by Emily Moré Hollis - CFA,
Partner of ALM First Financial Advisors
June 2010
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Some interest rate risk (IRR) is inherent in the business of banking, but what best practices and management techniques can I follow to ensure sound IRR management and minimize IRR exposure in this current market environment?
That’s an excellent question. Current financial market and economic conditions present significant risk management challenges to institutions of all sizes. Earlier this year NCUA, in conjunction with the financial regulators1, issued an advisory on interest rate risk management, in which they set expectations on how to evaluate, test, and plan for IRR. Key areas of focus for effective risk management were laid out as follows: Corporate Governance: - Put appropriate policies, procedures and internal controls in place.
- Create sufficient detailed reporting processes to inform senior management and the board of the level of IRR exposure.
Policies and Procedures: - Institutions are expected to have comprehensive policies and procedures.
Measurement and Monitoring of IRR: - Set expectations of robust IRR processes and systems relative to risk tolerances.
- Management may rely on third-party IRR models, but are expected to fully understand the underlying analytics, assumptions, and methodologies.
Measurement Methodologies: - Consider earnings and economic perspectives when assessing IRR exposure.
- IRR exposures are best projected over at least a two-year period.
- Institutions should also run static simulations if dynamic simulations are used.
Measurement Methodologies and Stress Testing: - Incorporate a stress-testing process to identify and quantify the institution’s IRR exposure and potential problem areas. This range should be sufficiently meaningful to fully identify basis risk, yield curve risk and the risks of embedded options.
- Regularly assess IRR exposures beyond typical industry conventions.
- Stress scenarios should include but not be limited to:
- Instantaneous and significant changes in the level of interest rates (instantaneous rate shocks);
- Substantial changes in rates over time (prolonged rate shocks);
- Changes in the relationships between key market rates (i.e., basis risk); and
- Changes in the slope and the shape of the yield curve (i.e., yield curve risk).
- Stress testing should include a sensitivity analysis to help determine which assumptions have the most influence on model output.
Risk Mitigating Steps: - Using derivative instruments to mitigate IRR exposures may be appropriate for institutions with the knowledge and expertise in these instruments.
- Reliance on outside consultants to assist in the establishment of such a strategy does not absolve the board and senior management of their responsibility to fully understand the risks of the derivatives hedging strategy.
Internal Controls and Validation: - Validations should be an independent review of the logical and conceptual soundness.
- Institutions that use vendor-supplied models are not required to test the mechanics and mathematics of the measurement model. However, the vendor should provide documentation showing a credible independent third party has performed such a function.
IRR management should be an integral component of an institution’s risk management infrastructure. Management should routinely assess their current IRR practices and determine whether they need to be strengthened based on the supervisory expectations and management techniques described here.
1 The financial regulators consist of the Board of Governors of the Federal Reserve System (FRB), the Federal Deposit Insurance Corporations (FDIC), the National Credit Union Administration (NCUA), the Office of the Comptroller of the Currency (OCC), the Office of Thrift Supervision (OTS), and the Federal Financial Institutions Examination Council (FFIEC) State Liaison Committee (collectively, the regulators).
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