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[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


 

[[Page 33170]]


 

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