On January 6, 2010, the depository institution regulatory agencies, under the auspices of the Federal Financial Institutions Examination Council (“FFIEC”), issued an “Advisory on Interest Rate Risk Management” (“Advisory”). The Advisory reminds regulated institutions (including banks, savings associations and credit unions) of supervisory expectations regarding sound practices for managing Interest Rate Risk (“IRR”) and clarifies the agencies’ position on various IRR management matters.

The Advisory notes that some degree of IRR is inherent in banking. It stresses, however, that the regulators expect institutions to have effective policies and procedures to measure, monitor and control IRR. The Advisory notes that institutions should “manage their IRR exposures using processes and systems commensurate with their earnings and capital levels, complexity, business model, risk profit and scope of operations.” The Advisory makes clear that IRR management requires not only identification and measurement of IRR, but also appropriate action to control that risk. Institutions that determine that core earnings and capital are insufficient to control existing IRR must act to mitigate the risk and/or increase capital.

Highlights of the Advisory are:

  • The Advisory emphasizes that each institution’s board of directors is responsible for IRR management and that directors should understand and be informed of their institution’s exposure. The Advisory notes that the board, or a board committee, should oversee and periodically review IRR management strategy, policies and tolerances. The Advisory envisions senior management as being responsible for appropriately implementing the board-approved strategies, policies and procedures, as well as for maintaining systems for measuring and analyzing IRR and establishing sufficiently detailed reporting procedures to inform management and the board of IRR exposure.
  • The Advisory reiterates that institutions are expected to have comprehensive policies and procedures concerning IRR management. The policies and procedures should ensure that the IRR implications of significant new strategies, products and businesses are integrated into the IRR management process. Policies and procedures should also document and provide for controls over permissible hedging strategies and hedging instruments. The Advisory indicates that IRR tolerances set forth in an institution’s policies should be explicit and address the potential impact of changing interest rates on earnings and capital from both short-term and long-term perspectives.
  • The Advisory mentions that existing guidance directs that each institution have a robust IRR measurement process to assess exposures relative to established risk tolerances, commensurate with its size and complexity. The Advisory emphasizes that, although institutions may rely on third-party IRR models, they are expected to fully understand the underlying analytics, assumptions and methodologies, and ensure such systems and processes are incorporated appropriately into their management of IRR exposures.
  • The Advisory notes that institutions use a variety of techniques to measure IRR exposure. The regulators believe that well-managed institutions will consider earnings and economic perspectives when evaluating IRR exposure. According to the Advisory, evaluating the impact of adverse changes in an institution’s economic value is also useful because it can signal future earnings and capital problems.
  • The Advisory indicates that, although simple maturity gap analysis for assessing the impact of changes in market rates on earnings may continue to be an appropriate tool for small institutions with uncomplicated IRR profiles, many institutions now use some form of simulation modeling to measure IRR exposure. The Advisory urges institutions to use the full complement of analytical capabilities of their IRR simulation models and provides guidance on various aspects of simulation modeling.
  • The Advisory encourages institutions to use a variety of measurement methods to assess their IRR profile. Regardless of the methods used, the Advisory emphasizes that an institution’s IRR measurement system should be sufficiently robust to capture all material on and off-balance sheet positions and incorporate a stress-testing process to identify and quantify the institution’s IRR exposure and potential problem areas.
  • The Advisory reminds institutions that stress testing, which includes both scenario and sensitivity analysis, is an integral component of IRR management. The Advisory notes that, while not all institutions may require a full range of stress testing if they are noncomplex, each institution should run interest rate shocks of sufficient magnitude and ensure that IRR exposures are incorporated and evaluated as part of an institution-wide risk analysis process. The Advisory clarifies the regulators’ views on certain aspects of stress testing and mentions that, at well-managed institutions, management compares stress test results against approved tolerance limits.
  • The Advisory suggests that proper IRR measurement requires regularly assessing the reasonableness of assumptions used in an institution’s IRR exposure analysis. Institutions are reminded to document, monitor and regularly update key assumptions used in IRR measurement models.
  • The Advisory indicates that limit controls should be in place to ensure that positions that exceed certain predetermined levels receive prompt attention. It stresses that an appropriate limit system should permit management to identify IRR exposures, initiate discussions about risk and, where necessary, take appropriate actions as identified in IRR policies and procedures, such as balance sheet alteration or hedging.
  • The regulators expect institutions to have an adequate system of internal controls to ensure the integrity of all aspects of their IRR management process. The Advisory notes, in particular, that independent validating of IRR models is a significant part of any effective internal control system.
  • The Advisory emphasizes that material weaknesses found in an institution’s risk management processes or high levels of IRR exposure relative to capital will result in corrective action that could include regulatory recommendations or directives to:
    • Raise additional capital;
    • Reduce levels of IRR exposure;
    • Strengthen IRR management expertise;
    • Improve IRR management information and measurement systems; or
    • Take other measures or some combination of actions, depending on the facts and circumstances of the individual institution.

The Advisory results from the regulatory concern that institutions may engage in strategies in the current environment without fully considering the IRR implications given an eventual rise in market rates. The Advisory notes that the current environment is one of historically low short-term interest rates and that institutions should have “robust processes” for measuring and, where necessary, reducing exposure to potential rate increases. The Advisory also recognizes (i) that institutions with increased loan losses and material declines in values of their securities portfolios are facing downward pressure on capital and earnings and (ii) that funding long-term assets with shorter-term liabilities can generate current earnings but at a risk to capital and earnings in future periods.