Get these 3 things right and you're on your way to a better, less stressful interest rate risk exam.
Welcome everyone to Meet Community Bank Asset Liability Regulatory Requirements, Calculate Interest Rate Risk Sensitivities and Document Your Compliance Automatically webinar. This is a special webinar I’m offering today.
My name is Howard Lothrop and I'll be your host on this webinar today. Everyone will be muted, so, please submit any questions from question box. I can't promise we would get to them all, but will try.
A quick disclaimer. We use data we believe to be reliable. We do not warrant its completeness or accuracy. We are not providing accounting, regulatory or legal services, and you must determine if this information is suitable for your specific needs.
Once again, my name is Howard Lothrop and I’m a Community Bank consultant at Echo Partners. I have over 30 years financial risk management experience, including 15 years as senior vice president at a large regional bank. For the past eight years I've been a Community Bank consultant. Bank Rating Reports.com is a standalone bank rating reports service and Community Bank Networker is an umbrella organization concerning Community Bank information. So with all of our introductions complete let's move on.
Regulatory Requirements.
You must know and be familiar with the regulatory requirements. Otherwise it's like playing a game without knowing the rules, and we know how that's likely to turn out. Even if fortune smiles upon you, you’ll do less well than you could have. So with that in mind let’s start beginning with OCC Bulletin 2000-16.
This is the great granddaddy of them all for interest rate risk and model validation is concerned. It clarified several key concepts including the fact that you must validate your model inputs. That is the information reported to model your financial results, you must validate the model processing. This is where we must examine and validate the arithmetic accuracy of the model and finally validate your outputs making sure that your results match up with reality. The key concepts are still equally valid today.
In January 2010 a joint regulatory advisory on interest rate risk was issued. Here we have a copy of the FDIC's version: the financial institution letter FIL-2 – 2010. Several key concepts introduced in this financial institution letter include the need for a full 400 basis point rate shock, an annual review of your interest rate risk model and your interest rate risk management process, and vendor validation of any models that you obtained from a vendor.
The environment with continued low interest rates caused the regulatory community to come up with these additional clarifications and extended requirements for interest rate risk. Finally, we have the OCC Bulletin 2011 -- 12 supervisory guidance on model risk management. While this supersedes, it really reiterates and reinforces the key concepts of OCC 2000-16.
If you know these three key regulatory releases and the information contained within you’re well on your way to a successful interest rate risk management exam.
Calculating Interest Rate Risk Sensitivities
Now let’s talk about calculating our interest rate risk sensitivities and that’s really what it's all about… quantifying your interest rate risk.
There are three main ways to do that. We will start first of all looking at Gap. Gap measures the difference between how many assets are scheduled to mature or otherwise reprice in any given time period relative to liabilities. If more assets reprice then you are said to be asset sensitive. If more liabilities reprice, you are liability sensitive.
Asset sensitive banks, generally speaking, will do well in rising rate environments, while liability sensitive banks will do well in a falling rate environments
What we do to create a gap report is we list out all of the line items on the balance sheet and take note of whether or not they are amortizing or a bullet maturity. Separate them into time buckets and adjusts them for likely prepayments.
It's really quite a straightforward process and it gives you even today, especially for a bank with a less complex balance sheet, a very good insight into your basic interest rate risk. An added benefit in the gap report of course is that most people in the bank understand it.
From there we go to earnings at risk. The calculation of earnings at risk is a more sophisticated simulation approach that tends to be more accurate with respect to things like optionality or prepayments.
We examine net interest income, group them, and we have cash flows that vary relative to interest rates. Look at familiar bar chart. Here you see the bar chart on the right rising showing your net interest income increasing as rates increase. The bank would be said to be asset sensitive.
And here's the key thing about this report is generally shown over a 12 month period time. You must however have additional earnings at risk time periods such as 24 months, 36 months or 60 month in order to fully get the benefit of this report.
Secondly there is a wealth of good management information here. Almost all bank managers want to know about earnings or are concentrating on earnings. So it's a good place to start look for strategies for what you might implement at the bank.
From here we will turn to the third and final major way to calculate interest rate risk, the economic value of equity. Now unlike the first two, gap and earnings at risk, economic value of equity is a measure of the long-term interest rate risk at the bank.
Instead of looking at a particular time, say 12 months or 24 months, the economic value of equity is calculated over a sufficiently long period of time so that all of the banks assets and liabilities are able to fully reprice.
The way EVE is calculated is that your book values are adjusted to base. That is, look at things like your securities portfolio and adjust them to fair market value. Then we’ll look at how they vary with changes in interest rates. Take the present value of these cash flow numbers and look at the residual difference between the PV of the asset CFs and the PV of the liability CFs and that is the economic value of equity. Again a lot of good information for bankers who could potentially spend more time getting to know this report.
Now to look at these measurements for analysis purposes, it is often best to look at them over the full range of interest rate shocks.
Here we’re looking at the change in cumulative gap. It's shows a different color line for each rate shock environment up or down 100, 200, 300 or 400 basis points. Here's the key on this cumulative gap snapshot, where the lines are tightest together is where the bank has the least interest rate risk and those places where there's a larger variability or distance between the lines such as in the 1 to 2 year or 2 to 3 year time buckets are the areas where the bank has the most interest rate risk.
Again, the earnings at risk snapshot shows us the same thing in the up and down 100, 200, 300 and 400 basis point change expected for an instantaneous a static rate shock. Here we see a very modestly asset sensitive bank. Net interest income is projected to increase with rate increases, but only a small 5% or less. Over the full 400 basis point range, the interest rate risk of this bank is very stable.
Economic value of equity, remember, is the long-term measure of interest rate risk where every asset and liability fully reprices. This shows a slightly different story. It shows a bank with a limited liability sensitive position as interest rates increase over the very long term.
This bank in a static sense, with no management or asset liability mix changes, no balance sheet mix changes would tend to have declining net interest income and therefore economic value of equity in the very long run.
Now many times, because of the long-term nature of the EVE these numbers become outsized percentages These here show very small and stable measures of EVE. Understand that EVE with big interest rate risk numbers associated with the EVE, keep in mind that this is a double-edged sword just because it is a long-term highly leveraged way of looking at your risk and tends to magnify the risk.
But it also means that when you actually implement some form of management strategy change or any change in balance sheet mix it really is the easiest risk to adjust.
Now that we've looked at the three main methods of calculating your interest rate risk sensitivities let’s talk about documenting your compliance.
Documenting Your Compliance
There are several things you must look at here. The first thing to look at is to look at assumptions. Assumptions are these actual unique individualistic changes and characteristics of your assets and liabilities that make a generic model into one that is unique to your bank.
Here you can see, we have changes in prepayment speeds over various rate change scenarios, for all of the time buckets, for each of the various line item for assets and liabilities. Then you can see at the bottom of the page, we allow you also to specify changes and decay rate and average life for your nonmaturity deposit accounts, such as your transaction accounts, your money market or savings accounts.
This is what differentiates your bank from any of the other banks running the same model…The specific assumptions that you use. Your assumptions are normally areas an examiner would look at, and especially if you have a log of your assumptions.
An assumptions log that shows a detail of who examined assumptions, why they either change them or let them alone, authorized changes and can replicate this then you know that that's really a step in the right direction for your interest rate risk exam.
The next item we’re going to look at is backtesting. We have annual backtest, and will jump one more page to look at the quarterly backtest.
The backtest is one of the ways we're going to validate the model outputs. Here's what we do. In the upper left hand corner you see, we had a forecast. The forecast is what the model said 3 months ago that it expected your results to be.
Next, look at the three things we didn't know three months ago. We didn't know how much the bank would grow or shrink. That’s the volume. We didn't know how the banks asset and liability or balance sheet mix would change. And we didn't know exactly what the interest rate risk position was. How were interest rates actually going to change.
So if we make adjustments for these three unknown variances, which are volume, mix, and
Rate, we will end up with the lower left-hand column, which is the adjusted forecast. The adjusted forecast represents the forecast the model would have made had it been possible to know with certainty the outcome of the banks growth, balance sheet mix, and the interest rate environment.
We then compare the adjusted forecast with your actual net interest income by line items and look at the dollar and percentage variance. Here you can see total interest income within 1 3/4%, total interest expense right at 3/4%, and net interest income or expense less than 2%. These are very good numbers…a very tight fit.
Generally speaking, if you can demonstrate results less than 10% these are considered good results. Now here's the key for backtest. If you did not have this sort of a good fit, then that’s the signal that says maybe you should consider adjusting your assumptions. Adjust assumptions, if you have results that do not provide a good backtests.
Then, finally take a look at the format of a third-party independent model validation opinion. We do this every year. We go out, we contracted with another consultant, an interest rate risk consultant, to perform an independent validation of the model.
This year’s is up to date and covers such things as data integrity, calculation accuracy and reporting. It is timely and is updated. This is the biggest, most common shortcoming that I find when I examine a bank’s interest rate risk management…they do not have a timely and updated independent 3rd party model validation opinion in their files.
Now, I know we've covered quite a bit of information very quickly. If you want to get more information, contact me at EchoPartners.com and I will be glad to give you a sample asset liability report, complimentary for your bank, and also be glad to answer any asset liability questions that you might have.
Once again this is Howard Lothrop. Thank you very much for attending. We look forward to seeing you on our next webinar. Thank you and goodbye.