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Financial Institution Letters

[Federal Register: June 26, 1996 (Volume 61, Number 124)]
[Page 33166-33172]
From the Federal Register Online via GPO Access []



Office of the Comptroller of the Currency
[Docket No. 96-13]


[Docket No. R-0802]


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.


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.

    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.


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 

    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 
    (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 
    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 
    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 
    (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 
    (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 

[[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 
    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


    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

    \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 

    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.


    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 

     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.

    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 
     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 
    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 
    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 
     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 
    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 

    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

Last Updated 07/17/1999

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