Managing Sensitivity to Market Risk in a Challenging Interest Rate Environment

October 25, 2013 at 2:39 pm Leave a comment

In response to a finding that certain financial institutions are unprepared for sustained increases in interest rates, the FDIC recently issued a Financial Institution Letter (FDIC Letter) to remind financial institutions about the importance of developing a comprehensive and effective interest rate risk management program.

Such a program and its corresponding policies will be instrumental to your bank’s continued success amid impending uncertainty regarding interest rates. The following provides a brief overview of information necessary for your financial institution to begin considering any undue exposure to interest rate risk.

The risks posed by sustained increases in interest rates to unprepared financial institutions are vast. Among other dangers, a rising rate environment exposes institutions with liability-sensitive positions to declines in net interest income. Additionally, financial institutions with bond holdings in long-duration issues could potentially experience severe and material depreciation of those holdings relative to their capital position. Furthermore, a period of sustained interest rate increases could create liquidity problems for institutions that rely primarily on a long-duration fixed-income portfolio for liquidity.

Because of these aforementioned risks, prudent interest rate risk oversight and effective risk management processes are vitally important. Effective measurement and monitoring systems, clear communication of modeling results, continuous evaluation of exposures relative to established policy limitations, and the consideration of risk mitigation options when appropriate is essential to the financial health of your institution over the coming months and years. The following FDIC-provided suggestions will ensure your institution is prepared for a period of rising interest rates in the future.

Board and Management Oversight: Bank directors must have a thorough understanding of their financial institution’s vulnerability to interest rate volatility, including the corresponding impact any volatility may have on earnings and capital. The board must implement sound strategies, procedures, policies, and risk tolerances to address these interest rate risks.

The board has the ultimate responsibility for all risks – including interest rate risk – undertaken by a financial institution. Therefore, bank directors must have a thorough understanding of the interest rate risk exposure faced by their institutions at all times and the interest rate risk strategies they pursue, including the potential impact on market, credit, liquidity, and operating risks. This understanding is crucial for the board to develop a sound strategy to balance exposure to interest rates.

Policy Framework and Prudent Exposure Limits: Bank directors must adopt prudent exposure limits and risk tolerance levels. Directors should also revise asset-liability management and investment policies on an annual basis.

The FDIC expects financial institutions to implement comprehensive policies and procedures governing all aspects of their interest rate risk management process. In this regard, the bank’s asset-liability management and investment policies should be annually reviewed, revised, and amended by the board to ensure that risk tolerance levels and exposure limits are prudent. The FDIC Letter emphasizes that these policy limitations should formalize the board’s risk philosophy, guide management’s decision making, and protect bank capital from undue risk. The FDIC also requires risk tolerances to specifically address the potential impact of changing interest rates on earnings and capital from both a short-term and long-term perspective.

Effective Measurement and Monitoring of Interest Rate Risk: The risk measurement tools used by banks to monitor interest rate risk must be effective and well-developed.

All financial institutions should have effective risk measurement tools for analyzing and monitoring interest rate risk. Rather than using a single measurement of interest rate risk, well-managed institutions generally use a holistic approach and review multiple types of data and modeling techniques. The methods available to banks include earnings simulations, gap analyses, economic value of equity estimations, and various stress tests. In addition, the FDIC Letter encourages financial institutions to analyze the impact of 300 to 400 basis point interest rate changes on their earnings and capital.

The FDIC provides guidance for effectively using the aforementioned modeling techniques. When performing interest rate risk simulation, a key aspect involves the selection of an appropriate time horizon over which to assess this risk exposure. Because of this, the FDIC recommends a projection of no less than a two year time period (noting, however, that a five to seven year time period is necessary for certain products with embedded options). In addition to simulation models, the FDIC also recommends using economic value methodologies to broaden the assessment of interest-rate risk exposure.

Such an approach focuses on a longer-term time horizon and captures all future cash flows expected from existing assets and liabilities. Similarly, the FDIC also encourages financial institutions to utilize stress testing, including both scenario and sensitivity analysis, because it is a fundamental component of interest rate risk management. Effective stress testing requires institutions to assess a range of alternative future interest rate scenarios in evaluating interest rate risk exposure.
Regardless of the methods used, an institution’s interest-rate risk measurement system should be sufficiently developed to capture all material on and off-balance sheet positions and incorporate a stress-testing process to identify and quantify the institution’s interest rate exposure and potential problem areas.

Employ risk mitigation strategies: If necessary, appropriate action must be taken to mitigate interest rate risk.

Should your financial institution’s interest rate risk exposure exceed or approach bank-established limits, prompt management attention is required and appropriate action must be taken. Included among the approaches available to financial institutions to mitigate interest rate risk include rebalancing earning asset and liability durations, proactively managing non-maturity deposits, increasing capital, and employing hedging strategies. According to the FDIC, the most common way financial institutions control interest rate risk is through the balance sheet alteration of assets and liabilities. Importantly, because hedging with derivatives is a potentially complex activity, the FDIC Letter cautions that the use of derivative instruments to mitigate interest rate risk exposures may only be appropriate for those institutions proficient in their use.

Conclusion

In conclusion, the FDIC Letter warns that significant, unmitigated levels of interest rate risk can lead to losses and liquidity constraints when prevailing rates change significantly. Understanding these risks and taking timely and proactive steps to mitigate them is crucial to your bank’s financial well being.

Special thanks to our new guy, Tanner Weigel, for preparing this beautifully written and researched blog post.  Welcome to the team, Tanner!

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