After reviewing IRR shock-test results for a few quarters it usually doesn’t take a person very long to start questioning the “reality” of the shock-test. The common observation is usually, “all rates never move up or down in parallel…that’s not very realistic!” This is inevitably followed-up with a redesign of the IRR stress-test that moves the yield curve in more “realistic” ways.

Although I’m quite skeptical of our ability to realistically and accurately predict future yield curve movements, there are changes other than parallel shifts that may be academically interesting to test. After all rates never really do move up or down in parallel. We’re more likely (historically speaking) to see short-term rates move down or up with little or no movement in long-term rates. These types of shifts are commonly referred to as “steeper” or “flatter” shifts. Each has its own unique characteristics to consider:

a) Steeper - Typically this is accomplished by dropping short-term rates. All points on the curve that are 1-year or less drop noticeably. The drop is less pronounced the further out you go on the curve until, finally, you don’t model any movement in long-term rates at all (perhaps somewhere between the 5-year and 30-year point.) The resulting steeper curve can have major impacts on a community bank’s balance sheet depending on the magnitude of the change in short-term rates. So much of a typical community bank’s balance sheet is tied to short-term rates: Prime-based loans, core checking, and CDs. A less common approach to modeling a steeper curve is to raise long-term rates and keep short-term rates stable. There are certainly examples of this behavior in history, it’s just not as common.

b) Flatter – Typically this is accomplished by raising short-term rates. All points on the curve that are 1-year or less increase noticeably. The increase is less pronounced the further out you go on the curve until, finally, you don’t model any movement in long-term rates at all (perhaps somewhere between the 5-year and 30-year point.) Again, because so much of a community bank’s balance sheet is tied to short-term rates, a flatter curve can have a major impact. A less common approach to modeling a flatter curve is to lower long-term rates and keep short-term rates stable. This has happened in history, but it is not as common. Short-term rates are usually much more volatile than long-term rates.

c) Twist – This test essentially moves both ends of the curve in opposite directions. This test is often referred to as the “inverted” test because typically the resulting yield curve shape is inverted (as opposed to “normally” shaped.) While much of a bank’s balance sheet is tied to short-term rates, there may be portfolios that are tied to longer-term rates like investments, mortgages, and borrowings. Income and expenses may change at different rates depending on the timing. A twist can highlight that dynamic.

(This post is part of a series which provides a basic overview and discussion of interest rate risk stress-testing.)