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Interest Rate Risk Management in Today’s Ultra-Low Rate Environment

By: Eric Schwartz

The Federal Reserve’s frequently reiterated position that economic conditions “are likely to warrant exceptionally low levels of the federal funds rate at least through late 2014” should come as no surprise. Chairman Ben Bernanke has acknowledged repeatedly in congressional testimony that the economic outlook remains uncertain. Global events, particularly in Europe, continue to weigh heavily on markets and investor confidence.

While there are some signs of recovery in the United States, most likely banks will operate in a low interest rate environment for the foreseeable future. Low rates, intended to encourage economic growth by providing cheaper credit, are a mixed blessing as many banks struggle with the impact on profitability. Compressed net interest margins, a lack of quality borrowers and an overabundance of liquidity have forced some banks to take larger credit risks or chase yield to supplement returns on their legacy portfolios. These short-term gains and the pressure to meet shareholder expectations may come at a significant price if loans fail to perform as expected or if interest rates begin to rise.

Compounding these challenges are moves by U.S. and international regulators to ensure that banks hold increased levels of highly liquid assets. Additional asset liquidity should help banks withstand stress events, but low yields on such assets puts additional pressure on earnings. Real returns on U.S. Treasuries have been negative or close to negative for some time.

An increase in interest rates is likely to occur as the economy strengthens. While the Fed can control short-term rates, it has less direct ability to manage longer-term rates. That said, it is evident that regulators are concerned about the implications of current market conditions and the potential impact on banks’ balance sheets and profitability, particularly with regard to interest rate risk.

After issuing the January 2010 Advisory on Interest Rate Risk Management, the federal banking regulators provided in mid-January a frequently asked questions document that underscores earlier guidance. Notwithstanding the probability that rates will remain low for the foreseeable future, supervisors expect banks to take steps to improve their IRR management programs. These include explicit board accountability for setting the risk appetite, for providing independent, credible challenge to risk management processes, and for ongoing monitoring of compliance with defined risk limits. Moreover, regulators expect policies, procedures and systems to be commensurate with the level of risk within the institution.

There will be no shortage of regulatory and market challenges facing bank chief financial officers and treasurers during 2012. There are, however, several proactive steps that banks can take to enhance their IRR programs.

First, complete an IRR diagnostic check to identify unintended sources of risk. Today’s low interest rate environment does not mean that balance sheets do not have embedded IRR. Many lenders have included interest rate floors in loan structures over the past several years.

In many situations, rates will need to increase 150 to 200 basis points before floating rate assets and liabilities begin to reprice in tandem, leading to further net interest margin compression. Moreover, some banks have assets or liabilities with certain embedded options that will cause them to behave differently as rates start to tick up. And non-maturity deposit decay analyses may no longer prove accurate in a rising rate environment, particularly after the flight-to-quality flood of deposits into the banking system over the past three years. Banks should consider the impact of these structural characteristics on IRR and take appropriate action to mitigate the risk.

Second, while it is perfectly acceptable to outsource IRR modeling, banks cannot outsource model oversight. In the past, large banks developed sophisticated IRR systems, though these remained a luxury for smaller institutions.

Technological developments throughout the past 10 to 15 years allow even the smallest of banks to measure the impact of rate changes in static and dynamic scenarios. Many institutions rely on outsourced providers of IRR models, either delivering IRR reporting on a standalone basis or integrated with their core processing systems. However, outsourcing IRR measurement presents unique challenges and expectations for model validation and vendor management. Best practices include:

Third, develop a reverse stress-testing program. While it is true that the U.S. economy has never faced an instantaneous rate shock of 400 or 500 basis points, regulators expect the use of significant parallel yield curve shocks when measuring IRR. Banks should determine what types of rate movements would result in breaches to board-approved IRR limits and management guidelines. Merging this reverse stress-testing approach with traditional rate shock and ramp scenarios will help institutions develop a more robust understanding of risk exposure. Banks should then evaluate steps to improve IRR positions based on the results of the analysis.

Examiners will continue to scrutinize the IRR management practices of banks even in a low and stable rate environment. Institutions that take regulatory guidance to heart and implement industry best practices will have a competitive advantage and the financial flexibility to withstand future changes in interest rates.
Eric Schwartz is a senior principal at Promontory Financial Group, where he focuses on matters involving banking strategy, balance sheet management, funding and market risk.

Copyright (c) July 2012 by BankNews Media