an 

additive, but not primary, cause of failure. 

MR. BROWN: I wanted to start getting into some 

detail by talking about modeling interest rate risk. 

Treatment of interest rate risk has made a lot of 

advances since the interest rate squeeze of the late 

1970s and early 1980s. Mortgage lenders and other 

institutions have had to prepare for—and model 

for—volatile interest rates. Reliance on models is 

reassuring to many, especially to economists, but 

clearly models have their shortcomings. They have 

their challenges in terms of the accuracy of the 

inputs, the validity and testing of assumptions, and 

policies involving independent review. 

I would like to hear your perspective on the art of 

modeling, and how reassured we should be with the 

results. 

MS. AZARCHS: Perhaps I am speaking more for 

myself than for S&P at large, but it raises all of my 

antennae when I hear that something is all modeldriven, because models are always very sensitive to the 

assumptions that you put into them. We are very leery 

of models because of these critical assumptions that 

have to be made, and we see different banks make very 

different assumptions that drive the outcome of the 

sensitivity models they run. 

We rarely see a bank, at least among the top 100 that 

we rate, that does not indicate in its disclosure a fairly 

modest amount of interest rate risk—2 percent, 3 

percent impact or something like that. Yet banks make 

critical assumptions about the duration of indeterminate maturity liabilities, like demand deposits and 

savings accounts. The assumptions vary all over the 

board; for example, we see assumed durations of seven 

months or seven years. You can make all the arguments 

that you want that maybe different deposit bases have 

different behaviors, but they are really not that different, not different enough to warrant an assumption of 

seven months versus seven years. 

“We are very leery of models 

because of these critical assumptions that have to be made.” 

Tanya Azarchs 

Some other assumptions that go into modeling are the 

prepayment of mortgage-related assets and the duration attributed to accrued receivables. There is also 

the issue with the large, complex banks where they 

sometimes carve out the trading book from the whole 

interest rate risk model. Trading books typically are 

short-funded because they are supposed to be shortlived assets, at least on the books, but whether you 

put in a large trading book or you take it out makes a 

big difference in terms of the results that you get from 

the model. 

So, what are the right assumptions to make when 

modeling interest rate risk? The real question might be, 

FDIC OUTLOOK 5 SPRING 2005 
In Focus This Quarter: Interest Rate Risk and Funds Management 

Tanya Azarchs makes a point, with Richard Brown at right. 

what are the conservative assumptions? What will give 

you an investment portfolio that will not leave you 

high and dry if interest rates really take a big move? 

MR. JOHNSON: I would certainly echo that the 

whole process of asset-liability management is an art, 

not a science. I think you have to look at your models 

as a series of tools that help you to build a circle 

around what your real exposures are and what your 

opportunities are. 

“I think you have to look at 

your models as a series of 

tools that help you to build a 

circle around what your real 

exposures are and what your 

opportunities are.” 

Hal Johnson 

We run a number of different models in our institution, 

and we look at all of the model outputs in the aggregate 

to determine the common themes that are impacting 

our institution and the unique things that some of the 

models show. 

Modeling itself is extremely complex. We have ten 

people in our organization dedicated to running risk 

management models, and 

that is only one set of many 

models that we run in our 

bank. We run monthly 

processes and quarterly 

processes as we try to determine our market risk. We 

try to define what is going 

on with the interest rate 

environment and with our 

competitive environment 

as it impacts items on our 

balance sheet. 

Given that we are coming off 

the lowest long-term interest 

rates in a generation, I think 

you have to question whether 

historical prepayment models will be accurate in the 

current environment. You have to put some parameters 

around that and shock the models and determine some 

reasonable levels of variation around the expectation 

that the model has given you. 

That is really where the art comes into the process. You 

have the science there in the form of a model. To turn 

that science into the art, you have to use common sense. 

You have to use your sense of what has happened in 

markets historically and what you think is different 

about the markets today. And you have to try not to 

get wedded to one particular model outcome. 

MR. STARK: As regulators, we have asked the question, what type of model does a bank need to have? 

We arrived at the conclusion that the bank should 

have a model that accurately measures its interest rate 

risk in light of the risk profile of the particular institution. There is, accordingly, no one-size-fits-all interest 

rate risk model. 

And I agree with Hal that the risk models are just tools, 

and that is all they will ever be. We sometimes get a 

little concerned with institutions that get so involved 

in the quantification process and the results that they 

begin to not question the outcomes. From a supervisory 

perspective, we focus more on the validity of the overall risk measurement system and validation process, 

including, specifically, the nature of the bank’s stress 

testing and that it is looking at a range of scenarios. 

FDIC OUTLOOK 6 SPRING 2005 
Perspectives on Interest Rate Risk Management 

“There is no one-size-fits-all 

interest rate risk model.” 

William Stark 

One area that we are fairly sensitive to is mortgage 

prepayments. If 25 percent of an institution’s balance 

sheet is mortgage-dependent, that means 25 percent of 

the balance sheet has to have prepayment assumptions 

assigned to it. These can be a range of assumptions, 

depending on the coupons and other factors. One of 

the things we have observed in the past is that institutions may not always keep their prepayment assumptions updated. Mortgage prepayments are directly 

dependent upon the current interest rate environment, 

and that interest rate environment changes over time. 

MR. BROWN: Are there any good, off-site quantitative measures that you can use to readily assess, 

at least at a broad level, the interest rate exposure 

of an institution? 

MR. STARK: There are, and I can tell you what we 

do at the FDIC. Nine years ago, our Capital Markets 

Group developed an off-site monitoring tool called 

Interest Rate Risk Standard Analysis (IRRSA). 

IRRSA uses data from bank and thrift Call Reports 

and targets seven different factors that our examiners 

look at as part of the examination preplanning process. 

If the IRRSA model sends out red flags, the examiners 

know they need to consider spending more time during 

the examination looking at interest rate risk in the 

institution. So we also have the ability to monitor 

banks off site back in my department using these tools, 

and we talk to the regions if we see things that are out 

of line. 

MS. AZARCHS: One of the things that we look at is 

the mortgage asset, which we think is really difficult, if 

not impossible, to hedge 100 percent. We look at the 

concentration in mortgage-backed securities and mortgage servicing rights (MSR), as well as the amount of 

other comprehensive income that more sophisticated 

banks may have. 

MR. JOHNSON: From an external perspective, I 

would look at the financial instrument disclosures 

about derivative use and the rate of change in that 

derivative portfolio from quarter to quarter. I think that 

tells you a lot about whether the bank is really hedging 

out longer-term risk or whether it is trying to create 

market opportunities. 

MR. BROWN: In the last interest rate cycle, during 

1994 and 1995 when the Federal Reserve raised 

short-term interest rates by 300 basis points in just 

over 12 months, we heard a lot about problems with 

structured notes, or notes with embedded options. 

Some of the problems appeared to arise from the use 

of structured notes by relatively unsophisticated 

investors, but there may have been broader issues 

with the ability to manage the risks in general. 

Are structured notes of any concern in the present 

environment? 

MS. AZARCHS: There are a lot more structured 

notes now. During the mid-1990s, many of the structured notes were, in fact, mortgage-backed securities 

of various kinds, either cash instruments or synthetic 

versions of the same. Currently, there are other types 

of structured notes. 

Collateralized debt obligations (CDOs) are extremely 

popular, but it is difficult to get the disclosure on how 

many of them there are. CDOs may essentially represent an investment—and think of it maybe as a mutual 

fund—which is a fixed-income, interest rate risk-taking 

mutual fund that tries to better the returns in the bond 

market in general. All the bank has on its balance 

sheet is the equity portion, so there is no earnings 

impact until the day of reckoning comes. A lot of the 

interest rate risk in the off-balance-sheet fund is not 

recognized, so there might be some of those kinds of 

concerns out there. [See Chart 1.] 

Chart 1 

The Volume of Structured Notes at Commercial Banks

 Has Surpassed the Highs of the Mid-1990s 

Notes: All data as of year-end except 2004, which is as of September 30. Structured notes 

are the fair value of those debt securities whose cash flow characteristics (coupon rate, 

redemption amount, or stated maturity) depend upon one or more indices or that have 

embedded forwards or options. Structured notes include step-up bonds, index amortizing 

notes, dual index notes, de-leveraged bonds, range bonds, or inverse floaters. 

Source: Federal Deposit Insurance Corporation Call Reports. 

Dollar Volume ($ billions) 

$0 

$5 

$10 

$15 

$20 

$25 

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 

FDIC OUTLOOK 7 SPRING 2005 
In Focus This Quarter: Interest Rate Risk and Funds Management 

MR. JOHNSON: I think there are a couple of issues 

that are tied to this. Many instruments on a bank’s 

balance sheet have imbedded optionality, and that 

makes the modeling and the assessment of those instruments more difficult. 

“I think actually the worst 

interest rate environment for 

banks is a sustained, very low 

interest rate environment.” 

Tanya Azarchs 

I think the mark-to-market issue is very interesting 

because you often have situations where one side of the 

transaction gets marked to market and the other side 

does not. If you properly structure a transaction, you 

may not have any real interest rate risk, but you might 

have an enormous amount of risk in that transaction 

from an accounting interest-rate-reporting standpoint. 

So I think you have to separate the economics from the 

accounting. 

We do not currently use CDO products in our bank, 

but we do use other structured products like collateralized mortgage obligation products and mortgage-backed 

products, and the models for these products are fairly 

robust. Coming out of this low interest rate environment, is there some incremental risk there? Possibly so, 

but the state of the art in modeling has made these 

structured notes more manageable today than ten years 

ago, and I think the incremental risk is fairly low. 

MR. STARK: One problem we have always had here 

in the regulatory community, going back to 1993 or 

1994 when we wrote the first guidance of structured 

notes, was the definition of a structured note. What is a 

“structured note” is not transparent, and that can create 

a problem. 

About a year ago I was speaking to a bankers’ group, 

and I was engaged by the group of bankers about how 

tough our examiners were being on their structured 

note holdings. What we discovered had been taking 

place was that the structured note item in the Call 

Report was rising very rapidly in a lot of banks, and 

that this increase had been causing some examiner 

inquiries, but the type of structured notes banks were 

buying were relatively short-term, single step-up notes, 

which are fairly harmless. Because there is a great buildup of liquidity all across the banking sector, but particularly in many community banks, bankers were placing 

their money in these types of short-term investments, 

which one could argue are just as safe as a short-term 

callable bond. These are agency-issued, so there is no 

significant credit risk associated with them. 

So, in September of last year, the FDIC issued some 

guidance to remind our examiners about the characteristics of structured notes and some of the advantages 

they have and advising them of the lack of complete 

transparency in the Call Report filings. 

MR. BROWN: We hear an awful lot about the 

so-called carry trade—the leverage programs that 

institutions and various types of investors have with 

playing the yield curve. Currently, short-term interest rates are rising and the yield curve is getting 

shallower. Are there still concerns about the carry 

trade and investors or institutions having a problem 

unwinding those positions? 

MS. AZARCHS: My concerns are not so much about 

unwinding those positions as just the dearth of further 

opportunities to use those kinds of positions to 

mismatch just a little bit and get some yield. We have 

seen the net interest margin in kind of a secular 

decline. I think actually the worst interest rate environment for banks is a sustained, very low interest rate 

environment, a bullish flattener kind of environment, 

where banks just cannot make any money on the free 

funds or the interest rate spread. 

It is almost a relief to see rates start to go up a little bit. 

A steeper yield curve will probably be better for that 

profitability opportunity, as long as the mismatch is not 

outsized. 

MR. JOHNSON: I agree with Tanya. I think the carry 

trade right now is a difficult thing to execute with the 

yield curve so flat. One of the outcomes that is least 

favorable to our bank would be either a continued flattening from where rates are or for rates to remain at 

these current levels. I think the general expectation of 

the banking industry was to have a little bit stronger 

increase in rates as we entered 2004, but the yield curve 

remained fairly flat last year. 

I do think there are things banks can do, and one of 

the things we are doing right now is looking at the 

FDIC OUTLOOK 8 SPRING 2005 
Perspectives on Interest Rate Risk Management 

scenario where interest rates remain at these levels and 

we do not get a strong increase in rates. We are looking 

at some of the things we can do to help to mitigate the 

potential impacts on our balance sheet. 

One strategy, for instance, is to take a mortgage product, put it on your balance sheet, and not hedge it out 

for the first year, then use a forward-starting swap to 

hedge it beyond the first year. You get somewhat of a 

carry trade for the first 12 months, and you have 

protected yourself from a flat or down interest rate 

environment. If rates move up, the hedge protects you 

after the first year. And if rates rise and you lose some 

margin on the position, for an asset-sensitive institution 

there are a number of other things on the balance sheet 

that will significantly improve the performance of the 

bank as rates rise. 

We are looking at a number of strategies like this as the 

kinds of opportunities available to us, depending on 

where we see rates going over the course of the next 

six months. 

MR. STARK: The carry trade really is making money 

off interest rate risk. Generally, it is mismatching long 

assets and short liabilities with some kind of overnight 

repo or something with a longer-dated asset and playing 

the positive yield curve. 

We understand that the business of banking is managing risk at a profit, and this is a form of risk being 

managed many times by institutions. Hal described a 

strategy where banks can manage the risk, building a 

wider spread in the first year and then backing it up 

after a year with some form of hedge. As regulators, we 

have no real problems with that. But we need to ensure 

that everybody in the bank’s management and board of 

directors understands the risks that are being taken by 

the bank, that the bank has sufficient capital, and that 

it has sufficient management resources to keep track of 

the bank’s risk positions over time. Interest rate risk is 

dynamic and can turn around on you. 

MR. BROWN: Let’s talk about mortgage lenders. 

With 80 percent of the mortgage loans having been 

written since 2002, and with a similar percentage of 

those loans being fixed-rate mortgages, we are clearly 

in uncharted waters. Are mortgage lenders significantly more at risk for rising rates now than they 

were five years ago? 

MS. AZARCHS: We do not really think so, although 

there probably are more mortgage assets as a proportion 

of total assets on banks’ books. But we are told the 

nature of that risk is not all that different than five 

years ago. We are told that banks have generally kept 

the adjustable-rate product on their balance sheet and 

securitized the fixed-rate product. So the 30-year fixedrate product is, broadly speaking, not on the balance 

sheet. [See Chart 2.] 

However, the adjustable-rate products are not quite as 

adjustable as they used to be, with some of the new 

hybrid products that are around—the three-year, fiveyear, and seven-year fixed-rate loans that then go to 

adjustable rates. These hybrids should be fairly easy to 

hedge, so the real issue goes back to how well they are 

hedged. 

MR. JOHNSON: I do not think that this period is any 

more risky, and I think the interest rate risk models 

that are out there do a pretty good job. Certainly, from 

the ability to hedge there is a full complement of products in the marketplace to use. 

I think the risk that exists today is in the potential for a 

significant disconnect in the prepayment expectations 

versus the prepayment realities over the next five to 

seven years. If the hedges and the underlying assets do 

not end up matching up over that period of time, banks 

could end up with a portion of their income with either 

a negative carry or generating a greater benefit. To me, 

that is the risk. 

Chart 2 

The Outstanding Volume of Mortgage-Related 

Holdings at Insured Institutions More than Doubled 

over the Past Decade 

Note: All data as of year-end except 2004, which is as of September 30. 

Source: Federal Deposit Insurance Corporation Call Reports.

 Dollar Volume ($ billions) 

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 

Residential 

Mortgage Loans 

Mortgage-Backed 

Securities 

Home Equity 

Lines of Credit 

$0 

$500 

$1,000 

$1,500 

$2,000 

$2,500 

$3,000 

$3,500 

FDIC OUTLOOK 9 SPRING 2005 
In Focus This Quarter: Interest Rate Risk and Funds Management 

“Accounting rules clearly do 

make it difficult for institutions 

to optimally hedge their risks, 

and in a significant way.” 

Hal Johnson 

MR. STARK: I agree. I do not think there is any more 

risk. There are some micro issues like how to model the 

newer hybrid products. I imagine getting the models to 

fully capture the behavioral characteristics of novel, 

hybrid products to reflect accurately the way they truly 

behave is a challenge at times for bankers. 

MR. BROWN: I would like to move on to deposit 

pricing, where in the third quarter of 2004 we saw 

the initial effects of the Federal Reserve raising 

short-term interest rates. For large banks—with 

total assets over $10 billion—we saw their cost of 

funds go up 15 basis points, but for the smallest 

groups of banks—with assets under $100 million— 

their cost of funds only went up 2 basis points. 

What do you see going forward in terms of the stability of core deposits if the short-term rates continue to 

increase as anticipated? 

MS. AZARCHS: We think that the volume of 

deposits will remain with the banks, because they have 

been relatively sticky and have not changed very much 

in a correlated way with interest rates. The real issue is 

the pricing on some of the discretionary deposits and 

deposits in general. I think what we are seeing now is a 

positive stickiness in pricing in a rising rate environment, where the deposit rates have been a little bit 

slow to move up. 

From the reports we are getting, I think the effect of 

the interest rate increase has already run its course. 

They may move up more in lock-step, but the value of 

the free funds is the thing we are looking to see turn 

positive as rates continue to move up. 

MR. JOHNSON: I think in general core deposits 

ought to actually be better off with the rates moving 

up. I think it has been challenging for people to find a 

home for their money that really earned them much. 

We do think that demand deposit account balances 

will decline, but I am actually surprised that there has 

not been more of a runoff to this point. So far, our 

demand accounts have been pretty sticky, but our 

expectation would be that as rates begin to move up 

and alternative uses for that cash among our commercial clients improve, we will see some of that money 

leave the bank. 

William Stark (left) and Hal Johnson. 

FDIC OUTLOOK 10 SPRING 2005 
Perspectives on Interest Rate Risk Management 

MR. STARK: I find it interesting that banks in the 

Southeast part of the country appear to be able to lag 

by maybe 25 percent the Federal Reserve’s short-term 

rate increases. But in the Midwest there is a little 

more competition for the money, and banks are having 

to raise their rates. It is interesting to see how rate 

increases can affect the regions differently. Also, the 

big banks have a much larger wholesale funding 

component, so their cost of funding could be going up 

more dramatically than the community banks and 

those banks that rely on core deposits. 

MR. BROWN: I would like to move on to hedge 

accounting. I know that there may be some issues 

out there in terms of the accounting standards 

applied to hedge positions and whether or not these 

standards help or hurt the ability to undertake a 

macro hedging strategy. Is there a sense in which 

the accounting rules make it difficult for institutions 

to optimally hedge their interest rate risks? 

MS. AZARCHS: Well, I do think the accounting 

rules make hedging more difficult. There is a sort of a 

double responsibility that every bank treasurer has—to 

think about what the real economic hedge is and what 

the accounting impact of it could be. Some of the more 

efficient hedging strategies no longer make it in terms 

of qualifying for hedge effectiveness under FAS 133, 

as well as the issue of the mortgage servicing rights. 

I do think it puts a spoke in the wheel in many cases, 

and maybe makes banks prefer the less efficient way of 

hedging, which would be the cash instrument rather 

than the synthetic derivative expression of the same. 

Maybe banks do less hedging because of the fear of the 

accounting. Right now I think the largest risk is the 

accounting risk, and the fear that it will be misperceived if there is a change in accounting method from 

hedge accounting to mark-to-market accounting and 

an attendant loss. That has a very negative effect on 

shareholders, on the stock market price, and things 

like that where people just see accounting risk and 

head for the exits. 

MR. JOHNSON: Accounting rules clearly do make 

it difficult for institutions to optimally hedge their 

risks, and in a significant way. If you look at accounting 

for things like the MSR asset, it is totally devoid from 

the actual cash flow of that asset. Additionally, when 

you have assets like the MSR asset and commercial 

mortgage-backed security pipelines, where the hedge is 

marked to market but the asset remains as the lower of 

cost or market, it makes the hedging extraordinarily 

difficult, because you no longer have an economic 

offset at the end of your accounting period. 

“When evaluating the soundness 

of the bank and the health of 

its franchise, it is extremely 

important for us to see what is 

happening operationally, and that 

is getting more and more difficult 

to do.” 

Tanya Azarchs 

So I think the accounting rules do have an impact, and 

I think they are hurting our ability to effectively hedge 

and take out the kinds of risk we want to, because we 

have to be sensitive to the potential accounting 

outcomes. 

MR. STARK: I am not the accountant in the crew 

here, but I agree with what I hear from Tanya and Hal. 

It is disturbing when accounting rules and economic 

reality differ, and it is generally going to lead to a bad 

result. From a safety and soundness viewpoint, we have 

an interest in avoiding a bad result, so these are areas 

that we monitor carefully. 

MR. BROWN: Tanya, as an analyst, do these developments make it harder to evaluate the institution? 

MS. AZARCHS: It does cause some loss of transparency. Hedge accounting makes it difficult to track 

what is happening from a cash flow sense, a liquidity 

sense, or an operational sense. Technically, when we 

get to full mark-to-market accounting, the income 

statement will only be the residual reconciliation 

between the balance sheet at Time A and the balance 

sheet at Time B. However, when evaluating the soundness of the bank and the health of its franchise, it is 

extremely important for us to see what is happening 

operationally, and that is getting more and more difficult to do. 

Securitization rules are another area of distortion from 

what is really happening operationally. All we can see 

FDIC OUTLOOK 11 SPRING 2005 
In Focus This Quarter: Interest Rate Risk and Funds Management 

is the change in the mark-to-market of the residuals, 

but we do not know what is happening to the pool of 

assets that underlies that. 

MR. BROWN: I want to move on to our bottom line 

question here, and, for the FDIC, many times the 

bottom line relates to scenario analysis. There are 

two interest rate scenarios I would like to consider. 

First, let’s consider a baseline scenario. Federal funds 

futures are implying that short-term interest rates 

will increase another 100 basis points by August and 

maybe another 50 basis points by the end of the year. 

So we are anticipating steady, moderate increases in 

short-term interest rates. What effect is that likely to 

have on the industry and individual institutions with 

regard to interest margins, securities gains, and credit 

quality? Are there any bad outcomes that we should 

be worried about? 

MS. AZARCHS: For Standard & Poor’s, one of the 

first things we think about is what economic scenario 

goes along with that. Assuming that we are getting a 

strong economy with good growth in discretionary 

income, the credit quality problems that could come 

from rising interest rates may be dampened. 

The greatest area of concern is the amount of 

consumer debt in the high-growth areas of home 

equity lending and other forms of unsecured or even 

secured consumer debt. In a high-rate environment, 

what is going to happen to that from a credit quality 

point of view? You need to have a really strong economy to offset any potential credit fallout in these areas. 

In terms of net interest margin, I think interest rate 

margins would be slow to recover to their historic 

norms under what we might call a bearish flattener. 

If the Federal Reserve raises rates but the long end 

stubbornly refuses to go up, there is going to be continued pressure on the margin. But I think there would 

be even more pressure if rates stayed very low and flat, 

a bullish flattener scenario. 

MR. JOHNSON: If we see a continued flattening yield 

curve, I agree that you have to look at what is happening to the economic scenario. If we do not see more 

robust loan demand and some relief on asset pricing, 

that is somewhat of a bearish scenario for 2005 from a 

bank earnings perspective. 

A good outcome would be a steepening yield curve, a 

little bit more robust economy, more loan demand, and 

a little less pressure on loan pricing. That is our 

preferred economic scenario. 

MR. STARK: In the supervisory business, we focus 

on banks’ risk management processes given that 

bank’s risk profile, and we try to steer clear of secondguessing bank management’s interest rate forecasts. 

We are concerned primarily about any extreme position in a bank where there is not sufficient capital. 

We do not differentiate whether it is an extreme long 

or an extreme short position. If the bank does not 

have sufficient capital and rates go the wrong way, the 

bank can get into trouble and may not be acting in a 

safe and sound manner. That is what we try to evaluate at all times. 

MR. BROWN: Let’s talk about an extreme case 

here—the worst case scenario. The United States is 

running a current account deficit in the neighborhood of $500 billion to $600 billion, and yet we have 

long-term yields around 4.15 percent today, which is 

pretty low. 

A lot of the slack is being picked up by the purchases 

of U.S. Treasury and agency securities by foreign 

central banks, especially in Asia. That represents 

an official policy that might change at some point if 

those central banks decided not to accumulate more 

dollar assets. If that were the case, there is the 

potential that we could see the dollar decline, and 

we could see long-term interest rates shoot up pretty 

dramatically. If long-term interest rates shoot up to 6 

or 7 percent, or even higher in some very adverse 

scenario, what effect would that have on the banking 

industry? Which institutions are going to be affected 

the worst, and how? 

MS. AZARCHS: When we look at stress tests that 

banks do in their asset-liability management, we see 

those types of scenarios being tested to some extent. 

I think higher rates are survivable as long as the economy does not decline and the asset liability managers 

hedge appropriately. 

What we are not necessarily seeing tested, and I 

wonder why not, is a stagflation scenario. In a very 

stagnant, high-unemployment kind of economy, the 

credit risks in the consumer sector would be extremely 

large. That is when I think we would see the consumer 

sector decline. 

FDIC OUTLOOK 12 SPRING 2005 
Perspectives on Interest Rate Risk Management 

MR. JOHNSON: I agree. I think it becomes a potential credit issue at that point, and I think the issue of 

inflation and stagflation is one that we have to keep 

a very close eye on. If we see those two things beginning to show up on the horizon, we need to be able to 

react, because neither of them is particularly attractive 

for banks. 

MR. BROWN: I want to thank you all for your willingness to talk about these issues and share your 

perspectives with us. It has been very interesting and 

helpful to us here at the FDIC. 

Lynne Montgomery provided editorial assistance for 

this article. 

Photographs are by Sally Kearney and Mary Ledwin Bean. 

Panelist Profiles 

Tanya S. Azarchs	 served in a leadership role in the merger-of-equals 

between Southern National and BB&T. In February Tanya S. Azarchs is a Managing Director in Financial 1995, upon consummation of the merger between Services Ratings at Standard & Poor’s, where she is BB&T and Southern National, Mr. Johnson assumed responsible for coordinating research on issues affecting the responsibilities of Strategic Planning and Corporate financial institutions worldwide. She is also responsible Finance Manager for the combined organization. Since for the ratings of large, complex banks and securities then, Mr. Johnson has been involved in more than 100 firms in the United States and Canada, and she is acquisitions, including 30 banks and thrifts, 53 insur­ involved in the analytical effort regarding Eastern Euro­ ance agencies, and 18 nonbank companies. pean banks. She is a member of the global financial institutions ratings criteria board, which develops ratings Mr. Johnson holds a B.S. in business administration and criteria and reviews ratings across the globe for consis­ an M.B.A. from East Carolina University. He is a Char­ tency. As a Senior Analyst, she participates in rating tered Financial Analyst. committees for banks in many regions of the world. 

Ms. Azarchs joined the Financial Institutions Ratings William A. Stark 

group in 1989 after following the largest U.S. banks as William A. Stark is an Associate Director in the FDIC’s 

an equities analyst for Standard & Poor’s since 1984. Division of Supervision and Consumer Protection 

Ms. Azarchs holds an M.A. and B.A. in English litera- where he heads the Capital Markets Branch. He is 

ture and has done graduate work in finance and compar- responsible for policy development and examiner guidative literature at New York University. She is a	 ance on FDIC-insured institutions’ involvement with 

Chartered Financial Analyst.	 all securities matters and related risk areas. Mr. Stark 

works closely with the Federal Financial Institutions 

Hal S. Johnson Examination Council Supervision Task Force on the 

development of various policy guidelines. He has been Hal S. Johnson is an Executive Vice President in the directly involved in the training of bank examiners and Funds Management Department of BB&T. Mr. John- industry representatives. In addition, he has served on son serves as the asset-liability committee balance numerous subgroups of the Basel Committee on Bank- sheet manager responsible for BB&T’s market risk ing Supervision. management, simulation modeling, and Treasury 

market functions. Mr. Stark came to the FDIC in 1990 after holding positions as Chief Financial Officer, Controller, and Trea- Mr. Johnson joined Southern National Corporation in surer of various financial institutions in the United 

1984 and was promoted to Marketing Director in 1986. States. Prior to that, he was employed by Peat, Marwick, In 1989, Mr. Johnson was tapped to develop a Strategic Mitchell and Company as an audit manager for banks Planning Department for Southern National. In that and thrift institutions. 

capacity he worked with Executive Management and 

the company’s Board of Directors to develop corporate Mr. Stark holds a degree in business administration from 

strategy, including acquisition strategy. Mr. Johnson the University of Missouri. 

FDIC OUTLOOK 13	 SPRING 2005 
Profiles of Depositories Exposed to Interest 


Rate Risk
 

Recent increases in short-term interest rates and the 

likelihood of further rate increases have some market 

participants concerned about how bank and thrift 

earnings will respond. These concerns are prompted, 

at least in part, by the fact that many institutions have 

increased their relative holdings of longer-term assets, 

especially mortgages, over the recent period of historically low interest rates.1 Also of concern are the possible indirect effects of interest rate increases on banks, 

including the effect of higher debt service costs on the 

ability of borrowers to repay. Certain types of borrowers, 

such as those with non-prime and high loan-to-value 

equity or commercial real estate borrowers whose loans 

have variable features, may show a greater sensitivity 

to rises in interest rates. 

Quantifying interest rate risk (IRR) is not as straightforward as, say, quantifying credit risk using easily 

obtainable loan performance measures such as delinquency and loan loss ratios. Accurate modeling of an 

institution’s IRR profile is data-intensive and generally 

requires more information than is available from financial or regulatory reports. Nevertheless, financial and 

supervisory data can help isolate many institutions that 

are potentially vulnerable to rising interest rates. Offsite data can also provide a measure, albeit an imperfect 

one, of how institutions might perform in a rising rate 

scenario. 

This article describes some general profiles of depositories that may be vulnerable to rising interest rates. It 

also discusses several reasons why prospects for rising 

interest rates appear to pose less concern today than 

during the turbulent interest rate environment of the 

1970s and early 1980s. Finally, the article places the 

discussion of IRR in a historical context by showing 

how the current regulatory and industry environments 

compare with those of the 1980s. 

1 For example, the proportion of insured banks holding in excess of 30 

percent of their assets in long-term mortgages and securities (those 

that mature or reprice in more than five years) increased from 9.1 

percent at year-end 1997 to 15.8 percent at September 30, 2004. 

Factors That Help Profile an Institution Exposed to 

Rising Rates 

For depository institutions, IRR is traditionally defined 

as the sensitivity of an institution’s earnings and net 

portfolio value to changes in interest rates.2 Depending 

on the interest rate environment, these sensitivities 

arise from the composition and characteristics of an 

institution’s assets, liabilities, and off-balance-sheet 

positions.3 This traditional view of IRR can be thought 

of as margin risk, because excessive IRR exposure most 

often manifests itself through adverse changes in net 

interest margins.4 Margin risk, however, produces an 

incomplete picture of the potential vulnerability of 

institutions insured by the Federal Deposit Insurance 

Corporation (FDIC) to rising interest rates. Two additional factors must be considered: (1) how rising interest rates affect credit quality (repayment risk for the 

purposes of this article) and (2) the effectiveness of 

bank management in monitoring and controlling an 

institution’s IRR exposures (management risk). 

Figure 1 illustrates a conceptual framework for identifying depository institutions along the three risk dimensions of margin, repayment, and management risk. For 

each risk dimension, asset compositions or supervisory 

indicators can help identify “outlier” institutions that 

exhibit characteristics making them relatively more 

vulnerable to rising interest rates than other institutions. Note that Figure 1 is drawn with overlapping risk 

dimensions, which implies that some institutions will 

be identified as outliers in more than one risk dimension. However, the incidence of intersection between 

two risk dimensions is relatively infrequent, and the 

2 Elizabeth Mays, “Interest-Rate Risk Models Used in the Banking 

and Thrift Industries,” in The Handbook of Fixed Income Securities, 

4th ed., eds. Frank J. Fabozzi and T. Dessa Fabozzi (Chicago: Irwin 

Professional Publishing, 1995), 696. 

3 Characteristics that must be considered include the various options 

(such as the ability to prepay a loan) that are embedded in securities, 

loans, deposits, borrowings, and off-balance-sheet contracts. 

4 Because changes in net portfolio values reflect changes in earnings 

power, they too will eventually lead to changes in earnings to the 

extent that the value changes are permanent. For depository institutions, most valuation changes will flow through the net interest 

margin. Some valuation fluctuations, such as changes in the value of 

mortgage servicing rights, flow through noninterest revenues or 

noninterest expenses. 

FDIC OUTLOOK 14 SPRING 2005 
Profiles of Depositories Exposed to Interest Rate Risk 

Figure 1 

Sources of Vulnerability to Rising Rates 

Management Risk 

Institutions with weak 

market sensitivity ratings 

Margin Risk Credit Risk 

Institutions whose interest Institutions whose credit 

margins are exposed quality could deteriorate 

to rising rates with rising rates 

Source: Federal Deposit Insurance Corporation. 

incidence of intersection among all three risk categories 

is very rare. 

Margin Risk Often Accompanies High Levels of 

Long-Term Loans and Securities 

Margin risk is commonly attributed to a mismatch in 

contractual maturities or repricing frequencies between 

assets and liabilities. The interest margins of institutions with a liability-sensitive position (that is, institutions with liabilities repricing more frequently than 

their assets) tend to benefit when rates fall, because 

funding costs decline more rapidly than their asset 

yields. On the other hand, the interest margins of these 

institutions tend to decline when interest rates rise. 

Institutions with liability-sensitive balance sheets are 

often typified by their large proportional holdings of 

securities and loans with longer-term contractual maturities or infrequent repricing opportunities, such as 

fixed-rate mortgage loans. A long-term asset ratio, 

defined as the proportion of loans and securities with 

remaining maturities or next repricing opportunity 

exceeding five years, is therefore a simplistic but 

straightforward way to identify institutions whose 

margins are vulnerable to rising rates.5 

5 This approach is simplistic for a variety of reasons: (1) it ignores the 

use of derivatives (interest rate swaps and options) to alter the maturity and repricing characteristics of balance sheet exposures; (2) it 

does not consider the options embedded in certain assets and liabilities, which could also alter the effective duration of assets and liabilities; and (3) it does not consider situations, albeit rare, where 

institutions have substantially matched these long-term assets with 

like-maturity funding sources. Despite its shortcomings, the long-term 

asset ratio is useful in developing a view of the prototypical institution 

whose margins are vulnerable to rising interest rates. 

Repayment Risk More Likely in Certain Types of 

Loan Exposures 

Conceptually, certain types of credit exposures may be 

more vulnerable to default in the event of a sharp rise 

in interest rates, because some borrowers may be unable 

to satisfy increased debt service requirements due to 

higher interest payments. In a rising-rate scenario, 

loans to highly leveraged consumers would appear to 

pose a risk, particularly for those consumers who hold 

large volumes of variable-rate debt such as adjustablerate mortgages, high loan-to-value mortgages, and 

home equity lines of credit. Loan Performance data 

indicate that 60.5 percent of the subprime, closed-end, 

first- and second-lien mortgages have variable rates, 

marking this class of loans as being more rate-sensitive 

than other mortgage portfolios.6 

Another type of variable-rate loan that could experience a higher rate of default in a rising-rate environment is that of loans secured by commercial real estate 

(CRE), where repayment is largely project-dependent. 

In a market where rents are generally under pressure 

nationwide, rising interest rates have the potential to 

increase debt service while tending to raise capitalization rates and pressure property values. For both consumer and CRE loans, the repayment capacity of 

borrowers could be impaired if there is no offsetting 

increase in income from wages, sales, or rental rates. 

There are several factors and considerations that could 

alleviate repayment risk concerns related specifically to 

higher interest rates. For example, changes in loan 

payments on many loan products (variable-rate mortgage loans, in particular) significantly lag changes in 

interest rates. For such loans, a slow and measured rise 

in rates should not lead to significantly different loan 

performance in the near term. In addition, many loan 

contracts contain provisions that cap how high 

payments can go in response to increases in market 

rates.7 These provisions effectively limit an institution’s 

exposure to repayment risk as defined in this article. 

Finally, it must be acknowledged that most rising-rate 

scenarios would be associated with an economic expansion, which would generally bode well for consumer 

incomes and the ability of CRE borrowers to obtain 

higher rental rates. Hence, the unlikely scenario of an 

6 The subprime, closed-end, first- and second-lien mortgages here 

include adjustable-rate mortgages, short-term balloon products, and 

London Interbank Offered Rate (LIBOR)-based mortgages. 

7 Most variable-rate mortgages contain both lifetime and periodic 

payment caps. 

FDIC OUTLOOK 15 SPRING 2005 
In Focus This Quarter: Interest Rate Risk and Funds Management 

immediate and steep rise in interest rates is where 

repayment risk becomes most relevant. Nevertheless, 

the significant increase in high loan-to-value and 

variable-rate mortgage products, including some interestonly products, may affect repayment risk in this cycle, 

particularly for those borrowers who have less financial 

cushion to withstand higher financing costs.8 

Call Reports and Thrift Financial Reports provide no 

direct information on the repayment ability of borrowers. These reports also do not contain sufficient information to isolate those loan portfolios where borrowers’ 

payment requirements could be expected to rise materially in the event of higher interest rates.9 As a result, 

crude proxies are used to help identify loan portfolios 

likely to contain either a significant proportion of variable-rate product or significantly higher credit risk in 

terms of the repayment capacity of borrowers. The 

kinds of proxies used include proportionally large holdings of subprime mortgages, home equity and other 

types of consumer loans, and CRE and development 

loans. Note that there are likely to be relatively few 

institutions that simultaneously exhibit both a significant degree of repayment risk, which results from holding relatively short-term, variable-rate loans, and a 

significant degree of margin risk, which stems largely 

from holding longer-term assets. 

Supervisory Ratings Highlight Weak Interest Rate 

Risk Management Practices 

Supervisory assessments of the ability of depository 

managers to measure and monitor their IRR exposures 

are perhaps the most critical considerations in this risk 

identification process. The “S” component of the 

CAMELS rating assesses the ability of management to 

identify, monitor, and control market risk exposures 

within a bank or thrift.10 The rating also encompasses 

an assessment of the level of earnings and capital that 

8 For more about home equity lending, see “Home Equity Lending:
 

Growth and Innovation Alter the Risk Profile” by Cynthia Angell in
 

FDIC Outlook, Winter 2004, http://www.fdic.gov/bank/analytical/
 

regional/ro20044q/na/2004winter_03.html.
 

9 For example, other than closed-end loans secured by one-to-four
 

family mortgages, Call Reports do not identify loans with variable-


rate payment structures.
 

10 All insured depositories are rated under the Uniform Financial
 

Institutions Rating System, which is a six-component system that
 

assesses capital adequacy (C), asset quality (A), management (M),
 

earnings (E), liquidity (L), and market sensitivity (S), or CAMELS.
 

Under this system, examiners assign component ratings as well as
 

a composite rating from “1” to “5,” with “1” representing the least
 

degree of risk and “5” representing the greatest degree of risk. 


is available to serve as an effective buffer against 

market risk exposures. Although the term market risk 

also encompasses foreign exchange, equity, and 

commodity price volatility, it most often manifests itself 

in the form of IRR. Institutions with a “3” or worse “S” 

component rating either have identified weaknesses in 

their market risk controls or have a significant potential to suffer adverse earnings or capital consequences 

due to their market risk exposures. 

Developing a Profile of Institutions Vulnerable to 

Rising Interest Rates 

Using the conceptual framework of the three risks 

described thus far, it is possible to develop a descriptive 

IRR profile of institutions that might be vulnerable to 

rising interest rates. (See inset box for an explanation 

of the methodology used to construct the IRR profiles 

used in this article.) Table 1, for example, shows 

selected average financial measures for the commercial 

banks defined to have margin, repayment, or management risk.11 While this rather abstract approach may 

not be applicable to every individual case, it has the 

benefit of allowing us to objectively measure relative 

exposures across institutions. 

It is useful to compare these financial measures between 

groups and with the financial measures of the vast 

majority of banks (the “All Other Banks” column in 

Table 1) that do not meet the risk criteria for the three 

risk dimensions. The following are some key observations from these comparisons: 

Margin Risk 

• The average, or prototypical, margin risk bank 

(see definition in Table 1) has a significantly 

higher proportion of longer-term earnings assets— 

assets that reprice in more than one year—than 

other institutions. This institution also tends 

to hold a significantly higher proportion of its 

assets in securities. These securities are centered 

primarily in longer-term Treasury and mortgagebacked securities. 

• Because of the heavy investment in securities, the 

prototypical margin risk bank has proportionally 

smaller holdings of loans. However, as might be 

11 Data in Table 1 represent the unweighted average for the institutions in each bank group. 

FDIC OUTLOOK 16 SPRING 2005 
Profiles of Depositories Exposed to Interest Rate Risk 

Table 1 

Financial Profile of Commercial Banks Vulnerable to Rising Interest Rates 

(as of September 30, 2004) 

Margin Risk Repayment Risk Management Risk All Other 

Banksa Banksb Banksc Banks 

Number of banks 1,212 622 312 5,693 

Combined assets $1,951 billion $457 billion $137 billion $5,884 billion 

Selected balance components 

(as a % of assets) 

Securities 34.9 10.4 28.0 22.8 

Total loans 55.2 79.8 58.6 64.1 

Noncore deposits 11.5 17.1 14.4 12.7 

FHLB advances 6.1 4.0 5.6 3.5 

Equity 11.0 10.9 10.4 11.8 

Assets repricing in more 

than 1 Year 68.3 44.5 55.1 49.6 

Selected earnings measures (%) 

Net interest margin 3.9 4.5 3.8 4.1 

Return on assets 1.1 1.3 0.4 1.1 

a Margin risk banks are those with long-term loans and securities greater than 30 percent of assets. Long-term assets include loans and securities with contractual maturities or a next repricing 

in excess of five years. 

b Credit risk banks are those with either a large proportion of their assets in non-prime loans, greater than 50 percent of their assets in CRE or construction loans, or greater than 50 percent of 

their assets in mortgage and consumer loans. 

c Management risk banks are those with weak market sensitivity, or “S” component ratings (“3” or worse). 

Note: All numbers in the table are within-group, unweighted averages. 

Source: Federal Deposit Insurance Corporation Call Reports. 

expected, its holdings of residential mortgages are 

proportionately higher than those of other banks. 

Repayment Risk 

• The average repayment risk bank is significantly 

more “loaned-up” than other institutions. Moreover, as the risk criteria used to develop this bank 

suggest, its loans tend to be heavily centered in 

higher-risk lending categories such as CRE and 

construction loans. These banks also tend to 

have somewhat higher levels of home equity and 

credit card lending.12 Not surprisingly, because 

these banks have a greater concentration of higherrisk loans, the net interest margin of repayment 

risk banks is the highest of the commercial bank 

group used in this analysis. The coexistence of 

higher margins (and therefore lower margin risk) 

and higher repayment risk within this group 

suggests a trade-off between these dimensions of 

12 The balance sheets of institutions engaged in non-prime lending 

activities are heavily concentrated in consumer lending, which 

includes home equity and credit card loans. 

risk that would tend to reduce the total IRR of 

these institutions. 

• Funding sources among these groups of banks are 

somewhat similar. However, the prototypical repayment risk bank tends to fund itself with more 

noncore deposit sources, whereas the prototypical 

margin risk bank funds itself with somewhat higher 

levels of Federal Home Loan Bank (FHLB) 

advances.13 Generally, however, all three risk groups 

have higher concentrations of noncore funding and 

noncore deposits and FHLB advances than all the 

other bank categories. 

Management Risk 

• Equity and earnings levels are weakest at the prototypical management risk bank. 

A review of the examination findings related to banks 

with weak market sensitivity ratings reveals additional 

13 Noncore deposits include time deposits greater than or equal to 

$100,000, brokered deposits, and foreign deposits. 

FDIC OUTLOOK 17 SPRING 2005 
In Focus This Quarter: Interest Rate Risk and Funds Management 

Methodology Used to Construct IRR Profiles
 

For analytical purposes, the criteria set forth below were 

used to develop an “average,” or prototypical, bank for 

each of the three bank risk groups identified by margin 

risk, repayment risk, and management risk. Performance 

measures and financial ratios for each bank group and 

the group of “All Other Banks” are provided in Table 1. 

Financial measures represent the unweighted average 

statistic for the banks within each group. 

Risk Criteria for Bank Groupings 

Margin risk banks are commercial banks with longterm loans and securities greater than 30 percent of 

assets. Long-term assets include loans and securities 

with contractual maturities or with a next repricing date 

in excess of five years. 

Repayment risk banks are commercial banks with a 

large proportion of assets centered in non-prime loans 

(identified with nonpublic examination information), 

commercial banks with greater than 50 percent of their 

assets centered in CRE or construction loans, or banks 

with greater than 50 percent of assets centered in mortgage and consumer loans. 

Due to lack of available loan and borrower data, it is 

difficult to identify all institutions that may experience 

repayment risk in a rising-rate environment. For this 

shared characteristics that can be included in the IRR 

profile. Specifically, these institutions tend to have 

weak IRR monitoring systems combined with weak 

earnings and capital. Because of their weak earnings 

and capital positions, they are less able to withstand 

any volatility in earnings prompted by changing interest rates. Such characteristics are most problematic 

when found in conjunction with capital leveraging 

programs or lending activities concentrated in mortgage 

or non-prime lending.14 

Most Banks and Thrifts Could Withstand a 

Significant Near-Term Rise in Interest Rates 

To illustrate how IRR can affect earnings and capital, 

consider the simple stress simulation in Table 2. This 

simulation uses Call Report maturity and repricing 

14 A capital leveraging program describes a strategy to enhance 

overall earnings returns by funding lending and securities investment 

programs with more volatile or noncore funding sources. 

exercise, the selected banks had higher concentrations of 

variable-rate, subprime loans and CRE and construction 

loans that exhibited the most pronounced vulnerability 

to higher interest rates in the current environment. 

Other consumer-oriented institutions were included 

on the list of identified subprime lenders, as many also 

hold small portfolios of non-prime loans to the repayment risk group. 

Management risk banks are those with weak market 

sensitivity, or “S” component ratings (“3” or worse). 

Simulation Test 

The second phase of the analysis simulated the effect of 

two scenarios of higher interest rates on the prototypical 

management risk bank. The prototypical management 

risk bank is constructed using the average ratios calculated from the entire management risk bank group. The 

two alternative interest rate scenarios are (1) an immediate 300-basis-point rise in short-term interest rates and 

(2) a 500-basis-point rise in short-term interest rates. 

Each rate shock is assumed to be permanent throughout 

the two-year simulation period. The simulation consists 

of a simple pro forma extrapolation of year-to-date 2004 

earnings for two additional years under these rate-shock 

scenarios. The result of this simplified simulation on the 

management risk banks is provided in Table 2. 

information to measure incremental changes in earnings for the prototypical management risk bank 

described in Table 1. Note that even when this proxy 

institution is subjected to an immediate rise in shortterm rates of 500 basis points, its capital falls only 

slightly from 10.4 percent to 9.9 percent over a twoyear projection period. Granted, such an extreme 

change in rates would have significant valuation 

implications as well. However, capital levels of this 

prototypical bank should serve as sufficient protection 

against net reductions in the value of its equity.15 

15 The Office of Thrift Supervision’s Quarterly Review of Interest Rate 

Risk gives some sense of the possible magnitude of such valuation 

changes. For example, in its second quarter 2004 report, a 300-basispoint increase in rates resulted in a 30 percent reduction, in aggregate, in the market value of thrifts’ net worth. If the asset and liability 

structure of the prototypical management risk bank is presumed to 

be similar to that of thrifts, then the bank’s equity-to-asset ratio would 

decline to 7.28 percent on a market-value basis following the 300­

basis-point rate shock. A 500-basis-point rate shock would produce 

a somewhat greater reduction in equity capital on a market-value 

basis but probably not of magnitudes that would suggest insolvency 

(in market-value terms). 

FDIC OUTLOOK 18 SPRING 2005 
Profiles of Depositories Exposed to Interest Rate Risk 

Table 2 

Year 2 Pro Forma Earnings of a Prototypical Bank with Weak Market Sensitivity Ratings 

Following an Immediate Rate Shock (data as of September 30, 2004) 

Unstressed Results (%) 300-Basis-Point Rise (%) 500-Basis-Point Rise (%) 

Net interest margin 3.84 3.23 2.82 

Return on assets 0.42 0.01 –0.26 

Equity to assets 11.11 10.41 9.94 

Methodology: 

This exercise quantifies incremental changes in year-to-date 2004 margins and overall earnings given changes in earning 

asset yields and funding costs due to an immediate increase in interest rates. To measure the incremental change in interest 

earnings and costs, the maturity and repricing information in the Call Reports was used. 

Key Assumptions: 

• Rate changes reflect immediate changes in short-term rates and are permanent through the projection period. 

• Changes in loan yields presume reinvestment/repricing into long-term loans and a narrowing of the yield curve. 

• Changes in securities yields presume reinvestment/repricing into medium-term securities and a narrowing of the yield 

curve. 

• Changes in funding costs for certificates of deposit, other borrowings, and short-term funding presume replacement of 

funding at short-term rates. 

• Changes in money market deposit accounts, savings, and transaction account costs are derived from a regression of 

historical changes in the cost of these funds (over a four-quarter period) relative to changes in federal funds rates. 

• Off-balance-sheet hedges and contractual options embedded in earnings assets (such as the right to prepay loans or call 

securities) or funding costs are not considered. 

• Asset and liability levels as well as the mix of assets and liabilities are assumed to remain static over the two-year projection period. 

Source: Federal Deposit Insurance Corporation Call Reports. 

The main point illustrated by these simulation results is 

that IRR would appear to manifest itself as an earningsrelated issue over the near-term rather than a solvency 

issue for the vast majority of FDIC-insured institutions. 

Even in such situations, a more critical concern is 

often how management responds to reduced earnings 

margins. If management chooses to invest in higher-risk 

investments to restore its margins, then solvency could 

become an issue when these investments fail to perform 

and the institution experiences higher investmentrelated losses. 

Finally, IRR can reduce or impair the ability of institutions to withstand financial adversity produced through 

a confluence of risk events. One of the more striking 

examples of this point was the performance of the thrift 

industry during the 1980s. During this period, declining 

interest margins largely eliminated the ability of many 

thrifts to absorb a substantial rise in real estate credit 

losses through earnings. 

Interest Rate Risk Faced by Depositories Today 

Should Be Viewed in Historical Context 

Although it is worthwhile to define characteristics of 

institutions exposed to rising interest rates, it should be 

recognized that IRR may not pose the same degree of 

risk to FDIC-insured depositories that it did some 20 

years ago. The following are some of the main reasons 

why today’s banks and thrifts, even those falling within 

the high-risk profiles described previously, are better 

able to withstand interest-rate shocks than institutions 

in the early 1980s: 

•	 Tools and techniques have improved. The market 

for financial products and services has evolved to 

provide banks and thrifts more options to control 

and reduce IRR. Because of the expanding depth of 

markets for such products as asset-backed securities 

and derivatives, depositories have the ability to securitize or hedge exposures that create undesirable IRR 

FDIC OUTLOOK 19	 SPRING 2005 
In Focus This Quarter: Interest Rate Risk and Funds Management 

more cost-effectively than would be the case with 

less developed markets. 

•	 The regulatory environment has changed significantly. During the 1980s and early 1990s, the 

regulation of banks and thrifts was undergoing 

significant change. The thrift industry was deregulated with the Depository Institutions Deregulation 

and Monetary Control Act of 1980 (which removed 

Regulation Q restrictions on interest paid on 

deposits) and the Garn-St. Germain Act of 1982. 

In the early 1990s, tighter investment and Prompt 

Corrective Action rules were imposed with the 

Financial Institutions Reform, Recover, and Enforcement Act of 1989 and the Federal Deposit Insurance 

Corporation Improvement Act (FDICIA) of 1991. 

Today’s regulatory environment for financial services 

in the United States is arguably far less turbulent, as 

evidenced by the relatively small number of bank 

and thrift failures since 1994. 

•	 Capital positions are much stronger. In the aftermath of FDICIA and newly implemented risk-based 

capital rules (Basel I), institutions today have a 

significantly higher buffer of capital with which to 

absorb financial shocks relative to their financial 

position than 20 years ago. For example, the equityto-asset ratios of thrifts and banks averaged 4.2 

percent and 6.2 percent, respectively, during the 

latter half of the 1980s. Today, thrifts and banks 

maintain an average equity-to-asset ratio of 9.2 

percent and 9.4 percent, respectively. 

Though IRR may pose less of a solvency threat to 

FDIC-insured depositories today than it has in the 

past, both banks and supervisors continue to monitor 

it closely. IRR can place significant downward pressure 

on margins and overall earnings if not properly 

managed. In such cases, supervisors may respond by 

downgrading one or more of a bank’s CAMELS 

ratings, including the market sensitivity rating. 

Accordingly, it is not surprising that weaknesses in 

IRR management and weak earnings go hand-in-hand. 

Referring back to Table 1, note that the annualized 

return on assets of commercial banks with weak 

market sensitivity ratings (“S” ratings of “3” or higher) 

as of September 30, 2004, was only 0.43 percent—70 

basis points lower than that of banks with satisfactory 

or better market sensitivity ratings. 

Conclusion 

An institution’s vulnerability to rising interest rates 

can be viewed along three different risk dimensions: 

margin risk, repayment risk, and management risk. 

Defined along these risk dimensions, the prototypical 

institution with exposure to rising rates is one with 

either a proportionally large volume of long-maturity 

assets or a proportionately high volume of adjustablerate loans to highly leveraged consumers or collateralized by CRE. Moreover, institutions with weak IRR 

controls and practices often display weak earnings and 

reduced capital levels. 

Although IRR in general appears to pose less of a risk 

to the industry than it did 20 years ago, it remains a 

critical risk assessment factor in the supervisory process. 

Through 20 years of FDIC failure experience, supervisors of depositories have seen how IRR can compound 

safety and soundness issues. If left unchecked, weakened earnings attributable to uncontrolled IRR could 

leave an institution vulnerable to other problems, so 

how management reacts to IRR-related weaknesses in 

earnings margins is often more important than the 

underlying IRR position of the institution. 

Steven Burton, Senior Financial Analyst 

FDIC OUTLOOK 20	 SPRING 2005 
Rate/Volume Analysis: An Off-Site Approach to 

Measuring Interest Rate Risk 

Interest rate risk (IRR) is the exposure of a bank’s Chart 1 

current or future earnings and capital to interest rate Federal Reserve Rate Hikes Led to a Flatter Yield changes.1 One method of assessing the level of IRR, or Curve during 2004 the sensitivity of an institution’s earnings to changing 6% 

interest rates, is by using rate/volume analysis (RVA). 

RVA is an effective, after-the-fact, off-site monitoring 5%

technique that measures IRR by analyzing the separate 4% 

Year-end 2004 

Mid-year 2004 

Year-end 2003 

3-month 6-month 1-year 2-year 3-year 5-year 7-year 10-year 20-year 

components of net interest income (NII) over a specific 

Yield* 

3% time period. (See the inset box for more on the basics 

of RVA.) In addition, RVA helps identify outlier institutions where changes in interest rates significantly 

affect NII. Using the RVA method, this article assesses 

the level of IRR among institutions insured by the 

Federal Deposit Insurance Corporation (FDIC) across 

the country during the 12-month period ending 

September 30, 2004. 

Background 

After two years of the lowest federal funds rates since 

the late 1950s, short-term rates began to rise in June 

2004 when the Federal Reserve’s Federal Open Market 

Committee (FOMC) raised the federal funds target 

interest rate a quarter point to 1.25 percent. During the 

remainder of 2004 the federal funds target rate was 

raised four more times, closing the year at 2.25 percent. 

In contrast, 10-year Treasury notes fluctuated within a 

band of between 4.73 percent and 4.10 percent during 

the same six-month period, ending the year at 4.23 

percent, which was slightly below year-end 2003 levels.2 

Taken in combination, the changes in short- and 

long-term interest rates during the year resulted in a 

modestly flatter yield curve by the end of 2004 (see 

Chart 1). The yield curve spread, defined as the difference between the yields on the 10-year Treasury bond 

and the 3-month Treasury bill, declined from a high of 

368 basis points at May 2004 to 201 basis points by 

year-end 2004.3 

1 IRR includes repricing risk, basis risk, yield curve risk, option risk,
 

and price risk. For more information, see the Federal Deposit Insurance Corporation Manual of Examination Policies, http://www.fdic.
 

gov/regulations/safety/manual/index.html. 


2 Based on monthly average data for the 10-year U.S. Treasury note. 


3 Treasury yields represent monthly averages. 


2% 

1% 

0% 

U.S. Treasuries 

* Treasury constant maturities.
 

Source: U.S. Treasury.
 

Typically, a flattening yield curve tends to compress net 

interest margins (NIMs) for financial intermediaries. 

However, despite a moderately flatter yield curve, 

NIMs actually improved at the majority of the nation’s 

community banks.4 During the first nine months of 

2004, 52 percent of community banks reported margin 

improvement, up from 27 percent a year earlier. 

The improvement in NIMs during the recent period of 

a flattening yield curve may be the result of a number 

of factors. First, this analysis is through third quarter 

2004 and represents only one-quarter of increases in 

the federal funds rate; further, only one increase was 

effective for the entire period. (Generally, there is a lag 

between rising market rates and increases in funding 

costs for some institutions, so the effects of the rate 

hike may not yet be fully reflected in funding costs.) 

In addition, the rise in the federal funds rate has taken 

place gradually at what FOMC statements have termed 

“a measured pace,” which means that the increases 

were relatively modest and widely anticipated by 

financial market participants. Further, despite recent 

flattening, the yield curve spread of 201 basis points at 

year-end 2004 remained relatively steep and above its 

20-year average of 180 basis points. The yield curve 

may need to flatten more significantly before there is a 

pronounced negative effect on community bank NIMs. 

4 Community banks consist of all FDIC-insured institutions with assets 

of less than $1 billion and exclude credit card and other specialty 

institutions as well as de novo institutions. 

FDIC OUTLOOK 21 SPRING 2005 
In Focus This Quarter: Interest Rate Risk and Funds Management 

Rate/Volume Analysis: The Basics
 

In an effort to assess the impact of interest rate changes on NII, RVA analyzes an institution’s change in NII by separating it into three components: changes in yields and costs (rate variance), fluctuations in volume of earning assets 

and interest-bearing liabilities (volume variance), and residual interest income and expense arising from the combination of rate and volume changes (mix variance). Conceptually, RVA follows a performance attribution methodology by 

breaking down NII into its components and then measuring the contribution of each component during a given 

period. RVA can be applied to any two consecutive periods (see Table 1). 

Table 1 

Rate/Volume Analysis Methodology 

Variance Measures Formula Components 

Income rate variance (3Q2004 earning asset yield less 3Q2003 earning asset yield ) times 3Q2003 average 

earning assets 

Expense rate variance (3Q2004 cost of funds less 3Q2003 cost of funds) times 3Q2003 average interest-bearing 

liabilities 

Income volume variance (3Q2004 average earning assets less 3Q2003 average earning assets) times 3Q2003 earning asset yield 

Expense volume variance (3Q2004 average interest-bearing liabilities less 3Q2003 average interest-bearing 

liabilities) times 3Q2003 cost of funds 

Income mix variance (3Q2004 average earning assets less 3Q2003 average earning assets) times (3Q2004 yield 

less 3Q2003 yield) 

Expense mix variance (3Q2004 average interest-bearing liabilities less 3Q2003 average interest-bearing 

liabilities) times (3Q2004 cost less 3Q2003 cost) 

Note: The “net” position for each of the variance measures is the difference between the income and expense variances. For example, the net rate variance is equal to the income rate 

variance less the expense rate variance. The sum of the three net variance measures (rate, volume, and mix) should equal the total change in net interest income during the period. 

Source: Federal Deposit Insurance Corporation. 

RVA is just one analytical tool to evaluate IRR in the banking system. Although RVA is an excellent tool for assessing how interest rate changes affect the components of NII, it is limited in its ability to forecast future results. These 

limitations arise from a reliance on historical data as well as the potential for change in a bank’s asset and liability mix 

over time. Regardless of the results of RVA for a past period, either balance-sheet repositioning or changes in the level 

or direction of interest rates could alter the degree and direction of IRR risk in future periods. In addition, RVA is 

limited in its ability to handle off-balance-sheet items. 

Results of Rate/Volume Analysis 

As of September 30, 2004, a trailing four-quarter 

RVA on the nation’s community banks indicates that 

the interest rate environment had a nearly equivalent 

influence on asset yields and liability costs. These 

data suggest that the IRR exposure of the average 

community bank during the past year was relatively 

limited. The average asset yield of community banks 

fell 44 basis points to 5.62 percent, while the interestbearing liability cost fell by an almost equivalent 

amount, 45 basis points, to 1.84 percent. As a result, 

the net interest spread for community banks remained 

relatively stable at 3.79 percent during the period.5 

Robust growth in earning assets, particularly in 

commercial, construction, and residential real estate 

loans, contributed to the increase in interest income 

(see Table 2). 

5 The net interest spread is calculated slightly differently from NIM. 

The net interest spread equals [interest income divided by average 

earning assets] less [interest expense divided by average interestbearing liabilities]. The NIM equals [interest income divided by 

average earning assets] less [interest expense divided by average 

earning assets]. 

FDIC OUTLOOK 22 SPRING 2005 
Table 2 

An Interest Rate/Volume Analysis Indicates Little Interest Rate Risk Was 

Prevalent at Community Banks during 2004 

4 Quarters Ending 9/30/2003 4 Quarters Ending 9/30/2004 Rate/

Average Income/ Rate Average Income/ Rate 

Balance ($) Cost ($) (%) Balance ($) Cost ($) (%) Volume ($) Rat

ASSETS INTEREST-EARNING ASSETS 

Short-Term Investments: 

Interest-bearing deposits 12,465,622 235,472 1.89 11,133,288 194,035 1.74 –25,167 –1Securities (includes United States, mortgagebacked securities, subdivision, equities) 230,463,431 9,339,732 4.05 255,868,829 9,544,735 3.73 1,029,576 –74Federal funds sold/repurchased 38,381,810 450,144 1.17 30,335,311 317,325 1.05 –94,370 –4Trading assets 95,974 3,917 4.08 64,710 2,264 3.50 –1,276 Total short-term investments 281,406,836 10,029,265 3.56 297,402,138 10,058,359 3.38 908,763 –81

Loans: 

Real estate 459,968,718 31,789,935 6.91 516,309,348 32,638,956 6.32 3,893,884 –2,71Agriculture 26,815,372 1,837,382 6.85 26,675,989 1,725,667 6.47 –9,550 –10Commercial & industrial 107,605,511 7,504,588 6.97 114,569,897 7,578,985 6.62 485,708 –38Consumer 58,952,463 5,255,430 8.91 57,263,410 4,731,651 8.26 –150,574 –38Total loans 664,700,220 46,957,306 7.06 727,200,873 47,234,409 6.50 4,415,317 –3,78

Lease Financing Receivables 3,170,310 251,655 7.94 3,208,173 240,122 7.48 3,005 –1

TOTAL INTEREST-EARNING ASSETS 949,277,366 57,503,300 6.06 1,027,811,184 57,799,612 5.62 4,757,254 –4,12

LIABILITIES INTEREST-BEARING LIABILITIES 

Interest-Bearing Deposits: 

Transaction accounts 93,180,729 785,716 0.84 100,599,189 665,802 0.66 62,554 –16Nontransaction accounts Savings deposits (including money market 

deposit accounts) 250,830,173 2,900,633 1.16 285,435,790 2,575,703 0.90 400,184 –63

Time deposits > $100,000 128,850,970 3,826,251 2.97 138,552,362 3,408,348 2.46 288,084 –65

Time deposits, all others 255,584,260 8,076,314 3.16 251,126,435 6,472,930 2.58 –140,865 –1,48

Federal Funds 17,750,355 244,710 1.38 21,955,977 270,602 1.23 57,980 –2Other Borrowed Money 45,278,892 2,232,537 4.93 54,732,243 2,247,923 4.11 466,110 –37

TOTAL INTEREST-BEARING LIABILITIES 791,988,786 18,098,165 2.29 853,133,579 15,671,644 1.84 1,397,253 –3,54

CHANGE IN NET INTEREST INCOME 157,288,580 39,405,135 3.77 174,677,605 42,127,968 3.79 3,360,001 –57Notes: Community banks are commercial banks with assets of $1 billion or less. For this analysis, the sample was limited to community banks open since September 30, 2001, and excludes specialty banks. Subcatedetail on minor categories may not be listed. Source: Federal Deposit Insurance Corporation Call Reports (merger-adjusted). 

FDIC OUTLOOK 23 SPRING 2005
In Focus This Quarter: Interest Rate Risk and Funds Management 

Table 3 

Community Banks Displaying High Interest Rate Sensitivity 

(during the four quarters ending 9/30/04) 

Community Banks Reporting a Community Banks Reporting a Total of All Community Banks 

Large Negative Reaction (%) Large Positive Reaction (%) Reporting a High Sensitivity (%) 

San Francisco 1.7 3.3 5.0 

Dallas 1.4 3.4 4.8 

New York 1.5 2.5 4.0 

Chicago 1.1 2.5 3.6 

Kansas City 1.4 1.8 3.2 

Atlanta 0.9 2.2 3.1 

Memphis 1.1 1.3 2.5 

Boston 0.8 1.2 2.0 

Nationwide 1.2 2.4 3.6 

Note: Sensitivity is defined as net rate variance exceeding 20 percent of the prior four quarters’ net interest income. This variance reflects reaction to the specific interest rate environment for 

a particular period. Different banks will likely display high sensitivity during differing rate movements. 

Source: Federal Deposit Insurance Corporation. 

Only a small subset—about 3.6 percent of the 6,904 

institutions analyzed—displayed a high level of sensitivity to rate movements during the period (see Table 

3).6 Of these institutions, approximately one-third 

reported a negative earnings reaction, whereas the 

earnings of the remaining “highly sensitive” institutions reacted favorably to recent interest rate changes. 

Geographically, community banks in the FDIC’s San 

Francisco and Dallas Regions reported the highest 

percentage of highly sensitive banks, and the Boston 

area reported the lowest percentage. Despite these 

differences, the percentage of highly sensitive institutions during this period was low—below 5 percent— 

in every FDIC region.7 

Conclusion 

Overall, this RVA analysis indicates that little IRR was 

prevalent among community banks, at least over the 

past year. For the most part, asset yields and liability 

costs of community institutions generally have moved 

in tandem with the changing rate environment, with 

increases in earning asset volume helping to raise NII. 

Even among the small group of institutions highly 

sensitive to rate movements, only one-third reported 

an adverse reaction to this rate environment, with the 

remainder reporting an improvement in spread income. 

Notwithstanding, this analysis represents an aggregate 

analysis of the nation’s community banks, and vulnerability to changes in interest rates will vary among individual institutions. 

Ronald Sims II, CFA, Senior Financial Analyst 

6 For this analysis, interest-rate-sensitive banks are defined as those 

banks where the net rate variance exceeded 20 percent or more of 

prior period NII. See Table 1 for a definition of net rate variance. 

7 Geographical variations reflect differences among individual institutions over this specific time period. Results will change during different interest rate periods. 

FDIC OUTLOOK 24 SPRING 2005 
Funding Asset Growth in a Rising Rate 

Environment: National and Regional Perspectives 

Funds management is a constant challenge for institutions insured by the Federal Deposit Insurance 

Corporation (FDIC) that becomes even more challenging and important during periods of rising interest 

rates. The federal funds rate rose throughout the 

second half of 2004, and the consensus estimate is for 

more increases in 2005.1 Rising short-term rates in a 

strengthening economy may alter the competitive 

landscape for core deposits, which remain a large but 

decreasing share of total bank funding. Should asset 

growth intensify as economic fundamentals improve, 

banks will have to focus more attention on funding 

strategies. This article explores national funding 

trends against this backdrop and highlights regional 

variations seen among FDIC-insured institutions. 

Asset Growth Continues to Outpace Core Deposit 

Growth at Community Banks 

During the past decade, greater competition for traditional deposits among FDIC-insured institutions and 

other financial intermediaries has contributed to an 

increased reliance on noncore funding by community 

banks.2 This long-term trend of declining levels of core 

deposits in relation to total assets appears likely to 

persist (see Chart 1).3 

In recent years, the banking industry has experienced 

relatively healthy core deposit trends, with community 

bank core deposit growth exceeding 7 percent in three 

of the past four years. Factors that may have contributed 

to higher core deposit and certificate of deposit (CD) 

growth include higher growth in gross domestic product, changes in interest rates, growth in corporate 

1 According to the February 1, 2005, issue of Blue Chip Financial 

Forecasts, the consensus estimate for the average federal funds 

rate is 3.6 percent for fourth quarter 2005. 

2 Community banks are defined here as both banks and thrift institutions with less than $1 billion in assets, excluding new institutions 

(those established within the past three years) and specialty lenders 

such as credit card banks. Noncore funding generally consists of 

large time deposits (greater than $100,000), borrowings, brokered 

deposits, federal funds purchased, repurchase agreements, and 

foreign deposits. 

3 Core deposits are defined as checking, savings, and money market 

accounts as well as certificates of deposit less than $100,000. 

Chart 1 

Core Funding at Community Banks Continues to Shrink
 

Relative to Assets
 

Percent Growth 

(year-over-year) Percent of Assets 

12 

Asset Growth 80 

78 

10 76 

8 74 

72 

6 70 

68 

4 66 

2 64 

62 

0 60 

Source: Federal Deposit Insurance Corporation Call and Thrift Reports. Merger-adjusted 

data as of September 30. 

(left axis) 

Core Deposit 

Growth (left axis) 

Core Funding to Assets

(right axis) 

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 

profits, growth in disposable income, the total return 

of the S&P 500, and growth in median housing prices.4 

Interestingly, although deposit growth has been relatively strong, assets have grown faster still, thereby 

putting pressure on FDIC-insured institutions to 

increase their use of noncore funding sources. With 

the recent rebound in equity market performance, 

core deposit growth has begun to slow, which could 

contribute to increased use of alternative funding.5 

With the increasing reliance on noncore funding by 

the industry, community banks have been trending 

toward liability structures that more closely resemble 

those of larger institutions—that is, funding a larger 

percentage of assets through noncore funding. In the 

past decade, the difference between large and small 

institutions has narrowed. Ten years ago, noncore funding represented only 13 percent of total community 

bank assets. As of September 30, 2004, that figure had 

almost doubled to 24 percent of assets. Nevertheless, 

the ratio of noncore funding to assets at large banks 

remains significantly higher at 41 percent of assets. 

4 Michael Mayo, “Are Deposits Hitting an Inflection Point?” Prudential 

Equity Group, LLC, January 14, 2005. 

5 Merger-adjusted community bank loan growth spiked from 7 percent 

to 12 percent from third quarter 2003 to third quarter 2004. If sustained, 

this loan growth may foreshadow stronger asset growth, as institutions may initially fund loan growth through the liquidation of 

marketable assets. 

FDIC OUTLOOK 25 SPRING 2005 
In Focus This Quarter: Interest Rate Risk and Funds Management 

Community Banks Are Increasing Their Use of 

Alternative Funding Sources 

For community banks, the most noteworthy funding 

trends have been increased use of Federal Home Loan 

Bank (FHLB) borrowings and brokered deposits. 

Although the banking industry overall has not reported 

an increase in FHLB borrowings relative to total assets 

during the past three years, more community banks 

have turned to this funding source. As of September 

30, 2004, 61 percent of community banks reported the 

use of FHLB borrowings, up from 52 percent three years 

earlier. The availability of FHLB credit has generally 

been positive for FDIC-insured institutions, as many 

small banks without easy access to capital markets can 

tap into this source of funds. 

The use of brokered deposits also has increased 

among FDIC-insured institutions, even though this 

form of funding is typically of higher cost and more 

sensitive to interest rate movements than core 

deposits. In 2004, 25 percent of community banks 

reported the use of brokered deposits, up from only 8 

percent ten years ago and 16 percent three years ago. 

Although more institutions are using this funding 

source, the percentage of brokered deposits to assets 

remains relatively low; only 4.5 percent of large bank 

assets and 2.3 percent of community bank assets are 

funded this way. 

If properly administered, such diversification of funding sources can benefit FDIC-insured institutions. 

The increased use of noncore funds can also enable a 

more precise structuring of liabilities than can be 

obtained primarily through changes in core deposit 

pricing. For instance, many institutions have found 

that brokered deposits can be a more cost-effective 

deposit-gathering mechanism than building new 

branches. 

Community Banks Continue to Experience Changing 

Depositor Preferences 

Since 2001 community banks have seen a shift in 

deposit maturities, a trend likely to continue as interest rates climb. As the percentage of time deposits 

maturing in more than one year increased from 22 

percent of all time deposits in 2001 to 33 percent in 

2004, all time deposits fell from 40 percent to 35 

percent of assets. During the same period nonmaturity deposits increased by an equal amount, from 42 

percent of assets to 47 percent of assets.6 These shifts 

highlight how depositor preference can fluctuate 

during periods of changes in interest rates or other 

market factors. Part of the shift toward nonmaturity 

deposits could reflect a flight to quality, as some 

customers may have sought to avoid turbulent equity 

markets and also perceived low opportunity costs 

associated with short-term deposits given historically 

low inflation as well as low interest rates. 

As bankers well know, managing depositor preference 

is a dynamic process. If depositors expect recent interest rate increases to continue, they will have less 

incentive to lock up funds for a longer duration, which 

may lead bank managers to alter deposit pricing or 

reposition the maturity structure of their noncore 

funding sources. 

Funding Costs Remain Sensitive to Interest Rate 

Movements 

Typically, there is some lag time between changes in 

market interest rates and rates offered on bank deposits. 

This pricing lag is a function of the repricing schedule 

of deposits, management’s deposit pricing strategy, and 

customer preferences. Part of the time lag arises from 

the fact that core deposit customers often consider 

factors other than interest rates when choosing where 

to bank, including the convenience of banking services 

and the extent and satisfaction of their current banking 

relationship. 

Early indications suggest, however, that banks may be 

finding it difficult to hold deposit rates steady in this 

rising rate environment. Given that retail deposit 

customers have endured a lengthy period of very low 

interest rates and short-term interest rates have risen 

quickly of late, these customers may now be more 

yield-conscious. For instance, a nationwide index of 

CD rates suggests that short-term CD rates began 

moving upward even before the initial rise in the 

federal funds rate (see Chart 2). Although deposit 

rates will vary across geographic markets and reflect 

the intensity of competition for local deposits, it 

appears that core deposit competition will remain 

strong and that funding costs will be sensitive to 

higher interest rates. Bank Call Report data suggest 

that the cost of funding is beginning to rise in 

6 Nonmaturity deposits include transaction, savings, and money 

market demand accounts. 

FDIC OUTLOOK 26 SPRING 2005 
Funding Asset Growth in a Rising Rate Environment 

Chart 2 

Short-Term CD Rates Have Risen Quickly 

Percent 

3.0 

2.5 

2.0 

1.5 

1.0 

Federal Funds Rate 

1-Year CD Rate 

2-Year CD Rate 

0.5 

4Q03 1Q04 2Q04 3Q04 4Q04 

Notes: Average yields on retail savings certificates of deposit (CDs) offered by leading
 

banks from 50 states and Washington, D.C. Four-week moving averages through January
 

21, 2005.
 

Source: Banxquote.com.
 

response to rising short-term rates. The target federal 

funds rate first moved upward by 25 basis points at 

the end of June 2004, with further 25 basis point 

increases in both August and September. Community 

banks’ cost of funding earning assets rose slightly, 

from 1.55 percent in second quarter 2004 to 1.60 

percent in the third quarter. 

Funds Management Assumptions May Need 

Revisiting 

The assumptions banks make about the rate sensitivity of their deposits, which are crucial inputs in interest rate risk management, may need to be revised in 

this interest rate cycle. Special consideration to the 

interest rate sensitivity of core deposits is warranted, 

as these assumptions are critical in the interest rate 

risk monitoring systems of most banks. Furthermore, 

heightened use of noncore funding, while often beneficial, can come at a cost. Often, this kind of funding 

will exhibit increased interest rate sensitivity or 

contain embedded options that can be difficult to 

value. 

In addition, continued strong growth in loans 

outstanding and unfunded commitments have the 

potential to generate significantly increased funding 

needs for FDIC-insured institutions. During the past 

ten years, the ratio of unfunded commitments to 

assets nearly doubled, with the median level reaching 

9 percent of assets in 2004. As banks and thrifts 

may not always be able to accurately anticipate the 

amount of loan draws that will take place, large 

unexpected draws over a short period of time could 

pressure bank funding needs. 

The remainder of this article highlights some of the 

most significant funding issues and trends occurring 

regionally, with commentary from analysts in each of 

the eight FDIC regional and area offices. 

Mike Anas, Senior Financial Analyst 

The Fastest-Growing Institutions in the Southeast 

Are Also the Biggest Users of Noncore Funding 

The decline in the ratio of core deposits to total funding has been most pronounced in Atlanta Region 

community banks that have displayed high rates of 

asset growth. In fact, during the first nine months of 

2004, some 29 percent of community banks headquartered in the Region reported particularly strong asset 

growth. These “fast-growing” banks had asset growth 

exceeding 20 percent year-over-year (see Map 1).7 To 

accommodate this growth, these banks have turned to 

alternative sources of funding, especially in active real 

estate markets where competition for core deposits has 

heightened because of new market entrants. While the 

increased availability of noncore funding has enabled 

many institutions to fund robust asset growth, the use 

of noncore funding does come at a cost, typically in 

the form of higher interest expenses. 

In third quarter 2004, combined borrowings and 

noncore deposits represented 36 percent of the total 

funding of fast-growing banks, compared with 31 

percent for other community banks. Fast-growing 

banks also reported higher funding costs, which 

contributed to narrowing net interest margins (NIMs). 

A diminished reliance on core deposits also may 

reflect the fact that 20 percent of the fast-growing 

banks are new institutions that face the high overhead 

costs typically associated with penetrating competitive 

deposit markets. 

Although fast-growing banks can be found throughout the Region, the largest clusters are in the three 

key market areas of Atlanta, Southwest Florida, and 

7 For the purposes of the Atlanta Region analysis, community banks 

are defined as insured commercial institutions with assets of less 

than $1 billion. Also, this analysis excluded special-purpose entities, 

new banks, and banks that had been involved in any merger activity. 

FDIC OUTLOOK 27 SPRING 2005 
In Focus This Quarter: Interest Rate Risk and Funds Management 

Map 1 

Location of Rapidly Growing 

Community Banks in the Southeast 

Areas with Concentrations of Fast-Growing Banks 

Atlanta 

Southwest Florida 

South Florida/Central Florida 

Northeast Florida 

Alabama Coast/Florida Panhandle 

Northern Virginia 

Key: 

= higher concentration 

= lesser concentration 

Note: Includes commercial banks with assets less than $1
 

billion as of third quarter 2004; excludes specialty lenders,
 

new banks, and institutions involved in merger activity over
 

the past year with asset growth of 20 percent or more over
 

the past year.
 

Source: Federal Deposit Insurance Corporation.
 

South Florida (see Map 1). Though less concentrated 

than the key markets, Central and Northeast 

Florida, the Alabama coast/Florida Panhandle, and 

Northern Virginia also are home to pockets of fastgrowing community banks. During a period of rising 

rates, greater reliance on more interest-rate-sensitive 

funding sources, combined with the competitive 

nature of these markets, may continue to pressure 

funding costs. 

Scott Hughes, Regional Economist 

Ronald Sims II, Senior Financial Analyst 

Large and Small Banks in the Mid-Atlantic States 

Differ in Their Funding Strategies 

Some of the world’s largest FDIC-insured institutions 

are headquartered in the Mid-Atlantic states. In fact, 

18 percent of the FDIC-insured institutions headquartered there have more than $1 billion in assets, while 

only 6 percent of institutions elsewhere meet that 

threshold. As a result, large institution funding trends 

significantly affect both the regional landscape and 

national trends. 

Larger institutions historically have relied more on 

noncore funding than have smaller institutions. The 

largest institutions in the Mid-Atlantic, those with 

assets greater than $10 billion, have noncore funding 

levels considerably greater than that of institutions 

with assets less than $1 billion (see Table 1). Over the 

past three years, the ratios of noncore funding to assets 

reported by institutions with assets of $1 billion to $10 

billion have been more than 10 percentage points 

higher than those of Mid-Atlantic community banks, 

while institutions with assets of $10 billion or more 

reported ratios of noncore funding to assets almost 30 

percentage points higher. The biggest difference 

between the funding profiles of large versus smaller 

banks is their use of FHLB advances, purchased federal 

funds, and foreign deposits.8 

The Mid-Atlantic’s larger institutions have reported 

funding costs slightly less than or roughly equivalent to 

those of community banks during the past three years, 

despite significantly higher noncore funding levels.9 

This may suggest that the largest institutions have some 

competitive advantage over smaller banks in gathering 

noncore funding. Larger institutions typically have 

greater access to capital markets and generally may be 

perceived as a lower-risk premium among investors 

when borrowing uninsured funds.10 Of course, many 

factors can affect a bank’s overall cost of funds, such as 

the maturity composition of liabilities and the 

perceived credit risk associated with borrowings. Nevertheless, higher levels of noncore funding do not necessarily equate to higher funding costs, particularly among 

larger institutions. 

For community banks, however, the incremental costs 

of adding noncore funding may be higher than for large 

banks. Community banks that have a significant 

reliance on noncore funding (greater than 30 percent 

of assets) typically have much higher funding costs 

than other community banks. In the Mid-Atlantic 

states, community banks below this threshold have a 

cost of funds of only 1.88 percent, compared with 2.23 

percent for those with a larger amount of noncore 

funds. A similar relationship holds nationwide and has 

existed for many years. 

Looking ahead, should core deposit competition intensify along with rising interest rates, Mid-Atlantic institutions are likely to continue to see noncore funding 

levels grow, particularly among smaller institutions. 

Moreover, while core deposit rates typically lag changes 

in market interest rates, rates on noncore funding are 

more sensitive to interest rate changes. For smaller institutions, rising rates, coupled with a shift to generally 

8 The larger amount of foreign deposits held by the Mid-Atlantic large 

banks reflects the presence of multinational operations. 

9 The cost of funds calculations represent the ratio of annualized 

year-to-date interest expense to average interest-bearing liabilities 

through September 30. 

10 Risk premiums differ by issuer based on individual credit risk and 

liquidity premiums. 

FDIC OUTLOOK 28 SPRING 2005 
Funding Asset Growth in a Rising Rate Environment 

Table 1 

Mid-Atlantic Funding Profile 

Institutions* 

Asset Size 

Less than $1 Billion $1 Billion to $10 Billion Greater than $10 Billion 

552 108 25 

Core deposits to assets 

Noninterest-bearing 

67.0% 53.2% 28.7% 

deposits to assets 10.7% 8.1% 8.7% 

Noncore funding to assets 22.4% 35.0% 55.3% 

Brokered deposits to assets 1.1% 3.0% 4.1% 

Large time deposits to assets 11.5% 12.1% 6.2% 

Foreign deposits to assets 0.1% 1.9% 24.4% 

Borrowings to assets 10.4% 20.5% 22.5% 

FHLB Advances to Assets 7.3% 8.7% 2.0% 

Banks with brokered deposits 18.5% 38.9% 80.0% 

Cost of funds** 

Net interest margin** 

1.96% 

3.60% 

1.80% 

3.18% 

1.94% 

3.05% 

*Individual insured institutions, not consolidated holding companies. Excludes new and specialty institutions. 

** Year-to-date, annualized. 

Source: Federal Deposit Insurance Corporation. Data as of September 30, 2004. 

higher-cost noncore funds, will potentially mean a more 

rapid increase in funding costs than during the past year. 

In the Mid-Atlantic, higher NIMs reported by smaller 

institutions as compared with larger banks should help 

absorb some incremental increases in funding costs.11 

Also, smaller institutions have had slightly higher levels 

of noninterest-bearing deposits and greater success in 

growing these deposits; if the trend continues, these 

noninterest-bearing deposits will help offset the costs 

associated with growing noncore funding. 

Mike Anas, Senior Financial Analyst 

Kathy R. Kalser, Regional Manager 

New England Institutions Use Noncore Funding to 

Support Longer-Term Asset Portfolios 

The composition of funding among New England 

community banks has changed markedly since the end 

of the 2001 recession. The dollar volume of borrowings 

grew almost 22 percent from third quarter 2001 to third 

11 For more information on net interest margin performance across 

bank asset sizes, see “Does Net Interest Margin Matter to Banks?” 

by Jack Phelps, Scott Hughes, Ronald Sims II, and Robert L. Burns in 

FDIC Outlook, Summer 2004, http://www.fdic.gov/bank/analytical/ 

regional/ro20042q/na/index.html. 

quarter 2004, compared with total deposit growth of 

only 3.0 percent. Borrowings are largely composed of 

FHLB advances, which have grown 30.2 percent since 

third quarter 2001. Community banks in New England, 

many of which are similar to thrifts by their specialization in mortgage lending, have long participated in the 

FHLB system. Almost 79 percent of New England 

community banks have outstanding FHLB advances, 

the highest percentage of any FDIC region in the country and well above the national average of 60.7 percent 

(see Chart 3). 

Chart 3 

New England Community Banks Are Increasing 

Use of Federal Home Loan Bank Borrowings 

Source: Federal Deposit Insurance Corporation. Data as of September 30. 

FHLB Borrowings

(right axis) 

% of Banks Borrowing

(left axis) 

$ Billions

Percent 

2001 2002 2003 2004 

0 

2 

4 

6 

8 

10 

72 

74 

76 

78 

80 

FDIC OUTLOOK 29 SPRING 2005 
In Focus This Quarter: Interest Rate Risk and Funds Management 

Nonmaturity deposits have also increased more than 

15 percent in dollar terms during the past three years, 

offsetting a similar decline in time deposits.12 Community banks generally have enjoyed an increase in 

nonmaturity deposits since the stock market decline 

of 2000, as investors pulled money out of the stock 

market and placed those funds in secure, liquid bank 

deposits. In addition, while brokered deposits support 

only 1.2 percent of total assets, the percentage of 

New England community banks using brokered deposits 

has grown substantially, from 5.2 percent in 2000 to 

19.3 percent in 2004. 

During the past five years, New England’s savings institutions have held portfolios with a historically high 

level of long-term assets, primarily mortgage loans.13 

With the low interest rates and a relatively steep yield 

curve that persisted through much of 2004, banks have 

retained a large portion of long-term assets on their 

books to help augment a narrowing NIM.14 However, 

the market value of these long-term assets may decline 

in value should interest rates rise. In addition, as 

longer-term interest rates have increased since mid2004, refinancing activity has declined, thereby scaling 

back an important stream of income for New England 

institutions. 

Paul M. Driscoll, Regional Manager 

Chicago Region Banks Use a Variety of Noncore 

Products to Address Their Funding Needs 

Consistent with the national trend, community banks 

in the Chicago Region are becoming more reliant on 

noncore funding sources (see Chart 4). Increasing 

competition among banks, thrifts, and nonbanks as well 

as higher-yielding investment alternatives have made it 

more difficult for many community banks in the Region 

to attract core deposits.15 

12 Nonmaturity deposits are deposits with no set maturity date, such
 

as demand accounts, savings accounts, NOW accounts, and money
 

market accounts.
 

13 Long-term assets are defined as assets that mature or reprice after
 

five years; see FDIC Call Report Instructions.
 

14 For further discussion on yield curves, see “Rate/Volume Analysis:
 

An Off-Site Approach to Measuring Interest Rate Risk” by Ronald
 

Sims II in this issue.
 

15 The increasing competition among banks as well as between banks
 

and nonbank financial companies is discussed in “The Future of
 

Banking in America: Summary and Conclusions” by George Hanc,
 

FDIC Banking Review 16, no. 1 (2004), http://www.fdic.gov/bank/
 

analytical/banking/2004nov/index.html.
 

Chart 4 

Chicago Community Institutions Are More Reliant on 

Noncore Sources of Funding 

Note: CD = certificate of deposit. 

Source: Federal Deposit Insurance Corporation Bank and Thrift Call Reports. Data as of 

September 30. 

Percent of 

Total Liabilities 

Core Deposits CDs > $100,000 Brokered Deposits Borrowings

50 

60 

70 

80 

90 

100 

200420032002200120001999199819971996199519941993 

Trends in noncore funding vary throughout the Region. 

Ohio, for example, is a very competitive banking 

market with a relatively high number of banking 

branches dominated by large regional banks. In the 

past two years, core deposits slowed for Ohio community banks as competition heated up. In response to 

weak core deposit growth, banks and thrifts in Ohio 

increased their reliance on noncore funding more than 

any other state in the Region—their ratio of noncore 

funding to total assets rose by 315 basis points to 25.8 

percent in the year ending September 30, 2004. Ohio 

institutions also reported the Region’s largest 12-month 

increase in the ratio of FHLB borrowings to assets, 

which grew by 140 basis points to 8.8 percent as of 

third quarter 2004. 

Although most banks in the Region saw an increase 

in noncore funding, the type of noncore funding used 

predominantly by banks in the different states varied. 

For instance, Wisconsin banks and thrifts funded 5.2 

percent of their assets with brokered deposits in third 

quarter 2004, up from 3.7 percent a year earlier. 

Although the share of large time deposits to assets 

increased across all community banks in the Region, 

community banks headquartered in Michigan reported 

the greatest shift, with the percentage of large time 

deposits to assets increasing by 225 basis points in the 

past year. And banks and thrifts based in Indiana and 

Kentucky are turning more frequently to FHLB 

borrowings—near the end of 2004, more than 80 

percent of FDIC-insured community banks in these 

two states reported some level of FHLB borrowings, 

up from approximately 72 percent three years earlier. 

Linda Lo, Financial Analyst 

FDIC OUTLOOK 30 SPRING 2005 
84 

82 

80 

72 

Funding Asset Growth in a Rising Rate Environment 

A Confluence of Factors Contribute to the Decline of 

Noncore Funding in the Kansas City Region 

Before 1990, the Kansas City Region’s small community banks consistently funded more than 80 percent 

of their total assets with core deposits.16 In the 1990s, 

however, the convergence of a number of factors has 

made it harder for these banks to continue to acquire 

core deposits. These factors include disintermediation 

caused by rapidly increasing stock markets, competition 

for deposits from large banks and credit unions, and 

depopulation in most of the Region’s rural areas. As a 

result, core funding as a percentage of total assets 

dropped steadily in the 1990s (see Chart 5). By 2000, 

just over 71 percent of small community bank assets 

were funded by core deposits. 

As core deposit levels declined in relation to total 

assets, institutions were forced to look to other sources 

of funds, including large time deposits, FHLB borrowings, and, in some instances, brokered deposits. The use 

of these funds reached a peak in third quarter 2000 as 

the Region’s small community banks used noncore 

funds to finance 17.8 percent of total assets, compared 

with 7.9 percent eight years earlier. And, while large 

time deposits made up the bulk of small community 

bank noncore funding, alternative sources such as 

FHLB borrowings were commonly used as well. FHLB 

borrowings nearly tripled from just under $3.0 billion 

in 1992 to $8.6 billion in 2000. 

Chart 5 

The Stock Market Again Is a Lure for Kansas City
 

Region Community Bank Core Deposits
 

16 Wilshire 5000 Index 

14 

Downward trends in core funding reversed temporarily 

at the beginning of this decade as declining stock 

markets led investors to seek the safety of FDIC-insured 

bank deposits (see Chart 5). From 2000 through 2003, 

the percentage of total assets funded by core deposits 

varied little (between 71.1 percent and 71.5 percent), 

marking the first period of stability in more than ten 

years. In part due to this stability in core funding, the 

median small community bank NIM improved by 14 

basis points in 2002. 

However, recent rebounds in the stock market may 

once again be luring funds away from the Region’s 

small community banks, and the long-term downward 

trend in core funding appears to have resumed. As of 

September 30, 2004, core funds made up only 69.6 

percent of bank assets, representing the first time that 

the ratio has fallen below 70 percent. Noncore funds, 

led by surges in FHLB borrowings (up by $1.2 billion, 

or 14.6 percent, during the 12 months ending September 30, 2004) and large time deposits (up $600 million, 

or 4.2 percent, over the same time period), funded a 

record 19 percent of total banking assets. As a result, 

the median NIM among the Region’s small community 

banks as of third quarter 2004 was 4.05 percent, down 

slightly from 2003 and far below the level of 4.42 

percent of a decade ago. 

John M. Anderlik, Regional Manager 

Rural Institutions in the Midsouth Area Have 

Significantly Increased Use of Noncore Funding 

As a result of slow growth in core deposits, the ratio of 

noncore funding to assets for community banks based 

in the Midsouth Area reached an all-time high in third 

quarter 2004.17 A major contributor to this trend is the 

12 

Aggregate Ratio of Core 

Deposits to Total Assets 

(right scale) 

(left scale) 

rapid increase in the number of commercial banks using 

FHLB advances (see Chart 6). 

The shift from core deposits to generally more costly 

funding alternatives has been most pronounced among

Index (thousands)

78 10 

76 8

Percent

74 6 

4 

FDIC-insured institutions in rural areas, although there 

is a wide variance in usage among those areas. The 

growth in noncore funding sources varies significantly 

2 

0 

1990 1995 2000 2004 between institutions in rural areas highly dependent on Sources: Federal Deposit Insurance Corporation Call Reports, Wall Street Journal. Data as of September 30. 

16 Small community banks in the Kansas City Region are defined as 

banks and thrifts with fewer than $250 million in total assets. These 

institutions currently represent 89 percent of the Region’s total 

institutions. 

17 The Midsouth Area includes Arkansas, Louisiana, Mississippi, and 

Tennessee. The ratio of noncore funding to total assets reached a 

historic median high of 22.7 percent in third quarter 2004. 

FDIC OUTLOOK 31 SPRING 2005 

70 

68 
In Focus This Quarter: Interest Rate Risk and Funds Management 

Chart 6 

Commercial Banks in Memphis Area Have Increased
 

Federal Home Loan Bank Membership and Borrowings
 

No. of Commercial
 

Banks in Midsouth
 No. and % of Commercial Banks $ Billions 

700 Area (left axis) in Midsouth Area That Are FHLB 

51%
 

Members (left axis)
 

63%
 57%
 58%
 

FHLB Borrowings


(right axis)
 

15
 

600
 

500
 10 

400 

300 

5 200 

100 

0 0 

2001 2002 2003 2004 

Sources: Federal Deposit Insurance Corporation Call Reports, Federal Housing Finance 

Board. Data as of September 30. 

manufacturing employment and those in areas less 

dependent on manufacturing.18 During the year ending 

September 2004, the median ratio of noncore funding 

to total assets increased 90 basis points to 22 percent of 

assets among rural-based FDIC-insured institutions in 

areas highly dependent on manufacturing employment. 

Although rural-based FDIC-insured institutions that 

are less dependent on manufacturing also have begun 

to use alternative funding sources, the degree of change 

has been much less dramatic at 6 basis points during 

the same period. Employment in rural areas traditionally has been centered in the manufacturing sector, 

which suffered severe job losses even before the 

national recession in 2001. 

The increasing reliance on noncore funding sources 

among banks and thrifts based in manufacturingdependent rural areas likely contributed to the median 

NIM decline of 7 basis points in third quarter 2004 

from one year ago. By contrast, the median NIM 

among FDIC-insured institutions less dependent on 

manufacturing was relatively unchanged in the same 

period. Should the use of noncore funding continue 

to grow among FDIC-insured institutions based in 

the Midsouth Area, it is reasonable to expect that 

pressures on NIMs could increase. 

F. Miguel Hasty, Senior Financial Analyst 

18 Areas highly dependent on manufacturing employment are defined 

as those with 32 percent or more of total employment attributed to the 

industry (top quartile). Areas less dependent on manufacturing are 

those with 13 percent or less of total employment (bottom quartile). 

Smaller Metropolitan Areas in the Southwest 

Report Stronger Core Deposit Growth than Larger 

Metropolitan Areas 

Community banks in the Southwest, especially those 

located in highly competitive banking markets, have 

increased their use of alternative funding sources.19 

Reflecting the heightened competition for business 

and consumer deposits, community banks based in the 

Southwest are reporting a median core deposit ratio of 

71.1 percent. Although this rate remains slightly above 

the national rate, it is the lowest level in two decades 

for Dallas Region institutions. As the Region’s economy 

continues to improve, historical trends suggest loan 

demand should increase as well, prodding community 

banks to consider alternative sources of funding when 

evaluating new loan and investment opportunities. 

Shifting funding strategies also can be observed by 

considering the kinds of markets where banks and 

thrifts operate—that is, metropolitan, micropolitan, 

or rural.20 In contrast to the rest of the Region, FDICinsured institutions in Southwest micropolitan counties 

have reported higher ratios of core deposits to assets 

during recent years (see Chart 7). The increase could 

be due, at least in part, to the significant growth in per 

capita income in these micropolitan areas, which was 

almost 18 percent during the four years ending December 31, 2003. This rate exceeds the 12 percent growth 

rate recorded in the Southwest’s metropolitan areas. 

Similarly, employment growth in micropolitan counties 

increased 6.1 percent over the same four-year period, 

significantly above 1.9 percent reported in metropolitan counties. This comparatively strong job growth in 

the Region’s micropolitan areas appears to be a positive 

factor for bank deposit growth. In addition, stronger job 

growth may allow banks headquartered in these micropolitan counties to be better positioned to attract core 

deposit funding. Alternatively, FDIC-insured institutions based in metropolitan counties may need to use 

alternative funding sources if the downward trend of 

the ratio of core deposits to assets continues. 

Jeffrey A. Ayres, Senior Financial Analyst 

19 The Southwest includes Colorado, New Mexico, Oklahoma, and 

Texas. 

20 According to the U.S. Census, a metropolitan statistical area must 

have at least one urbanized area of 50,000 or more inhabitants, a 

micropolitan statistical area must have at least one urban cluster of 

at least 10,000 but less than 50,000 in population, and a rural area 

does not contain an urban cluster of at least 10,000. 

FDIC OUTLOOK 32 SPRING 2005 
Funding Asset Growth in a Rising Rate Environment 

Chart 7 Chart 8 

Core Deposits Continue to Decline at FDIC-Insured
 

Community Banks, but Micropolitan Community Banks
 

May Buck the Trend
 

Ratio of Median Core Deposits to Assets80%

78% 

76% 

74% 

72% 

70% 

Community 

Banks in Rest 

of Southwest 

Southwest 

Micropolitan 

Community

Banks 

All U.S. 

Community 

Banks 

1994 1996 1998 2000 2002 2004 

Source: Federal Deposit Insurance Corporation Bank and Thrift Call Reports. Data as of 

September 30. 

Arizona and Nevada Community Institutions 

Report High Use of Brokered Deposits 

Note: All Alaska and Hawaii institutions are included. 

Source: Federal Deposit Insurance Corporation Bank and Thrift Call Reports. Data as of 

September 30, 2004. 

AZ 

NV 

ID 

WA 

OR 

HI 

UT 

WY 

CA AK 

MT 

Nation 

Share of Institutions Reporting

Brokered Deposits (percent)

2004 2001 

0 

10 

20 

30 

40 

50 

60 

70 

Brokered Deposits Are Becoming a More Important 

Source of Funds in a Number of Western States 

Community banks based in the West have experienced 

strong loan demand during the current economic 

expansion, particularly in construction loan portfolios. 

In turn, this loan demand has contributed to an 

increased need for funding. Although core deposits 

continue to comprise the bulk of funding, FDICinsured institutions based in the San Francisco Region 

are reporting an increased reliance on noncore funding 

sources, consistent with national trends. 

Brokered deposits have been an important component 

of the increase in noncore funding in the Region since 

2001. As of September 30, 2004, 37 percent of all 

FDIC-insured financial institutions in the Region 

reported the use of brokered deposits, up from less than 

Table 2 

25 percent three years ago. The use of brokered deposits 

was higher among institutions that have been in operation for less than nine years; 43 percent of these institutions reported brokered deposits. The percentage of 

FDIC-insured institutions reporting brokered deposits 

was particularly high among community banks based in 

Arizona, Nevada, and Idaho, where construction loan 

demand was propelled by strong housing construction 

activity, robust in-migration, and strong employment 

growth (see Chart 8). These markets also have had 

significant new bank chartering activity during the 

past nine years. 

As of September 30, 2004, banks and thrifts headquartered in Arizona, Nevada, and Idaho ranked in the top 

five states nationwide for FDIC-insured institutions 

with construction and development loan exposure, 

employment growth, and population growth, and in 

Strong Economic Growth Drives Use of Brokered Deposits 

Arizona Nevada Idaho 

MEASURE Percent Rank Percent Rank Percent Rank 

Institutions reporting brokered deposits 64.5 1 50.0 3 44.4 7 

Construction loan concentration 150.5 1 137.5 2 92.2 5 

GROWTH RATES (year-over-year) 

Deposits 20.7 3 22.7 1 20.9 2 

Population 3.0 2 4.1 1 1.9 4 

Employment 2.4 5 4.5 1 2.6 4 

Note: Rankings are among the 50 states and the District of Columbia. The construction loan concentration is the median percent of Tier 1 capital. 

Sources: U.S. Census Bureau, Bureau of Labor Statistics, and Federal Deposit Insurance Corporation Bank and Thrift Call Reports. All data are as of September 30, 2004, except the population 

growth rate ranks, which are as of July 1, 2004. 

FDIC OUTLOOK 33 SPRING 2005 
In Focus This Quarter: Interest Rate Risk and Funds Management 

the top ten for brokered deposit usage (see Table 2). Of tion of brokered deposits was similar to that of commubanks reporting brokered deposits, community banks nity banks across the nation. 

in Arizona reported more than twice the 3.9 percent 

national median level of brokered deposits to assets. In 

Nevada and Idaho, however, the median concentra- Robert E. Basinger, Senior Financial Analyst 

FDIC OUTLOOK 34 SPRING 2005 
FDIC OUTLOOK 35 FALL 2004

Visit us on the Web for 

more details about 

Deposit Insurance 

Bank Statistical Data 

Emerging Economic Trends 

Current Bank Analyses 

Past Studies on the Banking Industry 
✁
 

Subscription Form
 

To obtain a subscription to the FDIC Outlook, please print or type the following information: 

Institution Name __________________________________________________________________________ 

Contact Person __________________________________________________________________________ 

Telephone __________________________________________________________________________ 

Street Address __________________________________________________________________________ 

City, State, Zip Code __________________________________________________________________________ 

Please fax or mail this order form to:	 FDIC Public Information Center 

801 17th Street, N.W., Room 100 

Washington, D.C. 20434 

Fax Number (202) 416-2076 

Federal Deposit Insurance Corporation 

Washington, DC 20429-9990 

OFFICIAL BUSINESS 

PENALTY FOR PRIVATE USE, $300 

PRESORTED
 

STANDARD
 

MAIL
 

Postage &
 

Fees Paid
 

FDIC
 

Permit No. G-36