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Number 92-39, November 6, 1992

Interest Rate Risk and Bank

Capital Standards
Considerable attention recently has focused on
the interest rate risk exposure of
banks. This
new-found attention is due in part to a provision
in the Federal Deposit Insurance Corporation
Improvement Act of 1991 (FDIClA) that requires
federal banking regulators to incorporate interest
rate risk into bank capital standards by the middle of 1993. In their current form the risk-based
capital requirements focus on the credit risk of
bank assets, requiring banks to hold more capital
against assets assumed to pose a greater risk of
default. Although most observers believe that
interest rate risk is iessimportant for banks than
credit risk, this omission may mean that bank
capital levels do not accurately reflect the true
risk of bank portfolios.


The Federal Reserve Board has responded to the
requirements of FDICIA by proposing a framework for addressing interest risk in bank capital
standards. In this Letter, I provide some background on the notion of interest rate risk, and
describe the general features of the Fed's proposal. I also compare this proposal to an alternative met~odology proposed by thrift regulators.

What is interest rate risk?
Interest rate risk refers to the (possibly adverse)
effect that changes in interest rates can have on
the values of bank assets and liabilities. Financial
instruments typically provide a stream of payments
that is fixed in nominal terms for a period of time.
The fixed-payment period may be relatively short,
such as for a Treasury bill or an adjustable-rate
mortgage loan, or long, as with a long-term bond
or a fixed-rate mortgage loan. When market interest rates change, the value of financial instruments changes as well. An increase in market
rates during the fixed-payment period diminishes
the value of the fixed stream of payments and
thus reduces the market value of the instrument.
A decline in rates, in contrast, raises the value of
the fixed payment stream.
In general, the longer the period during which
the payments are fixed, the greater the relative

change in value from a given change in both
short- and long-term interest rates. Thus, the market val ue of a long-term bond or a 3D-year fixedrate mortgage is more sensitive to a parallel shift
in interest rates than a short-term debt security or
an adjustable-rate mortgage.
The impact of a change in interest rates on the
value of a bank depends on the maturity structure of both its assets and its liabilities. If the
fixed payments the bank receives from its assets
take longer to respond to interest rate changes
than the fixed payments it makes on its liabilities,
then a rise in interest rates would reduce the
value of assets more than the value of liabilities,
and the bank's net worth would fall. In practice,
most banks have a liability side of the balance
sheet that carries a shorter repricing period than
the asset side. That is, they typically borrow short
and lend long. Thus, a certain amount of interest
rate risk appears to be a normal part of the business of banking.
If exposure to interest rate risk is high, then an
unfavorable move in interest rates could significantly reduce an institution's net worth and eat
into its capital cushion. In extreme cases, an
adverse move in interest rates could reduce an
institution's capital below the level required by
regulators. This is what happened to many thrifts
in the late 1970s and early 1980s. Concerns
about a repeat of this episode have prompted
efforts to identify banks facing significant interest
rate risk, and to require them to hold more capital against the possibility of large interest rateinduced declines in value.

How do you measure it?
As the preceding discussion suggests, the interest rate risk associated with any financial instrument is directly related to the length of time over
which the instrument makes fixed payments.
One commonly used measure of the "length" or
effective maturity of a financial instrument is its
duration. The duration of a financial asset is the
weighted average maturity of its cash flows,

where the present values of the cash flows (as
a percent of total present value) serve as the
weights. For example, a financial asset that
makes a fixed nominal payment every year for
ten years has a duration somewhat less than five
years. This is because the asset pays more of its
present value in the first five years than it does
in the second five years; the present discounted
value of the fixed payments received far in the
future is less than the present value of payments
received earlier. In contrast, the duration of a tenyear zero-coupon bond (which makes no payments until maturity) is equal to ten years since
100 percent of the present value of its cash flows
are received at maturity. In practice, it is typical
to adjust an instrument's duration for noncon. tinuous compounding of interest, yielding the
more commonly used measure known as modified duration.
The duration measure is particuiariy useful as a
gauge of interest rate risk. The longer the duration of an asset or liability, the more its value will
change in response to a given percentage point
change in both short- and long-term market interest rates. A 30-year fixed-rate mortgage, for
example, has a relatively long duration. The value
of this asset fluctuates more from a parallel shift
in the yield curve than a shorter duration asset,
such as a short-term consumer loan. The concept
of duration can be applied to both the assets and·
liabilities of a gank's balance sheet; a weighted
average of these individual durations yields a
single measure of the exposure of the bank's net
worth to changes in interest rates. The measurement system proposed by the Federal Reserve
uses this method to assess interest rate risk.

The Fed's proposal
Any system intended to measure the interest rate
risk of bank portfolios requires information on
the maturity structure of bank assets and liabilities. Thus, the Fed's proposal requires banks to
assign their on- and off-balance sheet assets and
their liabilities to one of six time bands based
either on the maturity of the instrument or (for
floating rate instruments) on the length of time
until its interest rate adjusts.
in addition to the maturity information, the Fed's
proposed system also requires banks to assign
their assets to one of three categories: amortizing, nonamortizing, and deep discount. Amortizing assets make periodic payments of both principal and interest, while nonamortizing assets

pay interest only, delaying principal repayment
until maturity. Deep discount assets make neither
interest nor principal payments but instead are
sold at a discount from face value and then repay
principal at maturity. These differences in cash
flow characteristics affect the duration of the different types of assets. For a given maturity, an
amortizing asset has a shorter duration than a
nonamortizing one, which in turn has a shorter
duration than a deep discount asset.
Each bank reports to the regulators its dollar
positions in each of the time bands for the three
different types of assets and for liabilities. These
reported positions are then multiplied by "risk
weights" that are derived from the durations of
the corresponding assets and liabilities. The risk
weights are expressed in percent terms and represent the change in the value of an instrument
resulting from a 100 basis point (one percentage
point) change in aii interest rates. The resuit of
this multiplication is a series of risk-weighted
positions that measure the change in the value
of the bank's reported holdings that would follow
a 100 basis point change in interest rates. For
example, multiplying the bank's holdings of longterm fixed rate mortgage loans by the appropriate amortizing risk weight yields a number that
represents the change in the value of the bank's
mortgage holdings resulting from a 100 basis
point change in all rates.
Finally, total risk-weighted liabilities are subtracted from total risk-weighted assets to arrive at
the net risk-weighted position of the bank. This
number, expressed in dollars, is the change in
the net worth of the bank that would occur as a
result of a 100 basis point shift in interest rates.
Alternatively, this net risk-weighted position can
be expressed as a percent of total assets. In this
way, the interest rate risk of different banks can
be compared easily, just as bank capital ratios
are compared.

Normal vs. excessive interest rate risk
One guiding principle of the fed's proposal is
that a certain amount of interest rate risk is inherent in banking. Moreover, creditrisk is considered to be significantly more important than
interest rate risk in terms of the threat it poses to
bank solvency. The Fed's proposal suggests that
existing risk-based capital requirements are sufficient to cover "normal" levels of interest rate
risk. Banks that have "normal" interest rate risk
will not be required under the proposed system

to hold additional capital. Only those institutions
that are exposed to "excessive" risk would be
required to hold more capital.
The obvious next question is what constitutes
excessive risk. To answer this question, Fed researchers look to the historical distribution of
banking industry risk exposures. Applying the
proposed measurement system to the recent ex-

perience of

u.s. banks suggests that a net risk-

weighted position equal to 1 percent of a bank's
assets may be considered "normaL" That is, the
"normal" change in the net worth of a bank
arising from a 100 basis point change in all interest rates is 1 percent of assets. Drawing on this
result, the Fed proposal suggests that any bank
with a net risk-weighted position equal to 1 percent
of assets or less would not be required to hold
additional capital over and above the existing
risk-based capital requirements. Only exposures
in excess of 1 percent would require additional
capital, which would be equal to the amount in
excess of the 1 percent risk exposure.

flow characteristics of assets and liabilities, as
well as instrument-specific information on yield,
coupon, prepayment options, and so on. This
more detailed method would then simulate the
impact of a 200 basis point shift in all interest
rates, requiring thrifts to hold additional capital
equal to a portion of the simulated change in net
How different are these two approaches? The
OTS method provides a more accurate measure
of the interest rate sensitivity of net worth, and
thus of interest rate risk. However, it also imposes
a considerable reporting burden on thrifts. Since
little work has been done to assess the differences between the two approaches, it is unclear
whether the additional reporting requirements of
the OTS proposal are worth the cost. Some preliminary work comparing the two methods on a
sample of thrifts suggests that the two methodologies largely agree on identifying high interest
rate risk institutions. Differences arise between
the two approaches when considering institutions
with more moderate levels of interest rate risk.

Some pros and cons
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tern for measuring interest rate risk. The system
balances the need to obtain information to measure interest rate exposures with a desire to minimize the additional reporting burden for banks.
While the proposal calls for expanded reporting
of asset types and maturity structures, banks are
not required to report detailed yield information
on individual assets. Ideally, asset-specific yield
and coupon ·information would be required to
obtain more accurate duration-based risk factors.
Instead, the Fed's proposal uses representative
bank assets to derive the risk weights. This approach also neglects asset-specific information
like prepayment options and may fail to capture
unusual characteristics of new financialinstruments. This compromise reduces the accuracy of
the final risk measure but also reduces the bank's
reporting burden.

Some measure of interest rate riskwill become a
reality for the nation's financial intermediaries in
the next year, though the exact form of this measure is not yet known. Moreover, this measure will
be linked to risk-based capital standards. Some
have argued that the failure of the current system
to address interest rate risk creates an incentive
for banks and thrifts to substitute interest rate risk
for credit risk by altering the composition of their
portfolios. Recent large increases in bank holdings of Treasury securities, it is claimed, are
consistent with this incentive.

The Fed's approach differs somewhat from one
proposed last year for thrifts by the Office of
Thrift Supervision (OTS). The OTS would require
thrifts to report maturity information and cash

Of course, the rather simple systems proposed by
regulators should not preclude the use by bank
management of more sophisticated interest rate
risk monitoring mechanisms. Institutions that take
big interest rate risk exposures should already be
aware of the nature of their positions and the
risks they pose to net worth.

J9nathan A. Neuberger

Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of
San Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor or to the author.... Free copies of Federal Reserve publications can be
obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco 94120.
Phone (415) 974-2246, Fax (415) 974-3341.
Printed on recycled paper jQl, ...
with soybean inks.
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Index to Recent Issues of FRBSF Weekly Letter






Causes and Effects of Consumer Sentiment
California Banks' Problems Continue
Is a Bad Bank Always Bad?
An Unprecedented Slowdown?
Agricultural Production's Share of the Western Economy
Can Paradise Be Affordable?
The Silicon Valley Economy
EMU and the ECB
Perspective on California
Commercial Aerospace: Risks and Prospects
Low Inflation and Central Bank Independence
First Quarter Results: Good News, Bad News
Are Big U.s. Banks Big Enough?
What's Happening to Southern California?
Money, Credit, and M2
Pegging, Floating, and Price Stability: Lessons from Taiwan
Budget Rules and Monetary Union in Europe
The Slow Recovery
Ejido Reform and the NAFTA
The Dollar: Short-Run Volatility and Long-Run Adjustment
The European Currency Crisis
Southern California Banking Blues
Would a New Monetary Aggregate Improve Policy?

The FRBSF Weekly Letter appears on an abbreviated schedule in June, July, August, and December.