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Federal R eserve Bank

D. M c T E E R , J R .



752 6 5-5 9 06


July 26, 1996
Notice 96-68

The Chief Executive Officer of each
member bank and others concerned in
the Eleventh Federal Reserve District
Joint Agency Policy Statement on
Managing Interest Rate Risk

The Board of Governors of the Federal Reserve System has approved a joint
agency policy statement providing guidance to banks on sound practices to be followed
for managing interest rate risk.
The policy statement, which earlier had been approved by the Federal
Deposit Insurance Corporation and the Comptroller of the Currency, emphasizes the
importance of a sound risk management process and of adequate oversight by a bank’
board of directors and senior management. The assessment of interest rate risk manage­
ment made by examiners in accordance with the joint policy statement will be incorpo­
rated into a bank’ overall risk management rating.
A copy of the joint agency policy statement as it appears on pages 33166-172,
Vol. 61, No. 124, of the Federal Register dated June 26, 1996, is attached.
For more information, please contact Julie Mills at (214) 922-6229. For
additional copies of this Bank’ notice, please contact the Public Affairs Department at
(214) 922-5254.
Sincerely yours,

For additional copies, bankers and others are encouraged to use one o f the following toll-free numbers in contacting the Federal
Reserve Bank o f Dallas: Dallas Office (800) 333 -4460; El Paso Branch Intrastate (800) 592-1631, Interstate (800) 351-1012; H ouston
Branch Intrastate (800) 392-4162, Interstate (800) 221-0363; San A ntonio Branch Intrastate (800) 292-5810.

This publication was digitized and made available by the Federal Reserve Bank of Dallas' Historical Library (


Federal Register / Vol. 61, No. 124 / Wednesday, June 26, 1996 / Notices

Office of the Comptroller of the
[Docket No. 96-13]

[Docket No. R -0802]

Joint Agency Policy Statement:
Interest Rate Risk
AGENCIES: Office of the Comptroller of
the Currency (OCC), Treasury; Board o f
Governors of the Federal Reserve
System (Board); and Federal Deposit
Insurance Corporation (FDIC).
ACTION: Joint policy statement.

The OCC,-the Board, and the
FDIC (collectively referred to as the
agencies) are issuing this joint agency
policy statement (policy statement) to
bankers to provide guidance on sound

practices for managing interest rate risk.
The policy statement identifies the key
elements of sound interest rate risk
management and describes prudent
principles and practices for each of
these elements. It emphasizes the
importance of adequate oversight by a
bank’s board of directors and senior
management and of a comprehensive
risk management process. The policy
statement also describes the critical
factors affecting the agencies’ evaluation
of a bank’s interest rate risk when
making a determination of capital
adequacy. The principles for sound
interest rate risk management outlined
in this policy statement apply to all
commercial banks and FDIC-supervised
savings banks (banks).
This policy statement augments the
action taken by the agencies in August
1995 to implement th e portion of
section 305 of the Federal Deposit
Insurance Corporation Improvement Act
of 1991 (FDICIA) addressing risk-based
capital standards for interest rate risk. It
also replaces the proposed policy
statement that the agencies issued for
comment in August 1995 regarding a
supervisory framework for measuring
and assessing banks’ interest rate
exposures. The agencies have elected
not to pursue a standardized measure
and explicit capital charge for interest
rate risk at this time. This decision
reflects concerns about the burden,
accuracy, and complexity of a
standardized measure and recognition
that industry techniques for measuring
interest rate risk are continuing to
evolve. Rather than dampening
incentives to improve risk measures by
adopting a standardized measure at this
time, the agencies hope to encourage
these industry efforts. Nonetheless, the
agencies will continue to place
significant emphasis on the level of a
bank’s interest rate risk exposure and
the quality of its risk management
process when evaluating a bank’s
capital adequacy. The principles and
practices identified in this policy
statement provide the standards upon
which the agencies will evaluate the
adequacy and effectiveness of a bank’s
interest rate risk management.
EFFECTIVE DATE: June 26, 1996.

OCC: Christina Benson, Capital
Markets Specialist, or, Margot
Schwadron, Financial Analyst, (202/
874-5070), Office of the Chief National
Bank Examiner; Michael Carhill, Deputy
Director, Risk Analysis Division (202/
874-5700); and Ronald Shimabukuro,
Senior Attorney, Legislative and
Regulatory Activities Division (202/
874-5090), Office of the Comptroller of

F ederal Register / Vol. 61, No. 124 / Wednesday, June 26, 1996 / Notices
the Currency, 250 E Street, S.W.,
Washington, D.C. 20219.
Board of Governors: James Embersit,
Manager (202/452-5249), or William
Treacy, Supervisory Financial Analyst
(202/452-3859), Division of Banking
Supervision and Regulation; Gregory
Baer, Managing Senior Counsel (202/
452-3236), Legal Division, Board of
Governors of the Federal Reserve
System. For the hearing impaired only,
Telecommunication Device for the Deaf
(TDD), Dorothea Thompson (202/4523544), Board of Governors of the Federal
Reserve System, 20th and C Streets,
N.W., Washington, D.C. 20551.
FDIC: William A. Stark, Assistant
Director (202/898-6972) or Miguel
Browne, Deputy Assistant Director (202/
898-6789), Division of Supervision;
Jamey Basham, Counsel, (202/8987265), Legal Division, Federal Deposit
Insurance Corporation, 550 17th Street,
N.W., Washington, D.C. 20429.

I. Background
Interest rate risk is the exposure of a
bank’s current and future earnings and
capital arising from adverse movements
in interest rates. 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 of the bank’s assets,
liabilities, and off-balance sheet items.
These changes occur because the
present value of future cash flows, and
in many cases the cash flows
themselves, change w hen interest rates
change. The combined effects of the
changes in these present values reflect
the change in the bank’s underlying
economic value as well as provide an
indicator of the expected change in the
bank’s future earnings arising from the
change in interest rates. W hile interest
rate risk is inherent in the role of banks
as financial intermediaries, a bank that
has a high level of risk can face
diminished earnings, impaired liquidity
and capital positions, and, ultimately,
greater risk of insolvency.
II. FDICIA Requirements and Agencies’
Section 305 of FDICIA, Pub. L. 102242,105 Stat. 2236, 2354 (12 U.S.C.
1828 note), requires the agencies to
revise their risk-based capital guidelines
to take adequate account of interest rate
risk. On August 2,1995 the agencies
published a final rule implementing
section 305 that amended their riskbased capital standards to specify that
the agencies will include, in their

evaluations of a bank’s capital
adequacy, an assessment of the
exposure to declines in the economic
value of the bank’s capital due to
changes in interest rate risk. See 60 FR
39490 (August 2,1995). This final rule,
w hich became effective on September 1,
1995, adopts a “risk assessm ent”
approach under which capital for
interest rate risk is evaluated on a caseby-case basis, considering both
quantitative and qualitative factors.
The final rule did not adopt a
measurement framework for assessing
the level of a bank’s interest rate risk
exposure, nor did it specify a formula
for determining the amount of capital
that would be required. The intent of
the agencies at that time was to
implement an explicit m inim um capital
charge for interest rate risk at a future
date, after the agencies and the industry
had gained more experience w ith a
proposed supervisory measure that the
agencies issued for comment in August
1995. See 60 FR 39495 (August 2,1995).
The agencies have undertaken
considerable efforts to develop a
supervisory measure for interest rate
risk that provides sufficient accuracy,
transparency, and predictability for
establishing an explicit charge for
interest rate risk. These efforts, and the
comments the agencies received on
them, are summarized in sections III
and IV that follow. After careful
consideration of those comments and
additional.analyses and research by
agencies’ staff, the agencies have
decided that concerns about the
burdens, costs, and potential incentives
of implementing a standardized
measure and explicit capital treatment
currently outweigh the potential
benefits that such measures would
provide. The agencies are cognizant that
techniques for measuring interest rate
risk are continuing to evolve, and they
do not want to impede that progress by
mandating or implementing prescribed
risk measurement techniques. Rather,
the agencies wish to work with the
industry to encourage efforts to improve
risk measurement techniques. These
efforts, the agencies believe, may lead to
greater convergence w ithin the industry
on the methodologies used for
measuring this risk and may, at a future
date, facilitate more quantitative and
explicit capital treatments for interest
rate risk.
Hence, the agencies have concluded
that the best course of action at this
time, is to continue to assess capital
adequacy for interest rate risk under a
risk assessment approach and to provide
the industry w ith further guidance on
prudent interest rate risk management
practices. Section V of this preamble


describes the agencies’ risk assessment
approach for capital. The policy
statement, w hich follows section V,
provides the agencies’ guidance and
expectations on sound interest rate risk
III. Earlier Proposals for Supervisory
Model and Explicit Capital Charges
Since the enactment of FDICIA, the
agencies have issued two notices of
proposed rulemakings on interest rate
risk, as well as one advance notice of
proposed rulemaking (ANPR).
The ANPR was issued in 1992 and
sought comment on a proposed
supervisory m easurement system and an
explicit capital requirement based on
the results of that measurement system.
See 57 FR 35507 (August 10,1992). The
measurement system proposed in the
1992 ANPR would have applied to all
banks and used a duration-weighted
maturity ladder to estimate the change
in a bank’s economic value for an
assumed 100 basis point parallel shift in
market interest rates. Under the 1992
ANPR, a bank whose measured
exposure exceeded a threshold level,
equivalent to 1 percent of total assets,
would have been required to allocate
capital sufficient to compensate for the
estimated change in economic value
above the threshold level.
The agencies received approximately
180 comment letters on the 1992 ANPR.
The majority of commenters raised
concerns about the accuracy of the
proposed measure and its use as a basis
for an explicit capital charge. Therefore,
in September 1993, the agencies
published a notice of proposed
rulemaking w hich incorporated
numerous changes to the 1992 ANPR in
an effort to address those concerns and
improve the proposed m odel’s accuracy.
See 58 FR 48206 (September 14,1993).
These changes included:
(1) A proposed screen that w ould
exempt banks identified as potentially
low-risk from the supervisory
measurement framework.
(2) Various refinements to the
supervisory model, including changes to
the method for determining risk weights
to allow for different risk weights for
rising and falling interest rate
environments; the specific treatment of
non-maturity deposits; the reporting of
amortizing and non-amortizing financial
instruments; and the addition of another
time band to provide for greater
The September 1993 proposal also
sought comment on allowing banks to
use their own internal models as the
basis for establishing a capital charge
and on two different methods for
assessing capital. One method, referred


Federal Register / Vol. 61, No. 124 / Wednesday, June 26, 1996 / Notices

to as the minimum capital standard,
would establish an explicit capital
charge for interest rate risk based on
either the supervisory model or a bank’s
internal model results. The other
method, referred to as the risk
assessment approach, would evaluate
the need for capital on a case-by-case
basis, considering both quantitative and
qualitative factors.
The agencies collectively received a
total of 133 comments on the September
1993 proposal. The majority of industry
comments focused on four issues: a
preference for the risk assessment
approach, approval of the proposed use
of internal models, concerns about the
accuracy of the proposed supervisory
model, and suggestions that the
agencies’ primary focus should be on
near-term (i.e., one- to two-year)
reported earnings instead of economic
In August 1995, along w ith the final
rule amending risk-based capital
standards to adopt the risk assessment
approach, the agencies issued for
comment a joint policy statement that
would establish a supervisory
framework for measuring banks’ interest
rate risk exposures. See 60 FR 39495
(August 2,1995). The results of that
framework would be one factor that
examiners would consider in evaluating
a bank’s capital adequacy for interest
rate risk. In addition, the agencies noted
that the framework was intended to
provide the foundation for the
development of an explicit capital
charge once the agencies and industry
gained more experience with the
measurement framework.
The August 1995 proposal built upon
and modified the agencies’ earlier
proposals for a supervisory
measurement framework in an effort to
improve the framework’s accuracy and
applicability to a diverse population of
banks. Modifications included:
(1) Changing the proposed exemption
test so that only banks with total assets
less than $300 million, a “ 1” or “2”
composite supervisory CAMEL rating,
and only moderate holdings of assets
w ith intermediate or long term repricing
characteristics w ould be exempted from
new interest rate risk reporting
requirements and the supervisory
(2) Refinements to a baseline
supervisory model for which all non­
exempt banks would provide
Consolidated Reports of Condition and
Income (Call Report) information. These
refinements included separate reporting
and treatment of fixed- and adjustablerate residential mortgage loans and
securities and other amortizing assets;
requiring banks holding certain types of

(4) Any supervisory model may create
improper incentives for internal risk
management and measurement. Each of
these concerns is addressed in turn.
The agencies continue to believe
economic value sensitivity is a valid
and important concept, especially when
assessing an institution’s capital
adequacy and, as noted, have amended
their capital standards to reflect this
view. Nonetheless, the agencies
recognize that changes in a bank’s
reported earnings is also important and
that a bank needs to consider both
earnings and economic perspectives
:when assessing the full scope of its
exposure. This policy statement adopted
by the agencies sets forth principles for
monitoring and controlling interest rate
risk from both of these perspectives.
The industry’s concerns about the
validity and accuracy of a standardized
model present a more difficult and
serious issue. Some of the changes in
the August 1995 proposal attempted to
address these concerns. For example,
supplem ental schedules for residential
mortgage loans and pass-through
securities were a response to earlier
industry concerns regarding the use of
prepayment assumptions that were
IV. Factors Leading to the Agencies’
based on an average of outstanding
Decision to Not Pursue a Supervisory
mortgage securities. By collecting
additional data on the embedded
options in an individual bank’s
As already noted, the agencies have
mortgage portfolio, the accuracy of the
decided not to pursue a standardized
proposed model was potentially
model for supervisory purposes or
assessing capital charges for interest rate enhanced. However, the changes were
not without cost. In particular, the
risk at this time. This decision reflects
supplemental schedules and associated
the continued concerns expressed by
the industry in their comment letters on risk weights added to the reporting
burden and overall complexity of the
the August 1995 proposal and the
proposal. By giving the appearance of
numerous difficulties the agencies
providing a more precise measure of
encountered in trying to develop and
risk, they also increased the likelihobd
implement a standardized measure that
had sufficient accuracy and flexibility to that the standardized measure would
replace or stifle development of yet
be applicable to a broad range of
more accurate internal measures of risk
commercial banks, w hile not imposing
undue regulatory and reporting burdens exposure. This added reporting burden
and complexity illustrates the
on banks.
difficulties the agencies have faced in
Throughout the evolution of the
trying to strike an appropriate balance
agencies’ efforts to incorporate an
between accuracy and burden.
explicit capital charge for interest rate
Not only did the mortgage schedules
risk into their risk-based capital
add burden, they did not fundamentally
standards, industry comments have
solve the difficulties of structuring a
expressed four fundamental concerns:
standardized model which could take
(1) An approach whose sole focus is
into account the heterogenous nature of
on economic value, rather than on
commercial banks’ balance sheet
reported earnings, may be
structures and activities. In recent years,
banks have been offering and holding a
(2) A supervisory measure that by
growing variety of products. Many of
necessity, makes uniform and
these products, such as certain
simplifying assumptions about the
collateralized mortgage obligations and
characteristics of a typical bank’s assets
structured notes, can have complex cash
and liabilities may be inaccurate for a
flow characteristics that vary
given institution;
significantly w ith each transaction. The
(3) The proposed treatment for nonAugust 1995 proposal attempted to
maturity deposits may be inappropriate
address this problem by requiring banks
in many cases; and
financial instruments to report estimates
of changes in the market value
sensitivities of those instruments for a
200 basis point interest rate shock; and,
extending the range of maturities that
banks could use when reporting their
non-maturity deposits (demand
deposits, savings, NOW, and money
market demand accounts).
(3) The introduction of supplemental
modules for non-exempted banks that
had concentrations in fixed- or
adjustable-rate residential mortgage
loans and pass-through securities. Banks
subject to these modules would report
additional information on the coupon
distributions of their fixed-rate
mortgages and information on the
lifetime and periodic caps of their
adjustable-rate mortgages.
Although these modifications were
designed to enhance and improve upon
the agencies’ earlier proposals, the
majority of commenters on the August
1995 proposal reiterated many previous
concerns about accuracy, burden, and
incentives, and urged the agencies to
reconsider their approach and efforts to
devise a uniform and standardized

Federal Register / Vol. 61, No. 124 7 Wednesday, June 26, 1996 / Notices
to self-report the sensitivity of these and
certain other instruments. The diversity
and complexity in banks’ holdings,
however, are not limited to a bank’s
investment and off-balance sheet
instruments. Increasingly, banks have a
variety of pricing indices and embedded
options incorporated into their
commercial and retail bank products,
making it increasingly difficult to model
these products w ith any simple and
uniform measure.
The diversity and complexity of
commercial banks’ balance sheets is one
reason why the banking agencies have
decided not to pursue adopting the net
portfolio value model developed and
used by the Office of Thrift Supervision
(OTS) or any uniform supervisory
model. Although the banking agencies
have benefited a great deal from the
expertise and experience of the OTS in
this area, the OTS model was designed
to ascertain the interest rate risk
exposure of insured depository
institutions w ith concentrations of
residential mortgage assets, especially
adjustable rate mortgages. These
instruments require data-intensive,
complex m odels to obtain accurate
valuations and interest rate sensitivities.
Since most commercial banks do not
hold high concentrations of these
instrum ents' the agencies were
concerned about the substantial
reporting requirements and
measurement complexity that would be
associated w ith an OTS type of model
if applied to commercial banks.
Many industry commenters believe
that the agencies’ treatment in the
August 1995 proposal of non-maturity
deposits understated their effective
maturity and urged the agencies to
allow banks greater flexibility in the
reporting and treatment of them.
Assumptions about the effective
maturity of these deposits are critical
factors in assessing most commercial
banks’ interest rate risk exposure, since
these deposits often represent 40
percent or more of a bank’s liability
base. Thus, while the agencies have
elected not to adopt supervisory
'assumptions for calculating the effective
maturities o f non-maturity deposits, the
policy statem ent cautions banks to make
reasonable assum ptions about customer
behavior in this area, and periodically
re-evaluate w hether the assum ptions are
reasonable in light of experience.
The supervisory treatment of nonmaturity deposits in measuring interest
rate risk also illustrates the industry’s
concern regarding the potential
incentives a supervisory model could
present to a bank. In particular, some
industry commenters have stated that if
the agencies adopted assumptions that


understated the effective maturities of a
approaches for developing supervisory
bank’s non-maturity deposits, it could
risk measures, it reinforced their
induce a bank to inappropriately
appreciation for the critical roles that
shorten its asset maturities, leave the
management and board oversight, risk
bank exposed to falling interest rates,
controls, and prudent judgment and
and unnecessarily reduce its net interest experience play in the interest rate risk
margins. The agencies, however, are
management process.
Banks that are found to have high
also concerned that an assumption that
overstated the maturity of these deposits levels of exposure and/or weak
management practices will be directed
could mistakenly lead banks to extend
by the agencies to take corrective action.
their asset m aturities, leaving them
Such actions will include directives to
exposed to rising interest rates and
raise additional capital, strengthen
significant loss in economic value.
Many commenters voiced broader
management expertise, improve
concerns about the potential incentives
management information and
that a standardized supervisory model
measurement systems, reduce levels of
may have on how banks manage and
exposure, or a combination thereof.
measure their risk. A frequent concern
Joint Agency Policy Statement on
has been that a supervisory model
Interest Rate Risk
w ould become the industry standard
against w hich internal models would be Purpose
benchmarked and tested, thus diverting
This joint agency policy statement
resources away from improving internal (“ Statement”) provides guidance to
m odels and assumptions.
banks on prudent interest rate risk
The agencies neither wish to create
management principles. The three
inappropriate incentives, nor divert
federal banking agencies—the Board of
industry resources from the
Governors of the Federal Reserve
development of better interest rate risk
System, the Federal Deposit Insurance
measurements. The policy statement
Corporation, and the Office of the
consequently emphasizes each
Comptroller of the Currency
institution’s responsibility to develop
(“agencies”)—believe that effective
and refine interest rate risk management
interest rate risk management is an
practices that are appropriate and
essential component of safe and sound
effective for its specific circumstances.
banking practices. The agencies are
V. Risk Assessment Approach
issuing this Statement to provide
The risk assessment approach that the guidance to banks on this subject and to
agencies use to evaluate a bank’s capital assist bankers and examiners in
evaluating the adequacy of a bank’s
adequacy for interest rate risk relies on
management of interest rate risk.1
a combination of quantitative and
This Statement applies to all
qualitative factors. The agencies will use
federally-insured commercial and FDIC
various quantitative screens and filters
supervised savings banks [’’banks”].
as tools to identify banks that may have
high exposures or complex risk profiles, Because market conditions, bank
structures, and bank activities vary,
to allocate examiner resources, and to
each bank needs to develop its own
set examination priorities. These tools
interest rate risk management program
rely on Call Report data and various
tailored to its needs and circumstances.
economic indicators and data. To make
Nonetheless, there are certain elements
assessments about the level of a bank’s
that are fundamental to sound interest
interest rate exposure, examiners
rate risk management, including
augment the insights provided by these
appropriate board and senior
prelim inary indicators w ith the
management oversight and a
quantitative exposure estimates
comprehensive risk management
generated by a bank’s internal risk
process that effectively identifies,
measurement systems. For most banks
measures, monitors and controls risk.
the results of their internal risk
This Statement describes prudent
measures are and will continue to be the
principles and practices for each of
primary factor that examiners consider
these elements.
when assessing a bank’s level of
The adequacy an d effectiveness of a
bank’s interest rate risk management
On the qualitative side, examiners
process and the level of its interest rate
will continue to evaluate w hether a
exposure are critical factors in the
bank follows sound risk management
agencies’ evaluation of the bank’s
practices for interest rate risk when
capital adequacy. A bank w ith material
assessing its aggregate interest rate risk
exposure and its need for capital. Such
1 The focus of this Statement is on the interest
practices include, but are not limited to, rate risk found in banks’ non-trading activities.
adequate risk measurement systems.
Each agency has separate guidance regarding the
Indeed, as the agencies explored various prudent risk management of trading activities.


Federal Register / Vol. 61, No. 124 / Wednesday, June 26, 1996 / Notices

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
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.
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 maturitymismatch 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 raterelated 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 offbalance sheet instrum ents 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.
As financial intermediaries banks
accept and manage interest rate risk as
2 The 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.

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
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 w ithin 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 m onitor 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 dayto-day basis. In managing the bank’s
activities, senior management should:
• Develop and implement policies
and procedures that translate the
board’s goals, objectives, andTisk limits
into operating standards that are well
understood by bank personnel and that
are consistent w ith 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 am ount 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 iae'ntifying 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 significandy
among institutions, depending upon the
level of the bank’s risk and the
complexity of its holdings and
activities. Banks w ith 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.
More complex organizations and
those with higher interest rate risk
exposures or holdings of complex
instruments with significant interest
rate-related option characteristics fnay
require more elaborate and formal
interest rate risk management processes.
Risk management processes for thesa
banks should address the institution’s
broader and typically more complex
range of financial activities and provide
senior managers w ith the information
they need to monitor and direct day-today 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

Federal Register / Vol. 61, No. 124 / Wednesday, June 26, 1996 / Notices
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 w hich 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
Policies that establish appropriate risk
limits that reflect the board’s risk
tolerance are an im portant 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 w ithin 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 predeterm ined 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 w ith few holdings
of complex instrum ents and low risk
profiles, simple limits on permissible
holdings or allowable repricing
mismatches in intermediate- and long­
term instrum ents 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 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 wellmanaged bank w ill 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 instrum ents 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 (in) 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
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


Federal Register / Vol. 61, No. 124 / Wednesday, June 26, 1996 7 Notices

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 w ith 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.
Such instrum ents would include loans
that can be prepaid w ithout penalty
prior to m aturity or have limits on the
coupon adjustments, and deposits w ith
unspecified maturities or rights of early

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
• Evaluate the sensitivity and
reasonableness of key assumptions—
such as those dealing w ith changes in
the shape of the yield curve or in the
pace of anticipated loan prepayments or
deposit withdrawals.
• Verify compliance w ith the board’s
established risk tolerance levels and
limits and identify any policy
• 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

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
• 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
• The validity of the risk
measurement calculations. The validity
of the calculations is often tested by
comparing actual versus forecasted
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
w hich 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 u nit 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.
Dated: May 13,1996.

Eugene A. Ludwig,
Comptroller o f the Currency.
By order o f the Board o f Governors of the
Federal Reserve System.
Dated: May 23,1996.

W illiam W. Wiles,
Secretary of the Board.
By order of the Board of Directors.

Dated at Washington, DC, this 14th day of
May, 1996.

Robert E. Feldm an,
Deputy Executive Secretary.
[FR Doc. 96-16300 Filed 6 -2 5 -9 6 ; 8:45 am]
BILUNG CODES: 4810-33-P; «210-01-P; 8714-01-P

Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102