Why Strategic Planning is Key to Interest Rate Risk Management

February 2015

Why Strategic Planning is Key to Interest Rate Risk Management

Banks must incorporate interest rate risk management into their strategic plans – and make sure they have enough capital to withstand unanticipated hits to earnings. That’s the message that banks need to hear in in the post-recession regulatory environment.

“Strategic planning should include consideration of potential asset-liability management strategies to minimize earnings volatility and capital exposure under different rate scenarios,” the OCC advised in its semi-annual risk perspective.

It noted that as banks re-evaluate their business models to generate returns, “OCC examiners will focus on banks’ strategic planning” to make sure that banks have sufficient risk management processes in place. “Banks that extend asset maturities to pick up yield, especially if relying on the stability of non-maturity deposit funding in a rising rate environment, could face significant earnings pressure and capital erosion depending on the severity and timing of interest rate moves,” the OCC said.

The reason why interest rate risk oversight is such a key part of the safety and soundness exam is because of the potential impact changing rates can have on earnings and capital, the FDIC stressed in its latest issue of Supervisory Insights.

One way community banks can show examiners they are ready for a changing interest rate environment is by incorporating capital stress testing into their strategic planning process. 

Senior management should be ready to discuss their IRR measurement system and risk mitigation strategies with examiners.  During that discussion, examiners might be asked about assumptions and how they were developed.   The FDIC also advises that well-documented board and ALCO committee minutes will help show examiners that the bank understands its IRR strategies and controls.

“All banks should have an effective asset-liability risk management framework that identifies and monitors the institution’s IRR position and its potential impact on earnings and capital,” the FDIC said.

At a recent bank seminar in Georgia, FDIC risk examiners presented best practices in interest rate risk management and modeling and stressed that the ultimate responsibility lies with the board of directors. 

Some bankers in attendance said it was difficult to find directors willing and capable of sitting on ALCO committees, knowing they would be the subject of extra regulatory scrutiny.

“IRR management from a director’s perspective is not about projecting how and when rates will change; instead, it is about understanding how the bank will be affected by a range of outcomes and ensuring that assumed risks are reasonable and properly compensated for,”  Supervisory Insights noted.

The FDIC examiners said that directors must establish policies for risk limits, understand levels and trends of IRR exposures and oversee the implementation of IRR risk management and mitigation policies.  They recommended that management report results of IRR modeling at least quarterly, identify sensitivity and reasonableness of assumptions at least annually and determine capital adequacy for the level of interest rate risk.

“Risk mitigation is an ongoing process to maintain exposures within board-approved limits to ensure that earnings and capital are sufficient to allow the bank to withstand adverse interest rate changes,” the FDIC wrote in Supervisory Insights.

“Examiners expect banks to have effective IRR policies and measurement procedures in place so boards of directors can make informed decisions about balance sheet management, budgeting and capital adequacy,” the FDIC wrote. “This expectation has become increasingly important as the potential for a period of increasing interest rates continues to be identified by the regulators and industry observers as a primary risk facing the industry.”

Here are links to IRR supervisory guidance:

Joint Agency Policy Statement on Interest Rate Risk

FFIEC Advisory on Interest Rate Risk Management

FFIEC Supervisory Guidance on Interest Rate Risk Management (FAQs) 

Managing Sensitivity to Market Risk in a Challenging Interest Rate Environment  

Common Exam Findings – Interest Rate Risk Management and Modeling
  • Insufficient evidence of board and senior management discussion of IRR
  • Policy limits unrealistic or uninformed
  • Use of default model assumptions
  • Inadequate documentation or support of assumptions used
  • Lack of assumption sensitivity testing
  • Lack of non-parallel yield curve scenarios
  • Lack of bank-specific relevant model scenarios
  • Lack of back-testing or back-testing over an insufficient period of time
  • No regular independent reviews
  • Independent reviews do not cover all required areas
  • Lack of independent review expertise
  • Missing or outdated model validation

Source: FDIC presentation at Georgia Bankers Association

What Examiners Seek in an IRR Review
  • Asset-liability or funds management policies
  • Most recent ALCO package
  • Minutes of ALCO meetings
  • Results of IRR analysis and assumption details
  • Material changes to assumptions in last year
  • Deposit study
  • Sensitivity testing results  of assumptions
  • Independent review of IRR

Source: FDIC, Supervisory Insights