Having an Effective Interest Rate Risk Management Process
Author: Kenneth Bishop
Managing interest rate risk is one of the most important responsibilities for bank management and the board of directors. With interest rates expected to rise after several years of historic lows, have you taken a close look at your process for managing this risk?
An effective process can better prepare the bank to develop prudent strategies in a changing environment. When reflecting on your process, here are some simple questions to ask.
Do your written policies clearly document expectations?
The bank’s policy is the foundation of the process. The board should approve policies annually and establish lines of authority, include acceptable risk management strategies, identify meaningful tolerance limits, define allowable products, services and activities and determine how the measurement system and process is tested.
As noted in 2010 interagency advisory guidance, tolerance limits should be in place to ensure positions exceeding predetermined levels receive prompt management attention. An appropriate limit system should let management identify exposures, initiate risk discussions and take appropriate action as specified in the policies and procedures. Banks should establish limits that are neither so high that they are never breached nor so low that they are routinely exceeded.
Finally, the policy should identify relevant measurement scenarios for the bank. There are a number of measurements that can be applied to monitor interest rate risk, which the board should understand and tailor to the bank’s size and complexity. This can include parallel and nonparallel shocks, gradual shifts and dynamic or static conditions, along with determining the magnitude of rate increases and decreases over varying time horizons.
Have you identified and documented your key assumptions?
Banks are required to develop reasonable assumptions about how rates and customer behavior react to changes in conditions. This can be challenging for many banks because of historically low rates with little recent volatility.
There are certain critical assumptions that should be addressed. This includes identifying key driver rates for each product, asset prepayment assumptions and price sensitivity and decay rates of nonmaturity deposits. At a minimum, your process should consider each of these assumptions and be well-documented. If possible, it should be supported by bank historical data. A common deficiency noted by bank examiners is the use of unsupported or stale assumptions.
Are you doing enough to test your model?
There are three components to model testing: theoretical and mathematical accuracy of the model, variance analysis and independent review of the process.
Because most banks use standardized vendor software, the bank should receive validations from vendors to support the mechanics and mathematical calculations. When vendor validation is received, it is still the bank’s responsibility to review the results and conclude if the validation meets the bank’s standards of compliance.
The second form of testing is variance analysis, commonly referred to as backtesting. The purpose of backtesting is to determine if applied results and assumptions make sense or are considered reliable. This involves comparing previous forecasts with actual results, which can identify errors in the model setup or flaws in the assumptions; this is critical, since model results are used in developing strategies.
Lastly, the bank’s interest rate process should be subject to an independent review. This can be done in-house or by an outside consultant. This review should encompass all aspects of the interest rate risk management process, including accuracy of input information, assumption development and output reporting, including variance analysis. Common findings related to independent review include the lack of annual testing, deficiencies in scope and testing not performed by qualified individuals.
The process and requirements for managing interest rate risk are comprehensive, and this is just a small sample of things to consider when reflecting on your procedures. Having an effective interest rate management framework in place is essential for a bank to sustain profitability and preserve capital in an expected rising interest rate environment.
For more information, contact your BKD advisor.