Interest-Rate Risk

Sections in this Topic

Overview
Board and Management Responsibilities
Best Practices — Interest Rate Risk
Explanation of the Fed Perspective
Three Fundamental Issues to Address with ANY Model
What Should Drive a Bank's Model Decision?
What Are Some Safe and Sound Practices?
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Overview

Many minority bank officials have indicated that interest-rate risk is a critical element that should be managed well, particularly if a bank aggressively offers the most favorable rates in order to meet its community's needs as part of its long-term mission. For a general overview, please review Interest-Rate Risk in Manage Transition.

Board and Management Responsibilities

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.

Managing interest-rate risk involves many variables that affect a bank's income and equity. Management must ensure that controls are in place to monitor and report compliance with appropriate limits. Examples of the type of risks to consider are listed below.

Price Risk — The risk that an investment instrument or security will be sold at a discount prior to maturity.
Reinvestment Risk — The risk that the coupon will be reinvested at a lower rate than the original yield.
Yield Curve Risk — The risk that arises when unanticipated shifts of the yield curve have adverse effects on a bank's earnings or economic value.
Basis Risk — The risk that arises from imperfect correlation of rates earned and paid on different instruments with the same maturity when interest rates change.

Best Practices — Interest-Rate Risk

Management should implement adequate policies and procedures based on the bank's particular products and complexity. This includes using an interest-rate risk measurement commensurate with the risk on the bank's balance sheet. Also, management should present summary model results regularly to the board. This communication should include the major assumptions used in the modeling process and should also be communicated to the Asset Liability Committee (ALCO). A best practice is to have an independent test of the validity and accuracy of the model. Management should also maintain sufficient capital based on the interest-rate risk profile of the institution. Finally, management needs to understand the products offered and items on the balance sheet in terms of their interest-rate risk.

Explanation of the Fed Perspective

The bank's interest-rate risk modeling process should produce reasonably accurate risk measures that capture all risks material to the institution and provide clear and useful information to senior management and the board of directors. Remember this quote: "Risk cannot be managed unless its sources are identified and its magnitude measured."

Three Fundamental Issues to Address with ANY Model

Measurement Sufficiency

What are the material interest-rate risks?
Are these risks adequately measured by the tools used?

Model Integrity

Is the model reasonably accurate?
Does it measure what it says it does?

Level of Risk

Are risk limits reasonable?
Is the level of risk within stated limits?
Is this level excessive relative to the capital position?
What happens in a stressful environment?

What Should Drive a Bank's Model Decision?

Banks should consider several key elements when choosing which model to use. For example, the complexity of the bank and its organizational structure along with the products and services the bank offers are essential factors to consider. The materiality of risk and the level of exposure to risk factors are also key elements. Finally, the benefit versus the cost of implementation is an important consideration.

What Are Some Safe and Sound Practices?

The single most important factor is the quality of management. To successfully manage interest-rate risk, management should have some experience and knowledge of the concepts of interest-rate risk. It is also important to understand related issues that affect interest-rate risk for a given institution.

Other safe and sound practices to consider include the following:

The model must fit the bank's risk profile and needs.
The bank should have a review process for new products.
The bank should have a long-term and short-term measure of interest-rate risk and run sufficient scenarios.
The board should receive periodic training on interest-rate risk.
Reporting to the ALCO and the board should be:

Sufficiently frequent (minimum quarterly).
Concise and consistent.
Risk based versus reward based.

The bank should rely on an automated data feed.
The bank should review the process followed in order to ensure integrity.

The reviewer should be knowledgeable and independent.

All material risk positions should be included.
Risk should be broken down into constituent components.
The assumptions in the model should be well documented.

The most critical assumptions should be identified, updated as needed, clearly explained, and stress tested.