Federal regulators have traditionally warned banks about the dangers of interest rate risk (IRR). Today, with interest rates potentially poised to rise, it’s critical that banks have a robust program for managing IRR.
Assessing your risk
IRR refers to the risk that changes in market interest rates will have an adverse impact on a bank’s earnings or capital. Each bank is different, so it’s important to assess risk in light of your institution’s particular risk profile.
Federal regulators have observed that many banks use short-term or “more immediately repricing” deposits to fund longer-term loans and investments, which inherently exposes them to some level of IRR. To mitigate this risk, regulators emphasize, banks must implement a risk management program to lessen IRR exposures.
Designing a program
Regulators expect your bank’s IRR management program to conform to the following framework, adjusted for its risk profile.
Board oversight. Your board of directors bears the ultimate responsibility for all interest rate risks your bank undertakes. Thus, examiners expect your board (or a designated committee) to understand the different types of IRR, the bank’s exposure and the potential impact on that exposure from your business activities. The board also is responsible for overseeing the implementation of IRR management strategies, policies, procedures and risk tolerances.
Policies and procedures. Your bank should have comprehensive policies and procedures — updated regularly — that govern all aspects of IRR management. Among other things, these policies and procedures should:
- Describe the bank’s risk tolerance,
- Detail the methods used to identify, quantify and report IRR exposures,
- Identify the persons responsible for ongoing risk measurement and management, and
- Establish necessary controls and risk limits to ensure the program’s smooth operation.
Examiners are particularly interested in the board’s role when the bank exceeds those risk limits. Does the program direct, for example, the board to require management to develop an action plan to return risk to an acceptable level?
Potential risk mitigation strategies include rebalancing asset and liability durations, proactively managing nonmaturity deposits, increasing capital and hedging. Regulators warn that banks shouldn’t attempt hedging unless the board and senior management fully understand these transactions and their potential risks.
Measurement and monitoring. Examiners expect banks to have robust systems and processes in place to assess their risk exposure — to both earnings and capital — relative to set risk limits. Applicable techniques include measuring short-term earnings risk, such as gap analysis and earnings-at-risk (EAR) models, and measuring long-term capital risk, such as long-term EAR and economic value of equity (EVE) models.
Internal controls and audit. Examiners expect banks to have internal controls to ensure the integrity of their IRR management programs. Your bank should conduct periodic independent reviews of the data inputs and key assumptions in your IRR models, compliance with IRR policies, and the accuracy of reports to your board or asset-liability management committee.
Avoiding the pitfalls
In a recent issue of FedLinks, a bulletin focusing on community banks, the Federal Reserve underscored the importance of IRR and the need for a comprehensive risk management program. The publication also discussed the most common weaknesses in community banks’ programs, based on examiners’ observations. Three recurring IRR management deficiencies were:
- Discrepancies between board-prescribed risk limits and management’s risk measurement tools — for example, the board sets an IRR limit based on EVE, but management’s measurement tool doesn’t gauge EVE exposures.
- Use of vendor-supplied IRR model assumptions without evaluating their reasonableness or customizing them.
- Failure to conduct independent or third-party reviews — the Fed says these reviews can help identify weaknesses, the need for better reporting and other needed improvements.
4 common sources of interest rate risk
For community banks, four common sources of interest rate risk (IRR) are:
Repricing risk. This risk results when a bank’s assets and liabilities reprice or mature at different times, narrowing margins between interest income and interest expense.
Option risk. Many bank assets and liabilities contain embedded options, such as the right to prepay a loan or to withdraw deposits early with little or no penalty. The bank is compensated for this flexibility in the form of higher interest rates on loans or lower interest rates on deposits. The risk is that, if interest rates go up, deposit holders will move their funds into higher-yielding investments. If rates go down, borrowers will refinance their loans at a lower rate.
Basis risk. Even when assets and liabilities reprice or mature at similar intervals, changes in their interest rates don’t necessarily correlate to market rate changes. For example, if an asset and related liability are tied to different short-term market indexes, the spread between the two can fluctuate, creating basis risk.
Yield curve risk. This risk is derived from the disparate impact of market rate changes on yields from similar instruments with different maturities.
Strategies for mitigating IRR take time to implement. Act now to review your program and ensure your bank is prepared for the changes to come.
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