An analysis of regulatory guidance and expectations by financial regulators for monitoring, measuring and managing Interest Rate Risk (IRR) exposure

It is no secret that bankers have been facing historically low interest rates since the financial crisis began in earnest in 2008 with the collapse of Leaman Brothers.  These low rates coupled with the long running economic recession created an environment where bankers have struggled to maintain their margins.  Some banks decided to pursue new business lines in order to diversify its revenue stream – both interest income and non-interest income.  Along with these new business lines came risks in the form of operational, credit, liquidity, legal and reputational risks.  Some banks under took a basic strategy that was tried by banks in previous downturns: that is they extended asset maturities and/or increased bond holdings, many with embedded options, which resulted in widening spreads due to a higher level of interest rate risk.

This is particularly true in community banks (banks less than $10 billion in assets).  From information derived from the Call Reports of Condition filed from 2007 to 2011 assets maturing or re-pricing in more than three years increased from approximately 31% of total assets to approximately 38% of total assets.   Institutions extending asset maturities without a corresponding shift in liabilities are particularly exposed to rising interest rates.  Indeed, it was against this back drop which saw banks extending maturities and reaching for yield to improve their margins that the financial regulators issued an Interagency Advisory on Interest Rate Risk in 2010.  In January of 2012 the financial regulators followed this up with an interagency Advisory on Interest Rate Risk Management based on Frequently Asked Questions.

It should also be noted that Former FDIC Chairman Shelia Bair has even said “that abnormally low interest rates are creating the “mother of all bond bubbles.”  When rates eventually move up most analysts and bankers seem to agree that many banks, particularly community banks, will not be fully prepared for the turn; in fact, the risk is most pronounced in smaller community banks since they lack the management depth and staffing to properly manage their investment portfolios.  A small bank cashier or CFO wears many hats in a small bank, such as accounting, finance, and administrative functions as well as investment portfolio operations.

Based on the financial regulatory guidance issued in 2010 and 2012, I have outlined areas that should be considered when evaluating your current interest rate risk exposure and management.

The guidance makes clear that management is responsible for ensuring that board approved strategies, policies and procedures for managing IRR are appropriately executed within the designed lines of authority and responsibility.

Management also is responsible for maintaining:

• Appropriate policies,  procedures and internal controls address IRR management, including limits, controls over risk taking to stay with board-approved tolerances (Remember JP Morgan changed its VAR model during the Whale trading debacle, without informing the board or regulators, in order to avoid reporting losses that were growing at an exponential rate);
• Comprehensive systems and standards for measuring IRR, valuing positions, and assessing performance, including procedures for updating IRR measurement, scenarios and key underlying assumptions driving the institution’s IRR analysis and sufficiently detailed reporting processes to inform senior management and board of the level of IRR exposure.

The financials regulators the following elements to be part of a prudent IRR management program:

• Earnings simulations should be run over at least a 24-month time horizon. Longer term earnings simulations captures the impact of transactions and strategies taken to increase revenues, while shorter time horizons may hid the full impact of transactions and strategies undertaken.
• Earnings and economic perspectives are considered necessary to capture IRR effectively.  Most community banks are familiar with models that measure earnings at risk; however, they are less familiar with models that estimate the economic value of equity (EVE).  EVE models allow you to look beyond a one or two year earnings simulation and estimate the impact of rate movements on longer term equity and capital.  Changes in EVE may affect your capital adequacy as well as liquidity measures which are not captured in earnings simulations.
• Scenario analysis should include immediate rate shocks of up to 400 basis points. The regulatory guidance from the financial regulators indicates that interest rate shocks of at least +/-300 and 400 basis points.  The guidance specifically states that “in a period of extremely low rates, a 400 basis point shock would provide a meaningful stress scenario.”  It goes on to say that in low rate environments, “institutions may increase the number of positive rate shocks.  In addition, the guidance states that “even more extreme ramped rate curve shocks may be appropriate.”
• Dynamic earnings simulations need to be supplemented with static simulations. Static simulations are usually based on a no growth balance sheet help identify the potential interest rate exposures embedded in the bank’s current balance sheet.  Dynamic simulations incorporate new business strategies and assumptions and they are very good to use for business planning purposes; however, they can mask certain IRR exposures when combined with the results of new business lines/strategies and the associated balance sheet growth.
• Assumptions regarding sensitivity analysis should be performed at least annually.  The regulatory guidance recommends that banks perform an assumptions sensitivity analysis at least annually.  Minor changes in key assumptions (such as prepayment speeds, core deposit sensitivity and decay rates) can have a material impact on the risk measurements.   The sensitivity test should focus on the key assumptions and you should alter the assumptions to see how the changes affect earnings at risk and EVE at risk measurements.
• Model assumptions must be supportable and the rationale supporting the assumptions should be documented. The financial regulators allow you to rely on vendor-provided models, assumptions, or your own estimates.  What is important is that they are clearly documented and you can demonstrate their reasonableness and relevance to your bank.
• Interest rate risk measures must be compared to the policy limits and reported to the board of directors.  All reports supplied to The ALCO committee and the Board should demonstrate compliance with board approved policy limits and any changes to the assumptions and modeling must be documented and reported to the board (think of JP Morgan’s failures here).

If you are interested in an independent review of your IRR management models, processes and controls, please feel to contact info@chartwellcompliance.com.  We have experience with a variety of models used by community and large banks, and can recommend a  model that would be commensurate with your bank’s IRR profile.

Wes Ware, CFA, CFIRS (Kansas City) has 25 years of experience as a Senior Bank Examiner and Fiduciary Risk Management Specialist at the Federal Reserve Bank of San Francisco; a Senior Bank Examiner and Credit Risk Specialist in the Discount Window Unit of the Federal Reserve Bank of Kansas City; and a Safety and Soundness Bank Examiner at both the Office of Thrift Supervision and the Federal Home Loan Bank of Atlanta. He is a specialist in regulatory compliance; risk management; internal audit; business planning; bank lending; financial analysis; due diligence; registered investment advisors; mortgage banking subsidiaries; asset management; hedge funds; and broker dealers.