After a prolonged period of near-zero-percent short-term interest rates following the financial crisis in 2008, the Federal Reserve is poised to continue raising interest rates as the U.S. economy continues to expand. The Fed has raised its benchmark rate four times since December 2015 (three of which have come since December 2016), and many expect another increase by the end of the year. If interest rates continue to rise at this pace, community banks need to make sure they’re not taking on more risk than they should.
In a rising interest rate environment, community banks must have a robust program in place for managing interest rate risk (IRR): the risk that changing market interest rates could have on an institution’s earnings or capital.
Since banks primarily use short-term or more immediately repricing deposits to fund longer-term loans, banks need to implement a program to lessen the effects of IRR exposure. Community banks are especially susceptible to IRR as larger banks tend to have more variable-rate loans on their books (such as commercial and industrial loans) which reprice more quickly than fixed-rate loans.
IRR is the Board’s Responsibility
Regulators have made it clear that oversight of IRR rests squarely on the shoulders of a bank’s board of directors. The OCC made the following statement in 2010:
“Existing interagency and international guidance identifies the board of directors as having the ultimate responsibility for the risks undertaken by an institution, including IRR. As a result, the regulators remind boards of directors that they should understand and be regularly informed about the level and trend of their institutions’ IRR exposure. The board of directors or its delegated committee of board members should oversee the establishment, approval, implementation and annual review of IRR management strategies, policies, procedures and limits. Institutions should understand the implications of the IRR strategies they pursue, including their potential impact on market, liquidity, credit and operating risks.”
Types of interest rate risk
In a Community Banking Connections communication by the Federal Reserve’s Doug Gray, the Fed outlined the types of interest rate risk community banks face as well as the key elements of an interest rate risk management program. The first step in developing an effective interest rate management program is to fully understand the different types of IRR that exists, including:
- Repricing risk – the risk that liabilities (primarily deposits) and assets (such as variable-rate loans) will reprice at different times. Narrowing margins result when interest income increases more slowly than interest expense.
- Basis risk – the risk that margins will narrow when underlying index rates used to price assets and liabilities do not change in a correlated manner.
- Yield curve risk – the risk that asset values or cash flows will be disproportionately affected by disparate changes in the yield curve.
- Prepayment risk – the risk that customers will move funds into higher yielding accounts or investments when interest rates rise, or refinance loans at lower rates when interest rates decline.
Key elements of an IRR management program
An effective interest rate risk management program —one that appropriately identifies, measures, monitors, and controls exposure to IRR – includes four key elements:
- Board and senior management oversight
As mentioned above, examiners expect the board to set the bank’s IRR risk tolerances and limits and fully understand the different types of interest rate risk, the bank’s level of exposure to these risks, how the exposure is trending, and the impact that business activities could have on IRR exposure.
Senior management is responsible for the day-to-day management of the bank’s IRR program. This includes developing operating procedures for bank staff based on the board of directors’ goals, objectives and risk tolerances; ensuring adherence to risk tolerances, measurement standards and exposure reporting; and implementing a system of adequate internal controls.
- Policies and risk limits
Adequate policies and procedures should be developed and updated regularly that clearly govern all aspects of the institution’s IRR management process. These policies and procedures should:
- Describe the bank’s risk tolerance and appetite
- Contain methods to identify, quantify and report IRR exposures
- Identify those individuals responsible for ongoing risk measurement and management
- Communicate the controls and risk limits developed to ensure proper IRR management and oversight
- Address the board’s role when policy limits are breached
- Risk measurement and reporting
Measurement and reporting are critical components to any IRR management strategy; however, there is no one-size-fits-all solution. Examiners expect an institution’s IRR measurement tools and techniques to sufficiently quantify its risk exposure to both earnings and capital. The two primary measurement categories include short-term earnings risk measurements (such as gap analysis and earnings-at-risk [EAR]) and long-term capital risk measures (such as long-term EAR and economic value of equity [EVE] models).
- Internal controls and audit
Institutions should have adequate internal controls to ensure integrity in their risk management strategy. Examiners expect banks to take greater steps to ensure that data, assumptions and outputs are both reasonable and accurate. On an annual basis, the following items should be conducted and reported to the board: an independent review of data inputs, key assumptions, the accuracy of board or asset/liability management committee (ALCO) reports, and policy compliance. For those institutions with an elevated risk profile, however, a more robust independent review is expected.
While we don’t have a crystal ball to determine exactly when or how quickly interest rates will rise, all financial institutions will be impacted when they do. Understanding how your bank will be impacted and the assumptions going into those estimations is critical to effectively managing interest rate exposure. For more information on IRR and how to develop a robust interest rate management program, contact your CSH advisor, Leonard Wagers at [email protected], or Scott Deters at [email protected].