A Changing Rate Environment Challenges Rate Management

Interest rate risk is fundamental to the discusses potential associated business of banking. Changes in interest with a rising rate environment and a rates can expose an institution to adverse continued flattening of the , shifts in the level of interest income and analyzes banking industry aggre- or other rate-sensitive income sources gate balance sheet information and and impair the underlying of its trends. It also reviews findings from assets and liabilities. Examiners review recent bank examination reports in an insured institution’s risk which or related exposure and the adequacy and effec- management practices raised concern tiveness of its interest rate risk manage- and highlights common weaknesses in ment as a component of the supervisory , measurement, and process. Examiners consider the modeling practices. strength of the institution’s interest rate risk measurement and manage- ment program and conduct a review The Current Rate in light of that institution’s risk profile, Environment earnings, and capital levels. When a Since the 1980s, and despite upward review reveals material weaknesses in rate spikes in 1994 and 2000, the level risk management processes or a level of interest rates has generally been ofexposure to interest rate risk that is declining (see Chart 1). In September high relative to capital or earnings, a 1981, the rate on the 10-year Treasury remedial response can be required. reached a high of over 15 percent; In today’s changing rate environment, it has since declined to a low of just over bank supervisors are monitoring indus- 3 percent in June 2003. During roughly try balance sheet and income state- the same period, other rate indices ment trends to assess the industry’s also fell in generally the same manner, overall exposure to and management of though not always in tandem. For exam- interest rate risk. This article reviews ple, the rate fell from the current interest rate environment, over 19 percent to 1 percent, and the

Chart 1 Short-Term Rates Are Turning Up from Historic Lows Rates 20% Fed funds, 10-year 18% Treasury, and 30-year mortgage rates hit 16% highs in 1981 Fed funds rate 14% begins ratcheting upward without 12% equal increases in longer-term rates 10%

8%

6% 5.75% 4% 4.28% 3.00% 2%

0% May 2005 1976 1980 1984 1988 1992 1996 2000 2004 30-Year Mortgage 10-Year Treasury Fed Funds Source: FDIC

5 Supervisory Insights Summer 2005 Interest Rate Risk continued from pg. 5

30-year mortgage rate average peaked FOMC has moved the target Federal at over 18 percent and dropped to under funds rate steadily upward, the nominal 6 percent. yield on the 10-year treasury has rarely crested above 4.5 percent and actually During the past 12 months, however, has declined from its July 2, 2004, the banking industry has sustained a level. This “conundrum,” evidenced by well-forecasted series of “measured” nonparallel movement in short- and increases to the target Federal funds long-term rates, has resulted in a flat- rate. Since June 2004, the Federal tening of the yield curve.1 Open Committee (FOMC) has steadily increased the intended Federal Looking forward, many market partici- funds rate in moderate 25 pants anticipate further measured increments to its current level of 3 increases in the and percent. Generally, changes in the similar, although not equal, increases Federal funds rate will affect other in longer-term rates. Over the next short-term interest rates (e.g., bank year, Blue Chip Financial Forecasts2 prime rates), foreign exchange rates, is predicting an additional 130 basis and less directly, long-term interest point increase in short-term rates and rates. However, increases to the a 104 basis point increase in longer- Federal funds rate have yet to drive term rates—a forecast that portends similar increases in longer-term yields. continued flattening of the yield curve In fact, over the 12 months that the (see Chart 2). Chart 2 Continued Flattening of the Yield Curve Is Forecasted Forecasted change of 10-Year Treasury Bond over the next 12 6% Forecasted change of 3-Month months = 104 bps Treasury Bill over the next 12 months = 130 basis points 5%

4%

3%

2%

1%

0% 012345678910 Years BCFF for week ended April 22, 2005 BCFF for Fourth Quarter of 2005 BCFF for Second Quarter of 2006 Source: Blue Chip Financial Forecasts (BCFF)

1The Federal funds rate is the interest rate at which depository institutions lend balances overnight from the to other depository institutions. The intended Federal funds rate is established by the FOMC of the Federal Reserve System. Federal Reserve Board Chairman Alan Greenspan said during his February 16, 2005, testimony to the Senate Banking Committee, “For the moment, the broadly unanticipated behavior of world bond markets remains a conundrum.” (Source: Bloomberg News) 2Blue Chip Financial Forecasts is based on a survey providing the latest in prevailing opinions about the future direction and level of U.S. interest rates. Survey participants such as Deutsche Banc Alex Brown, Banc of America Securities, Fannie Mae, Goldman Sachs & Co., and JPMorganChase provide forecasts for all significant rate indices for the next six quarters.

6 Supervisory Insights Summer 2005 into longer-term assets. In such a favor- Assessing ’ Interest Rate able environment, opportunities exist to Risk Exposure generate spread-related earnings driven A rising rate environment in conjunc- by asset and liability term structures. tion with a continued flattening of the A flattening yield curve can deprive yield curve presents the potential for banks of these opportunities and raises heightened interest rate risk. A flattening concern about a possible inversion in yield curve can pressure banks’ margins the yield curve. An inverted yield curve, generally, and rising rates can be particu- where long-term rates are lower than larly challenging to institutions with a short-term rates, can present a most “liability-sensitive” balance sheet—an challenging environment for financial asset/liability profile characterized by institutions. Also, an inverted yield curve liabilities that reprice faster than assets. is associated with the potential for The extent of this mismatch between the economic and declining rates. maturity or repricing of assets and liabili- Given recent rising rates and flattening ties is a key element in assessing an insti- of the yield curve, bank supervisors have tution’s exposure to interest rate risk. been monitoring trends in bank net interest margins (NIMs) and balance The shape of the yield curve is an sheet composition. important factor in assessing the overall rate environment. A steep yield curve While various factors (, provides the greatest spread between earning asset levels, etc.) affect NIMs, short- and long-term rates and is gener- a flattening yield curve is associated ally associated with favorable economic with declining NIMs. Chart 3 shows that conditions. Long-term , antici- during the 1990s, generally declining pating an improving and higher industry NIMs followed the overall flat- rates, will demand greater yields to tening of the yield curve. As the spread compensate for the risk of being locked between long- and short-term rates (the bars) generally decreased from 1991 to

Chart 3 Net Interest Margins (NIMs) Are Trending Down Yield NIM Spread 350 4.7 Trailing 4-quarter NIM 300 4.5 Treasury Yield Spread— 250 the difference between 4.3 the 10-year and 3-month Treasury rates—on a 200 3-month moving average 4.1 150

3.9 100

3.7 50

3.5 0

3.3 -50 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 Source: FDIC and Federal Reserve Note: Median NIMs for banks excluding specialty banks.

7 Supervisory Insights Summer 2005 Interest Rate Risk continued from pg. 7

1999—resulting in a flattening of the Treasury yield curve—bank NIMs also Bank Balance Sheet declined (the line on Chart 3 plots trail- Composition—The Asset Side ing four-quarter NIM). Beginning in Despite strong industry profitability, 2000, after a brief period of inversion, bank supervisors are monitoring changes the yield curve steepened dramatically, in the nature, trend, and type of expo- and over the next five quarters, bank sures on bank balance sheets. Recent NIMs increased. NIMs have since contin- aggregate balance sheet information ued their general decline, and recent shows the industry increasing its expo- quarters have seen the yield curve sure to longer-term assets, holding continue to flatten, raising the potential greater proportions of mortgage-related for continued pressure on bank NIMs. assets, and relying more on rate-sensitive, Even though median bank NIMs have noncore sources—all factors been declining since 1994, this trend that can contribute to higher levels of has been accompanied by strong and, in interest rate risk.4 recent years, record levels of profitability. In general, the earnings and capital Noninterest income sources (combined ofa liability-sensitive institution will be with overall strong industry perfor- affected adversely by a rising rate envi- mance) have helped mitigate the effects ronment. A liability-sensitive bank has a of declining NIMs. Institutions with over long-term asset maturity and repricing $1 billion in assets report significant structure relative to a shorter-term liabil- reliance on noninterest income; it ity structure. In an increasing interest accounts for more than 43 percent of rate environment, the NIM of a liability- their net operating revenue. While this sensitive institution will worsen (other diversification of income sources is less factors being equal) as the cost of the prevalent in smaller community banks bank’s funds increases more rapidly (institutions that hold less than $1 billion than the yield on its assets. The higher in assets derive only 25 percent of net its proportion of long-term assets, the operating revenue from noninterest more liability-sensitive a bank may be. income sources), NIMs reported by these smaller institutions generally are higher The industry’s exposure to long-term and recently have improved compared to assets increased during the 1990s (see those of the larger institutions. Chart 4). Exposure to long-term assets in relation to total assets has risen steadily, In short, while individual banks may from 13 percent in 1995 to nearly 24 be experiencing margin pressures, the percent in 2004, indicating the potential downward trend in bank NIMs has yet for heightened liability sensitivity.5 Signifi- to result in an industry-wide decline in cant exposure to longer-term assets could levels of net income. It is too early to generate further inquiry from examiners gauge the effects of a continuing or about the precise flow characteris- prolonged period of flattening in the tics of a particular bank’s assets and a 3 shape of the yield curve. review of the bank’s assessment of the

3Refer to the Fourth Quarter 2004 FDIC Quarterly Banking Profile for complete 2004 industry performance results. 4Except where noted otherwise, data are derived from the December 31, 2004, Consolidated Reports of Condition and Income (Call Reports). Call Reports are submitted quarterly by all insured national and state nonmember commer- cial banks and state-chartered banks and are a widely used source of timely and accurate financial data. 5Long-term assets include fixed- and floating-rate with a remaining maturity or next repricing frequency of over five years; U.S. Treasury and agency, mortgage pass-through, municipal, and all other nonmortgage securities with a remaining maturity or repricing frequency of over five years; and other mortgage-backed secu- rities (MBS) like collateralized mortgage obligations (CMOs), mortgage conduits (REMICs), and stripped MBS with an expected average life of over three years.

8 Supervisory Insights Summer 2005 Chart 4

Exposure to Longer-Term Assets Is Increasing Ratio to Total Assets

23%

21%

Longer-term asset holdings hit a high of 23.8% in March 2004 19% and declined slightly to 22.4% by year-end 2004

17%

15%

13% 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Year Source: FDIC Note: All FDIC-Insured Commercial Banks. nature and extent of its asset-liability It is difficult to assess fully the current mismatch and resulting rate sensitivity. magnitude of liability sensitivity or exten- sion risk confronting the banking indus- In addition to increasing its exposure try. Even though exposure to long-term to long-term assets, the industry has and mortgage-related assets has been increased its exposure to mortgage- moving steadily upward in recent years, related assets. Current data show that there are signs that bank risk managers bank holdings of mortgage loans and are responding to a changing rate envi- mortgage-backed securities comprise 28 ronment and altering their asset mix. percent of all bank assets (see Chart 5),6 Since June 2003, banks have reduced compared to 18 percent in 1990. their exposure to fixed-rate mortgage Mortgage-related assets present unique assets and are recently offering more risks because of the prepayment adjustable-rate mortgage products that is granted the borrower and embed- (ARMs). As shown in Chart 6, industry ded within the . Due to exposure to fixed-rate mortgages, while lower prepayments in a rising rate envi- generally increasing since 1995, began ronment, the duration of lower-coupon, to turn sharply downward in the third fixed-rate mortgages will extend and quarter of 2003. banks will be locked into lower-yielding And, according to Federal Housing assets for longer periods. Like mortgage Finance Board data, the percentage of loans, longer-term, fixed-rate mortgage- adjustable-rate, conventional single- backed securities are also exposed to family mortgages originated by major extension risk.

6Mortgage-related assets includes loans secured by one- to four-family residential properties, including revolving lines of , and closed-end loans secured by first and junior liens; mortgage pass-through securities and MBS, including CMOs, REMICs, and stripped MBS. Extension risk can be explained as follows: Changes in interest rates can pressure the value of mortgages and MBS because of the embedded prepayment option held by the mortgage debtor. These options can affect the holder of such assets adversely in a falling or rising rate environment. As rates fall, mortgages likely will experience higher prepayments, requiring the bank to reinvest the proceeds in lower-yielding assets. Conversely, as rates rise, prepayments will slow and result in a longer, extended period for principal return.

9 Supervisory Insights Summer 2005 Interest Rate Risk continued from pg. 9 Chart 5 Bank Balance Sheets Are Heavily Exposed to Mortgage-Related Assets Interest and noninterest bearing balances 5% 1–4 family loans and MBS Other loans 28% 15%

Consumer loans 10% CRE loans 5%

Other assets Other securities 18% 8% C&I loans Source: FDIC 11% Note: Commercial Bank Assets as of December 31, 2004.

Chart 6

Ratio to Fixed-Rate Mortgage-Related Loans Reverse Trend Total Assets 11.0%

10.5%

10.0%

9.5%

9.0%

8.5%

8.0% Fixed-rate mortgage holdings generally increased until September 7.5% 2003, and subsequently dropped sharply to 8.65% of total assets. 7.0% 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 Year Source: FDIC Note: All FDIC-Insured Commercial Banks. Fixed-Rate loans secured by 1–4 family residential properties.

lenders increased from 15 percent in higher levels of ARMs could increase 2003 to a recent peak of 40 percent in an institution’s asset sensitivity. Such June 2004. Lower levels of fixed-rate changes in balance sheet structure mortgages would reduce an institution’s could mitigate potential exposure to exposure to extension risk. In addition, rising interest rates.7

7All ARMs are not the same, and the degree of asset sensitivity will depend on each product’s unique structure. ARMs with an initial fixed-rate period of one to five years (“hybrid” loans) have grown in popularity. Freddie Mac’s 2004 ARM Survey found that 40 percent of all adjustable-rate mortgages were hybrid products, primarily 3/1 and 5/1 structures. The interest rate on such hybrid loans are fixed for three or five years, respectively, adjusting annually thereafter based on some interest rate . Accordingly, such hybrid products will not reduce liability sensitivity during the fixed-rate period of the loan.

10 Supervisory Insights Summer 2005 sources have climbed steadily from about Bank Balance Sheet 25 percent of total assets in 1992 to over Composition— 35 percent today. This trend is mirrored The Liability Side by core deposits falling from 62 percent of total assets in 1992 to 48 percent in The potential for interest rate risk 2004 (see Chart 7). Combined with an driven by maturity or repricing mismatch increase in holdings of long-term assets, cannot be assessed by looking only at a shorter-term and more volatile liability the asset side of the balance sheet. structure could expose an institution to Information on the nature and dura- significant interest rate risk in a rising tion of banks’ liabilities is also needed. rate environment. Banks that rely heavily on short-term and more rate-sensitive funding sources To assess fully the impact of the could experience a material increase increase in noncore funding sources in funding costs as interest rates rise. and the decrease in core deposits, more Some banks may not be able to offset information about the tenor of noncore such higher funding costs through liabilities is needed. FHLB advances are increased asset yields. Increased expo- a significant component of noncore fund- sure to short-term, rate-sensitive whole- ing for many institutions and illustrate sale funding sources can render a bank the importance of looking deeper into more liability sensitive, increasing its the repricing structure of a bank’s fund- exposure to rising rates. ing sources. Call Report data provide some information on the maturity struc- Over the past several years, banks ture of FHLB advances, but the picture is have increased their reliance on whole- clouded. Recent reports show that while sale, noncore funding sources such as the use of shorter-term FHLB advances overnight funds, certificates of deposit (under one year) has been on the rise, (greater than $100,000), brokered 67 percent of all FHLB advances have a deposits, and Federal Home Loan Bank maturity greater than one year (see (FHLB) advances. Noncore funding Chart 8). Chart 7 Banks Increase Reliance on Noncore Funding Sources Ratio to Total Assets

65%

Core Deposits 60%

55%

50%

45%

40% Noncore Liabilities

35%

30%

25% 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 Year Source: FDIC Note: All FDIC-Insured Commercial Banks. Noncore liablities include time deposits over $100 million, other borrowed , Federal funds purchased and securities sold, insured brokered deposits less than $100,000, and total foreign office deposits.

11 Supervisory Insights Summer 2005 Interest Rate Risk continued from pg. 11 Chart 8

FHLB Advances Use of Shorter-Term FHLB Advances Is Increasing (in billions) $160

$140 38% of Total

$120 33% of Total $100

$80

$60 29% of Total $40

$20

$0 2001 2002 2003 2004 Year FHLB advances with a remaining maturity of one year or less FHLB advances with a remaining maturity of more than one year through three years Source: FDIC FHLB advances with a remaining maturity of more than three years

The Call Report, however, does not information. In a rising rate environ- capture the nature and extent of options ment, the probability increases that embedded within the FHLB advance the FHLB will exercise its option to call structures. Call Report instructions or convert lower-yielding advances, provide that FHLB advances with a three- thereby exposing the borrowing year (or longer) contractual maturity are institution to higher funding costs. to be recorded in the long-term bucket, In conclusion, aggregate industry even if the advance is callable or convert- trends—specifically higher levels of ible by the FHLB at any time. A callable exposure to long-term assets, mortgage- or convertible advance allows the FHLB related assets, and noncore funding to convert the advance from fixed- to sources that exhibit optionality—raise floating-rate or terminate the advance and concerns about the potential for height- renew the extension at current market ened levels of interest rate risk in today’s rates. Therefore, advances such as those environment. These concerns must be reported as having a three-year maturity tempered by awareness that off-site data may actually reprice in the near term, provide only a rough, opaque, and end- 8 depending on the rate environment. of-period view of banks’ balance sheet Many advances contain embedded cash flow characteristics and composi- options. The FHLB Combined Financial tion. Each bank is unique in terms of Report (as of June 30, 2004) reflects asset and liability mix, risk appetite, that of then-outstanding advances, hedging activities, and related risk approximately 55 percent were callable profile. Moreover, bank risk exposures and 22 percent were convertible. Trans- are not static. Interest rate risk man- lated to bank balance sheets, these data agement strategies can change an indicate the presence of a greater level institution’s risk profile quickly—even of option risk on banks’ balance sheets overnight—through the use of financial than currently included in Call Report derivatives (e.g., interest rate swaps).

8See Instructions for Preparation of Consolidated Reports of Condition and Income (FFIEC 031 and 041) at RC-M–Memorandum Item 5, which provides, “Callable Federal Home Loan bank advances should be reported without regard to their next call date unless the advance has actually been called.”

12 Supervisory Insights Summer 2005 Thus, it is difficult to draw conclusions rial weaknesses in the bank’s risk about the level of interest rate risk management process or high levels of strictly from off-site information. Off-site exposure to interest rate risk relative to and industry-wide analyses must be earnings and capital. Chart 9 indicates joined with on-site examination results that the number of FDIC-insured insti- to derive a more comprehensive super- tutions with an unsatisfactory “S” com- visory assessment of interest rate risk ponent rating is minimal out of the exposure, its measurement, and its population of nearly 9,000 insured insti- management. tutions. Fewer than 5 percent of insured institutions are rated 3 or worse for this component, and most of those are in the Supervisory Assessment of less severe 3 rating category. Moreover, Interest Rate Risk since 2000, the number of institutions Bank examiners assess the level of with an adverse “S” component rating interest rate risk exposure in light of has declined steadily. a bank’s asset size, complexity, levels To capture emerging trends, FDIC of capital and earnings, and most supervisors are conducting periodic important, the effectiveness of its risk reviews of bank examination reports in management process. At the core of an effort to discern the nature and cause the interest rate risk examination of adverse “S” component ratings. A process is a supervisory assessment review of recent examination reports that ofhow well bank management identi- presented supervisory concerns about fies, monitors, manages, and controls interest rate risk reveals several common- interest rate risk.9 This assessment alities in the banks’ operating activities: is summarized in an assigned risk • Concentrations in mortgage-related rating for the component known as assets, sensitivity to , which is part of the CAMELS rating system.10 • Ineffective or improperly managed “leverage” programs,11 and An unsatisfactory rating for sensitivity to market risk (the “S” component of • Acquisition of complex securities CAMELS) represents a finding of mate- without adequate prepurchase and ongoing risk analyses.

9“Effective board and senior management oversight of a bank’s interest rate risk activities is the cornerstone of a sound risk management process.” Joint Agency Policy Statement on Interest Rate Risk, 12 FR 33166 at 33170 (1996); distributed under Financial Institution Letter 52-96 (hereafter Interest Rate Risk Policy Statement). 10Sensitivity to market risk is rated under the Uniform Financial Institutions Rating System (UFIRS), which is used by the Federal Financial Institutions Examination Council member regulatory agencies. Under the UFIRS, each financial institution is assigned a composite rating based on an evaluation and rating of six essential components of an institution’s financial condition and operations: the adequacy of capital (C), the quality of assets (A), the capability of management (M), the quality and level of earnings (E), the adequacy of liquidity (L), and the sensitivity to market risk (S). The resulting acronym is referred to as the CAMELS rating. Composite and component ratings are assigned based on a 1 to 5 numerical scale. 1 indicates the highest rating, strongest performance and risk management practices, and least degree of supervisory concern, while 5 indicates the lowest rating, weakest performance, inadequate risk management practices, and, therefore, the highest degree of supervisory concern. In general, fundamentally strong or sound conditions and practices are reflected in 1 and 2 ratings, whereas supervisory concerns and unsatisfactory performance are increasingly reflected in 3, 4, and 5 ratings. 11A “leverage” strategy is a coordinated borrowing and investment program with the goal of achieving a positive net interest spread. Leverage programs are intended to increase profitability by leveraging the bank’s capital through the purchase of earning assets using borrowed funds. While “leverage” in general defines banking, a typical leverage strategy focuses on a bank’s acquisition of wholesale funding, such as Federal Home Loan Bank advances, and the targeted investment of such proceeds into bonds with a different maturity or credit rating, or both, such that a higher yield is earned from the bonds than the interest rate on the borrowings. Profitability may be achieved if a positive net interest spread is maintained, despite changes in interest rates. When improperly managed, these strategies cause increased interest rate risk and supervisory concern.

13 Supervisory Insights Summer 2005 Interest Rate Risk continued from pg. 13 Chart 9 Unsatisfactory “S” Component Ratings Are Declining

700

3 600 53 0 34 500 4 1 27 5 30 1 29 400 28 1 22

510 300 555 457 418 373 366 356 200

100

0 1998 1999 2000 2001 2002 2003 2004

3 Rated 4 Rated 5 Rated Source: FDIC

In addition, concerns have emerged • Assumptions must be appropriate about the adequacy and effectiveness and tested. Model results are ofbank management’s use of interest extremely sensitive to the assump- rate risk models. Weaknesses center tions used; these assumptions should on (1) the accuracy of model inputs be reasonable and reviewed periodi- as well as the accuracy and testing of cally. For example, prepayment assumptions, (2) whether the models speeds can change significantly in are capturing the cash flow characteris- any given rate environment. And tics of complex instruments, specifically a bank’s historical prepayments instruments with embedded options, experience may differ materially and (3) whether management is using from vendor-supplied prepayment adequate stress tests to determine speeds. The model’s sensitivity to sensitivity to interest rate changes. changes in key material assumptions Key supervisory concerns identified should be evaluated periodically. from a review of examination com- ments specific to interest rate risk • Option risk embedded in assets models include: and funding sources should be captured effectively. Many banks • Data input should be accurate, have options embedded in their complete, and relevant. Many balance sheet through exposure loans, securities, or funding items to mortgage-related assets, callable may present complex or unique or convertible advances, or other cash flow structures that require structured products. Interest rate special, tailored data entry. Aggre- risk measurement systems should gating structural information at too be capable of identifying and high a level may result in the loss of measuring the effect of embedded necessary detail, and the reliability options. of the cash flows projections may become questionable.

14 Supervisory Insights Summer 2005 • Significant leverage programs common cause of insured depository should be understood fully. Man- institution . agement should understand fully The FDIC review studied the causes the nature ofthe leverage programs ofthe bank insolvencies that occurred and the risks of the instruments during three periods of rising rates: the used, and effectively assess the period from 1978 to 1982 and the rate impact of adverse rate movements spikes in 1994 and 2000. The analysis or yield curve changes. Given that revealed that no institution failures in leverage programs often are the 1990s were caused by the move- designed to take advantage of ment of interest rates. However, certain spreads between short- and long- insolvencies in the early 1980s, prima- term rates, measurement systems rily of savings and loan institutions, should capture the effects of were affected by changes in the inter- nonparallel shifts of the yield curve. est rate environment. The review deter- • Sensitivity stress tests should include mined that these insolvencies followed a reasonable range of unexpected a period of rapid and prolonged rate shocks; for example, stress increases in short- and long-term rates, tests should not simply approxi- during which the yield curve was mate market expectations of a inverted (for the most part, the yield modest ratcheting up of the yield curve was inverted from September curve over the next 12 months. 1978 through April 1982). These insti- Bank management should provide tutions were heavily concentrated in for stress tests that include potential longer-term, fixed-rate mortgage loans, interest rate changes and meaningful and were also challenged by a new and stress situations using a sufficiently unregulated market for deposits. Addi- wide range in market interest rates, tional factors that contributed to these immediate and gradual shifts in early insolvencies were economic reces- market rates, as well as changes in sion, capital weakness, and regulatory the shape of the yield curve. The forbearance. A historical depiction of Interest Rate Risk Policy Statement institution failures, in relation to the suggests at least a 200 basis point 10-year Treasury bond yield and over a one-year horizon. general periods of yield curve inver- sion, is shown in Chart 10. From a • The variance between the model’s historical perspective, only in the forecasted risk levels and actual unique circumstances of the early risk exposures should be analyzed 1980s can rising rates be associated routinely (sometimes called “back- with bank or thrift . testing”). This exercise will highlight areas of material variance and Today’s environment is markedly improve identification of errors in different. Despite rising rates and a flat- assumptions, inputs, or calculations. tening yield curve, the curve remains upward sloping. The economy generally has been improving, and the regulatory Lessons from History Help environment has changed considerably. Place Concerns About Rising Stricter regulatory capital standards Rates in Context were mandated in 1988, and limits on permissible were adopted Current concerns about the risks of in 1989. Prudential standards were a rising rate environment should be implemented following the enactment viewed in historical context. An internal of the Federal Deposit Corpo- FDIC review of bank and thrift failures ration Improvement Act of 1991, and discloses that interest rate risk is not a

15 Supervisory Insights Summer 2005 Interest Rate Risk continued from pg. 15 Chart 10 A Historical Review Places Today’s Concerns in Context 10-Year Bank/Thrift Treasury Rate Failures 16 600

Periods of Inverted Yield Curve 14 500

12 Post-FDICIA

400 10

8 300

6 200

4

100 2

0 0 1954 1958 1962 1966 1970 1974 1978 1982 1986 1990 1994 1998 2002 # of Commercial Bank/Thrift Failures 10-Year Treasury Bond Yield

Source: Haver Analytics, Federal Reserve, and FDIC Note: Failure data prior to 1980 include only commercial bank failures.

interest rate risk and investment activi- ever, these aggregate measures of ties policy statements were issued in bank balance sheet and income state- 1996 and 1998. In addition, the indus- ment composition serve only as indi- try now relies on more advanced interest cators of the possible presence of rate risk measurement and manage- interest rate risk. Off-site analysis and ment methodologies. Taken together, on-site examinations identify excessive these developments mitigate the level or poorly managed interest rate risk of supervisory concern about the aggre- relative to a particular institution’s gate level of interest rate risk in the risk profile, earnings, and capital industry today. levels. Examination findings, while revealing weaknesses in some circum- stances, overall indicate that bank risk Conclusion managers are acting effectively to Interest rate risk is garnering atten- moderate their institutions’ exposure tion given the changing rate environ- to interest rate risk in this challenging ment and trends in aggregate bank environment. balance sheet and income statement Keith Ligon information. Rising rates and a flatten- ing yield curve could pressure NIMs, Chief, Capital Markets Branch particularly for institutions that exhibit The author acknowledges the assis- liability sensitivity, given their rela- tance provided by Examiners Thomas tively greater exposure to long-term Wiley, Lawrence Reynolds, and John assets. In addition, banks are exhibit- Falcone in the Division of Supervision ing increased exposure to more and ; and Finan- volatile, rate-sensitive funding sources cial Analyst Douglas Akers with the with degrees of optionality not fully Division of Insurance and Research, captured by Call Report data. How- in the preparation of this article.

16 Supervisory Insights Summer 2005