By Theresa Batoon, Catalyst Strategic Solutions Senior ALM Consultant
At one time or another, you’ve probably heard the term “backtesting” from your auditors or ALM provider. Backtesting is simply the comparison of your actual income statement to your projected income statement. This technique can provide valuable insights into the accuracy and reasonableness of your interest rate risk model.
By identifying and investigating the material differences between actuals and model projected results, you can fine-tune the applicable modeling assumptions, so your modeling is more accurate and, consequently, more valuable. It is recommended that you backtest annually, at a minimum.
There are four common causes for the differences found from your backtesting efforts:
- Rate differences are likely to occur between actual market rates and those the model projected. The significant rate cuts that occurred in March, due to COVID-19, will have a large impact on the variance when backtesting 2020 results.
- Volume differences between projected and actual growth will also affect the disparity. The central purpose of the ALM model is to assess the risk of the financial institution. The most effective way to gauge risk is with a flat balance sheet, which ignores the growth or volume changes that occur over a particular timeframe. Even if you model volume changes, it is difficult to do so perfectly.
- Change in product mix is another factor that will influence the results of actual and projected net interest income. This is partially an extension of the volume point. But here, it captures management goals or member desires to emphasize growth in certain loan, investment or funding methods.
- The fourth, and easiest to compare, is non-interest items, such as fee income, provision for loan losses and non-interest expenses. These are typically set forth as part of the budget cycle.
When you start backtesting, first choose a timeframe – the typical timeframe is one year. Next, compare your income statement projection from your ALM report, by product, against your actual income statement for the same period. This will assist in identifying which categories have the largest differences requiring you to research and provide explanation.
A comparison of the balance sheet from beginning to end will help determine if the variances are due to a change in volume size or movement between products. Volume variance isolates the impact on the income statement, because the average balance was different than expected.
Actual rates and projected rates by product, along with actual and projected yield curves, should also be differentiated. Rate variance analysis is beneficial, as it measures the way interest income (or expense) was affected, because the actual rate earned on an account was different than the budgeted rate. Rate volume variance quantifies the compounding effect of the rate variance and the volume variance. It is important to remember, there will always be differences, but most variances are explainable.
Backtesting is beneficial for many reasons. For example, it can help you better understand your net interest income forecast, changes in the balance sheet, and the assumptions used in your projection. Or, it can simply satisfy your auditor's requirements. No matter the reason, Catalyst Strategic Solutions can assist you in getting it done! Contact us today, for more information.