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5000 - Statements of Policy
{{6-28-96 p.5421}}
JOINT AGENCY POLICY STATEMENT ON INTEREST RATE RISK
Purpose
This joint agency policy statement ("Statement") provides
guidance to banks on prudent interest rate risk management principles.
The three federal banking agencies--the Board of Governors of the
Federal Reserve System, the Federal Deposit Insurance Corporation, and
the Office of the Comptroller of the Currency
("agencies")--believe that effective interest rate risk
management is an essential component of safe and sound banking
practices. The agencies are issuing this Statement to provide guidance
to banks on this subject and to assist bankers and examiners in
evaluating the adequacy of a bank's management of interest rate
risk. 1
This Statement applies to all federally-insured commercial and FDIC
supervised savings banks ["banks"]. Because market conditions,
bank structures, and bank activities vary, each bank needs to develop
its own interest rate risk management program tailored to its needs and
circumstances. Nonetheless, there are certain elements that are
fundamental to sound interest rate risk management, including
appropriate board and senior management oversight and a comprehensive
risk management process that effectively identifies, measures, monitors
and controls risk. This Statement describes prudent principles and
practices for each of these elements.
The adequacy and effectiveness of a bank's interest rate risk
management process and the level of its interest rate exposure are
critical factors in the agencies' evaluation of the bank's capital
adequacy. A bank with material weaknesses in its risk management
process or high levels of exposure relative to its capital will be
directed by the agencies to take corrective action. Such actions will
include recommendations or directives to raise additional capital,
strengthen management expertise, improve management information and
measurement systems, reduce levels of exposure, or some combination
thereof, depending upon the facts and circumstances of the individual
institution.
When evaluating the applicability of specific guidelines provided in
this Statement and the level of capital needed for interest rate risk,
bank management and examiners should consider factors such as the size
of the bank, the nature and complexity of its activities, and the
adequacy of its capital and earnings in relation to the bank's overall
risk profile.
Background
Interest rate risk is the exposure of a bank's financial condition
to adverse movements in interest rates. It results from differences in
the maturity or timing of coupon adjustments of bank assets,
liabilities and off-balance-sheet instruments (repricing or
maturity-mismatch risk); from changes in the slope of the yield curve
(yield curve risk); from imperfect correlations in the adjustment of
rates earned and paid on different instruments with otherwise similar
repricing characteristics (basis risk--e.g. 3 month Treasury bill
versus 3 month LIBOR); and from interest rate-related options embedded
in bank products (option risk).
Changes in interest rates affect a bank's earnings by changing its
net interest income and the level of other interest-sensitive income
and operating expenses. Changes in interest rates also affect the
underlying economic value 2
of the bank's assets, liabilities and off-balance sheet instruments
because the present value of future cash flows and in some cases, the
cash flows themselves, change when interest rates change. The combined
effects of the changes in these present values reflect the change in
the bank's underlying economic value.
{{6-28-96 p.5422}}
As financial intermediaries banks accept and manage interest rate
risk as an inherent part of their business. Although banks have always
had to manage interest rate risk, changes in the competitive
environment in which banks operate and in the products and services
they offer have increased the importance of prudently managing this
risk. This guidance is intended to highlight the key elements of
prudent interest rate risk management. The agencies expect that in
implementing this guidance, bank boards of directors and senior
managements will provide effective oversight and ensure that risks are
adequately identified, measured, monitored, and controlled.
Board and Senior Management Oversight
Effective board and senior management oversight of a bank's interest
rate risk activities is the cornerstone of a sound risk management
process. The board and senior management are responsible for
understanding the nature and level of interest rate risk being taken by
the bank and how that risk fits within the overall business strategies
of the bank. They are also responsible for ensuring that the formality
and sophistication of the risk management process is appropriate for
the overall level of risk. Effective risk management requires an
informed board, capable management and appropriate staffing.
For its part, a bank's board of directors has two broad
responsibilities:
• To establish and guide the bank's tolerance for interest
rate risk, including approving relevant risk limits and other key
policies, identifying lines of authority and responsibility for
managing risk, and ensuring adequate resources are devoted to interest
rate risk management.
• To monitor the bank's overall interest rate risk profile
and ensure that the level of interest rate risk is maintained at
prudent levels.
Senior management is responsible for ensuring that interest rate
risk is managed on both a long range and day-to-day basis. In managing
the bank's activities, senior management should:
• Develop and implement policies and procedures that
translate the board's goals, objectives, and risk limits into operating
standards that are well understood by bank personnel and that are
consistent with the board's intent.
• Ensure adherence to the lines of authority and
responsibility that the board has approved for measuring, managing, and
reporting interest rate risk exposures.
• Oversee the implementation and maintenance of management
information and other systems that identify, measure, monitor, and
control the bank's interest rate risk.
• Establish internal controls over the interest rate risk
management process.
Risk Management Process
Effective control of interest rate risk requires a comprehensive
risk management process that includes the following elements:
• Policies and procedures designed to control the nature and
amount of interest rate risk the bank takes including those that
specify risk limits and define lines of responsibilities and authority
for managing risk.
• A system for identifying and measuring interest rate risk.
• A system for monitoring and reporting risk exposures.
• A system of internal controls, review and audit to ensure
the integrity of the overall risk management process.
The formality and sophistication of these elements may vary
significantly among institutions, depending upon the level of the
bank's risk and the complexity of its holdings and activities. Banks
with non-complex activities and relatively short-term balance sheet
structures presenting relatively low risk levels and whose senior
managers are actively involved in the details of day-to-day operations
may be able to rely on a relatively basic and less formal interest rate
risk management process, provided their procedures for managing and
controlling risks are communicated clearly and are well understood by
all relevant parties.
{{6-28-96 p.5423}}
More complex organizations and those with higher interest rate risk
exposures or holdings of complex instruments with significant interest
rate-related option characteristics may require more elaborate and
formal interest rate risk management processes. Risk management
processes for these banks should address the institution's broader and
typically more complex range of financial activities and provide senior
managers with the information they need to monitor and direct
day-to-day activities. Moreover, the more complex interest rate risk
management processes employed at these institutions require adequate
internal controls that include internal and/or external audits or other
appropriate oversight mechanisms to ensure the integrity of the
information used by the board and senior management in overseeing
compliance with policies and limits. Those individuals involved in the
risk management process (or risk management units) in these banks must
be sufficiently independent of the business lines to ensure adequate
separation of duties and to avoid conflicts of interest.
Risk Controls and Limits
The board and senior management should ensure that the structure of
the bank's business and the level of interest rate risk it assumes are
effectively managed and that appropriate policies and practices are
established to control and limit risks. This includes delineating clear
lines of responsibility and authority for the following areas:
• Identifying the potential interest rate risk arising from
existing or new products or activities;
• Establishing and maintaining an interest rate risk
measurement system;
• Formulating and executing strategies to manage interest
rate risk exposures; and,
• Authorizing policy exceptions.
In some institutions the board and senior management may rely on a
committee of senior managers to manage this process. An institution
should also have policies for identifying the types of instruments and
activities that the bank may use to manage its interest rate risk
exposure. Such policies should clearly identify permissible
instruments, either specifically or by their characteristics, and
should also describe the purposes or objectives for which they may be
used. As appropriate to the size and complexity of the bank, the
policies should also help delineate procedures for acquiring specific
instruments, managing portfolios, and controlling the bank's aggregate
interest rate risk exposure.
Policies that establish appropriate risk limits that reflect the
board's risk tolerance are an important part of an institution's risk
management process and control structure. At a minimum these limits
should be board approved and ensure that the institution's interest
rate exposure will not lead to an unsafe and unsound condition. Senior
management should maintain a bank's exposure within the board-approved
limits. Limit controls should ensure that positions that exceed certain
predetermined levels receive prompt management attention. An
appropriate limit system should permit management to control interest
rate risk exposures, initiate discussion about opportunities and risk,
and monitor actual risk taking against predetermined risk tolerances.
A bank's limits should be consistent with the bank's overall
approach to measuring interest rate risk and should be based on capital
levels, earnings, performance, and the risk tolerance of the
institution. The limits should be appropriate to the size, complexity
and capital adequacy of the institution and address the potential
impact of changes in market interest rates on both reported earnings
and the bank's economic value of equity (EVE). From an earnings
perspective a bank should explore limits on net income as well as net
interest income in order to fully assess the contribution of
non-interest income to the interest rate risk exposure of the bank.
Such limits usually specify acceptable levels of earnings volatility
under specified interest rate scenarios. A bank's EVE limits should
reflect the size and complexity of its underlying positions. For banks
with few holdings of complex instruments and low risk profiles, simple
limits on permissible holdings or allowable repricing mismatches in
intermediate- and long-term instruments may be adequate. At more
complex institutions, more extensive limit structures may be necessary.
Banks that have significant intermediate- and long-term mismatches or
complex options
{{6-28-96 p.5424}}positions should have limits in
place that quantify and constrain the potential changes in economic
value or capital of the bank that could arise from those positions.
Identification and Measurement
Accurate and timely identification and measurement of interest rate
risk are necessary for proper risk management and control. The type of
measurement system that a bank requires to operate prudently depends
upon the nature and mix of its business lines and the interest rate
risk characteristics of its activities. The bank's measurement
system(s) should enable management to recognize and identify risks
arising from the bank's existing activities and from new business
initiatives. It should also facilitate accurate and timely measurement
of its current and potential interest rate risk exposure.
The agencies believe that a well-managed bank will consider both
earnings and economic perspectives when assessing the full scope of its
interest rate risk exposure. The impact on earnings is important
because reduced earnings or outright losses can adversely affect a
bank's liquidity and capital adequacy. Evaluating the possibility of an
adverse change in a bank's economic value of equity is also useful,
since it can signal future earnings and capital problems. Changes in
economic value can also affect the liquidity of bank assets, because
the cost of selling depreciated assets to meet liquidity needs may be
prohibitive.
Since the value of instruments with intermediate and long maturities
or embedded options is especially sensitive to interest rate changes,
banks with significant holdings of these instruments should be able to
assess the potential longer-term impact of changes in interest rates on
the value of these positions and the future performance of the bank.
Measurement systems for evaluating the effect of rates on earnings
may focus on either net interest income or net income. Institutions
with significant non-interest income that is sensitive to changing
rates should focus special attention on net income. Measurement systems
used to assess the effect of changes in interest rates on reported
earnings range from simple maturity gap reports to more sophisticated
income simulation models. Measurement approaches for evaluating the
potential effect on economic value of an institution may, depending on
the size and complexity of the institution, range from basic position
reports on holdings of intermediate, long-term and/or complex
instruments to simple mismatch weighting techniques to formal static or
dynamic cash flow valuation models.
Regardless of the type and level of complexity of the measurement
system used, bank management should ensure the adequacy and
completeness of the system. Because the quality and reliability of the
measurement system is largely dependent upon the quality of the data
and various assumptions used in the model, management should give
particular attention to these items.
The measurement system should include all material interest rate
positions of the bank and consider all relevant repricing and maturity
data. Such information will generally include (i) current balance and
contractual rate of interest associated with the instruments and
portfolios, (ii) principal payments, interest reset dates, maturities,
and (iii) the rate index used for repricing and contractual interest
rate ceilings or floors for adjustable-rate items. The system should
also have well-documented assumptions and techniques.
Bank management should ensure that risk is measured over a probable
range of potential interest rate changes, including meaningful stress
situations. In developing appropriate rate scenarios, bank management
should consider a variety of factors such as the shape and level of the
current term structure of interest rates and historical rate movements.
The scenarios used should incorporate a sufficiently wide change in
market interest rates (e.g., +/- 200 basis points over a one year
horizon) and include immediate or gradual changes in market interest
rates as well as changes in the shape of the yield curve in order to
capture the material effects of any explicit or embedded options.
Assumptions about customer behavior and new business activity should
be reasonable and consistent with each rate scenario that is
evaluated. In particular, as part of its measurement process, bank
management should consider how the maturity, repricing and cash flows
of instruments with embedded options may change under various
scenarios.
{{6-28-96 p.5425}}Such instruments would include loans
that can be prepaid without penalty prior to maturity or have limits on
the coupon adjustments, and deposits with unspecified maturities or
rights of early withdrawal.
Monitoring and Reporting Exposures.
Institutions should also establish an adequate system for monitoring
and reporting risk exposures. A bank's senior management and its board
or a board committee should receive reports on the bank's interest rate
risk profile at least quarterly. More frequent reporting may be
appropriate depending on the bank's level of risk and the potential
that the level of risk could change significantly. These reports should
allow senior management and the board or committee to:
• Evaluate the level and trends of the bank's aggregated
interest rate risk exposure.
• Evaluate the sensitivity and reasonableness of key
assumptions--such as those dealing with changes in the shape of the
yield curve or in the pace of anticipated loan prepayments or deposit
withdrawals.
• Verify compliance with the board's established risk
tolerance levels and limits and identify any policy exceptions.
• Determine whether the bank holds sufficient capital for the
level of interest rate risk being taken.
The reports provided to the board and senior management should be
clear, concise, and timely and provide the information needed for
making decisions.
Internal Control, Review, and Audit of the Risk Management
Process
A bank's internal control structure is critical to the safe and
sound functioning of the organization generally, and to its interest
rate risk management process in particular. Establishing and
maintaining an effective system of controls, including the enforcement
of official lines of authority and the appropriate separation of
duties, are two of management's more important responsibilities.
Individuals responsible for evaluating risk monitoring and control
procedures should be independent of the function they are assigned to
review.
Effective control of the interest rate risk management process
includes independent review and, where appropriate, internal and
external audit. The bank should conduct periodic reviews of its risk
management process to ensure its integrity, accuracy and
reasonableness. Items that should be reviewed and validated include:
• The adequacy of, and personnel's compliance with, the
bank's internal control system.
• The appropriateness of the bank's risk measurement system
given the nature, scope and complexity of its activities.
• The accuracy and completeness of the data inputs into the
bank's risk measurement system.
• The reasonableness and validity of scenarios used in the
risk measurement system.
• The validity of the risk measurement calculations. The
validity of the calculations is often tested by comparing actual versus
forecasted results.
The scope and formality of the review and validation will depend on
the size and complexity of the bank. At large banks, internal and
external auditors may have their own models against which the bank's
model is tested. Banks with complex risk measurement systems should
have their models or calculations validated by an independent
source--either an internal risk control unit of the bank or by outside
auditors or consultants.
The findings of this review should be reported to the board on an
annual basis. The report should provide a brief summary of the bank's
interest rate risk measurement techniques and management practices. It
also should identify major critical assumptions used in the risk
measurement process, discuss the process used to derive those
assumptions and provide an assessment of the impact of those
assumptions on the bank's measured exposure.
By order of the Board of Directors, May 14, 1996.
[Source: 61 Fed. Reg. 33169, June 26, 1996]
1The focus of this Statement is on the interest rate risk found
in banks' non-trading activities. Each agency has separate guidance
regarding the prudent risk management of trading activities. Go Back to Text
2The economic value of an instrument represents an assessment
of the present value of the expected net future cash flows of the
instrument, discounted to reflect market rates. A bank's economic value
of equity (EVE) represents the present value of the expected cash flows
on assets minus the present value of the expected cash flows on
liabilities, plus or minus the present value of the expected cash flows
on off-balance sheet instruments. Go Back to Text
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