The ombudsman
received a formal appeal concerning the ''sensitivity to market
risk'' component rating.
Background
Bank
management and the board stated that while the Report of Examination
(ROE) concludes that interest rate risk is ''high and stable,'' they
believed that interest rate risk was not high and was
decreasing. The board
believed the downgrade in the sensitivity rating from a 2 to a 3
rating was not appropriate.
The bank's submission noted that the risk profile of the bank
was actually better than at the prior examination and that interest
rate risk was incorrectly evaluated as being high. The appeal also noted that
the supervisory office did not consider additional information
provided during the examination and that peer standards for
sensitivity assessment are not clear.
The
supervisory office concluded in the ROE that the option features in
the bank's funding sources and investments contributed to the
complexity and high quantity of risk, which warranted strong risk
management systems. The
ROE further stated that management of interest rate risk was weak
because effective risk limits or board reporting processes were not
in place and senior management did not effectively measure and
monitor the risk. The
previous ROE suggested that management obtain periodic stress
testing reports to better gauge the potential impact of their
decisions.
Discussion
In accordance
with OCC Bulletin 97-1 (''Uniform Financial Institutions Rating
System''), the sensitivity to market risk rating is intended to
reflect the degree to which changes in interest rates can adversely
affect the earnings and capital of a financial institution. Primary considerations in
determining the sensitivity rating are management's ability to
identify, measure, monitor, and control market risk, the nature, and
complexity of the institution's activities, and the adequacy of the
capital and earnings in relation to level of market
risk.
In discussion
with bank management and the supervisory office, there was a
consensus that the bank had a significant level of
interest-sensitive assets and liabilities at the time of the
examination. Adding to
the complexity of the balance sheet, several of the asset and
liability categories had features (embedded options, caps and
floors, etc.) that increase or decrease the level of risk in a
changing rate environment.
When these conditions are present, it is critical that risk
management processes accurately identify,
measure, monitor, and control the risk.
As a result of
recommendations made in the previous ROE, management had improved
the bank's risk management process, specifically by measuring the
effects of interest rate shocks on the balance sheet. However, the assumptions
associated with this modeling were not well supported and hindered
an accurate assessment of the risk. Management did not initiate
changes to the assumptions until the examination. In addition, the model did
not provide the degree of sophistication required to capture the
risk, given the complexity of the balance sheet. Finally, risk management
limits were not appropriately defined and board minutes did not
reflect discussion of the issues associated with interest rate
risk.
Conclusion
At the time of
the examination, the bank had a significant level of re-pricing and
options risk in its balance sheet. There was a concern that the
level of earnings and capital would not adequately support the
degree of market risk present, particularly when considering the
increased level of credit risk from the bank's lending
activities. While
management had taken steps to strengthen the tools used to measure
the impact of interest rate risk, the modeling weaknesses identified
during the examination warranted further action. Therefore, the ombudsman
concluded that the 3 rating assigned during the examination was
appropriate.
