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Trading and Capital-Markets Activities Manual

Capital-Markets Activities: Interest-Rate Risk Management (Continue)
Source: Federal Reserve System 
(The complete Activities Manual (pdf format) can be downloaded from the Federal Reserve's web site)

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EXPOSURE OF EARNINGS TO IRR

When evaluating the potential effects of changing interest rates on an institution's earnings, examiners should assess the key determinants of the net interest margin, the effect that fluctuations in net interest margins can have on overall net income, and the rate sensitivity of non-interest income and expense. Analyzing the historical behavior of the net interest margin, including the yields on major assets, liabilities, and off-balance-sheet positions that make up that margin, can provide useful insights into the relative stability of an institution's earnings. For example, a review of the historical composition of assets and the yields earned on those assets clearly identifies an institution's business mix and revenue-generating strategies, as well as potential vulnerabilities of these revenues to changes in rates. Similarly, an assessment of the rates paid on various types of deposits over time can help identify the institution's funding strategies, how the institution competes for deposits, and the potential vulnerability of its funding base to rate changes. 

Understanding the effect of potential fluctuations in net interest income on overall operating performance is also important. At some banks, high overhead costs may require high net interest margins to generate even moderate levels of income. Accordingly, relatively high net interest margins may not necessarily imply a higher tolerance to changes in interest rates. Examiners should fully consider the potential effects of fluctuating net interest margins when they analyze the exposure of net income to changes in interest rates. 

Additionally, examiners should assess the contribution of non-interest income to net income, including its interest-rate sensitivity and how it affects the IRR of the institution. Significant sources of rate-insensitive non-interest income provide stability to net income and can mitigate the effect of fluctuations in net interest margins. 

A historical review of changes in an institution's earnings-both net income and net interest income-in relation to changes in market rates is an important step in assessing the rate sensitivity of its earnings. When appropriate, this review should assess the institution's performance during prior periods of volatile rates.

Important tools used to gauge the potential volatility in future earnings include basic maturity and repricing gap calculations and income simulations. Short-term repricing gaps between assets and liabilities in intervals of one year or less can provide useful insights on the exposure of earnings. These can be used to develop rough approximations of the effect of changes in market rates on an institution's profitability. Examiners can develop rough gap estimates using available call report information, as well as the bank's own internally generated gap or other earnings exposure calculations if risk-management and measurement systems are deemed adequate. When available, a bank's own earnings-simulation model provides a particularly valuable source of information: a formal estimate of future earnings (a baseline) and an evaluation of how earnings would change under different rate scenarios. Together with historical earnings patterns, an institution's estimate of the IRR sensitivity of its earnings derived from simulation models is an important indication of the exposure of its near-term earnings stability. 

As detailed in the preceding subsection, sound risk-management practices require IRR to be measured over a probable range of potential interest-rate changes. At a minimum, an instantaneous shift in the yield curve of plus or minus 200 basis points should be used to assess the potential impact of rate changes on an institution's earnings. 

Examiners should evaluate the exposure of earnings to changes in interest rates relative to the institution's overall level of earnings and the potential length of time such exposure might persist. For example, simulation estimates of a small, temporary decline in earnings, while likely an issue for shareholders and directors, may be less of a supervisory concern if the institution has a sound earnings and capital base. On the other hand, exposures that could offset earnings for a significant period (as some thrifts experienced during the 1980s) and even deplete capital would be a great concern to both management and supervisors. Exposures measured by gap or simulation analysis under the minimum 200 basis point scenario that would result in a significant decline in net interest margins or net income should prompt further investigation of the adequacy and stability of earnings and the adequacy of the institution's risk-management process. Specifically, in institutions exhibiting significant earnings exposures, examiners should focus on the results of the institution's stress tests to determine the extent to which more significant and stressful rate moves might magnify the erosion in earnings identified in the more modest rate scenario. In addition, examiners should emphasize the need for management to understand the magnitude and nature of the institution's IRR and the adequacy of its limits. 

While an erosion in net interest margins or net income of more than 25 percent under a 200 basis point scenario should warrant considerable examiner attention, examiners should take into account the absolute level of an institution's earnings both before and after the estimated IRR shock. For example, a 33 percent decline in earnings for a bank with a strong return on assets (ROA) of 1.50 percent would still leave the bank with an ROA of 1.00 percent. In contrast, the same percentage decline in earnings for a bank with a fair ROA of 0.75 percent results in a marginal ROA of 0.50 percent. 

Examiners should ensure that their evaluation of the IRR exposure of earnings is incorporated into the rating of earnings under the CAMELS rating system. Institutions receiving an earnings rating of 1 or 2 would typically have minimal exposure to changing interest rates. However, significant exposure of earnings to changes in interest rates may, in itself, provide sufficient basis for a lower rating. 

Exposure of Capital and Economic Value 

As set forth in the capital adequacy guidelines for state member banks, the risk-based capital ratio focuses principally on broad categories of credit risk and does not incorporate other factors, including overall interest-rate exposure and management's ability to monitor and control financial and operating risks. Therefore, the guidelines point out that in addition to evaluating capital ratios, an overall assessment of capital adequacy must take account of ''a bank's exposure to declines in the economic value of its capital due to changes in interest rates. For this reason, the final supervisory judgment on a bank's capital adequacy may differ significantly from conclusions that might be drawn solely from the level of its risk-based capital ratio.'' 

Banking organizations with (1) low proportions of assets maEagle Tradersg or repricing beyond five years, (2) relatively few assets with volatile market values (such as high-risk CMOs and structured notes or certain off-balance-sheet derivatives), and (3) large and stable sources of non-maturity deposits are unlikely to face significant economic-value exposure. Consequently, an evaluation of their economic-value exposure may be limited to reviewing available internal reports showing the asset/liability composition of the institution or the results of internal-gap, earnings-simulation, or economic-value simulation models to confirm that conclusion. 

Institutions with (1) fairly significant holdings of assets with longer maturities or repricing frequencies, (2) concentrations in value-sensitive on- and off-balance-sheet instruments, or (3) a weak base of non-maturity deposits warrant more formal and quantitative evaluations of economic-value exposures. This includes reviewing the results of the bank's own internal reports for measuring changes in economic value, which should address the adequacy of the institution's risk-management process, reliability of risk-measurement assumptions, integrity of the data, and comprehensiveness of any modeling procedures. 

For institutions that appear to have a potentially significant level of IRR and that lack a reliable internal economic-value model, examiners should consider alternative means for quantifying economic-value exposure, such as internal-gap measures, off-site monitoring, or surveillance screens that rely on call report data to estimate economic-value exposure. For example, the institution's gap schedules might be used to derive a duration gap by applying duration-based risk weights to the bank's aggregate positions. When alternative means are used to estimate changes in economic value, the relative crudeness of these techniques and lack of detailed data (such as the absence of coupon or off-balance-sheet data) should be taken into account-especially when drawing conclusions about the institution's exposure and capital adequacy. 

An evaluation of an institution's capital adequacy should also consider the extent to which past interest-rate moves may have reduced the economic value of capital through the accumulation of net unrealized losses on financial instruments. To the extent that past rate moves have reduced the economic or market value of a bank's claims more than they have reduced the value of its obligations, the institution's economic value of capital is less than its stated book value. 

To evaluate the embedded net loss or gain in an institution's financial structure, fair value data on the securities portfolio can be used as the starting point; this information should be readily available from the call report or bank internal reports. Other major asset categories that might contain material embedded gains or losses include any assets maEagle Tradersg or repricing in more than five years, such as residential, multifamily, or commercial mortgage loans. By comparing a portfolio's weighted average coupon with current market yields, examiners may get an indication of the magnitude of any potential unrealized gains or losses. For companies with hedging strategies that use derivatives, the current positive or negative market value of these positions should be obtained, if available. For banks with material holdings of originated or purchased mortgage-servicing rights, capitalized amounts should be evaluated to ascertain that they are recorded at the lower of cost or fair value and that management has appropriately written down any values that are impaired pursuant to generally accepted accounting rules. 

The presence of significant depreciation in securities, loans, or other assets does not necessarily indicate significant embedded net losses; depreciation may be offset by a decline in the market value of a bank's liabilities. For example, stable, low-cost non-maturity deposits typically become more profitable to banks as rates rise, and they can add significantly to the bank's financial strength. Similarly, below-market-rate deposits, other borrowings, and subordinated debt may also offset unrealized asset losses caused by past rate hikes. 

For banks with (1) substantial depreciation in their securities portfolios, (2) low levels of nonmaturity deposits and retail time deposits, or (3) high levels of IRR exposure, unrealized losses can have important implications for the supervisory assessment of capital adequacy. If stressful conditions require the liquidation or restrucEagle Tradersg of the securities portfolio, economic losses could be realized and, thereby, reduce the institution's regulatory capitalization. Therefore, for higher-risk institutions, an evaluation of capital adequacy should consider the potential after-tax effect of the liquidation of available-for-sale and held-to-maturity accounts. Estimates of the effect of securities losses on the regulatory capital ratio may be obtained from surveillance screens that use call report data or from the bank's internal reports. 

Examiners should also consider the potential effect of declines and fluctuations in earnings on an institution's capital adequacy. Using the results of internal model simulations or gap reports, examiners should determine whether capital-impairing losses might result from changes in market interest rates. In cases where potential rate changes are estimated to cause declines in margins that actually result in losses, examiners should assess the effect on capital over a two- or three-year earnings horizon. 

When capital adequacy is rated in the context of IRR exposure, examiners should consider the effect of changes in market interest rates on the economic value of equity, level of embedded losses in the bank's financial structure, and impact of potential rate changes on the institution's earnings. The IRR of institutions that show material declines in earnings or economic value of capital from a 200 basis point shift should be evaluated fully, especially if that decline would lower an institution's pro forma prompt-corrective-action category. For example, a well-capitalized institution with a 5.5 percent leverage ratio and an estimated change in economic value arising from an appropriate stress scenario amounting to 2.0 percent of assets would have an adjusted leverage ratio of 3.5 percent, causing a pro forma two-tier decline in its prompt-corrective-action category to the undercapitalized category. After considering the level of embedded losses in the balance sheet, the stability of the institution's funding base, its exposure to near-term losses, and the quality of its risk-management process, the examiner may need to give the institution's capital adequacy a relatively low rating. In general, sufficiently adverse effects of market interest-rate shocks or weak management and control procedures can provide a basis for lowering a bank's rating of capital adequacy. Moreover, even less severe exposures could contribute to a lower rating if combined with exposures from asset concentrations, weak operating controls, or other areas of concern. 

EXAMINATION PROCESS FOR IRR 

As the primary market risk most banks face, IRR should usually receive consideration in full-scope exams. It may also be the topic of targeted examinations. To meet examination objectives efficiently and effectively while remaining sensitive to potential burdens imposed on institutions, the examination of IRR should follow a structured, risk-focused approach. Key elements of a risk-focused approach to the examination process for IRR include (1) off-site monitoring and risk assessment of an institution's IRR profile and (2) appropriate planning and scoping of the on-site examination to ensure that it is as efficient and productive as possible. A fundamental tenet of this approach is that supervisory resources are targeted at functions, activities, and holdings that pose the most risk to the safety and soundness of an institution. Accordingly, institutions with low levels of IRR would be expected to receive relatively less supervisory attention than those with more severe IRR exposures. 

Many banks have become especially skilled in managing and limiting the exposure of their earnings to changes in interest rates. Accordingly, for most banks and especially for smaller institutions with less complex holdings, the IRR element of the examination may be relatively simple and straightforward. On the other hand, some banks consider IRR an intended consequence of their business strategies and choose to take and manage that risk explicitly-often with complex financial instruments. These banks, along with banks that have a wide array of activities or complex holdings, generally should receive greater supervisory attention. 

Off-Site Risk Assessment 

Off-site monitoring and analysis involves developing a preliminary view or ''risk assessment'' before initiating an on-site examination. Both the level of IRR exposure and quality of IRR management should be assessed to the fullest extent possible during the off-site phase of the examination process. The following information can be helpful in this assessment: 

  organizational charts and policies identifying authorities and responsibilities for managing IRR 
  IRR policies, procedures, and limits 
  asset/liability committee (ALCO) minutes and reports (going back six to twelve months before the examination) 
  board of directors reports on IRR exposures 
  audit reports (both internal and external) 
  position reports, including those for investment securities and off-balance-sheet instruments 
  other available internal reports on the bank's risks, including those detailing key assumptions 
  reports outlining the key characteristics of concentrations and any material holdings of interest-sensitive instruments 
  documentation for the inputs, assumptions, and methodologies used in measuring risk 
  Federal Reserve surveillance reports and supervisory screens 

The analysis for determining an institution's quantitative IRR exposure can be assessed offsite as much as possible, including assessments of the bank's overall balance-sheet composition and holdings of interest-sensitive instruments. An assessment of the exposure of earnings can be accomplished using supervisory screens, examiner-constructed measures, and internal bank measures obtained from management reports received before the on-site engagement. Similar assessments can be made on the exposure of capital or economic value. 

An off-site review of the quality of the risk-management process can significantly improve the efficiency of the on-site engagement. The key to assessing the quality of management is an organized discovery process aimed at determining whether appropriate policies, procedures, limits, reporting systems, and internal controls are in place. This discovery process should, in particular, ascertain whether all the elements of a sound IRR management policy are applied consistently to material concentrations of interest-sensitive instruments. The results and reports of prior examinations provide important information about the adequacy of risk management. 

Scope of On-Site Examination 

The off-site risk assessment is an informed hypothesis of both the adequacy of IRR management and the magnitude of the institution's exposure. The scope of the on-site examination of IRR should be designed to confirm or reject that hypothesis and should target specific areas of interest or concern. In this way, on-site examination procedures are tailored to the activities and risk profile of the institution, using flexible and targeted work-documentation programs. Confirmation of hypotheses on the adequacy of the IRR management process is especially important. In general, if off-site analysis identifies IRR management as adequate, examiners can rely more heavily on the bank's internal IRR measures for assessing quantitative exposures. 

The examination scope for assessing IRR should be commensurate with the complexity of the institution and consistent with the off-site risk assessment. For example, only baseline examination procedures would be used for institutions whose off-site risk assessment indicates that they have adequate IRR management processes and low levels of quantitative exposure. 

For those and other institutions identified as potentially low risk, the scope of the on-site examination would consist of only those examination procedures necessary to confirm the risk-assessment hypothesis. The adequacy of IRR management could be confirmed through a basic review of the appropriateness of policies, internal reports, and controls and the institution's adherence to them. The integrity and reliability of the information used to assess the quantitative level of risk could be confirmed through limited sampling and testing. In general, if the risk assessment is confirmed by basic examination procedures, the examiner may conclude the IRR examination process. 

Institutions assessed to have high levels of IRR exposure and strong IRR management may require more extensive examination scopes to confirm the off-site risk assessment. These procedures may entail more analysis of the institution's IRR measurement system and the IRR characteristics of major holdings. When high quantitative levels of exposure are found, examiners should focus special attention on the sources of this risk and on significant concentrations of interest-sensitive instruments. Institutions assessed to have high exposure and weak risk-management systems would require an extensive work-documentation program. The institution's internal measures should be relied on cautiously, if at all. 

Regardless of the size or complexity of an institution, care must be taken during the on-site phase of the examination to ensure confirmation of the risk assessment and identification of issues that may have escaped off-site analysis. Accordingly, the examination scope should be adjusted as on-site findings dictate. 

CAMELS Ratings 

As with other areas of the examination, the evaluation of IRR exposure should be incorporated into an institution's CAMELS rating. Findings on the adequacy of an institution's IRR management process should be reflected in the examiner's rating of risk management-a key component of an institution's management rating. Findings on the quantitative level of IRR exposure should be incorporated into the earnings and capital components of the CAMELS ratings. 

An overall assessment of an institution's IRR exposure can be developed by combining assessments of the adequacy of IRR management practices with the evaluation of the quantitative IRR exposure of the institution's earnings and capital base. The assessment of the adequacy of IRR management should provide the primary basis for reaching an overall assessment since it is a leading indicator of potential IRR exposure. Accordingly, overall ratings for IRR sensitivity should be no greater than the rating given to IRR management. Unsafe exposures and management weaknesses should be fully reflected in these ratings. Unsafe exposures and unsound management practices that are not resolved during the on-site examination should be addressed through subsequent follow-up actions by the examiner and other supervisory personnel.

Interest-Rate Risk Management 

Examination Objectives 

1. To evaluate the policies for interest-rate risk established by the board of directors and senior management, including the limits established for the bank's interest-rate risk profile. 

2. To determine if the bank's interest-rate risk profile is within those limits. 

3. To evaluate the management of the bank's interest-rate risk, including the adequacy of the methods and assumptions used to measure interest-rate risk. 

4. To determine if internal management-reporting systems provide the information necessary for informed interest-rate management decisions and to monitor the results of those decisions. 

5. To initiate corrective action when interest-rate management policies, practices, and procedures are deficient in controlling and monitoring interest-rate risk.

Interest-Rate Risk Management 

Examination Procedures 

These procedures represent a list of processes and activities that may be reviewed during a full-scope examination. The examiner-in-charge will establish the general scope of examination and work with the examination staff to tailor specific areas for review as circumstances warrant. As part of this process, the examiner reviewing a function or product will analyze and evaluate internal audit comments and previous examination work-papers to assist in designing the scope of examination. In addition, after a general review of a particular area to be examined, the examiner should use these procedures, to the extent they are applicable, for further guidance. Ultimately, it is the seasoned judgment of the examiner and the examiner-in-charge as to which procedures are warranted in examining any particular activity. 

REVIEW PRIOR EXCEPTIONS AND DETERMINE SCOPE OF EXAMINATION

1. Obtain descriptions of exceptions noted and assess the adequacy of management's response to the most recent Federal Reserve and state examination reports and the most recent internal and external audit reports. 

OBTAIN INFORMATION 

1. Obtain the following information: 
a. interest-rate risk policy (may be incorporated in the funds management or investment policy) and any other policies related to asset/liability management (such as derivatives) 
b. board and management committee meeting minutes since the previous examination, including packages presented to the board 
c. most recent internal interest-rate risk management reports (these may include gap reports and internal-model results, including any stress testing) 
d. organization chart 
e. current corporate strategic plan 
f. detailed listings of off-balance-sheet derivatives used to manage interest-rate risk 
g. copies of reports from external auditors or consultants who have reviewed the validity of various interest-rate risk, options-pricing, and other models used by the institution in managing market-rate risks, if available 
h. other management reports and first-day letter items 

REVIEW POLICIES AND PROCEDURES 

1. Review the bank's policies and procedures (written or unwritten) for adequacy. (See item 1 of the internal control questionnaire.) 

ASSESS MANAGEMENT PRACTICES 

1. Determine if the function is managed on a bank-only or a consolidated basis. 

2. Determine who is responsible for interest-rate risk review (an individual, ALCO, or other group) and whether this composition is appropriate for the function's decision-making structure. 

3. Determine who is responsible for implementing strategic decisions (for example, with a flow chart). Ensure that the scope of that function's authority is reasonable. 

4. Review the background of individuals responsible for IRR management to determine their level of experience and sophistication (obtain resumes if necessary). 

5. Review appropriate committee minutes and board packages since the previous examination and detail significant discussions in work-papers. Note the frequency of board and committee meetings to discuss interest-rate risk. 

6. Determine if and how the asset liability management function is included in the institution's overall strategic planning process. 

ASSESS BOARD OF DIRECTORS OVERSIGHT 

1. Determine how frequently the IRR policy is reviewed and approved by the board (at least annually). 

2. Determine whether the results of the measurement system provide clear and reliable information and whether the results are communicated to the board at least quarterly. Board reports should identify the institution's current position and its relationship to policy limits. 

3. Determine the extent to which exceptions to policies and resulting corrective measures are reported to the board, including the promptness of reporting. 

4. Determine the extent to which the board or a board committee is briefed on underlying assumptions (major assumptions should be approved when established or changed, and at least annually thereafter) and any significant limitations of the measurement system. 

5. Assess the extent that major new products are reviewed and approved by the board or a board committee. 

INTEREST-RATE RISK PROFILE OF THE INSTITUTION 

1. Identify significant holdings of on- and off-balance-sheet instruments and assess the interest-rate risk characteristics of these items. 

2. Note relevant trends of on- and off-balance-sheet instruments identified as significant holdings. Preparing a sources and uses schedule may help determine changes in the levels of interest-sensitive instruments. 

3. Determine whether the institution offers or holds products with embedded interest-rate floors and caps (investments, loans, deposits). Evaluate their potential effect on the institution's interest-rate exposure. 

4. For those institutions using high-risk mortgage derivative securities to manage interest-rate risk- 
a. determine whether a significant holding of these securities exists and 
b. assess management's awareness of the risk characteristics of these instruments. 

5. Evaluate the purchases and sales of securities since the previous examination to determine whether the transactions and any overall changes in the portfolio mix are consistent with management's stated interest-rate risk objectives and strategies. 

6. Review the UBPR, interim financial statements, and internal management reports for trend and adequacy of the net interest margin and economic value. 

7. Based on the above items, determine the institution's risk profile. (What are the most likely sources of interest-rate risk?) Determine if the profile is consistent with stated interest-rate risk objectives and strategies. 

8. Determine whether changes in the net interest margin are consistent with the interest-rate risk profile developed above. 

EVALUATE THE INSTITUTION'S RISK-MEASUREMENT SYSTEMS AND INTEREST-RATE RISK EXPOSURE

The institution's risk-measurement system and corresponding limits should be consistent with the size and complexity of the institution's on and off-balance-sheet activities. 

1. Review previous examinations and audits of the IRR management system and model. 
a. Review previous examination work-papers and reports concerning the model to determine which areas may require especially close analysis. 
b. Review reports and work-papers (if available) from internal and external audits of the model, and, if necessary, discuss the audit process and findings with the institution's audit staff. Depending on the sophistication of the institution's on- and off-balance-sheet activities, a satisfactory audit may not necessarily address each of the items listed below. The scope of the procedures may be adjusted if they have been addressed satisfactorily by an audit or in previous exams. Determine whether the audits accomplished the following: 

  Identified the individual or committee that is responsible for making primary model assumptions, and whether this person or committee regularly reviews and updates these assumptions. 
  Reviewed data integrity. Auditors should verify that critical data were accurately downloaded from computer subsystems or the general ledger. 
  Reviewed the primary model assumptions and evaluated whether these assumptions were reasonable given past activity and current conditions. 
  Reviewed whether the assumptions were incorporated into the model as management indicated. 
  Reviewed assumptions concerning how account balances will be replaced as items mature for models that calculate earnings or market values. Assumptions should be reasonable given past patterns of account balances and current conditions. 
  Reviewed methodology for determining cash flows from or market values of off-balance-sheet items, such as futures, forwards, swaps, options, caps, and floors. 
  Reviewed current yields or discount rates for critical account categories. (Determine whether the audit reviewed the interest-rate scenarios used to measure interest-rate risk.) 
  Verified the underlying calculations for the model's output. 
  Verified that summary reports presented to the board of directors and senior management accurately reflect the results of the model. 

c. Determine whether adverse comments in the audit reports have been addressed by the institution's management and whether corrective actions have been implemented. 
d. Discuss weaknesses in the audit process with senior management. 

2. Review management and board of directors oversight of model operation. 
a. Identify which individual or committee is responsible for making the principal assumptions and parameters used in the model. 
b. Determine whether this individual or committee reviews the principal assumptions and parameters regularly (at least annually) and updates them as needed. If reviews have taken place, state where this information is documented. c. Determine the extent to which the appropriate board or management committee is briefed on underlying assumptions (major assumptions should be approved when established or changed, and at least annually thereafter) and any significant limitations of the measurement system. 

3. Review the integrity of data inputs. 
a. Determine how the data on existing financial positions and contracts are entered into the model. Data may be downloaded from computer subsystems or the general ledger or they may be manually entered (or a combination of both). 
b. Determine who has responsibility for inputting or downloading data into the model. Assess whether appropriate internal controls are in place to ensure data integrity. For example, the institution may have procedures for reconciling data with the general ledger, comparing data with data from previous months, or error checking by an officer or other analyst. 
c. Check data integrity by comparing data for broad account categories with- 

  the general ledger, and 
  appropriate call report schedules. 

d. Ensure that data from all relevant non-bank subsidiaries have been included. 
e. Assess the quality of the institution's financial data. For example, data should allow the model to distinguish maturity and repricing, identify embedded options, include coupon and amortization rates, identify current asset yields or liability costs. 

4. Review selected rate-sensitive items. 
a. Review how the model incorporates residential mortgages and mortgage-related products, including adjustable-rate mortgages, mortgage pass-throughs, CMOs, and purchased and excess mortgage-servicing rights.

  Determine whether the level of data aggregation for mortgage-related products is appropriate. Data for pass-throughs, CMOs, and servicing rights should identify the type of security, coupon range, and maturity to capture prepayment risk. 
  Identify the sources of data or assumptions on expected cash flows, including prepayment rates and cash flows on CMOs. Data may be provided by brokerage firms, independent industry information services, or internal estimates. 
  If internal prepayment and cash-flow estimates are used for mortgages and mortgage-related products, note how the estimates are derived and review them for reasonableness.
  If internal prepayment estimates are used, determine who has responsibility for reviewing these assumptions. Determine whether this person or committee reviews prepayment rates regularly (at least quarterly) and updates the prepayment assumptions as needed. 
  For each interest-rate scenario, determine if the model adjusts key assumptions and parameters to account for possible changes in- 
- prepayment rates, 
- amortization rates, 
- cash flows and yields, and 
- prices and discount rates. 
  Determine if the model appropriately incorporates the effects of annual and lifetime caps and floors on adjustable-rate mortgages. In market-value models, determine whether these option values are appropriately reflected. b. Determine whether the institution has structured notes or other instruments with similar characteristics. 
  Identify the risk characteristics of these instruments, with special attention to embedded call/put provisions, caps and floors, or repricing opportunities. 
  Determine if the interest-rate risk model is capable of accounting for these risks and, if a simplified representation of the risk is used, whether that treatment adequately reflects the risk of the instruments. 

c. Review how the model incorporates non-maturity deposits. Review the repricing or sensitivity assumptions. Review and evaluate the documentation provided. 
d. If the institution has significant levels of non-interest income and expense items that are sensitive to changes in interest rates, determine whether these items are incorporated appropriately in the model. This would include items such as amortization of core deposit intangibles and purchased or excess servicing rights for credit card receivables. 
e. Review how the model incorporates futures, forwards, and swaps.   

  For simulation models, review the methodology for determining cash flows of futures, forwards, and swaps under various rate scenarios. 
  For market-value models- 
-determine if the durations of futures and forward contracts reflect the duration of the underlying instrument (durations should be negative for net sold positions) and - review the methodology for determining market values of swaps under different interest-rate scenarios. Compare results with prices obtained or calculated from standard industry information services. 

f. Review how the model incorporates options, caps, floors, and collars. 
  For simulation models, review the methodology for determining cash flows of options, caps, floors, and collars under various rate scenarios. 
  For market-value models, review the methodology used to obtain prices for options, caps, and floors under different interest-rate scenarios. Compare results with prices obtained or calculated from standard industry information services. 

g. Identify any other instruments or positions that tend to exhibit significant sensitivity, including those with significant embedded options (such as loans with caps or rights of prepayment) and review model treatment of these items for accuracy and rigor. 

5. Review other modeling assumptions. 
a. For simulation models that calculate earnings, review the assumptions concerning how account balances change over time, including assumptions about replacement rates for existing business and growth rates for new business. (These items should be reviewed for models that estimate market values in future periods.) 

  Determine whether the assumptions are reasonable given current business conditions and the institution's strategic plan. 
  Determine whether assumptions about future business are sensitive to changes in interest rates. 
  If the institution uses historical performance or other studies to determine changes in account balances caused by interest-rate movements, review this documentation for reasonableness. 

b. For market-value models, review the treatment of balances not sensitive to interest-rate changes (building and premises, other long-term fixed assets). Identify whether these balances are included in the model and whether the effect is material to the institution's exposure. 

6. Review the interest-rate scenarios. 
a. Determine the interest-rate scenarios used in the internal model to check the interest-rate sensitivity of those scenarios. If there is flexibility concerning the scenarios to be used, determine who is responsible for selecting the scenario. 
b. Determine whether the institution uses scenarios that encompass a significant rate movement, both increasing and decreasing. 
c. Review yields/costs for significant account categories for future periods (base case or scenario) for reasonableness. The rates should be consistent with the model's assumptions and with the institution's historical experience and strategic plan. 
d. For market-value models, indicate how the discount rates in the base case and alternative scenarios are determined. 
e. For Monte Carlo simulations or other models that develop a probability distribution for future interest rates, determine whether the volatility factors used to generate interest-rate paths and other parameters are reasonable. 

7. Provide an overall evaluation of the internal model. 
a. Review ''variance reports,'' reports that compare predicted and actual results. Comment on whether the model has made reasonably accurate predictions in earlier periods. 
b. Evaluate whether the model's structure and capabilities are adequate to 

  accurately assess the risk exposure of the institution and 
  support the institution's risk-management process and serve as a basis for internal limits and authorizations. 

c. Evaluate whether the model is operated with sufficient discipline to- 

  accurately assess the risk exposure of the institution and 
  support the institution's risk-management process and serve as a basis for internal limits and authorizations. 

If the institution uses a gap report, continue with question 8. Otherwise skip to question 9. 

8. Review the most recent rate-sensitivity report (gap), evaluating whether the report reasonably characterizes the interest-rate risk profile of the institution. Assumptions underlying the reporting system should also be evaluated for reasonableness. This evaluation is particularly critical for categories, on- or off-balance-sheet, in which the institution has significant holdings. 
a. Review the reasonableness of the assumptions used to slot non-maturity deposits in time bands. 
b. Determine whether residential mortgages, pass-through securities, or CMOs are slotted by weighted average life or maturity. (Generally, weighted average life is preferred.) 
c. If applicable, review the assumptions for the slotting of securities available for sale. 
d. If the institution has significant holdings of other highly rate-sensitive instruments (such as structured notes), review how these items are incorporated into the measurement system. 
e. If applicable, review the slotting of the trading account for reasonableness. 
f. If applicable, evaluate how the report incorporates futures, forwards, and swaps. The data should be entered in the correct time bands using offsetting entries, ensuring that each cash flow has the appropriate sign (positive or negative). 
g. Ensure all assumptions are well documented, including a discussion of how the assumptions were derived. 
h. Confirm that management, at least annually, tests, reviews, and updates, as needed, the assumptions for reasonableness. 
i. Determine if the measurement system used is able to adequately model new products that the institution may be using since the previous examination. 
j. Determine whether the report accurately measures the interest-rate exposure of the institution. 
k. Assess management's review and understanding of the assumptions used in the institution's rate-sensitivity report (gap), as well as the system's strengths and weaknesses. 

Highly sensitive instruments, including structured notes, have interest-rate risk characteristics that may not be easily measured in a static gap framework. If the institution has a significant holding of these instruments, gap may not be an appropriate way to measure interest-rate risk. 

9. Review the current interest-sensitivity position for compliance with internal policy limits. 

10. Evaluate the institution's overall interest-rate risk exposure. If the institution uses a gap schedule, analyze the institution's gap position. If the institution uses an internal model to measure interest-rate risk- 
a. indicate whether the model shows significant risks in the following areas: 

  changing level of rates 
  basis or shape risk 
  velocity of rate changes 
  customer reactions; 

b. for simulation models, determine whether the model indicates a significant level of income at risk as a percentage of current income or capital; and 
c. for market-value models, determine whether the model indicates significant market value at risk relative to assets or capital. 

11. Determine the adequacy of the institution's method of measuring and monitoring interest-rate exposure, given the institution's size and complexity. 

12. Review management reports. 
a. Evaluate whether the reports on interest-rate risk provide an appropriate level of detail given the institution's size and the complexity of its on- and off-balance-sheet activities. Review reports to- 

  senior management and 
  the board of directors or board committees. 

b. Indicate whether the reports discuss exposure to changes in the following: 
  level of interest rates 
  shape of yield curve and basis risk 
  customer reactions 
  velocity of rate changes 

13. Review management's future plans for new systems, improvements to the existing measurement system, and use of vendor products. 

EVALUATE INSTRUMENTS USED IN RISK MANAGEMENT 

1. Review the institution's use of various instruments for risk-management purposes (such as derivatives). Assess the extent that policies require the institution to- 
a. document specific objectives for instruments used in risk management; 
b. prepare an analysis showing the intended results of each risk-management program before the inception of the program; and 
c. assess at least quarterly the effectiveness of each risk-management program in achieving its stated objectives. 

2. Review the institution's use of derivative products. Determine if the institution has entered into transactions as an end-user to manage interest-rate risk, or is acting in an intermediary or dealer capacity. 

3. When the institution has entered into a transaction to reduce its own risk, evaluate the effectiveness of the hedge. 

4. Determine whether transactions involving derivatives are accounted for properly and in accordance with the institution's stated policy. 

5. Complete the internal control questionnaire on derivative products used in the management of interest-rate risk. 

ASSESS STRESS TESTING AND CONTINGENCY PLANNING 

1. Determine if the institution conducts stress testing and what kinds of market stress conditions management has identified that would seriously affect the financial condition of the institution. These conditions may include (1) abrupt and significant shifts in the term structure of interest rates or (2) movements in the relationships among other key rates. 

2. Assess management's ability to adjust the institution's interest-rate risk position under- 
a. normal market conditions and 
b. under conditions of significant market stress. 

3. Determine the extent to which management or the board has considered these risks (normal and significant market stress) and evaluate contingency plans for adjusting the interest-rate risk position should positions approach or exceed established limits. 

VERIFY FINDINGS WITH DEPARTMENT OFFICIALS 

1. Verify examination findings with department officials to ensure the accuracy and completeness of conclusions, particularly negative conclusions. 

SUMMARIZE FINDINGS 

1. Summarize the institution's overall interest-rate risk exposure. 

2. Ensure that the method of measuring interest-rate risk reflects the complexity of the institution's interest-rate risk profile. 

3. Assess the extent management and the board of directors understand the level of risk and sources of exposure. 

4. Evaluate the appropriateness of policy limits relative to (1) earnings and capital-at-risk, (2) the adequacy of internal controls, and (3) the risk-measurement systems. 

5. If the institution has an unacceptable interest-rate risk exposure or an inadequate interest-rate risk management process, discuss findings with the examiner-in-charge. 

6. Prepare comments for the work-papers and examination report, as appropriate, concerning the findings of the examination of this section including the following: a. scope of the review 
b. adequacy of written policies and procedures, including- 

  the consistency of limits and parameters with the stated objectives of the board of directors; 
  the reasonableness of these limits and parameters given the institution's capital, sophistication and management expertise, and the complexity of its balance sheet; 

c. instances of non-compliance with written policies and procedures; 
d. apparent violations of laws and regulations, indicating those noted at previous examinations; 
e. internal control deficiencies and exceptions, indicating those noted during previous examinations or audits;
f. other matters of significance; and g. corrective actions planned by management. 

ASSEMBLE AND REVIEW WORK-PAPERS 

1. Ensure that the work-papers adequately document the work performed and conclusions of this assignment. 

2. Forward the assembled work-papers to the examiner-in-charge for review and approval. 

Interest-Rate Risk Management 

Internal Control Questionnaire 

MANAGEMENT, POLICIES, AND PROCEDURES 

1. Has the board of directors, consistent with its duties and responsibilities, adopted written policies and procedures related to interest-rate risk that establish a. the risk-management philosophy and objectives regarding interest-rate risk, 
b. clear lines of responsibility, 
c. definition and setting of limits on interest-rate risk exposure, 
d. specific procedures for reporting and the approvals necessary for exceptions to policies and limits, 
e. plans or procedures the board and management will implement if interest-rate risk falls outside established limits, 
f. specific interest-rate risk measurement systems, 
g. acceptable activities used to manage or adjust the institution's interest-rate risk exposure, 
h. the individuals or committees who are responsible for interest-rate risk management decisions, and 
i. a process for evaluating major new products and their interest-rate risk characteristics? 

2. Is the bank in compliance with its policies, and is it adhering to its written procedures? If not, are exceptions and deviations- 
a. approved by appropriate authorities, 
b. made infrequently, and 
c. nonetheless consistent with safe and sound banking practices? 

3. Does the board review and approve the policy at least annually? 

4. Did the board and management review IRR positions and the relationship of these positions to established limits at least quarterly? 

5. Were exceptions to policies promptly reported to the board? 

6. Does one individual exert undue influence over interest-rate risk management activities? 

INTERNAL MODELS 

1. Has the internal model been audited (by internal or external auditors)? 

2. Does one individual control the modeling process or otherwise exert undue influence over the risk-measurement process? 

3. Is the model reconciled to source data to ensure data integrity? 

4. Are principal assumptions and parameters used in the model reviewed periodically by the board and senior management? 

5. Are the workings of and the assumptions used in the internal model adequately documented and available for examiner review? 

6. Is the model run on the same scenarios on which the institution's limits are established? 

7. Does management compare the historical results of the model with actual back-testing results? 

CONCLUSIONS 

1. Is the foregoing information an adequate basis for evaluating the systems of internal controls? Are there significant deficiencies in areas not covered in this questionnaire that impair any controls? If so, explain answers briefly, indicate additional internal control questions or elements deemed necessary, and forward recommendations to the supervisory examiner or designee. 

2. Based on a composite evaluation, as evidenced by answers to the foregoing questions, are the systems of internal control considered adequate?

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