Question

Banks are competing vigorously in the market for fixed rate mortgages at present. Given interest rates are at historic lows at present, how can banks manage the interest rate risk this lending causes?

Question 20: Banks are competing vigorously in the market for fixed rate mortgages at present. Given nterest rates are at historic lows at present, how can banks manage the interest rate risk this lending causes?

Answer 1

Generally speaking, interest rate risk is the risk that an adverse outcome will result from changes in interest rates. While interest rate risk can arise from various sources, four key types of interest rate risk are common to community bank balance sheets:

• Mismatch/Repricing Risk: The risk that assets and liabilities reprice or mature at different times, causing margins between interest income and interest expense to narrow.
• Basis Risk: The risk that changes in underlying index rates used to price assets and liabilities do not change in a correlated manner, causing margins to narrow. For example, loans priced off national prime rates might not change in the same manner as certificates of deposit priced off U.S. Treasury rates.
• Prepayment/Extension Risks: The risk that asset repayments accelerate at a time when interest rates are low, resulting in diminished interest income and the need to reinvest repaid funds in lower-yielding assets. This risk intensifies when loan customers or bond issuers exercise their explicit call options to pay off the bank’s asset prior to maturity and interest rates decline. The flip side of prepayment risk is extension risk, which stems from the lengthening of asset payoff rates in a rising rate environment, thereby reducing the funds available to invest at higher yields.
• Yield Curve Risk: The risk that nonparallel changes in the yield curve will disproportionately affect asset values or cash flows. For example, mortgage assets tend to be priced off 10-year U.S. Treasury rates. Suppose 10-year Treasury rates change significantly, while all other Treasury rates remain unchanged. The value and cash flows from mortgage loans and mortgage-related securities will also change significantly, but other assets and liabilities will not experience similar changes. Thus, banks with significant mortgage asset holdings would be exposed to greater yield curve risk than those with mortgage assets comprising a lower percentage of assets.

Key Risk Management Elements

Because banks are in the business of transforming short-term deposits into longer-term loans, they are inherently exposed to some degree of interest rate risk. Those exposures warrant risk management programs that allow the bank’s management team and board of directors to appropriately identify, measure, monitor, and control these exposures. The rigor and expense applied to these programs should be commensurate with the size of the risk exposures and complexity of activities and holdings. Therefore, while there are elements of interest rate risk management that all banks should have in place, community banks would not necessarily need the same level of sophistication in their risk management practices as those that are in use at larger, more complex banking organization

Board and Senior Management Oversight

A bank’s board of directors is ultimately responsible for setting the institution’s risk tolerance/appetite and overseeing the establishment of appropriate risk controls, both of which affect the level of interest rate risk exposure at the bank. While many community bank directors may have limited involvement with interest rate risk management in their own professional careers outside the institution, a bank’s board is expected to have a collective fundamental working knowledge of the different types of interest rate risk, how business activities could create or change the bank’s exposure, and how risk measurement reports can be used to identify exposures. In the past 15 years, significant progress has been made in the banking industry to develop interest rate risk and other training materials for directors, an example of which is the Federal Reserve System’s Bank Director’s Desktop

Policies and Risk Limits

Effective communication of the board’s intentions regarding interest rate risk taking and risk management is important and should be accomplished through policies that are reviewed and updated periodically. Interest rate risk policies can be standalone documents or housed in a broader asset/liability management policy. At a minimum, board policies should describe the bank’s risk tolerance/appetite; methods to identify, quantify, and report exposures; parties responsible for ongoing risk measurement and management; and the controls and risk limits necessary to ensure that the risk management function is operating appropriately. When bank examiners evaluate interest rate risk policies, these are the key components considered.

Risk Measurement and Reporting

Perhaps the most discussed interest rate risk management topic for community banks is risk measurement. Questions often arise regarding the types of tools or models that are needed, how to fine-tune those tools, and how often measurement reports should be provided to the ALCO and the board. At the most basic level, regulatory expectations require a bank’s interest rate risk measurement tools and techniques to be sufficient to quantify the bank’s risk exposure. Measurement techniques typically fall into two broad categories: short-term and long-term risk measures

Internal Controls and Audit

The interagency advisory and subsequent FAQs attempt to bring greater clarity to regulatory expectations about internal controls and audit requirements. Examiners have long expected all banks to maintain appropriate controls over risk measurement and reporting processes. Generally speaking, these controls include secondary reviews of data accuracy in risk measurement tools, reporting of compliance with policy limits, and periodic review and documentation of the reasonableness of assumptions used in risk measurement tools.

Common Pitfalls

One of the unique opportunities examiners have is to observe both best practices and common weaknesses at a broad cross-section of banks. At community banks, three common deficiencies in interest rate risk management tend to recur and are often cited in examination reports as matters requiring board attention.

First, many examiners have reported that they often find gaps between board-prescribed risk limits and the risk measurement tools used to quantify risk exposures. For example, a bank policy may specify a risk limit in terms of EVE, but the bank’s risk measurement tool may not measure EVE exposures. While not every risk measure captured by the measurement tool requires a risk limit, the risk limits established by the board should be routinely calculated and reported. If the risk limit can’t be captured by the risk measurement tool in place, the board should determine whether a new, appropriate, and calculable limit should be established or whether a new risk measurement tool is needed.

Second, many examiners have evaluated assumptions used in interest rate risk models and determined that default or industry standard assumptions provided by the vendor have never been evaluated or customized by the bank’s management team. While certain vendor-provided assumptions may be appropriate for some banks, the management team should evaluate the reasonableness of those assumptions before accepting them for use in a given model.