Interest-Rate Risk Management Section 3010.1 Interest-rate risk (IRR) is the exposure of an SOURCES OF IRR institution’s financial condition to adverse move- ments in interest rates. Accepting this risk is a As financial intermediaries, banks encounter normal part of banking and can be an important IRR in several ways. The primary and most source of profitability and shareholder value. discussed source of IRR is differences in the However, excessive levels of IRR can pose a timing of the repricing of bank assets, liabilities, significant threat to an institution’s earnings and and off-balance-sheet (OBS) instruments. capital base. Accordingly, effective risk manage- Repricing mismatches are fundamental to the ment that maintains IRR at prudent levels is business of banking and generally occur from essential to the safety and soundness of banking either borrowing short-term to fund longer-term institutions. assets or borrowing long-term to fund shorter- Evaluating an institution’s exposure to changes term assets. Such mismatches can expose an in interest rates is an important element of any institution to adverse changes in both the overall full-scope examination and, for some institu- level of interest rates (parallel shifts in the yield tions, may be the sole topic for specialized or curve) and the relative level of rates across the targeted examinations. Such an evaluation yield curve (nonparallel shifts in the yield curve). includes assessing both the adequacy of the Another important source of IRR, commonly management process used to control IRR and referred to as basis risk, occurs when the adjust- the quantitative level of exposure. When assess- ment of the rates earned and paid on different ing the IRR management process, examiners instruments is imperfectly correlated with other- should ensure that appropriate policies, proce- wise similar repricing characteristics (for exam- dures, management information systems, and ple, a three-month Treasury bill versus a three- internal controls are in place to maintain IRR at month LIBOR). When interest rates change, prudent levels with consistency and continuity. these differences can change the cash flows and Evaluating the quantitative level of IRR expo- earnings spread between assets, liabilities, and sure requires examiners to assess the existing OBS instruments of similar maturities or repric- and potential future effects of changes in interest ing frequencies. rates on an institution’s financial condition, An additional and increasingly important including its capital adequacy, earnings, liquid- source of IRR is the options in many bank asset, ity, and, where appropriate, asset quality. To liability, and OBS portfolios. An option pro- ensure that these assessments are both effective vides the holder with the right, but not the and efficient, examiner resources must be appro- obligation, to buy, sell, or in some manner alter priately targeted at those elements of IRR that the cash flow of an instrument or financial pose the greatest threat to the financial condition contract. Options may be distinct instruments, of an institution. This targeting requires an such as exchange-traded and over-the-counter examination process built on a well-focused contracts, or they may be embedded within the assessment of IRR exposure before the on-site contractual terms of other instruments. Examples engagement, a clearly defined examination of instruments with embedded options include scope, and a comprehensive program for follow- bonds and notes with call or put provisions ing up on examination findings and ongoing (such as callable U.S. agency notes), loans that monitoring. Both the adequacy of an institution’s IRR and guidance provided in SR-96-13, ‘‘Interagency Guidance management process and the quantitative level on Sound Practices for Managing Interest Rate Risk.’’ It also of its IRR exposure should be assessed. Key incorporates, where appropriate, fundamental risk-management elements of the examination process used to principles and supervisory policies and approaches identified in SR-93-69, ‘‘Examining Risk Management and Internal assess IRR include the role and importance of a Controls for Trading Activities of Banking Organizations’’; preexamination risk assessment, proper scoping SR-95-17, ‘‘Evaluating the Risk Management of Securities of the examination, and the testing and verifica- and Derivative Contracts Used in Nontrading Activities’’; tion of both the management process and inter- SR-95-22, ‘‘Enhanced Framework for Supervising the U.S. 1 Operations of Foreign Banking Organizations’’; SR-95-51, nal measures of the level of IRR exposure. ‘‘Rating the Adequacy of Risk Management Processes and Internal Controls at State Member Banks and Bank Holding Companies’’; and SR-96-14, ‘‘Risk-Focused Safety and Sound- 1. This section incorporates and builds on the principles ness Examinations and Inspections.’’ Trading and Capital-Markets Activities Manual February 1998 Page 1 3010.1 Interest-Rate Risk Management give borrowers the right to prepay balances to reflect market rates. By extension, an institu- without penalty (such as residential mortgage tion’s economic value of equity (EVE) can be loans), and various types of nonmaturity deposit viewed as the present value of the expected cash instruments that give depositors the right to flows on assets minus the present value of the withdraw funds at any time without penalty expected cash flows on liabilities plus the net (such as core deposits). If not adequately man- present value of the expected cash flows on OBS aged, the asymmetrical payoff characteristics of instruments. Economic values, which may differ options can pose significant risk to the banking from reported book values due to GAAP institutions that sell them. Generally, the options, accounting conventions, can provide a number both explicit and embedded, held by bank cus- of useful insights into the current and potential tomers are exercised to the advantage of the future financial condition of an institution. Eco- holder, not the bank. Moreover, an increasing nomic values reflect one view of the ongoing array of options can involve highly complex worth of the institution and can often provide a contract terms that may substantially magnify basis for assessing past management decisions the effect of changing reference values on the in light of current circumstances. Moreover, value of the option and, thus, magnify the economic values can offer comprehensive insights asymmetry of option payoffs. into the potential future direction of earnings performance since changes in the economic value of an institution’s equity reflect changes in the present value of the bank’s future earnings EFFECTS OF IRR arising from its current holdings. Generally, commercial banking institutions Repricing mismatches, basis risk, options, and have adequately managed their IRR exposures, other aspects of a bank’s holdings and activities and few banks have failed solely as a result of can expose an institution’s earnings and value to adverse interest-rate movements. Nevertheless, adverse changes in market interest rates. The changes in interest rates can have negative effect of interest rates on accrual or reported effects on bank profitability and must be care- earnings is the most common focal point. In fully managed, especially given the rapid pace assessing the effects of changing rates on earn- of financial innovation and the heightened level ings, most banks focus primarily on their net of competition among all types of financial interest income—the difference between total institutions. interest income and total interest expense. How- ever, as banks have expanded into new activities to generate new types of fee-based and other SOUND IRR MANAGEMENT noninterest income, a focus on overall net income is becoming more appropriate. The noninterest PRACTICES income arising from many activities, such as As is the case in managing other types of risk, loan servicing and various asset-securitization sound IRR management involves effective board programs, can be highly sensitive to changes in and senior management oversight and a compre- market interest rates. As noninterest income hensive risk-management process that includes becomes an increasingly important source of the following elements: bank earnings, both bank management and supervisors need to take a broader view of the • effective policies and procedures designed to potential effects of changes in market interest control the nature and amount of IRR, includ- rates on bank earnings. ing clearly defined IRR limits and lines of Market interest rates also affect the value of a responsibility and authority bank’s assets, liabilities, and OBS instruments • appropriate risk-measurement, monitoring, and and, thus, directly affect the value of an institu- reporting systems tion’s equity capital. The effect of rates on the • systematic internal controls that include the economic value of an institution’s holdings and internal or external review and audit of key equity capital is a particularly important consid- elements of the risk-management process eration for shareholders, management, and supervisors alike. The economic value of an The formality and sophistication used in man- instrument is an assessment of the present value aging IRR depends on the size and sophistica- of its expected net future cash flows, discounted tion of the institution, the nature and complexity February 1998 Trading and Capital-Markets Activities Manual Page 2 Interest-Rate Risk Management 3010.1