Joint Advisory on Interest Rate Risk Management
On January 6, 2010, the financial regulators issued a joint Advisory on Interest Rate Risk Management. The advisory re-emphasizes, clarifies, and reviews best practices for measuring, monitoring, and controlling interest rate risk. Key points are summarized below.
Corporate Governance
The board of directors has the ultimate responsibility for the risks undertaken by the institution. The board should understand, and be regularly informed about, the level and trend of their bank’s IRR exposure. Senior management is responsible for ensuring that board-approved strategies, policies, and procedures for managing IRR are executed. Management is also responsible for maintaining appropriate policies, procedures, and internal controls which should the IRR measurement and reporting process.
Measurement and Monitoring of IRR
Systems to measure and monitor IRR should be commensurate with the size and complexity of the institution. Banks may rely on third-party IRR models, but are expected to fully understand the underlying analytics, assumptions, and methodologies of the system.
Measurement Methodologies
Methodologies for measuring IRR exposure include Gap analysis (which may be a viable analytical tool for smaller, less complex banks), simulation of Earnings at Risk (typically focused on shorter term time horizons), and market value approaches, such as Economic Value of Equity (which measure longer term IRR horizons). When using EaR, IRR exposures are best projected over at least a 2 year period, and may require 5 year or longer horizons. Static simulations, which are based on current exposures and assume a constant balance sheet with no new growth, provide a complete and comparative description of the bank’s IRR exposure. EVE methodologies, capturing all future cash flows over a longer term horizon, also typically use a static approach.
Stress Testing
Stress testing, consisting of both scenario and sensitivity analysis, is an integral part of IRR management. In many cases, static parallel interest rate shocks of plus and minus 200bps may not be sufficient to adequately assess a bank’s IRR exposure. Banks should regularly assess IRR exposures beyond typical industry conventions, including changes in rates of greater magnitude (up and down 300-400bp), as well as different tenors, slopes, or twists. Scenarios should be severe but plausible given the existing level of interest rates. Again, the stress tests should be commensurate with the size and complexity of the bank. Non-complex banks may run fewer or less intricate scenarios, but interest rate shocks of sufficient magnitude should be run regardless of the bank’s size or complexity.
Assumptions
The regulators remind banks to document, model, and regularly update key assumptions used in IRR measurement models. Sensitivity analysis should be run to illustrate the influence that assumptions have on model output. At a minimum, banks should ensure the reasonableness of asset prepayment, non-maturity deposit, and rate driver assumptions. Given their influence on IRR exposure measurement, assumptions about non-maturity deposit accounts (NMDAs) are critical. Actual experience should be compared with past assumptions and expectations. When assumptions are adjusted, the change and effect on model outputs should be documented and clearly identified.
Risk Mitigation
Well managed banks must find a balance between establishing risk limits that are neither so high that they are never breached nor so low that exceeding the limits is considered routine and not worthy of action. When limits are approached or breached, risk may be mitigated through balance sheet alteration and hedging. Outside consultants may be relied upon to help establish hedging programs and strategies, but they do not absolve the board and senior management of their responsibilities to fully understand derivative hedging strategies.
Model Validation
An important element of model validation is independent review of the logical and conceptual soundness, including reasonableness of assumptions, the process used to determine assumptions, and backtesting model accuracy versus actual results. These reviews should be available for regulatory review. Banks that use vendor-supplied models are not required to test the mechanics and mathematics of the IRR measurement model. Rather, the vendor should provide documentation of an independent third-party review.
Conclusion
The adequacy and effectiveness of a bank’s IRR management process and the level of its IRR exposure are critical factors in the regulators’ evaluation of a bank’s sensitivity to changes in interest rates and capital adequacy. When evaluating the applicability of the specific guidelines provided in this joint advisory and the level of capital needed for the level of interest rate risk, the institution’s management and regulators should consider factors, such as the size of the institution, the nature and complexity of its activities, and the adequacy of its level of capital and earnings in relation to its over all interest rate risk profile. Interest rate risk management should be an integral component of an institution's risk management infrastructure. Management should assess the need to strengthen existing IRR practices by incorporating the supervisory expectations and management techniques highlighted in this advisory.
Wondering how these rules apply to you? Call us today for a free analysis and consultation at 1.800.971.1378. We’ll help you understand these complex standards and then advise you on the right approach for your financial situation — ultimately helping you maximize your financial potential.
Click here to view Joint Advisory on IRR Management as a PDF.