- Hi. I'm Dan Frye,
and I'm with the FDIC's Division of Risk
Management Supervision. It's my pleasure
to welcome you to this presentation
on Interest Rate Risk. This video is one of several
that are part of the FDIC's
Community Banking Initiative and has been developed
to provide directors with an overview
of the key aspects of the interest rate
risk management process. We also have
a companion video series that provides a deeper dive
into the more technical aspects of interest rate
risk management. That video series is targeted
at bank management and those involved in
the asset/liability management function, including members of a bank's Asset Liability Committee. Interest rate risk is a topic
of concern to community bankers, and we share that concern
here at the FDIC. When you are done
viewing this presentation, we hope that you will have developed a better awareness of industry trends and why interest rate risk
is a concern of both regulators
and bankers alike. This presentation
will provide an overview of several key aspects
of interest rate risk management that are important to directors, including their responsibility
as board members to ensure that there is
a comprehensive interest rate risk management framework
in place at their bank. You should have
a better understanding of the different forms
that interest rate risk can take and the common types
of measurement systems or models that banks use to measure their exposure
to movements in interest rates. We'll also discuss some
key critical assumptions that drive model results, which will hopefully provide
a general understanding of how important they are to
quantifying a bank's exposure, and how important it is
to ensure those assumptions are reasonable. Finally, we'll discuss
the importance of establishing an adequate
internal control system, including an independent
review of the bank's interest rate
risk management framework. We'll wrap up
the presentation by providing you
with some additional resources to help broaden your knowledge of interest rate
risk management. We don't expect directors
to be experts on interest rate risk management, but they certainly should
have a general knowledge of the topic, particularly in the areas
I just mentioned. That general knowledge level
will contribute greatly to building a robust
interest rate risk management framework for the bank. Now let's take a brief look
at some industry trends. This chart reflects the median
pre-tax return on assets for community banks. As you can see,
earnings have bounced back from the lows reached
during the recession; however, they remain well below pre-recession levels because net interest margins,
or NIMs, have continued to fall throughout the low interest
rate environment that has persisted
since late 2008. Net interest income
is the primary driver of community bank earnings,
and it typically represents 80 to 90% of their
operating income. As the chart reflects, NIMs
have not been a contributor to the earnings improvement
over the past several years and largely explain the overall
lower profitability of community banks relative
to pre-recession levels. Having fallen considerably
since the early 2000s, net interest margins
for community banks continue to reach
historic lows. Banks have reacted to
the earnings and NIM pressures in many ways, including
exploring new sources of non-interest income, altering their asset mix
towards higher risk assets, and implementing
cost containment strategies. Lower provisions
for loan losses have contributed to earnings
improvement in recent years, but prior profitability levels will be difficult to attain until margins improve. Another strategy we are seeing
at many community banks is to bolster
depressed margins by taking on
interest rate risk through investment
in higher-yielding, longer-term assets. This chart reflects
data for banks under a billion dollars
that have continuously filed Call Reports
for the periods shown. The chart clearly reflects
a significant increase in the willingness
of community banks to hold longer-term assets. In 2006,
18% of these institutions reported that 30% or more
of their earning assets were long term,
which we define here as those assets
that mature or reprice in over five years
from the Call Report date. That percentage has increased
from 18% to 50% as of June 2015. Also, back in 2006, only 9% of banks reported
long-term asset concentrations of 40% or more. This percentage has increased
to 32% as of June 2015. Between June 2004
and July 2006, the Federal Reserve
raised the Federal funds rate 425 basis points. So let's take a look
at what happened to net interest margins
through that period based on long-term
asset concentration levels back in June 2004. This chart reflects
the trend in community bank median net interest margins
grouped by long-term asset exposure as of June 2004. By the first quarter of 2007, the median net interest
margin decline for banks with long-term asset
concentrations exceeding 50% was 43 basis points,
and as the chart reflects, the decline was not small
by any means for banks with concentrations
in the 30 and 40% buckets. As of June 2015, a much higher
percentage of community banks are reporting elevated
concentrations of long-term assets as reflected
on the previous slide, and net interest margins
are significantly lower than where they were
when we entered the last rate tightening cycle. These trends suggest
a growing need for enhanced oversight
of interest rate risk to minimize the negative effects that may result from a higher rate environment. So, let's take a look
at community banks to see how widespread the growth in long-term
asset concentrations has been. The following maps
are focused on community banks that were in existence
as of June 2015 and reflect the percentage
of those banks in each state that had
a long-term asset concentration in excess of 30%
of earning assets. This map shows what
the concentrations levels looked like back in 2006. As you see, long-term
asset concentrations were centered
in the Northeast. The darker the blue shading, the higher the percentage
of community banks in that state
that reported concentrations in excess of 30%
of earning assets. For example, more than
75% of banks in Maine had such a concentration
in 2006. This was just after
the Federal Reserve had raised the Federal funds
rate by 425 basis points and margins
were beginning to slide. As we moved forward
through a period where margins were steadily declining across the industry, banks across the nation
soon followed the Northeast's appetite for longer term assets to cushion the margin erosion. This is clearly reflected
in these maps, and this is where we are today. There's no doubt that exposure
to interest rate risk has significantly increased
for many community banks across the country, and it is incumbent upon
boards of directors to ensure that this risk
is properly managed. The rest of this presentation will provide
a high-level overview of the interest rate
risk management process. I'd like to now introduce you
to Frank Hughes, who is also from the FDIC's Division of Risk Management
Supervision; he'll take you through
the bulk of this presentation, and I'll wrap it up
by providing you with some additional resources
that will help broaden your knowledge of interest
rate risk management. - Thank you, Dan.
Let's start our discussion by reviewing
what interest rate risk is. It's the risk that changes
in interest rates can adversely affect a bank's
earnings or capital. More specifically, the primary
types of interest rate risk are: Repricing risk, which results
from timing differences between rate changes or cash
flows of assets, liabilities, and off-balance sheet
instruments. Yield curve risk,
which is the risk from nonparallel changes
in the yield curve. Option risk, which is the risk
that cash flows change due to embedded options. And, finally, Basis risk,
which is the risk that different indices with the same maturity
do not move together. The board of directors
is ultimately responsible for the interest rate risk
undertaken by a bank. To fulfill its responsibility,
a board of directors should: Oversee the establishment,
approval, implementation, and annual review of interest
rate risk management policies, procedures,
and strategies; Establish risk tolerances; And establish lines of
authority and responsibilities for managing interest rate risk
and oversee management. The board
should regularly monitor the bank's overall
interest rate risk profile, and ensure
that interest rate risk is maintained
at prudent levels. Finally, board members
must understand the implications of the interest rate risk
strategies the bank pursues, including their potential
impact on market, liquidity, credit,
and operating risks; and ensure that adequate internal controls and independent
review functions are in place. Next, we will be discussing
policy expectations and factors
directors should consider when establishing
risk tolerances and overseeing the interest
rate risk management process. We expect banks to have
comprehensive policies and procedures governing
all aspects of the interest rate
risk management process. A bank's policies
and procedures should translate
the board's goals, objectives, and risk appetite
into operating standards that are well understood
by bank personnel and that are consistent
with the board's intent. In general, policies
and procedures should: Specify risk limits related
to both earnings and economic value
of equity exposures, Document lines of authority
and responsibilities, Establish reporting standards and an independent
review process, and Identify the types
of instruments and activities the bank may use to manage
interest rate risk exposure. Note that if policies
and procedures allow for hedging strategies
as a method to manage interest rate risk exposure, they should be specific
as to what is permissible. Directors commonly ask, "What are appropriate
risk limits?" That's a question
we can't answer, because there is
no single right answer. The board and management
should consider various factors when determining the appropriate
policy limits for their bank and establish limits
for each scenario modeled. First, limits should reflect
the board's risk tolerance and serve to control
interest rate risk. So directors
should ask themselves, "How much interest rate risk
are we comfortable with?" Second, the board
should consider the strength of earnings
and capital and the complexity
of the bank's balance sheet, products, services,
and activities. The board and management
should also consider changes in the bank's risk profile
and should ensure that risk limits are revised
to reflect those changes. For example, a bank
that has high-risk assets or that is experiencing
asset quality problems should consider the increased
pressure on capital from these factors. Capital levels
that are exposed to higher-risk balance
sheet products from a credit perspective
may not be able to withstand the same level of
interest rate risk as banks with a lower
balance sheet risk profile. Finally, risk limits should
trigger appropriate action as identified in
policies and procedures and ensure that positions exceeding certain
predetermined levels receive prompt
management attention. Directors should consider
the impact of a decline in net interest income
on the bottom line. It's important
for directors to consider what the limit is based on. For example, a 20% change
in net interest income is different than a 20%
change in pre-tax return on average assets. As shown in this graph,
we can observe the impact to the median community bank
pre-tax earnings if net interest income
were to decline by 5%, 10%, 15%,
and 20%. As you can see,
pre-tax earnings would decline
more than 60% through what may have been
considered an acceptable degree of net interest income
exposure at 20%. Therefore, directors
should consider net interest income limits
in relation to the bottom line to determine whether risk limits are reasonable for their bank. Second, some banks
engage in activities that result in rate sensitive
non-interest income, such as mortgage banking. Therefore, management should
develop net income limits to assist in the overall control
of interest rate risk exposure. Directors should oversee
the interest rate risk management process
and management's various responsibilities and practices. All banks should have
a comprehensive risk management process
that includes Risk Controls and Limits; Identification and Measurement; Monitoring and Reporting; and Internal Controls,
Review, and Audit. Specifically, management
is responsible for maintaining: Appropriate policies
and procedures that delineate clear lines of authority
and responsibility and that control and limit risk; Comprehensive systems
and standards for identifying and measuring
interest rate risk, including procedures to ensure
inputs and assumptions are appropriate and documented; Sufficient reporting to allow management and the board to assess the interest rate
risk exposure and compliance with risk limits; And an adequate
internal control system, including an independent review. Findings of the review
should be reported to the board on an annual basis. When measuring
interest rate risk, management and the board
should consider both earnings and economic value. Here we've listed
the typical measurement systems community banks use. Gap models measure
the maturity mismatch of a bank's balance sheet. Income Simulation models measure the effects
of interest rate changes on net interest income
and net income. Extended Income Simulations
consider the long-term earnings perspective by measuring
the impact of rate changes on income beyond two years. Economic value
of equity models also provide a long-term
view of interest rate risk by measuring the change
in net present value of the bank's assets, liabilities, and off-balance sheet items in different
interest rate scenarios. For most banks,
a Gap model should not be the primary analytical tool for assessing
interest rate risk. Gap models are limited
as they typically cannot measure the effects of embedded options, nonparallel yield curve shifts, and basis risk. However,
if properly calibrated, income simulation and economic
value of equity models can capture additional types
of interest rate risk. Importantly, the ability
of any of these models to measure interest rate risk
is highly dependent on appropriate inputs
and assumptions. We will discuss
some critical assumptions later in the presentation. First, let's talk about
an income simulation model. Income simulations
estimate cash flows from assets and liabilities
over selected time periods to project future
earnings performance under assumed interest rate
scenarios. Here is a simplified example of how an income simulation
model works to measure the change
in income when rates change. The base case is simply
an estimation of the bank's income based on
the current balance sheet and contractual interest rates, assuming
no market rate changes. In the scenario analysis,
the model estimates the bank's income based on
the new market interest rate. In a +300 basis points
scenario, the rate on loans and municipal bonds did not increase because those assets
are fixed rate and long term. However, the rate on
non-maturity deposits increased but not by the full
300 basis points. It only increased
100 basis points. That's because of
model assumptions, which we will discuss later
in the presentation. Looking back at our example,
after calculating interest income and expense
on the bank's earning assets and interest-bearing
liabilities, the model estimates
net interest income if market rates increase
300 basis points. The model performs
these calculations for each scenario modeled. Models typically also
calculate the change in net interest income between
the base case and each scenario. In our example,
in a +300 basis points scenario, net interest income
is expected to decline 23%. Directors should review
and assess model reports to monitor the bank's
interest rate risk level and ensure levels are compliant
with policy risk limits and that the level of interest
rate risk taken is prudent. Next, let's talk about
economic value of equity. So what is economic
value of equity? Economic Value of Equity,
or EVE, is the difference between
the present value of assets and the present value
of liabilities (and the value of off-balance
sheet items, if applicable). How is this different
than the book value? Net present value
is different because it considers
the difference between book yield and market yield. Let's look at an example. Let's say the bank
has a loan on the books earning the 5%
prevailing market rate. What will happen to
the value of the loan if market rates increase? The value of the loan
will decrease. And the present value
of the loan is less than book value. Why? Because it's earning 5% while newly originated comparable loans are earning more than that. On the other side
of the balance sheet, the bank has
a time deposit paying the 1% prevailing market rate. What will happen to the value
of the time deposit if rates increase? The value decreases
because the bank is paying less than the prevailing market rate. This is a good thing
for the bank, because a decrease
in the value of liabilities increases the economic value
of equity. Remember the formula,
present value of assets minus present value
of liabilities equals
economic value of equity. So what is the net impact
of the changes on both sides
of the balance sheet? Let's look at a sample
EVE model report. The model calculates
the bank's EVE in the current rate environment,
which is the base case. So to measure
interest rate risk, we need to look at how
the present values of assets and liabilities change in different rate environments. As you can see,
like the example we discussed previously,
when rates increased, the present value of assets
and liabilities declined. Again, this is because
the bank is now holding an asset earning less than
the market rate and holding a liability paying less than the market rate (remember a decline
in liability values has a positive impact on EVE). The opposite occurred in
the -100 basis points scenario. The change in EVE,
or the potential risk exposure, occurs when asset values
and liability values do not decline
by the same amount. In the -100 basis
points scenario, asset values
and liability values both increased
by $5 million, and there was no net
change in EVE. But in the +300 basis
points scenario, asset values decline
more than liability values, causing a net decline in EVE. Comparing base EVE to shocked
EVE provides a measurement of the bank's level of
interest rate risk exposure. In our example,
economic value of equity declined from the base case
of $90 million to $75 million, a decline of about 17%. And as with
Income Simulation results, directors should review
and assess EVE model results to monitor the bank's interest rate risk level and ensure levels are compliant
with policy risk limits and that the level of interest
rate risk taken is prudent. We are frequently asked
why it's necessary to run both an EVE
and income simulation model. Well, as we've discussed, an EVE model's calculation
of present value captures the cash flows
and rate sensitivity of all assets
and liabilities, whereas an income simulation
is typically shorter term and only captures
these attributes for the time period
it measures. Because most community banks
have long-term assets and liabilities with options,
risk needs to be assessed beyond the short-term focus
of income simulation. A longer-term interest rate
risk measurement, such as EVE, will allow management to assess how today's strategic decisions could impact the bank's
financial position and earnings in the future. On the other hand,
because the income simulation is performed for
specific time periods, it allows banks to identify when
the interest rate risk occurs, which the EVE can't point to. Therefore, using a combination
of both models provides banks with a more complete picture of the interest rate risk
exposure. As we mentioned previously, model assumptions
are an important component of the modeling process. We will discuss those next. Reasonable and realistic
model assumptions are vital to measuring
the bank's interest rate risk. We will focus on three
critical model inputs: rate changes,
deposit assumptions, and prepayment estimates. But before we do, there are a variety
of other assumptions required for modeling,
including: Those for other embedded
options such as calls, puts,
and step-ups. Account aggregation, which is an important
consideration because each asset or liability has unique characteristics that affect cash flows
differently. Therefore,
items with similar terms and cash flow characteristics can be grouped together, but more complex instruments
should be modeled individually. Driver rates, which capture
the relationship between market rates
and the pricing of bank products
within the model. Zero balance sheet growth
or static modeling versus dynamic modeling, which anticipates growth
or other changes. Dynamic modeling is highly
dependent on assumptions that are extremely difficult
to project accurately and that can mask a bank's actual interest rate
risk position; therefore, banks that perform
dynamic simulations should also run
static simulations. Because of their importance,
directors should ask for written documentation
of critical assumptions. In addition,
changes to key assumptions and their impacts
on model outputs should be reviewed
and reported to the board. First, let's discuss
rate change assumptions. The magnitude
of rate changes modeled is critical to interest
rate risk measurement. Looking back over
the last 50 years or so, there have been many periods when short-term rates
changed significantly and in a relatively
compressed timeframe. This chart illustrates
year-over-year changes in the Federal funds rate. Despite the stability
of the Federal funds rate over the last seven years, in about one-third
of the years the Federal funds rate
has changed 200 basis points or more in a year's time. This indicates
that a plus and minus 200 basis point rate scenario may not be sufficient
to adequately assess a bank's interest rate risk exposure,
and scenarios of a greater magnitude
should be performed. Scenarios should include
instantaneous rate shocks and prolonged rate changes. An instantaneous
rate shock assumes the rate changes immediately
as opposed to a gradual ramp which assumes the rate change
occurs over time. One of the benefits
of interest rate risk modeling is to understand the effect of low probability/high
impact events, so bank management
can make contingency plans and take mitigating steps to
ensure earnings sustainability. Therefore, it's important
that modeling include scenarios of a sufficient magnitude that capture material changes
in cash flows and value. A key aspect
of rate change assumptions is how rates will change
for different maturities. As you will see in this graph, rate changes
typically do not occur uniformly across maturities
on a yield curve. The solid gray line
depicts a yield curve as of February 2004. When rates rose through 2006, rates rose much more dramatically for the shorter maturities
than longer-term maturities. In fact, rates remained
relatively unchanged for the 20-
and 30-year maturities. In other words, the yield
curve shift was not parallel. A parallel shift would have
resulted in a yield curve depicted by the dotted line. However, non-complex
interest rate risk models usually assume that all rates
along the yield curve change together,
which is not realistic. Depending on the bank's
interest rate risk profile, management should model
changes to the slope and to the shape
of the yield curve to measure the exposure
from nonparallel changes. Next, we will discuss
assumptions related to the measurement and value
of a bank's deposit base. Non-maturity deposits
represent nearly 60% of a typical community bank's
earning assets, as of June 30, 2015, up from pre-recession levels
closer to 40%. Therefore, non-maturity
deposit assumptions can have a material impact
on model results, and the board should
be aware of those assumptions. The three primary non-maturity
deposit assumptions the board should be
familiar with are: price sensitivity (which is commonly
referred to as beta), decay rates,
and average life. The price sensitivity assumption
measures the degree that the rate of a deposit
will change when the market rate changes. In the earlier discussion
on earnings simulation, the rate
on the non-maturity deposits only changed 100 basis points
in the up 300 basis points shock because management assumed
a beta of 33%. Betas may differ
based on the direction and magnitude of rate changes as well as the current level
of market interest rates. Directors should understand
the beta assumptions used within their bank's model to ensure that the assumptions are reasonable in both rising
and falling rate environments. Depending on the current
level of market rates and competitive factors,
some banks may experience different betas in rising versus
falling rate environments. They should also expect to see
different betas for scenarios of
different magnitudes. For instance, in an
up 400 basis points scenario, directors would likely see
a higher beta than in an up 200 basis
point scenario. This is particularly relevant
in today's low rate environment. Decay rate is the annual
percentage of deposit run-off or attrition. The average life
is the average time (expressed in years) deposits are expected
to remain with the bank. These assumptions are
typically based on an analysis of historical data adjusted
for qualitative factors such as changes
in competition, customer behavior,
or the economy. These are also
critical assumptions given the high level
of nonmaturity deposits held by banks. Given the importance
of these assumptions, the board should understand
the methods management uses to develop the assumptions and ensure the appropriateness of those methods. The final important assumption
I'll discuss is estimated prepayments
on loans and securities, particularly
mortgage-related assets which represented over a quarter
of the typical bank's assets as of June 30, 2015. The chart shown here illustrates how prepayment speed assumptions impact the average life
of a mortgage pool and the timing of cash flows which are key to income
simulation and EVE modeling. In a -100 basis points
scenario, when borrowers are
more likely to refinance and prepayment speeds are higher than the stable scenario, the weighted average life
is shorter. Banks have to reinvest
those cash flows at lower yields. This is called
prepayment risk. Conversely,
in rising rate scenarios when borrowers have
less incentive to refinance and prepay,
prepayment speeds slow, causing the weighted
average life to increase. This is called
extension risk. The bank is left
holding an asset earning a below market yield. Because prepayment assumptions
are important, directors should review management's
prepayment estimates to understand whether
they are internally generated or based on market proxies and to ensure they are
appropriately supported. To conclude our discussion
on assumptions, we will discuss
sensitivity testing which allows a bank to
determine which assumptions have the most influence
on model output. Sensitivity analysis
is performed by changing a single key assumption,
re-running the model, and reviewing the differences
between the two results. By holding
all other model variables and assumptions constant, management can determine
both the extent to which an assumption influences
model results and at what point that exposure becomes potentially excessive or breaches policy limits. This process should be
performed separately for each key assumption. This sensitivity analysis
example shows net interest income results under multiple deposit
beta assumptions. As you can see, a small change
in the beta assumption can have a material impact
on net interest income results which can cause a bank to move
from policy compliance to non-compliance
or vice versa. The board should receive reports
that allow them to evaluate the sensitivity
of key assumptions. Before we conclude, let's talk about one final
and important part of the interest rate
risk management process; internal control and review. The board is responsible
for ensuring that management has established an appropriate
internal control system, which includes
the items listed here, and an independent review
and validation process. The independent review should: Review the entire interest rate risk management process, Cover all of the elements
shown here, and Reported
to the board annually. The report should provide
a summary of the bank's interest rate
risk measurement techniques and management practices,
identify key assumptions, and provide an assessment of
the impact of those assumptions on the bank's measured exposure. A strong
internal control system verified by independent
review and validation helps ensure a more robust interest rate risk management process. This presentation
highlighted the overall interest rate risk management
process and discussed the board's responsibilities. To aid in fulfilling
their duties, there are several questions
directors can ask their management team
in order to understand the bank's interest rate
risk profile and process. These questions include: What rate scenarios
are most problematic given the bank's
balance sheet structure? What are the key assumptions
and how are they developed? Is sensitivity analysis
conducted on key assumptions? Are any new products
or initiatives planned that will impact the bank's
interest rate risk profile? What strategies can be
implemented to mitigate interest rate risk
within board-approved risk mitigation techniques? Are assumptions, data inputs,
and model results reliable, and does an independent review
verify this reliability? And does the independent
review process also include back-testing
and validation? Now I'll turn it back to Dan
to wrap this up. - That concludes
our Director's Presentation on interest rate risk. It was, by design, intended to provide
a high level overview of the topic
and to highlight those areas that are of critical importance
to directors as they carry out their
oversight responsibilities. There are many other
sources of information available to further
supplement your knowledge of interest rate
risk management. Listed here
are several resources, including
existing regulatory guidance, that are available on the FDIC's website at fdic.gov. As you can see,
most of these resources were issued in recent years
as concerns related to interest rate risk
have increased. As I mentioned earlier,
there is a series of videos that provide a deeper dive into the more technical aspects of measuring, monitoring, and mitigating
interest rate risk. You may want to visit
our Directors' Resource Center for information on this and many other topics
of interest to directors. In addition, each of the FDIC's
regional offices has specialists
that are happy to discuss interest rate risk concerns
or questions with bankers. Bankers can contact
their case managers to obtain the name
and contact information of their Region's Senior
Capital Markets Specialist. You can also email questions
to us at supervision@fdic.gov. Finally, interest rate risk
should be viewed in the context of a bank's
overall risk management process. Market rate changes
may adversely affect other areas of the bank such as
credit quality and liquidity. For example,
even moderate rate increases may adversely impact
floating rate borrowers by driving down their ability
to service debt. Higher rates may also affect
deposit volumes or impact market values
of investments maintained for pledging
and liquidity purposes. Directors should fully
understand the potential impact of significant changes
in interest rates on all aspects of the bank. Thank you for your interest
in this topic, and please be sure to check
our website for other videos on various consumer protection and risk management topics that are of keen interest to
bankers and supervisors alike.
