Page 37 - September 26, Bulletin

The larger the variance, the more questions that need to be properly. Continuing with the same example, we saw CD rates
answered. What we often see is a variance range, or threshold, skyrocket as the federal funds rate rose. But will we see that
that institutions try to stay within for the variance to be same impact as the federal funds rate falls? These are questions
considered “acceptable.” However, even if a back test is within we should ask, and then use the back test to help answer these
the acceptable range, it is still important to understand what is questions.
driving these variances. Focusing solely on an overall variance
range and not the variance drivers themselves can lead to flawed To reiterate, independent reviews are an important aspect within
model assumptions and outputs. It is recommended to perform the ALM and IRR process. Back testing helps to affirm a good
a back test at least annually. process by validating model assumptions and assists in making
improvements to model inputs when necessary. And while the
Variances in back testing are often driven by balance sheet variance range from a back test is important, it is also important
composition changes and rate changes. An example of this type to not solely focus on that one output. Instead, it is crucial to
of variance can be seen over the most recent rate cycle. As the understand the reason, or lack thereof, for the variance in the
federal funds rate rose over 500 basis points from March of first place. As we continue through this rocky rate cycle, IRR
2022 to July of 2023, the average institution saw a large shift in and back testing will continue to take a front seat in helping
deposits moving from non-maturity deposits into higher paying institutions make important decisions.
CDs and borrowed funds. This large volume movement and
aggressive rise in rates resulted in significant variances in back
tests from March of 2022 to today.
Luke Mikles is a vice president in the Financial Strategies Group
So, what does this variance truly tell us? Why is it important at The Baker Group. He joined the firm in 2019, serving in the
and what is the big deal with this variance? Let’s take the large Interest Rate Risk Department. In 2023, Luke moved to the
Financial Strategies Group, where he assists institutions with
variances that we saw in relation to CDs as an example. These the risk management process and speaks at Baker’s educational
variances would suggest that it may be appropriate to review seminars across the country. Luke holds a Bachelor of Business
rising rate shift sensitivities (Betas) on these products. Accurate Administration degree in energy economics from the University
assumptions and inputs result in accurate outputs. If we ignore of Central Oklahoma. Contact: 405-415-7307, LMikles@
variances from a back test and do not make proper adjustments GoBaker.com.
to assumptions, the results from the IRR model can become
skewed and misleading. It is important to note that one should
not wait for a large variance on a back test to adjust assumptions.
The process should be proactive and ongoing. Back testing
allows us to validate the assumption development process and
make additional adjustments if needed. As the Federal Reserve
gears up for rate cuts, it will be critical to check falling rate
assumptions and ensure they are modeled realistically and

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