Expect Interest Rate Risk Management Scrutiny from Examiners in 2014

January 2014

Expect Interest Rate Risk Management Scrutiny from Examiners in 2014

Bank examiners will assess how community banks manage interest rate risk (IRR) exposures in 2014. They want to know if a bank’s interest rate risk measurement process is adequate based on its risk profile and size.

All the federal regulators repeatedly issued warnings in 2013 about the need to monitor IRR and the responsibility of the board in setting a bank’s risk tolerance and then overseeing proper risk controls.  The Federal Deposit Insurance Corp. and the Federal Reserve have featured articles on interest rate risk in their most recent community bank publications. The Office of the Comptroller of the Currency cites interest rate risk as a major concern in its latest semi-annual risk perspective, saying that examiners are “focusing on banks with significant concentrations in longer-term assets or liability structures that make them vulnerable to quickly increasing rates.”

The winter issue of the Federal Deposit Insurance Corp.’s Supervisory Insights explores the challenges banks face in proactively managing and assessing their interest rate risk. “The recent environment of sustained low interest rates has led some banks to alter balance sheets in a reach for higher yields,” which has increased interest rate risk, writes Doreen R. Eberley, FDIC Director of the Division of Risk Management Supervision.

The FDIC is concerned that many banks could see a significant securities portfolio depreciation in relation to capital when interest rates increase. Banks need to look now at the characteristics and duration of assets, funding sources and off-balance sheet exposures and how they contribute to the bank’s overall interest rate risk profile, the FDIC warns.

“To meet the challenge of generating positive earnings and more suitable returns for their stakeholders, many banks have lengthened asset maturities or increased assets with embedded optionality,” writes Doug Gray, Managing Examiner at the Federal Reserve Bank of Kansas City, in Community Bank Connections.

Examiners want to make sure a bank’s policies, procedures, risk limits and strategies governing interest rate risk have been reviewed and approved by senior management and the board of directors.  Common mistakes banks are making:

  • Risk limits are not defined or appropriate for the bank’s risk tolerance, or bank. 
  • The board is not regularly reviewing the bank’s policies, procedures and strategies. Directors need to know the impact of strategic decision on interest rate exposures.  
  • Policies do not outline specific oversight responsibility for measuring, monitoring and controlling interest rate risk.  If interest rate exposures exceed the bank’s risk limits, the bank’s senior management must report that to the board and provide an action plan to get the limits under control, the Fed notes. Examiners will want to see such documentation and progress.  
  • Banks are using inadequate tools to determine their risk exposures. FDIC examiners have found banks using inadequate stress tests that don’t incorporate significant rate shocks (for example, 300- and 400-basis point shocks) and other scenarios specific to the bank’s unique risks.  
  • The models banks are using can’t accurately assess the complexity of their bank’s balance sheet.  Fed examiners say that some banks are using off-the-shelf models that are not customized for their bank. A rural bank, for instance, that has 50 percent of its assets in callable bonds should not rely simply on a maturity gap, the Fed points out. 
  • Some banks are not comparing the results of stress tests to their internal risk limits. 
  • Examiners will scrutinize the capabilities and accuracy of internal measurement systems as well as stress testing scenarios and assumptions, the FDIC warns. ƒSome banks are not routinely  updating their assumptions, or they are using unreasonable assumptions for a given interest rate shock scenario, such as unrealistic asset prepayments or non-maturity deposit price sensitivity and decay rates,  or the bank is not accounting for specific characteristics of assets and liabilities.  Some banks are using unrealistic decay rates in their IRR models to show little or no runoff of deposits in a rising market.

OCC examiners will focus on IRR measurement processes, the adequacy of stress scenarios and the support for key modeling assumptions, particularly in on-maturity deposits, the agency says.