As a service to our clients and prospective clients, we want to provide some unique insights into some of the “hottest” Risk Management topics facing financial institutions on the West Coast. We have addressed an update on "Best Practices" associated with the Interest Rate Risk Management.
BankVision, Inc. is a premier provider of internal audit and Risk Management services to community banks and financial institutions. The firm is focused on implementing Risk Management solutions for the full spectrum of financial institutions. Our clients range from “de novo” institutions that may need a complete package of Risk Management services to multi-billion dollar regional banks that need audit “augmentation” in specific technical areas. We are organized in specialized teams of subject matter experts covering every major discipline associated with financial services.
Interest Rate Risk - What’s safe?
Exposure to interest rate risk has garnered a significant amount of attention over the past several years, and rightfully so. Excess liquidity and demand for high quality loans compressed investment and loan yields. While banks have enjoyed an unprecedented run of historically low deposit (liability) rates, the ability to manage your net interest margin is paramount. Given a twist on the old saying, “what goes up, must come down,” it is likely that within the next year or so, “what has come down will certainly go up.” So, unless you have a crystal ball and can forecast when, how much and how sharply rates will move, what steps can you take to ensure that your institution’s income statement and balance sheet is relatively risk “neutral” (i.e., not subject unplanned rate change)?
Here’s a refresher on what to consider:
The FDIC provided a fair amount of clarity with their issuance of FIL 46-2013, “Managing Sensitivity to Market Risk in a Challenging Interest Rate Environment.” The impetus for the FIL was the FDIC’s analysis that many institutions had significant liability-sensitive balance sheets. In short, the FDIC is increasingly concerned that certain institutions may not be sufficiently prepared or positioned for sustained increases in, or volatility of, interest rates. For example, institutions with a decidedly liability-sensitive position could experience declines in net interest income and potential deposit run-off in a rising rate environment. Moreover, rate sensitive liabilities may re-price faster than earning assets as coupons on variable rate loans and investments remain below their floor.
Not surprisingly, the FDIC believes that asset-liability management should be viewed as an ongoing process that requires effective measurement and monitoring systems, clear communication of modeling results, evaluation of exposures relative to established policy limitations and consideration of risk mitigation options, as appropriate.
In the guidance, the FDIC is re-emphasizing the following practices to ensure state non-member institutions have adopted a comprehensive asset-liability and interest rate risk management process covering the following:
Board and Management Oversight
Effective Board governance and oversight are critical to developing a strong asset-liability management process. Boards of Directors should be aware of interest rate risk exposure during the current business cycle, not just in advance of volatile periods. Therefore, Directors need to devise sound policies and a clear understanding of their institution’s susceptibility to interest rate volatility and the corresponding impact on earnings and capital. Furthermore, management should ensure that interest rate risk measurement tools and output provided to Board members is accurate and functioning effectively. Back-Testing of Model output (comparison of actual results to forecast) is a key tool to evaluate the accuracy and effectiveness of your Interest Rate Risk Model. In the current environment, the back-test does not offer as much value is it did several years ago, as core “driver” rates have been stagnant since December 2008 (Prime, Fed Funds). However, the back test will still identify gaps and root causes for differences between forecasts and actual results. Along with the back test, a rigorous review of Model assumptions (including re-pricing assumptions for changes in rates for both fixed rate and variable rate assets/ liabilities) is critical.
Policy Framework and Prudent Exposure Limits
Asset-liability Management and investment policies should be revised at least annually to ensure authorities, risk tolerance levels and exposure limits are prudent. Policy limitations should formalize the Board’s risk philosophy/tolerance, guide management’s day-to-day decision making and protect capital from undue risk. Given the potential for prospective interest rate volatility, management and the Board should review policies and exposure limits to promote safe-and-sound banking. A good time to do this is during Q4 or Q1, when budgets and forecasts are developed and approved.
Effective Measurement and Monitoring of Interest Rate Risk
All institutions should have well-developed risk measurement tools for monitoring interest rate risk. Management should not focus on a single measurement of interest rate risk, but instead review multiple types of data (i.e., use a holistic approach to help institutions develop a comprehensive interest rate risk assessment process). This would include not only assessing the results of your IRR model, but internal deposit decay studies and pre-payment tendencies. In addition, the Advisory suggests that institutions should consider the impact of 300 to 400 basis point interest rate changes on earnings and capital. Boards of Directors should revisit and validate the effectiveness of current measurement tools in relation to their institution’s rate sensitivity position. Does your institution have a concentration of fixed-rate, longer duration securities? If so, management should ensure that the investment portfolio is stress-tested for significant increases in market rates. In most (if not all) cases, your investment securities/bond accounting vendor can readily perform this analysis. The results of the analysis should be shared with the Board, including explanations for the root causes that affect the results of the analysis.
The "Take Away"
While nobody has a "crystal ball" regarding the precise direction and magnitude of interest rates, their potential impact can be effectively managed. By taking the appropriate steps in advance, a community bank can be prepared to react and adjust when the inevitable rate changes occur.
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