Bank capital performs several very important functions. It absorbs losses, promotes public confidence, helps restrict excessive asset growth, and provides protection to depositors and the deposit insurance fund. Regulatory capital requirements have evolved as innovations in financial instruments and investment activities introduce greater complexity to the banking industry. Additionally, certain community banking organizations may elect the Community Bank Leverage Ratio framework.
Liquidity and Funds Management
Liquidity reflects a financial institution's ability to fund assets and meet financial obligations. It is essential to meet customer withdrawals, compensate for balance sheet fluctuations, and provide funds for growth. Funds management involves estimating liquidity requirements and meeting those needs in a cost-efficient manner. To mitigate funding stress, it is important that institutions maintain sufficient levels of liquid assets and access to borrowing lines and other sources to meet expected and contingent liquidity demands.
Investment securities can provide banks with earnings, liquidity and capital appreciation. Carefully constructed portfolios can also help reduce overall risk exposure. The risks presented by investment securities may include market, credit, liquidity, legal, operational, and settlement. To effectively manage these risks, it is important to establish effective policies, due diligence and risk selection standards, risk limits, and other risk management controls.
Interest Rate Risk
Interest rate risk is the exposure of a bank's current or future earnings and capital to adverse changes in market interest rates. Interest rate risk is a normal part of banking and can be an important source of profitability and shareholder value; however, excessive interest rate risk can threaten banks' earnings, capital, liquidity, and solvency. Therefore, it is important to effectively identify, measure, monitor and control interest rate risk exposure through effective policies and risk management processes.
Derivative contracts generally represent agreements between parties either to make or receive payments or to buy or sell an underlying asset on a certain date (or dates) in the future. Parties generally use derivative contracts to mitigate risk, although such transactions may serve other purposes. For example, an interest rate derivative contract allows a party to manage the risk associated with a change in interest rates, while a commodity derivative contract allows a party to fix commodity prices in the future and thereby minimize any exposure attributable to unfavorable movements in those prices.
London Interbank Offered Rate (LIBOR) Transition
The transition away from LIBOR as a reference rate benchmark poses financial, legal, operational, and consumer protection risks for institutions with exposure. Exposure is generally measured as the size of any activity and the number of counterparties or consumers with financial contracts that reference LIBOR across all products. It is important that institutions with LIBOR exposure have appropriate risk management processes in place to identify and mitigate transition risks.
The Volcker Rule generally restricts banking entities from engaging in proprietary trading and from owning, sponsoring, or having certain relationships with hedge funds or private equity funds. A bank that does not have (and is not controlled by a company that has) more than $10 billion in total consolidated assets and does not have (and is not controlled by a company that has) total trading assets and liabilities of 5 percent or more of total consolidated assets is excluded from the Volcker Rule.