[Federal Register: June 26, 1996 (Volume 61, Number 124)]
[Notices]
[Page 33166-33172]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
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DEPARTMENT OF THE TREASURY
Office of the Comptroller of the Currency
[Docket No. 96-13]
FEDERAL RESERVE SYSTEM
[Docket No. R-0802]
FEDERAL DEPOSIT INSURANCE CORPORATION
Joint Agency Policy Statement: Interest Rate Risk
AGENCIES: Office of the Comptroller of the Currency (OCC), Treasury;
Board of Governors of the Federal Reserve System (Board); and Federal
Deposit Insurance Corporation (FDIC).
ACTION: Joint policy statement.
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SUMMARY: The OCC, the Board, and the FDIC (collectively referred to as
the agencies) are issuing this joint agency policy statement (policy
statement) to bankers to provide guidance on sound practices for
managing interest rate risk. The policy statement identifies the key
elements of sound interest rate risk management and describes prudent
principles and practices for each of these elements. It emphasizes the
importance of adequate oversight by a bank's board of directors and
senior management and of a comprehensive risk management process. The
policy statement also describes the critical factors affecting the
agencies' evaluation of a bank's interest rate risk when making a
determination of capital adequacy. The principles for sound interest
rate risk management outlined in this policy statement apply to all
commercial banks and FDIC-supervised savings banks (banks).
This policy statement augments the action taken by the agencies in
August 1995 to implement the portion of section 305 of the Federal
Deposit Insurance Corporation Improvement Act of 1991 (FDICIA)
addressing risk-based capital standards for interest rate risk. It also
replaces the proposed policy statement that the agencies issued for
comment in August 1995 regarding a supervisory framework for measuring
and assessing banks' interest rate exposures. The agencies have elected
not to pursue a standardized measure and explicit capital charge for
interest rate risk at this time. This decision reflects concerns about
the burden, accuracy, and complexity of a standardized measure and
recognition that industry techniques for measuring interest rate risk
are continuing to evolve. Rather than dampening incentives to improve
risk measures by adopting a standardized measure at this time, the
agencies hope to encourage these industry efforts. Nonetheless, the
agencies will continue to place significant emphasis on the level of a
bank's interest rate risk exposure and the quality of its risk
management process when evaluating a bank's capital adequacy. The
principles and practices identified in this policy statement provide
the standards upon which the agencies will evaluate the adequacy and
effectiveness of a bank's interest rate risk management.
EFFECTIVE DATE: June 26, 1996.
FOR FURTHER INFORMATION CONTACT:
OCC: Christina Benson, Capital Markets Specialist, or, Margot
Schwadron, Financial Analyst, (202/874-5070), Office of the Chief
National Bank Examiner; Michael Carhill, Deputy Director, Risk Analysis
Division (202/874-5700); and Ronald Shimabukuro, Senior Attorney,
Legislative and Regulatory Activities Division (202/874-5090), Office
of the Comptroller of
[[Page 33167]]
the Currency, 250 E Street, S.W., Washington, D.C. 20219.
Board of Governors: James Embersit, Manager (202/452-5249), or
William Treacy, Supervisory Financial Analyst (202/452-3859), Division
of Banking Supervision and Regulation; Gregory Baer, Managing Senior
Counsel (202/452-3236), Legal Division, Board of Governors of the
Federal Reserve System. For the hearing impaired only,
Telecommunication Device for the Deaf (TDD), Dorothea Thompson (202/
452-3544), Board of Governors of the Federal Reserve System, 20th and C
Streets, N.W., Washington, D.C. 20551.
FDIC: William A. Stark, Assistant Director (202/898-6972) or Miguel
Browne, Deputy Assistant Director (202/898-6789), Division of
Supervision; Jamey Basham, Counsel, (202/898- 7265), Legal Division,
Federal Deposit Insurance Corporation, 550 17th Street, N.W.,
Washington, D.C. 20429.
SUPPLEMENTARY INFORMATION:
I. Background
Interest rate risk is the exposure of a bank's current and future
earnings and capital arising from adverse movements in interest rates.
Changes in interest rates affect a bank's earnings by changing its net
interest income and the level of other interest-sensitive income and
operating expenses. Changes in interest rates also affect the
underlying economic value of the bank's assets, liabilities, and off-
balance sheet items. These changes occur because the present value of
future cash flows, and in many cases the cash flows themselves, change
when interest rates change. The combined effects of the changes in
these present values reflect the change in the bank's underlying
economic value as well as provide an indicator of the expected change
in the bank's future earnings arising from the change in interest
rates. While interest rate risk is inherent in the role of banks as
financial intermediaries, a bank that has a high level of risk can face
diminished earnings, impaired liquidity and capital positions, and,
ultimately, greater risk of insolvency.
II. FDICIA Requirements and Agencies' Response
Section 305 of FDICIA, Pub. L. 102-242, 105 Stat. 2236, 2354 (12
U.S.C. 1828 note), requires the agencies to revise their risk-based
capital guidelines to take adequate account of interest rate risk. On
August 2, 1995 the agencies published a final rule implementing section
305 that amended their risk-based capital standards to specify that the
agencies will include, in their evaluations of a bank's capital
adequacy, an assessment of the exposure to declines in the economic
value of the bank's capital due to changes in interest rate risk. See
60 FR 39490 (August 2, 1995). This final rule, which became effective
on September 1, 1995, adopts a ``risk assessment'' approach under which
capital for interest rate risk is evaluated on a case-by-case basis,
considering both quantitative and qualitative factors.
The final rule did not adopt a measurement framework for assessing
the level of a bank's interest rate risk exposure, nor did it specify a
formula for determining the amount of capital that would be required.
The intent of the agencies at that time was to implement an explicit
minimum capital charge for interest rate risk at a future date, after
the agencies and the industry had gained more experience with a
proposed supervisory measure that the agencies issued for comment in
August 1995. See 60 FR 39495 (August 2, 1995).
The agencies have undertaken considerable efforts to develop a
supervisory measure for interest rate risk that provides sufficient
accuracy, transparency, and predictability for establishing an explicit
charge for interest rate risk. These efforts, and the comments the
agencies received on them, are summarized in sections III and IV that
follow. After careful consideration of those comments and additional
analyses and research by agencies' staff, the agencies have decided
that concerns about the burdens, costs, and potential incentives of
implementing a standardized measure and explicit capital treatment
currently outweigh the potential benefits that such measures would
provide. The agencies are cognizant that techniques for measuring
interest rate risk are continuing to evolve, and they do not want to
impede that progress by mandating or implementing prescribed risk
measurement techniques. Rather, the agencies wish to work with the
industry to encourage efforts to improve risk measurement techniques.
These efforts, the agencies believe, may lead to greater convergence
within the industry on the methodologies used for measuring this risk
and may, at a future date, facilitate more quantitative and explicit
capital treatments for interest rate risk.
Hence, the agencies have concluded that the best course of action
at this time, is to continue to assess capital adequacy for interest
rate risk under a risk assessment approach and to provide the industry
with further guidance on prudent interest rate risk management
practices. Section V of this preamble describes the agencies' risk
assessment approach for capital. The policy statement, which follows
section V, provides the agencies' guidance and expectations on sound
interest rate risk management.
III. Earlier Proposals for Supervisory Model and Explicit Capital
Charges
Since the enactment of FDICIA, the agencies have issued two notices
of proposed rulemakings on interest rate risk, as well as one advance
notice of proposed rulemaking (ANPR).
The ANPR was issued in 1992 and sought comment on a proposed
supervisory measurement system and an explicit capital requirement
based on the results of that measurement system. See 57 FR 35507
(August 10, 1992). The measurement system proposed in the 1992 ANPR
would have applied to all banks and used a duration-weighted maturity
ladder to estimate the change in a bank's economic value for an assumed
100 basis point parallel shift in market interest rates. Under the 1992
ANPR, a bank whose measured exposure exceeded a threshold level,
equivalent to 1 percent of total assets, would have been required to
allocate capital sufficient to compensate for the estimated change in
economic value above the threshold level.
The agencies received approximately 180 comment letters on the 1992
ANPR. The majority of commenters raised concerns about the accuracy of
the proposed measure and its use as a basis for an explicit capital
charge. Therefore, in September 1993, the agencies published a notice
of proposed rulemaking which incorporated numerous changes to the 1992
ANPR in an effort to address those concerns and improve the proposed
model's accuracy. See 58 FR 48206 (September 14, 1993). These changes
included:
(1) A proposed screen that would exempt banks identified as
potentially low-risk from the supervisory measurement framework.
(2) Various refinements to the supervisory model, including changes
to the method for determining risk weights to allow for different risk
weights for rising and falling interest rate environments; the specific
treatment of non-maturity deposits; the reporting of amortizing and
non-amortizing financial instruments; and the addition of another time
band to provide for greater accuracy.
The September 1993 proposal also sought comment on allowing banks
to use their own internal models as the basis for establishing a
capital charge and on two different methods for assessing capital. One
method, referred
[[Page 33168]]
to as the minimum capital standard, would establish an explicit capital
charge for interest rate risk based on either the supervisory model or
a bank's internal model results. The other method, referred to as the
risk assessment approach, would evaluate the need for capital on a
case-by-case basis, considering both quantitative and qualitative
factors.
The agencies collectively received a total of 133 comments on the
September 1993 proposal. The majority of industry comments focused on
four issues: a preference for the risk assessment approach, approval of
the proposed use of internal models, concerns about the accuracy of the
proposed supervisory model, and suggestions that the agencies' primary
focus should be on near-term (i.e., one- to two-year) reported earnings
instead of economic value.
In August 1995, along with the final rule amending risk-based
capital standards to adopt the risk assessment approach, the agencies
issued for comment a joint policy statement that would establish a
supervisory framework for measuring banks' interest rate risk
exposures. See 60 FR 39495 (August 2, 1995). The results of that
framework would be one factor that examiners would consider in
evaluating a bank's capital adequacy for interest rate risk. In
addition, the agencies noted that the framework was intended to provide
the foundation for the development of an explicit capital charge once
the agencies and industry gained more experience with the measurement
framework.
The August 1995 proposal built upon and modified the agencies'
earlier proposals for a supervisory measurement framework in an effort
to improve the framework's accuracy and applicability to a diverse
population of banks. Modifications included:
(1) Changing the proposed exemption test so that only banks with
total assets less than $300 million, a ``1'' or ``2'' composite
supervisory CAMEL rating, and only moderate holdings of assets with
intermediate or long term repricing characteristics would be exempted
from new interest rate risk reporting requirements and the supervisory
model.
(2) Refinements to a baseline supervisory model for which all non-
exempt banks would provide Consolidated Reports of Condition and Income
(Call Report) information. These refinements included separate
reporting and treatment of fixed- and adjustable-rate residential
mortgage loans and securities and other amortizing assets; requiring
banks holding certain types of financial instruments to report
estimates of changes in the market value sensitivities of those
instruments for a 200 basis point interest rate shock; and, extending
the range of maturities that banks could use when reporting their non-
maturity deposits (demand deposits, savings, NOW, and money market
demand accounts).
(3) The introduction of supplemental modules for non-exempted banks
that had concentrations in fixed- or adjustable-rate residential
mortgage loans and pass-through securities. Banks subject to these
modules would report additional information on the coupon distributions
of their fixed-rate mortgages and information on the lifetime and
periodic caps of their adjustable-rate mortgages.
Although these modifications were designed to enhance and improve
upon the agencies' earlier proposals, the majority of commenters on the
August 1995 proposal reiterated many previous concerns about accuracy,
burden, and incentives, and urged the agencies to reconsider their
approach and efforts to devise a uniform and standardized model.
IV. Factors Leading to the Agencies' Decision to Not Pursue a
Supervisory Model
As already noted, the agencies have decided not to pursue a
standardized model for supervisory purposes or assessing capital
charges for interest rate risk at this time. This decision reflects the
continued concerns expressed by the industry in their comment letters
on the August 1995 proposal and the numerous difficulties the agencies
encountered in trying to develop and implement a standardized measure
that had sufficient accuracy and flexibility to be applicable to a
broad range of commercial banks, while not imposing undue regulatory
and reporting burdens on banks.
Throughout the evolution of the agencies' efforts to incorporate an
explicit capital charge for interest rate risk into their risk-based
capital standards, industry comments have expressed four fundamental
concerns:
(1) An approach whose sole focus is on economic value, rather than
on reported earnings, may be inappropriate;
(2) A supervisory measure that by necessity, makes uniform and
simplifying assumptions about the characteristics of a typical bank's
assets and liabilities may be inaccurate for a given institution;
(3) The proposed treatment for non-maturity deposits may be
inappropriate in many cases; and
(4) Any supervisory model may create improper incentives for
internal risk management and measurement. Each of these concerns is
addressed in turn.
The agencies continue to believe economic value sensitivity is a
valid and important concept, especially when assessing an institution's
capital adequacy and, as noted, have amended their capital standards to
reflect this view. Nonetheless, the agencies recognize that changes in
a bank's reported earnings is also important and that a bank needs to
consider both earnings and economic perspectives when assessing the
full scope of its exposure. This policy statement adopted by the
agencies sets forth principles for monitoring and controlling interest
rate risk from both of these perspectives.
The industry's concerns about the validity and accuracy of a
standardized model present a more difficult and serious issue. Some of
the changes in the August 1995 proposal attempted to address these
concerns. For example, supplemental schedules for residential mortgage
loans and pass-through securities were a response to earlier industry
concerns regarding the use of prepayment assumptions that were based on
an average of outstanding mortgage securities. By collecting additional
data on the embedded options in an individual bank's mortgage
portfolio, the accuracy of the proposed model was potentially enhanced.
However, the changes were not without cost. In particular, the
supplemental schedules and associated risk weights added to the
reporting burden and overall complexity of the proposal. By giving the
appearance of providing a more precise measure of risk, they also
increased the likelihood that the standardized measure would replace or
stifle development of yet more accurate internal measures of risk
exposure. This added reporting burden and complexity illustrates the
difficulties the agencies have faced in trying to strike an appropriate
balance between accuracy and burden.
Not only did the mortgage schedules add burden, they did not
fundamentally solve the difficulties of structuring a standardized
model which could take into account the heterogenous nature of
commercial banks' balance sheet structures and activities. In recent
years, banks have been offering and holding a growing variety of
products. Many of these products, such as certain collateralized
mortgage obligations and structured notes, can have complex cash flow
characteristics that vary significantly with each transaction. The
August 1995 proposal attempted to address this problem by requiring
banks
[[Page 33169]]
to self-report the sensitivity of these and certain other instruments.
The diversity and complexity in banks' holdings, however, are not
limited to a bank's investment and off-balance sheet instruments.
Increasingly, banks have a variety of pricing indices and embedded
options incorporated into their commercial and retail bank products,
making it increasingly difficult to model these products with any
simple and uniform measure.
The diversity and complexity of commercial banks' balance sheets is
one reason why the banking agencies have decided not to pursue adopting
the net portfolio value model developed and used by the Office of
Thrift Supervision (OTS) or any uniform supervisory model. Although the
banking agencies have benefited a great deal from the expertise and
experience of the OTS in this area, the OTS model was designed to
ascertain the interest rate risk exposure of insured depository
institutions with concentrations of residential mortgage assets,
especially adjustable rate mortgages. These instruments require data-
intensive, complex models to obtain accurate valuations and interest
rate sensitivities. Since most commercial banks do not hold high
concentrations of these instruments, the agencies were concerned about
the substantial reporting requirements and measurement complexity that
would be associated with an OTS type of model if applied to commercial
banks.
Many industry commenters believe that the agencies' treatment in
the August 1995 proposal of non-maturity deposits understated their
effective maturity and urged the agencies to allow banks greater
flexibility in the reporting and treatment of them. Assumptions about
the effective maturity of these deposits are critical factors in
assessing most commercial banks' interest rate risk exposure, since
these deposits often represent 40 percent or more of a bank's liability
base. Thus, while the agencies have elected not to adopt supervisory
assumptions for calculating the effective maturities of non-maturity
deposits, the policy statement cautions banks to make reasonable
assumptions about customer behavior in this area, and periodically re-
evaluate whether the assumptions are reasonable in light of experience.
The supervisory treatment of non-maturity deposits in measuring
interest rate risk also illustrates the industry's concern regarding
the potential incentives a supervisory model could present to a bank.
In particular, some industry commenters have stated that if the
agencies adopted assumptions that understated the effective maturities
of a bank's non-maturity deposits, it could induce a bank to
inappropriately shorten its asset maturities, leave the bank exposed to
falling interest rates, and unnecessarily reduce its net interest
margins. The agencies, however, are also concerned that an assumption
that overstated the maturity of these deposits could mistakenly lead
banks to extend their asset maturities, leaving them exposed to rising
interest rates and significant loss in economic value.
Many commenters voiced broader concerns about the potential
incentives that a standardized supervisory model may have on how banks
manage and measure their risk. A frequent concern has been that a
supervisory model would become the industry standard against which
internal models would be benchmarked and tested, thus diverting
resources away from improving internal models and assumptions.
The agencies neither wish to create inappropriate incentives, nor
divert industry resources from the development of better interest rate
risk measurements. The policy statement consequently emphasizes each
institution's responsibility to develop and refine interest rate risk
management practices that are appropriate and effective for its
specific circumstances.
V. Risk Assessment Approach
The risk assessment approach that the agencies use to evaluate a
bank's capital adequacy for interest rate risk relies on a combination
of quantitative and qualitative factors. The agencies will use various
quantitative screens and filters as tools to identify banks that may
have high exposures or complex risk profiles, to allocate examiner
resources, and to set examination priorities. These tools rely on Call
Report data and various economic indicators and data. To make
assessments about the level of a bank's interest rate exposure,
examiners augment the insights provided by these preliminary indicators
with the quantitative exposure estimates generated by a bank's internal
risk measurement systems. For most banks the results of their internal
risk measures are and will continue to be the primary factor that
examiners consider when assessing a bank's level of exposure.
On the qualitative side, examiners will continue to evaluate
whether a bank follows sound risk management practices for interest
rate risk when assessing its aggregate interest rate risk exposure and
its need for capital. Such practices include, but are not limited to,
adequate risk measurement systems. Indeed, as the agencies explored
various approaches for developing supervisory risk measures, it
reinforced their appreciation for the critical roles that management
and board oversight, risk controls, and prudent judgment and experience
play in the interest rate risk management process.
Banks that are found to have high levels of exposure and/or weak
management practices will be directed by the agencies to take
corrective action. Such actions will include directives to raise
additional capital, strengthen management expertise, improve management
information and measurement systems, reduce levels of exposure, or a
combination thereof.
Joint Agency Policy Statement on Interest Rate Risk
Purpose
This joint agency policy statement (``Statement'') provides
guidance to banks on prudent interest rate risk management principles.
The three federal banking agencies--the Board of Governors of the
Federal Reserve System, the Federal Deposit Insurance Corporation, and
the Office of the Comptroller of the Currency (``agencies'')--believe
that effective interest rate risk management is an essential component
of safe and sound banking practices. The agencies are issuing this
Statement to provide guidance to banks on this subject and to assist
bankers and examiners in evaluating the adequacy of a bank's management
of interest rate risk.1
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\1\ The focus of this Statement is on the interest rate risk
found in banks' non-trading activities. Each agency has separate
guidance regarding the prudent risk management of trading
activities.
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This Statement applies to all federally-insured commercial and FDIC
supervised savings banks [''banks'']. Because market conditions, bank
structures, and bank activities vary, each bank needs to develop its
own interest rate risk management program tailored to its needs and
circumstances. Nonetheless, there are certain elements that are
fundamental to sound interest rate risk management, including
appropriate board and senior management oversight and a comprehensive
risk management process that effectively identifies, measures, monitors
and controls risk. This Statement describes prudent principles and
practices for each of these elements.
The adequacy and effectiveness of a bank's interest rate risk
management process and the level of its interest rate exposure are
critical factors in the agencies' evaluation of the bank's capital
adequacy. A bank with material
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weaknesses in its risk management process or high levels of exposure
relative to its capital will be directed by the agencies to take
corrective action. Such actions will include recommendations or
directives to raise additional capital, strengthen management
expertise, improve management information and measurement systems,
reduce levels of exposure, or some combination thereof, depending upon
the facts and circumstances of the individual institution.
When evaluating the applicability of specific guidelines provided
in this Statement and the level of capital needed for interest rate
risk, bank management and examiners should consider factors such as the
size of the bank, the nature and complexity of its activities, and the
adequacy of its capital and earnings in relation to the bank's overall
risk profile.
Background
Interest rate risk is the exposure of a bank's financial condition
to adverse movements in interest rates. It results from differences in
the maturity or timing of coupon adjustments of bank assets,
liabilities and off-balance-sheet instruments (repricing or maturity-
mismatch risk); from changes in the slope of the yield curve (yield
curve risk); from imperfect correlations in the adjustment of rates
earned and paid on different instruments with otherwise similar
repricing characteristics (basis risk--e.g. 3 month Treasury bill
versus 3 month LIBOR); and from interest rate-related options embedded
in bank products (option risk).
Changes in interest rates affect a bank's earnings by changing its
net interest income and the level of other interest-sensitive income
and operating expenses. Changes in interest rates also affect the
underlying economic value 2 of the bank's assets, liabilities and
off-balance sheet instruments because the present value of future cash
flows and in some cases, the cash flows themselves, change when
interest rates change. The combined effects of the changes in these
present values reflect the change in the bank's underlying economic
value.
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2 The economic value of an instrument represents an
assessment of the present value of the expected net future cash
flows of the instrument, discounted to reflect market rates. A
bank's economic value of equity (EVE) represents the present value
of the expected cash flows on assets minus the present value of the
expected cash flows on liabilities, plus or minus the present value
of the expected cash flows on off-balance sheet instruments.
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As financial intermediaries banks accept and manage interest rate
risk as an inherent part of their business. Although banks have always
had to manage interest rate risk, changes in the competitive
environment in which banks operate and in the products and services
they offer have increased the importance of prudently managing this
risk. This guidance is intended to highlight the key elements of
prudent interest rate risk management. The agencies expect that in
implementing this guidance, bank boards of directors and senior
managements will provide effective oversight and ensure that risks are
adequately identified, measured, monitored and controlled.
Board and Senior Management Oversight
Effective board and senior management oversight of a bank's
interest rate risk activities is the cornerstone of a sound risk
management process. The board and senior management are responsible for
understanding the nature and level of interest rate risk being taken by
the bank and how that risk fits within the overall business strategies
of the bank. They are also responsible for ensuring that the formality
and sophistication of the risk management process is appropriate for
the overall level of risk. Effective risk management requires an
informed board, capable management and appropriate staffing.
For its part, a bank's board of directors has two broad
responsibilities:
To establish and guide the bank's tolerance for interest
rate risk, including approving relevant risk limits and other key
policies, identifying lines of authority and responsibility for
managing risk, and ensuring adequate resources are devoted to interest
rate risk management.
To monitor the bank's overall interest rate risk profile
and ensure that the level of interest rate risk is maintained at
prudent levels.
Senior management is responsible for ensuring that interest rate
risk is managed on both a long range and day-to-day basis. In managing
the bank's activities, senior management should:
Develop and implement policies and procedures that
translate the board's goals, objectives, and risk limits into operating
standards that are well understood by bank personnel and that are
consistent with the board's intent.
Ensure adherence to the lines of authority and
responsibility that the board has approved for measuring, managing, and
reporting interest rate risk exposures.
Oversee the implementation and maintenance of management
information and other systems that identify, measure, monitor, and
control the bank's interest rate risk.
Establish internal controls over the interest rate risk
management process.
Risk Management Process
Effective control of interest rate risk requires a comprehensive
risk management process that includes the following elements:
Policies and procedures designed to control the nature and
amount of interest rate risk the bank takes including those that
specify risk limits and define lines of responsibilities and authority
for managing risk.
A system for identifying and measuring interest rate risk.
A system for monitoring and reporting risk exposures.
A system of internal controls, review and audit to ensure
the integrity of the overall risk management process.
The formality and sophistication of these elements may vary
significantly among institutions, depending upon the level of the
bank's risk and the complexity of its holdings and activities. Banks
with non-complex activities and relatively short-term balance sheet
structures presenting relatively low risk levels and whose senior
managers are actively involved in the details of day-to-day operations
may be able to rely on a relatively basic and less formal interest rate
risk management process, provided their procedures for managing and
controlling risks are communicated clearly and are well understood by
all relevant parties.
More complex organizations and those with higher interest rate risk
exposures or holdings of complex instruments with significant interest
rate-related option characteristics may require more elaborate and
formal interest rate risk management processes. Risk management
processes for these banks should address the institution's broader and
typically more complex range of financial activities and provide senior
managers with the information they need to monitor and direct day-to-
day activities. Moreover, the more complex interest rate risk
management processes employed at these institutions require adequate
internal controls that include internal and/or external audits or other
appropriate oversight mechanisms to ensure the integrity of the
information used by the board and senior management in overseeing
compliance with policies and limits. Those individuals involved in the
risk management process (or risk management units) in these banks must
be sufficiently independent of the business lines to ensure adequate
[[Page 33171]]
separation of duties and to avoid conflicts of interest.
Risk Controls and Limits
The board and senior management should ensure that the structure of
the bank's business and the level of interest rate risk it assumes are
effectively managed and that appropriate policies and practices are
established to control and limit risks. This includes delineating clear
lines of responsibility and authority for the following areas:
Identifying the potential interest rate risk arising from
existing or new products or activities;
Establishing and maintaining an interest rate risk
measurement system;
Formulating and executing strategies to manage interest
rate risk exposures; and,
Authorizing policy exceptions.
In some institutions the board and senior management may rely on a
committee of senior managers to manage this process. An institution
should also have policies for identifying the types of instruments and
activities that the bank may use to manage its interest rate risk
exposure. Such policies should clearly identify permissible
instruments, either specifically or by their characteristics, and
should also describe the purposes or objectives for which they may be
used. As appropriate to the size and complexity of the bank, the
policies should also help delineate procedures for acquiring specific
instruments, managing portfolios, and controlling the bank's aggregate
interest rate risk exposure.
Policies that establish appropriate risk limits that reflect the
board's risk tolerance are an important part of an institution's risk
management process and control structure. At a minimum these limits
should be board approved and ensure that the institution's interest
rate exposure will not lead to an unsafe and unsound condition. Senior
management should maintain a bank's exposure within the board-approved
limits. Limit controls should ensure that positions that exceed certain
predetermined levels receive prompt management attention. An
appropriate limit system should permit management to control interest
rate risk exposures, initiate discussion about opportunities and risk,
and monitor actual risk taking against predetermined risk tolerances.
A bank's limits should be consistent with the bank's overall
approach to measuring interest rate risk and should be based on capital
levels, earnings, performance, and the risk tolerance of the
institution. The limits should be appropriate to the size, complexity
and capital adequacy of the institution and address the potential
impact of changes in market interest rates on both reported earnings
and the bank's economic value of equity (EVE). From an earnings
perspective a bank should explore limits on net income as well as net
interest income in order to fully assess the contribution of non-
interest income to the interest rate risk exposure of the bank. Such
limits usually specify acceptable levels of earnings volatility under
specified interest rate scenarios. A bank's EVE limits should reflect
the size and complexity of its underlying positions. For banks with few
holdings of complex instruments and low risk profiles, simple limits on
permissible holdings or allowable repricing mismatches in intermediate-
and long-term instruments may be adequate. At more complex
institutions, more extensive limit structures may be necessary. Banks
that have significant intermediate- and long-term mismatches or complex
options positions should have limits in place that quantify and
constrain the potential changes in economic value or capital of the
bank that could arise from those positions.
Identification and Measurement
Accurate and timely identification and measurement of interest rate
risk are necessary for proper risk management and control. The type of
measurement system that a bank requires to operate prudently depends
upon the nature and mix of its business lines and the interest rate
risk characteristics of its activities. The bank's measurement
system(s) should enable management to recognize and identify risks
arising from the bank's existing activities and from new business
initiatives. It should also facilitate accurate and timely measurement
of its current and potential interest rate risk exposure.
The agencies believe that a well-managed bank will consider both
earnings and economic perspectives when assessing the full scope of its
interest rate risk exposure. The impact on earnings is important
because reduced earnings or outright losses can adversely affect a
bank's liquidity and capital adequacy. Evaluating the possibility of an
adverse change in a bank's economic value of equity is also useful,
since it can signal future earnings and capital problems. Changes in
economic value can also affect the liquidity of bank assets, because
the cost of selling depreciated assets to meet liquidity needs may be
prohibitive.
Since the value of instruments with intermediate and long
maturities or embedded options is especially sensitive to interest rate
changes, banks with significant holdings of these instruments should be
able to assess the potential longer-term impact of changes in interest
rates on the value of these positions and the future performance of the
bank.
Measurement systems for evaluating the effect of rates on earnings
may focus on either net interest income or net income. Institutions
with significant non-interest income that is sensitive to changing
rates should focus special attention on net income. Measurement systems
used to assess the effect of changes in interest rates on reported
earnings range from simple maturity gap reports to more sophisticated
income simulation models. Measurement approaches for evaluating the
potential effect on economic value of an institution may, depending on
the size and complexity of the institution, range from basic position
reports on holdings of intermediate, long-term and/or complex
instruments to simple mismatch weighting techniques to formal static or
dynamic cash flow valuation models.
Regardless of the type and level of complexity of the measurement
system used, bank management should ensure the adequacy and
completeness of the system. Because the quality and reliability of the
measurement system is largely dependent upon the quality of the data
and various assumptions used in the model, management should give
particular attention to these items.
The measurement system should include all material interest rate
positions of the bank and consider all relevant repricing and maturity
data. Such information will generally include (i) current balance and
contractual rate of interest associated with the instruments and
portfolios, (ii) principal payments, interest reset dates, maturities,
and (iii) the rate index used for repricing and contractual interest
rate ceilings or floors for adjustable-rate items. The system should
also have well-documented assumptions and techniques.
Bank management should ensure that risk is measured over a probable
range of potential interest rate changes, including meaningful stress
situations. In developing appropriate rate scenarios, bank management
should consider a variety of factors such as the shape and level of the
current term structure of interest rates and historical rate movements.
The scenarios used should incorporate a sufficiently wide change in
market interest rates (e.g., +/- 200 basis points over a one year
horizon) and include immediate or gradual changes in market interest
rates as well as changes in the shape of the
[[Page 33172]]
yield curve in order to capture the material effects of any explicit or
embedded options.
Assumptions about customer behavior and new business activity
should be reasonable and consistent with each rate scenario that is
evaluated. In particular, as part of its measurement process, bank
management should consider how the maturity, repricing and cash flows
of instruments with embedded options may change under various
scenarios. Such instruments would include loans that can be prepaid
without penalty prior to maturity or have limits on the coupon
adjustments, and deposits with unspecified maturities or rights of
early withdrawal.
Monitoring and Reporting Exposures
Institutions should also establish an adequate system for
monitoring and reporting risk exposures. A bank's senior management and
its board or a board committee should receive reports on the bank's
interest rate risk profile at least quarterly. More frequent reporting
may be appropriate depending on the bank's level of risk and the
potential that the level of risk could change significantly. These
reports should allow senior management and the board or committee to:
Evaluate the level and trends of the bank's aggregated
interest rate risk exposure.
Evaluate the sensitivity and reasonableness of key
assumptions--such as those dealing with changes in the shape of the
yield curve or in the pace of anticipated loan prepayments or deposit
withdrawals.
Verify compliance with the board's established risk
tolerance levels and limits and identify any policy exceptions.
Determine whether the bank holds sufficient capital for
the level of interest rate risk being taken.
The reports provided to the board and senior management should be
clear, concise, and timely and provide the information needed for
making decisions.
Internal Control, Review, and Audit of the Risk Management Process
A bank's internal control structure is critical to the safe and
sound functioning of the organization generally, and to its interest
rate risk management process in particular. Establishing and
maintaining an effective system of controls, including the enforcement
of official lines of authority and the appropriate separation of
duties, are two of management's more important responsibilities.
Individuals responsible for evaluating risk monitoring and control
procedures should be independent of the function they are assigned to
review.
Effective control of the interest rate risk management process
includes independent review and, where appropriate, internal and
external audit. The bank should conduct periodic reviews of its risk
management process to ensure its integrity, accuracy and
reasonableness. Items that should be reviewed and validated include:
The adequacy of, and personnel's compliance with, the
bank's internal control system.
The appropriateness of the bank's risk measurement system
given the nature, scope and complexity of its activities.
The accuracy and completeness of the data inputs into the
bank's risk measurement system.
The reasonableness and validity of scenarios used in the
risk measurement system.
The validity of the risk measurement calculations. The
validity of the calculations is often tested by comparing actual versus
forecasted results.
The scope and formality of the review and validation will depend on
the size and complexity of the bank. At large banks, internal and
external auditors may have their own models against which the bank's
model is tested. Banks with complex risk measurement systems should
have their models or calculations validated by an independent source--
either an internal risk control unit of the bank or by outside auditors
or consultants.
The findings of this review should be reported to the board on an
annual basis. The report should provide a brief summary of the bank's
interest rate risk measurement techniques and management practices. It
also should identify major critical assumptions used in the risk
measurement process, discuss the process used to derive those
assumptions and provide an assessment of the impact of those
assumptions on the bank's measured exposure.
Dated: May 13, 1996.
Eugene A. Ludwig,
Comptroller of the Currency.
By order of the Board of Governors of the Federal Reserve
System.
Dated: May 23, 1996.
William W. Wiles,
Secretary of the Board.
By order of the Board of Directors.
Dated at Washington, DC, this 14th day of May, 1996.
Robert E. Feldman,
Deputy Executive Secretary.
[FR Doc. 96-16300 Filed 6-25-96; 8:45 am]
BILLING CODES: 4810-33-P; 6210-01-P; 6714-01-P