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Federal Reserve Ban k
new York, N.Y.
of
N ew Y ork
10045-0001
AREA CODE 212-720-5000
fir-/D6frS'
August 13, 1996
To the Chief Executive Officer of
State Member Banks, Bank Holding Companies,
and Branches and Agencies of Foreign Banks
in the Second Federal Reserve District:
The Federal Reserve has recently issued a Joint Agency Policy Statement on Managing
Interest Rate Risk. The Policy Statement was adopted by the Federal banking agencies to
provide bank management and examiners with guidance on sound practices for managing
interest rate risk. These guidelines will form the basis for the agencies' ongoing evaluations of
the adequacy of interest rate risk management at supervised institutions. While the Policy
Statement applies to all commercial banks and FDIC-supervised savings banks, the principles
espoused in the Policy Statement should also prove useful to managements o f branches and
agencies of foreign banks.
The Policy Statement also makes clear that the agencies have elected not to pursue a
standardized interest rate risk measurement framework at this time. This decision reflects
concerns about the burden, accuracy and complexity of a standardized measure, as well as
recognition that industry techniques for measuring interest rate risk are evolving.
The approach in the Policy Statement emphasizes the fundamental elements o f sound
management identified in previous Federal Reserve guidance. The guidance emphasizes the
need for active board and senior management oversight of a comprehensive risk management
process which effectively identifies, measures, monitors and controls interest rate risk.
Federal Reserve examiners will incorporate their assessment of interest rate risk management
into the overall risk management rating.
If you have any questions about the Policy Statement, please contact Brian Peters,
Examining Officer (212 720-2715), or your Financial Examinations portfolio manager.
Sincerely,
O l l l Id Ulllt 1YX. \_ U lllii± iilg
Senior Vice President
Attachments
33166
F e d e r a l R e g is te r / V o i. 6 1 , N’o. 124 / W e d n e s d a y . J u n e 2 6 , 1 9 9 6 / N o tic e s
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).
%
V
■r
♦
it
N
DEPARTMENT OF THE TREASURY
►
r*
Office of the Comptroller of the
Currency
[Docket No. 9*-13]
FEDERAL RESERVE SYSTEM
[Docket No. R-0902]
FEDERAL DEPOSIT INSURANCE
CORPORATION
Joint Agency Policy Statement:
Interest Rate Risk
agencies: Office o f the Comptroller o f
*
the Currency (OCC), Treasury; Board of
Governors o f the Federal Reserve
System (Board); and Federal Deposit
Insurance Corporation (FDIC).
action: Joint policy statem ent
summary: The OCC, the Board, and the
t
FDIC (collectively referred to as the
agencies) are issuing this joint agency
policy statement (policy statement) to
bankers to provide guidance on sound
This policy statem ent augm ents the
action taken by the agencies in August
1995 to im plem ent the portion o f
section 305 o f the Federal D eposit
Insurance Corporation Improvement Act
of 1991 (FDICLA) addressing risk-based
capital standards for interest rate risk. It
also replaces the proposed p olicy
statement that the agencies issued for
com m ent 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 exp licit capital charge for interest
rate risk at this tim e. T his decision
reflects concerns about the burden,
accuracy, and com plexity o f a
standardized measure and recognition
that industry techniques for measuring
interest rate risk are continuing to
evolve. Rather than dam pening
incentives to improve risk m easures by
adopting a standardized measure at this
time, the agencies hope to encourage
these industry efforts. N onetheless, the
agencies w ill continue to place
significant em phasis on the level of a
bank’s interest rate risk exposure and
the quality o f its risk management
process w hen evaluating a bank’s
capital adequacy. The principles and
practices Identified in th is p o licy
statem ent provide the standards upon
w hich the agencies w ill evaluate the
adequacy and effectiven ess o f a bank’s
interest rate risk m anagem ent
EFFECTIVE DATE: June 26. 1996.
FOR FURTHER INFORMATION CONTACT:
O CC: Christina Benson, Capital
Markets Specialist, or, Margot
Schwadron, Financial Analyst, (202/
8 74-5070), Office o f the Chief National
Bank Examiner; M ichael Carhill, Deputy
Director, Risk A nalysis D ivision (202/
874-5700); and Ronald Shimabukuro,
Senior Attorney. Legislative and
Regulatory A ctivities D ivision (202/
8 7 4-5090), Office of the Comptroller o f
F e d e ra l R e g is te r / V o l. 61, N o. 124 / W e d n e s d a y , Ju ne 26, 1996 / N o tic e s
the Currency, 250 E Street, S.W.,
evaluations of a bank’s capital
Washington, D.C. 20219.
adequacy, an assessment of the
Board o f Governors: James Embersit,
exposure to declines in the economic
value of the bank’s capital due to
Manager (202/452-5249), or William
changes in interest rate risk. See 60 FR
Treacy, Supervisory Financial Analyst
39490 (August 2, 1995). This final rule,
(202/452-3859), Division of Banking
which became effective on September 1,
Supervision and Regulation; Gregory
1995, adopts a “risk assessment"
Baer, Managing Senior Counsel (202/
approach under which capital for
452-3236), Legal Division. Board of
interest rate risk is evaluated on a caseGovernors of the Federal Reserve
by-case basis, considering both
System. For the hearing impaired only,
Telecommunication Device for the Deaf quantitative and qualitative factors.
The final rule did not adopt a
CTDD), Dorothea Thompson (202/4523544), Board of Governors of the Federal measurement framework for assessing
the level of a bank’s interest rate risk
Reserve System, 20th and C Streets,
exposure, nor did it specify a formula
N.W., Washington, D.C. 20551.
for determining the amount of capital
FDIC: William A. Stark, Assistant
that would be required. The intent of
Director (202/898-6972) or Miguel
Browne, Deputy Assistant Director (202/ the agencies at that time was to
implement an explicit minimum capital
898-6789), Division of Supervision;
charge for interest rate risk at a future
Jamey Basham, Counsel, (202/898date, after the agencies and the industry
7265), Legal Division, Federal Deposit
had gained more experience with a
Insurance Corporation, 550 17th Street,
proposed supervisory measure that the
N.W., Washington, D.C. 20429.
agencies issued for comment in August
SUPPLEMENTARY INFORMATION:
1995. See 60 FR 39495 (August 2. 1995).
The agencies have undertaken
I. Background
considerable efforts to develop a
Interest rate risk is the exposure of a
supervisory measure for interest rate
bank’s current and future earnings and
risk that provides sufficient accuracy,
capital arising from adverse movements transparency, and predictability for
in interest rates. Changes in interest
establishing an explicit charge for
rates affect a bank’s earnings by
interest rate risk. These efforts, and the
changing its net interest income and the comments the agencies received on
level of other interest-sensitive income
them, are summarized in sections III
and operating expenses. Changes in
and IV that follow. After careful
interest rates also affect the underlying
consideration of those comments and
economic value of the bank’s assets,
additional analyses and research by
liabilities, and off-balance sheet items.
agencies’ staff, the agencies have
These changes occur because the
decided that concerns about the
present value of future cash flows, and
burdens, costs, and potential incentives
in many cases the cash flows
of implementing a standardized
them selves, change w h en interest rates
measure and explicit capital treatment
change. The combined effects of the
currently outweigh the potential
changes in these present values reflect
benefits that such measures would
the change in the bank’s underlying
provide. The agencies are cognizant that
economic value as well as provide an
techniques for measuring interest rate
indicator of the expected change in the
risk are continuing to evolve, and they
bank’s future earnings arising from the
do not want to impede that progress by
change in interest rates. While interest
mandating or implementing prescribed
rate risk is inherent in the role of banks
risk measurement techniques. Rather,
the agencies wish to work with the
as financial intermediaries, a bank that
industry to encourage efforts to improve
has a high level of risk can face
diminished earnings, impaired liquidity risk measurement techniques. These
efforts, the agencies believe, may lead to
and capital positions, and, ultimately,
greater convergence within the industry
greater risk of insolvency.
on the methodologies used for
II. FDICIA Requirements and Agencies’ measuring this risk and may, at a future
Response
date, facilitate more quantitative and
Section 305 of FDICIA, Pub. L. 102— explicit capital treatments for interest
242, 105 Stat. 2236, 2354 (12 U.S.C.
rate risk.
Hence, the agencies have concluded
1828 note), requires the agencies to
revise their risk-based capital guidelines that the best course of action at this
to take adequate account of interest rate time, is to continue to assess capital
adequacy for interest rate risk under a
risk. On August 2, 1995 the agencies
risk assessment approach and to provide
published a final rule implementing
the industry with further guidance on
section 305 that amended their riskprudent interest rate risk management
based capital standards to specify that
practices. Section V of this preamble
the agencies will include, in their
33167
describes the agencies’ risk assessment
approach for capital. The policy
statement, which follows section V,
provides the agencies’ guidance and
expectations on sound interest rate risk
management.
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 measurement 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 which incorporated
numerous changes to the 1992 ANPR in
an effort to address those concerns and
improve the proposed model’s accuracy.
See 58 FR 48206 (September 14, 1993).
These changes included.
(1) A proposed screen that would
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
accuracy.
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
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F e d e ra l R e g is te r / V o l. 61, N o. 124 / W e d n e s d a y , Ju ne 26, 1996 / N o tic e s
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
value.
In August 1995, along with 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
with intermediate or long term repricing
characteristics would be exempted from
new interest rate risk reporting
requirements and the supervisory
model.
(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
financial instruments to report estimates
(4)
Any supervisory model may create
of changes in the market value
improper incentives for internal risk
sensitivities of those instruments for a
management and measurement. Each of
200 basis point interest rate shock; and, these concerns is addressed in turn.
extending the range of maturities that
The agencies continue to believe
banks could use when reporting their
economic value sensitivity is a valid
non-maturity deposits (demand
and important concept, especially when
deposits, savings, NOW, and money
assessing an institution’s capital
market demand accounts).
adequacy and, as noted, have amended
(3)
The introduction of supplemental their capital standards to reflect this
modules for non-exempted banks that
view. Nonetheless, the agencies
had concentrations in fixed- or
recognize that changes in a bank’s
adjustable-rate residential mortgage
reported earnings is also important and
loans and pass-through securities. Banks that a bank needs to consider both
subject to these modules would report
earnings and economic perspectives
additional information on the coupon
when assessing the full scope of its
distributions of their fixed-rate
exposure. This policy statement adopted
mortgages and information on the
by the agencies sets forth principles for
lifetime and periodic caps of their
monitoring and controlling interest rate
adjustable-rate mortgages.
risk from both of these perspectives.
The industry's concerns about the
Although these modifications were
designed to enhance and improve upon validity and accuracy of a standardized
model present a more difficult and
the agencies’ earlier proposals, the
serious issue. Some of the changes in
majority of commenters on the August
1995 proposal reiterated many previous the August 1995 proposal attempted to
address these concerns. For example,
concerns about accuracy, burden, and
supplemental schedules for residential
incentives, and urged the agencies to
reconsider their approach and efforts to mortgage loans and pass-through
securities were a response to earlier
devise a uniform and standardized
industry concerns regarding the use of
model.
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
Model
additional data on the embedded
As already noted, the agencies have
options in an individual bank’s
decided not to pursue a standardized
mortgage portfolio, the accuracy of the
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
implement a standardized measure that risk, they also increased the likelihood
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, while 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,
inappropriate;
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
characteristics of a typical bank’s assets collateralized mortgage obligations and
structured notes, can have complex cash
and liabilities may be inaccurate for a
flow characteristics that vary
given institution;
significantly with each transaction. The
(3) The proposed treatment for nonmaturity deposits may be inappropriate August 1995 proposal attempted to
address this problem by requiring banks
in many cases; and
F e d e ra l R e g is te r / V o l. 61, N o . 124 / W e d n e s d a y , June 26, 1996 / N o tic e s
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 with 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 with concentrations of
residential mortgage assets, especially
adjustable rate mortgages. These
instruments require data-intensive,
complex models to obtain accurate
valuations and interest rate sensitivities.
Since most commercial banks do not
hold high concentrations of these
instruments, the agencies were
concerned about the substantial
reporting requirements and
measurement complexity that would be
associated with 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 of non-maturity deposits, the
policy statement cautions banks to make
reasonable assumptions about customer
behavior in this area, and periodically
re-evaluate whether the assumptions are
reasonable in light of experience.
The supervisory treatment of non
maturity 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
bank's non-maturity deposits, it could
induce a bank to inappropriately
shorten its asset maturities, leave the
bank exposed to falling interest rates,
and unnecessarily reduce its net interest
margins. The agencies, however, are
also concerned that an assumption that
overstated the maturity of these deposits
could mistakenly lead banks to extend
their asset maturities, leaving them
exposed to rising interest rates and
significant loss in economic value.
Many commenters voiced broader
concerns about the potential incentives
that a standardized supervisory model
may have on how banks manage and
measure their risk. A frequent concern
has been that a supervisory model
would become the industry standard
against which internal models would be
benchmarked and tested, thus diverting
resources away from improving internal
models and assumptions.
The agencies neither wish to create
inappropriate incentives, nor divert
industry resources from the
development of better interest rate risk
measurements. The policy statement
consequently emphasizes each
institution's responsibility to develop
and refine interest rate risk management
practices that are appropriate and
effective for its specific circumstances.
V. Risk Assessment Approach
The risk assessment approach that the
agencies use to evaluate a bank’s capital
adequacy for interest rate risk relies on
a combination of quantitative and
qualitative factors. The agencies will use
various quantitative screens and filters
as tools to identify banks that may have
high exposures or complex risk profiles,
to allocate examiner resources, and to
set examination priorities. These tools
rely on Call Report data and various
economic indicators and data. To make
assessments about the level of a bank’s
interest rate exposure, examiners
augment the insights provided by these
preliminary indicators with the
quantitative exposure estimates
generated by a bank’s internal risk
measurement systems. For most banks
the results of their internal risk
measures are and will continue to be the
primary factor that examiners consider
when assessing a bank’s level of
exposure.
On the qualitative side, examiners
will continue to evaluate whether a
bank follows sound risk management
practices for interest rate risk when
assessing its aggregate interest rate risk
exposure and its need for capital. Such
practices include, but are not limited to,
adequate risk measurement systems.
Indeed, as the agencies explored various
33169
approaches for developing supervisory
risk measures, it reinforced their
appreciation for the critical roles that
management and board oversight, risk
controls, and prudent judgment and
experience play in the interest rate risk
management process.
Banks that are found to have high
levels of exposure and/or weak
management practices will be directed
by the agencies to take corrective action.
Such actions will include directives to
raise additional capital, strengthen
management expertise, improve
management information and
measurement systems, reduce levels of
exposure, or a combination thereof.
Joint Agency Policy Statement on
Interest Rate Risk
Purpose
This joint agency policy statement
(“Statement”) provides guidance to
banks on prudent interest rate risk
management principles. The three
federal banking agencies—the Board of
Governors of the Federal Reserve
System, the Federal Deposit Insurance
Corporation, and the Office of the
Comptroller of the Currency
("agencies”)—believe that effective
interest rate risk management is an
essential component of safe and sound
banking practices. The agencies are
issuing this Statement to provide
guidance to banks on this subject and to
assist bankers and examiners in
evaluating the adequacy of a bank’s
management of interest rate risk.1
This Statement applies to all
federally-insured commercial and FDIC
supervised savings banks [’’banks’’].
Because market conditions, bank
structures, and bank activities vary,
each bank needs to develop its own
interest rate risk management program
tailored to its needs and circumstances.
Nonetheless, there are certain elements
that are fundamental to sound interest
rate risk management, including
appropriate board and senior
management oversight and a
comprehensive risk management
process that effectively identifies,
measures, monitors and controls risk.
This Statement describes prudent
principles and practices for each of
these elements.
The adequacy and effectiveness of a
bank's interest rate risk management
process and the level of its interest rate
exposure are critical factors in the
agencies’ evaluation of the bank’s
capital adequacy. A bank with material
1The focus of this Statement is on the Interest
rate risk found in banks' non-trading activities.
Each agency has separate guidance regarding the
prudent risk management of trading activities.
33170
F e d e ra l R e g is te r / V o l. 61, N o. 124 / W e d n e s d a y , Ju ne 26, 1996 / N o tic e s
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
institution.
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.
Background
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 value2
of the bank’s assets, liabilities and offbalance sheet instruments 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
JThe 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
Oversight
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 within 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 monitor 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, and risk limits
into operating standards that are well
understood by bank personnel and that
are consistent with 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 amount 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 identifying 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 significantly
among institutions, depending upon the
level of the bank’s risk and the
complexity of its holdings and
activities. Banks with 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 may
require more elaborate and formal
interest rate risk management processes.
Risk management processes for these
banks should address the institution's
broader and typically more complex
range of financial activities and provide
senior managers with 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
F e d e ra l R e g is te r / V o l. 61, N o. 124 / W e d n e s d a y , Ju ne 26, 1996 / N o tic e s
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 which 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
exposure.
Policies that establish appropriate risk
limits that reflect the board’s risk
tolerance are an important 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 within 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 predetermined 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 with few holdings
of complex instruments and low risk
profiles, simple limits on permissible
holdings or allowable repricing
mismatches in intermediate- and long
term instruments 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 will 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 instruments with
intermediate and long maturities or
embedded options is especially
sensitive to interest rate changes, banks
33171
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 (iii) 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
techniques.
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
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monitoring and control procedures
should be independent of the function
they are assigned to review.
Assumptions about customer behavior
Effective control of the interest rate
and new business activity should be
risk
management process includes
reasonable and consistent with each rate independent
review and, where
scenario that is evaluated. In particular,
appropriate,
internal
and external audit.
as part of its measurement process, bank
The bank should conduct periodic
management should consider how the
reviews of its risk management process
maturity, repricing and cash flows of
to ensure its integrity, accuracy and
instruments with embedded options
reasonableness.
Items that should be
may change under various scenarios.
reviewed and validated include:
Such instruments would include loans
• The adequacy of, and personnel’s
that can be prepaid without penalty
compliance with, the bank's internal
prior to maturity or have limits on the
coupon adjustments, and deposits with control system.
unspecified maturities or rights of early
• The appropriateness of the bank’s
withdrawal.
risk measurement system given the
nature, scope and complexity of its
Monitoring and Reporting Exposures
activities.
Institutions should also establish an
• The accuracy and completeness of
adequate system for monitoring and
the data inputs into the bank’s risk
reporting risk exposures. A bank’s
measurement system.
senior management and its board or a
board committee should receive reports
• The reasonableness and validity of
on the bank's interest rate risk profile at scenarios used in the risk measurement
least quarterly. More frequent reporting system.
may be appropriate depending on the
• The validity of the risk
bank’s level of risk and the potential
measurement calculations. The validity
that the level of risk could change
of the calculations is often tested by
significantly. These reports should
allow senior management and the board comparing actual versus forecasted
results.
or committee to:
The scope and formality of the review
• Evaluate the level and trends of the
and validation will depend on the size
bank’s aggregated interest rate risk
and complexity of the bank. At large
exposure.
• Evaluate the sensitivity and
banks, internal and external auditors
reasonableness of key assumptions—
may have their own models against
such as those dealing with changes in
which the bank’s model is tested. Banks
the shape of the yield curve or in the
with complex risk measurement systems
pace of anticipated loan prepayments or should have their models or
deposit withdrawals.
calculations validated by an
• Verify compliance with the board’s independent source—either an internal
established risk tolerance levels and
risk control unit of the bank or by
limits and identify any policy
outside auditors or consultants.
exceptions.
The findings of this review should be
• Determine whether the bank holds
sufficient capital for the level of interest reported to the board on an annual
basis. The report should provide a brief
rate risk being taken.
The reports provided to the board and summary of the bank's Interest rate risk
measurement techniques and
senior management should be clear,
management practices. It also should
concise, and timely and provide the
identify major critical assumptions used
information needed for making
in the risk measurement process,
decisions.
discuss the process used to derive those
Internal Control, Review, and Audit of
assumptions and provide an assessment
the Risk Management Process
of the impact of those assumptions on
the bank’s measured exposure.
A bank’s internal control structure is
critical to the safe and sound
Dated: May 13, 1996.
functioning of the organization
Eugene A. Ludwig,
generally, and to its interest rate risk
C om ptroller o f the Currency.
management process in particular.
Establishing and maintaining an
By order of the Board of Governors of the
effective system of controls, including
Federal Reserve System.
the enforcement of official lines of
Dated: May 23. 1996.
authority and the appropriate separation William W. Wiles.
of duties, are two of management’s more
Secretary o f the Board.
important responsibilities. Individuals
By order of the Board of Directors.
responsible for evaluating risk
yield curve in order to capture the
material effects of any exp licit or
em bedded options.
Dated at Washington, DC. this 14th day of
May, 1996.
Robert E. Feldman,
Deputy Executive Secretary.
(FR Doc. 96-16300 Filed 6-25-96, 8 45 am|
BILLMO CODES: 4410-03-P: C210-01-P; C714-01-P
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