Maturity transformation

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Maturity transformation

Converting short-term liabilities to long term assets (banks deal with large number of lenders and borrowers, and reconcile their conflicting needs).

Financial regulators issue interest rate risk advisory

The Federal Financial Institutions Examination Council (FFIEC) released an advisory today reminding institutions of supervisory expectations for sound practices to manage interest rate risk (IRR). This advisory, adopted by each of the financial regulators,1 reiterates the importance of effective corporate governance, policies and procedures, risk measuring and monitoring systems, stress testing, and internal controls related to the IRR exposures of depository institutions. It also clarifies elements of existing guidance and describes some IRR management techniques used by effective risk managers.

The financial regulators recognize that some IRR is inherent in the business of banking. At the same time, institutions are expected to have sound risk-management practices to measure, monitor, and control IRR exposures. The financial regulators expect each depository institution to manage its IRR exposures using processes and systems commensurate with its complexity, business model, risk profile, and scope of operations.

The financial regulators remind depository institutions that an effective IRR management system does not involve only the identification and measurement of IRR, but also addresses appropriate actions to control this risk. If an institution determines that its core earnings and capital are insufficient to support its level of IRR, it should take steps to mitigate its exposure, increase its capital, or both.

Attachment: Advisory on Interest Rate Risk Management

FDIC has new concern about interest rate risks

Two senior FDIC officials tell FinCri Advisor that they are becoming increasingly concerned that banks are not focused sufficiently on interest rate risk or being aggressive enough in their modeling of it. The concern spans all four regulatory agencies, which are working on a joint statement on the issue that will increase the severity of shocks that banks should model, a third regulatory official reveals.

"We do have a concern that some banks are setting themselves up for problems down the road," says George French, deputy director for policy in the FDIC's Division of Supervision and Consumer Protection. Some banks appear to be loading up on short-term liabilities and long-term assets to generate interest rate spread, he notes, adding that "We are asking examiners to look at that issue and give it focus."

The FDIC's warnings come just a week before the first anniversary of the current record low Federal Funds rate band of 0.0%-0.25%. Declining rates - which have been on a downward slope since mid-2006 - initially fueled lending. But that changed with the crisis. Loan growth was negative in the third quarter, pushing banks to look for other ways to increase earnings.

"Anytime you have an ultra low interest rate environment, you get concerned banks will reach for yield," says FDIC Chief Economist Richard Brown. "In this environment you have a steep yield curve, so there is a temptation to lock up long term assets and earn that spread." As one banker notes, some institutions are tempted to "earn their way out of credit problems."

As the economy recovers, rates should rise, which could lead to mismatches that erode earnings and capital. "In the last cycle, that happened pretty rapidly," Brown says. "Clearly, there is a concern that institutions have not positioned themselves" properly and will be forced to become less selective with underwriting as borrowers' cash flow and collateral improve.

Why Rate Risk has Emerged as an Issue

Concern about interest rate risk first emerged at the FDIC's Quarterly Banking Profile briefing two weeks ago. John Corston, FDIC's deputy director for Supervision and Consumer Protection, revealed that the FDIC has been "watching" institutions extend their assets and increase their interest rate exposure. At the same briefing, Brown noted that a key time for regulators to watch for mismatches is the transition from an "ultralow interest rate environment" to rising rates.

In speaking with FinCri Advisor, Brown describes this as a common pattern among banks after a recession. "The risk du jour is still credit risk," he says. "That is the risk of today. Interest rate risk is the risk of tomorrow." However, bank concern about credit risk has led many to load up on longer-term fixed rate assets that could be a problem once rates spike.

"Banks are cutting back on credit risk exposure right now, and to maintain some level of income they are substituting interest rate risk," explains former examiner Leonard Matz, principal at Liquidity Risk Advisors in New Castle, Pa. "They borrow money at 1% and put it out at five years at 2%. That's not a great return. As the FDIC points out, there is a lot of interest rate risk."

Field examiners have taken note. In 2009 alone, there have been 138 FDIC enforcement orders that include mentions of interest rate risk, including about two dozen with full-blown sections on it. The orders typically demand development of a new interest rate risk policy and new procedures that include goals, measures and identifying responsible parties.

The OCC in its handbook on interest rate risk notes four interest rate risks that examiners focus on most:

  • Basis risk, when yields on assets and costs of liabilities come from different indices (prime rate vs. LIBOR, for instance). This means they can move at different rates or in different directions;
  • Yield curve risk (or "twist risk"), when the relationship between long- and short-term rates shifts quickly, sometimes to the point where investments pay less than the cost of funds;
  • Re-pricing risk, when assets and liabilities re-price at different times and rates, as could happen with a variable rate loan funded with fixed rate deposits; and
  • Option risk, when securities or loans allow for prepayment. The concern in a rising rate environment would be mortgage borrowers who are slow to repay low-rate loans.

"Loan growth is hard to come by," Matz says. "That means you have to turn to the investment portfolio. It's the only thing they can do. But banks always do this. They reach for yield when rates are low. FDIC is just anticipating a repeat of historical experience. The spread goes away when rates rise and the cost of borrowing goes up. The more short-term rates rise, the more squeezed the banks get. It easily could get to where the bank's margin dwindles very low or becomes negative."

A related concern is that banks have become so focused on credit risk that they are not paying much attention to interest rate risk. Regulators may be contributing to this, says W. Kendall Chalk, interim president of the Risk Management Association (RMA) in Philadelphia and former chief credit officer at BB&T ($148 billion) in Winston-Salem, N.C.

Chalk cites banks' hyper focus before the financial crisis on compliance with Sarbanes-Oxley. "Financial institutions spent millions of dollars and millions of hours micromanaging governance issues," he says. "While important, the amount of effort that went into SOX requirements was disproportionate to the true risk. Be careful not to isolate your thinking around one single risk issue like credit risk. Think about the broader view of risk in an institution and where those risks intersect."

New Joint Policy Statement on Deck

These issues have raised red flags at all four bank regulatory agencies, which plan to issue a "communication" to banks in the "not too distant future" regarding interest rate risk, reveals a different bank regulatory official. He asked for anonymity because the guidance still is being ironed out and he has not been authorized by FFIEC to speak about it.

But the statement will outline expectations of how banks manage interest rate risk and update guidance on how to model risk and conduct stress testing, the official adds. In particular, there has been confusion by banks regarding the rate shock scenarios they should use. The key 1996 joint policy statement on interest rate risk states that scenarios should incorporate a "sufficiently wide change in market interest rates." It gives an example of 200 basis points over a 1-year horizon, varying the speed of rate changes and changes in the yield curve.

But the range should be 300 to 400 basis points, the official says. "The whole point of interest rate management is to understand the risk and not just use it as budget tool," he says. "We didn't mean [200 bp] as a hard and fast rule. That has caused confusion. Tease out that rate shock, not just a bland straight yield shift. When banks realize they are pushing up on their tolerance, they must take steps" to protect capital and earnings.

Examiners also focused on interest rate risk models the last time rates began to rise, in 2005-2006, wrote Keith Ligon, then-chief of the FDIC's Capital Markets Branch, in an essay in FDIC's Supervisory Insights journal. They focused on assumptions used, the model's ability to capture cash flow characteristics of complex instruments and the use of stress tests. Supervisors were especially concerned about mortgage-related assets, improperly managed leverage programs that take advantage of rate spreads, and acquisition of complex securities without adequate pre-purchase risk analysis.

That is happening again, the RMA's Chalk says. "We are seeing more attention from regulators and institutions around the models," he says, especially large banks that engage in extensive daily trading activity. The 1996 policy statement requires such banks to conduct internal and/or external audits at least annually to ensure the integrity of the information and involvement of risk managers who are "sufficiently independent of the business lines."

Risk Models Get Stronger Oversight

Large banks typically rely on Value at Risk (VaR) trading portfolio risk models. But they tend to be overly conservative with VaR, failing to adjust it quickly enough when markets are in turmoil, piling up losses and endangering liquidity, according to a North Carolina State University department of economics study. Meantime, regulators often fail to detect problematic VaRs, the study notes.

During the financial crisis, "There were lots of models that tried to anticipate the value at risk from the variations in interest rates, but did not include how to measure the risk of a counterparty failing," Chalk says. "And the counterparty couldn't perform."

Such failures led to a review of risk models by most of the 45 global money center banks that responded to a recent RMA survey regarding model validation. About 84% have written policies to test their models, but only half have formed a "model risk validation management committee," Chalk says. "You can't go back and blame it all on the model. Concerns have been raised" that banks are not putting sufficient emphasis on management oversight.

The 1996 joint policy statement mentions board oversight 23 times, emphasizing a process that matches risk tolerance to business strategy and "identifies, measures, monitors and controls risks" to predetermined limits. Board reviews are expected quarterly. It is up to senior management to manage the day-to-day interest rate risks, including implementation of board policies into operating standards.

"Governance over models has clearly escalated in the last year," Chalk says. "There is more concern that the models are tested, that there are no flaws in the model and that it has included all potential assumptions about future risk. And they are looking more broadly at the components of risk."

Banks have dealt with rising interest rate risk in a number of ways, including use of "collars" (simultaneous purchase and sale of derivatives with interest rate caps and floors) and derivatives swaps (paying a counterparty a fixed rate from an underlying fixed-rate loan in return for a floating-rate payment based on an interest rate index), which have become harder to use under FAS 133.

But former examiner Matz says banks should start by lowering rates on deposits, particularly brokered and Internet CDs. Although this will shrink the bank and reduce ROE, a rate reduction also will reduce exposure. "It exchanges lower ROE now for more opportunities and wider margins in the future," he says.

"Banks are looking at what would happen if rates rise and if funding costs escalate and if net interest income falls," Chalk concludes. "But credit risk is getting the most attention. Banks need to keep an eye on the ball."

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