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. Off-site 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.

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 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

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 adjustable-rate 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 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 interest-only 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 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 (seedefinition 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 mortgage-backed securities.



• Because of the heavy investment in securities, the prototypical margin risk bank has proportionally smaller holdings of loans. However, as might be 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 higher-risk 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 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 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 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 short-term rates of 500 basis points, its capital falls only slightly from 10.4 percent to 9.9 percent over a two-year 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

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 earnings-related 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 investment-related 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 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 equity-to-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 adjustable-rate 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

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.

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.

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.

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.

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-ratepayment 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 acomposite rating from "1" to "5," with "1" representing the least degree of risk and "5" representing the greatest degree of risk.

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

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.

¹³ Noncore deposits include time deposits greater than or equal to $100,000, brokered deposits, and foreign deposits.

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.

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-basis-point 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).