The Federal Deposit Insurance Corp. (FDIC) issued a recent letter to financial institutions saying the agency is increasingly concerned that some banks and thrifts are not sufficiently prepared for volatility or a sustained rise in interest rates. The FDIC is reemphasizing the need for oversight by the board and management, policy frameworks and prudent exposure limits, effective measurement and monitoring of interest rate risk, and risk mitigation strategies. But it also has introduced some new statements in its latest letter worth noting:
“...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.”
“If interest rates were to rise markedly, institutions that have concentrated bond holdings in long-duration issues could experience severe depreciation of a magnitude that could be material relative to their capital position. Institutions that rely primarily on a long-duration fixed-income portfolio for liquidity could have difficulty meeting short-term cash needs if other marketable assets or funding sources are not readily available.”
“...significant, unmitigated levels of interest rate or market risk can lead to losses and liquidity constraints when prevailing rates change significantly.”
Long duration assets, such as step-up bonds or fixed-rate mortgages, will likely be a focus of the FDIC during its next exam of your institution and should be an important concern for the asset liability committee (ALCO). Due to historically low interest rates, bankers have been forced to extend the duration of the investment and loan portfolio in an effort to increase margins; at the same time, depositors are favoring shorter term certificates of depositors or money market funds as they anticipate rising rates. Some banks have a high risk due to extending cash flow on the asset side and not matching the re-pricing on the liabilities side. This has also manifested in significant unrealized losses on securities available for sale. While these unrealized losses do not affect regulatory capital, they do affect GAAP (Generally Accepted Accounting Practices) capital, which can affect market perception and the overall health of the institution should liquidity needs emerge.
The board has the ultimate responsibility for the risks undertaken by its institution. In response to the most recent letter, it is imperative that the foundations listed below are continually and proactively addressed and revisited by the board and management.
- Has the board approved the interest rate risk policy in the last twelve months and evaluated the bank’s policy limits? We often hear that the limits set within a policy are the “industry standards.” The policy limits should reflect the institution’s risk appetite that is commensurate with the institution’s strategic plan and capital position.
- Have the internal controls of the model been reviewed by an independent third party? Although management may seem to understand the asset-liability committee process and the model it is working with, it is crucial that each institution have its model independently validated. Key assumptions such as prepayment speeds (the change in the behavior of long term assets due to a change in rates, and decay (the speed with which the accounts “decay” or roll off your balance sheet) can alter the model results in ways to make the institution look like it is within policy or vice versa.
- Is the board receiving appropriate reporting from management? At minimum, the board should receive a quarterly interest rate risk analysis. The board should get analysis more often if it is managing risk outside policy limits. The income simulations should have a minimum horizon of two years, preferably with a static balance sheet rather than a dynamic balance sheet. The immediate interest rate shocks should include changes in rates of at least 300 and 400 basis points, nonparallel rate shocks (shocks of the yield curve using twists or changing slopes) and account for basis risk and yield curve risk. The market value equity simulation should also include changes in rates of greater magnitude and include nonparallel rate shocks.
- Has the board and management considered alternative risk measurement and monitoring tools? Analyzing the bank’s interest rate risk position using alternative methods can provide varying pictures of how well the bank is postured in the current and expected interest rate cycles. In addition to the static interest rate risk and market value of equity calculations, the Asset Liability Committee should consider a variety of modeling techniques such as gap Analysis (the difference between a bank’s rate sensitive assets and rate sensitive liabilities distributed by maturity), stress testing and earnings simulations in a variety of interest rate scenarios.
Economists are still predicting rates will remain fairly flat for the near term; however, rates are unlikely to remain low forever. The time is now to evaluate the bank’s interest rate risk appetite and act if the current position puts the bank’s capital position at risk.