managing interest rate risk - fdic: federal deposit ... · pdf filetypes of interest rate risk...

Managing Interest Rate Risk

FEDERAL DEPOSIT INSURANCE CORPORATION

Scope of Discussion

Industry Trends

Board Responsibilities

Types of IRR

Measurement Systems

Critical Assumptions

Internal Control and Review

Resources


Earnings Have Begun to Recover, but Lower Margins Continue to Hamper Performance

Source: Call / TFR Reports. Insured institutions under $1B in total assets only. Unless otherwise noted, figures illustrated represent year‐end figures.

3.0

3.5

4.0

4.5

0.0

0.5

1.0

1.5

2.0

2000 2003 2006 2009 2012 2Q15

Pre‐tax ROAA, %

Net Interest Margin (right axis)

Pre‐tax ROAA (left axis)

Net Interest Margin, %


Long-Term Asset Exposures Have Risen

0

10

20

30

40

50

2Q91 2Q94 2Q97 2Q00 2Q03 2Q06 2Q09 2Q12 2Q15

Long‐term Earning Assets* to Total Earning Assets %

Over 50%

40% to 50%

30% to 40%

% of Community Banks

Source: Call Reports. Quarterly data. Banks with assets under $1B, excludes former TFR filers. *Assets maturing / repricing > 5 years.


Long-term Concentrations Led to Lower Margins During the Last Rate Cycle

Source: Call Reports, based on median figures. *Earning assets maturing / repricing > 5 years. Consistent sample of Call Report filers under $1B in assets as of 2Q04 only.

3.0

3.4

3.8

4.2

4.6

2Q04 3Q04 4Q04 1Q05 2Q05 3Q05 4Q05 1Q06 2Q06 3Q06 4Q06 1Q07

Under 30% 30‐40% 40‐50% Over 50%

‐2 bps

‐16 bps

‐32 bps

‐43 bps

Net Interest Margin, %

Median NIMs grouped by long‐term earning assets* as of June 30, 2004Federal funds rate increased 425 bps between June 2004 and July 2006

FEDERAL DEPOSIT INSURANCE CORPORATIONSource: Call Reports. Based on consistent sample of active Call Report filers as of 2Q15 with assets <$1B. Excludes any former TFR filers.

Share of Banks with Long‐term Assets Representing 30% or More of Earning Assets

Increased Exposure to Long-term Assets

Share of Community Banks

0 to 10%10 to 25%25 to 50%50 to 75%75 to 100%

2006



0 to 10%10 to 25%25 to 50%50 to 75%75 to 100%



Source: Call Reports. Based on consistent sample of active Call Report filers as of 2Q15 with assets <$1B. Excludes any former TFR filers.

2007



0 to 10%10 to 25%25 to 50%50 to 75%75 to 100%




2008



0 to 10%10 to 25%25 to 50%50 to 75%75 to 100%




2009



0 to 10%10 to 25%25 to 50%50 to 75%75 to 100%




2010



0 to 10%10 to 25%25 to 50%50 to 75%75 to 100%




2011



0 to 10%10 to 25%25 to 50%50 to 75%75 to 100%




2012



0 to 10%10 to 25%25 to 50%50 to 75%75 to 100%




2013



0 to 10%10 to 25%25 to 50%50 to 75%75 to 100%




2014



0 to 10%10 to 25%25 to 50%50 to 75%75 to 100%




2Q15



0 to 10%10 to 25%25 to 50%50 to 75%75 to 100%




2006 2Q15


Types of Interest Rate Risk

INTEREST RATE RISK

Yield Curve Risk

Option RiskBasis Risk

RepricingRisk


Board Responsibilities

Oversee Policy Establishment

Ensure Prudent IRR Levels

Establish Risk Tolerances

Understand Impact of IRR Strategies

Establish Lines of Authority and

Responsibilities

Internal Control & Review

Monitor IRR Position


Policies Should Govern the IRR Process & Translate the Board’s Goals

Risk Limits on Earnings and Economic Value of Equity

Lines of Authority and Responsibilities

Reporting Standards

Independent Review Process

Types of Instruments and Activities that may be used to Manage IRR


How to Establish Appropriate Risk Limits

Reflect the Board’s Risk Tolerance

Consider Earnings and Capital, and Complexity

Change with Risk Profile

Trigger Appropriate Action


Evaluation of Risk Limits

Hypothetical impact to 2Q15 median pre‐tax ROAA (1.07%) for insured institutions under $1B in assets. Based on applying simple haircut to net interest income, holding all other income drivers constant.

Consider impact of net interest income declines on net income Consider impact of non-interest income on net income and establish net income limits

-16%

-31%

-47%

-62%‐80%

‐60%

‐40%

‐20%

0%5% Haircut 10% Haircut 15% Haircut 20% Haircut

Estimated Impact to Earnings if Net Interest Income DeclinesPercent Decline in Pre‐Tax ROAA


Board Oversight of the IRR Process

• Internal Controls• Independent Review• Annual Board Report

• Model Selection• Data Inputs• Assumptions• Documentation

• Policies & Procedures• Authority & Responsibility• Risk Limits• Risk Mitigation

• Management & Board Reporting

• Assess Reports• Risk Limit Compliance

Risk Controls &

LimitsIdentify & Measure

Monitor & Report

Internal Controls &

Audit


Types of Measurement Systems

Short-term Models

Gap AnalysisGap

Income SimulationIncomeSim

Long-term Models

Economic Valueof Equity (EVE)

ExtendedIncome Simulation

EVE

ExtendedIncomeSim


Income Simulation: Measures Income if Rates Change

Product Type Balance

Base Case +300 bps Scenario

Rate Income Rate Income

Fixed Rate Loans $1,000 4% $40 4% $40

15 Year Muni Bonds $1,000 4% $40 4% $40

Non‐maturity Deposit $1,500 1% $15 2% $30

Net Interest Income $65 $50

Assess Reports to Monitor IRR Levels Ensure Levels Comply with Policy Limits

Percent Change in Net Interest Income ‐ 23%


What is Economic Value of Equity?

Present Value (Assets) – Present Value (Liabilities) = EVE

Considers the difference between book yield and the market yield

LoanRate 5% Values

Decrease

Time DepositRate 1%

Rates Increase


Compare Base EVE to Shocked EVE

Rate Scenarios

‐100 bps Base Case +300 bps

PV (Assets), $ in millions $555 $550 $525

PV (Liabilities), $ in millions $465 $460 $450

Economic Value of Equity, $ in millions $90 $90 $75

% Change from Base 0% ‐ ‐17%

Asset values decreased more than liability values, resulting in a

net decrease in EVE


Combination of Income Simulation and EVE Provides a More Complete Picture of IRR EVE

• Captures All Cash Flows and Rate Sensitivity• Long-term

Income Simulation• Captures Cash Flows and Rate Sensitivity for Periods Measured• Can Point to “when” IRR Occurs

Use of Both Models Provides a More Complete Picture of an Institution’s IRR Exposure


Model Assumptions

Written documentation Review changes

Driver RatesAccount Aggregation

Static or DynamicBalance Sheet

Other Embedded Options

Prepayment Estimates

Rate Changes

Deposit Assumptions


Dramatic Rate Changes are Fairly Common

‐8

‐6

‐4

‐2

0

2

4

6

8

10

‐8

‐6

‐4

‐2

0

2

4

6

8

10

Jul‐59 Jul‐63 Jul‐67 Jul‐71 Jul‐75 Jul‐79 Jul‐83 Jul‐87 Jul‐91 Jul‐95 Jul‐99 Jul‐03 Jul‐07 Jul‐11 Jul‐15

Year‐Over‐Year Change in Fed Funds RatePercentage Percentage

+/‐200 bps Range

Source: Federal Reserve Board


Rate Changes: Yield Curve Shifts can beNon-parallel

Source: Federal Reserve Board / Haver Analytics

1Q 20041Q 2005

1Q 2006

0

1

2

3

4

5

6

7

8

3M 1Y 5Y 10Y 30Y

Yield Curve – 2004 to 2006Rate, %

Parallel +200 bpsBased on 1Q 2004


Deposit Assumptions

Price Sensitivity

(Beta)

Measures deposit rate changes relative to market rate changes

Example: 33%

Average LifeDecay Rates

Annual percentage of deposit run-off

Weighted average time (in years) until deposits are withdrawn

Track historical information and adjust for qualitative factors


Prepayment Speeds

0%

20%

40%

60%

80%

0

3

6

9

12

15

‐100 Stable +100 +200 +300

Rate Changes can have Considerable Impact on Prepayment SpeedsWAL, in Years Principal Repaid

Rate Scenario (bps)

Weighted Average Life (left axis)

Principal Cash Flow Repaid within 3 Years

(right axis)


Sensitivity Testing

Beta Assumption Net Interest Income Risk Limit

20% ‐5% ‐10%

25% ‐10% ‐10%

30% ‐15% ‐10%

Impact of beta assumption changes on model results

IncomeSim


Internal Control and Review

Internal Control System:

Roles, Responsibilities, and Lines of Authority

Separation of Duties

Adequacy of System Inputs and Measurement Systems

Policy Compliance

Corrective Action Procedures

Independent Review & Validation

Adequacy of Internal Control System Compliance

with Internal Control System

Adequacy of Measurement

System

Accuracy of Data Inputs

Adequacy of Assumptions

Validity of Calculations

Backtesting

Annual Report to Board


Questions to Ask Management

Problematic rate scenarios

Key assumptions / sensitivity analysis

New products / initiatives

Mitigation strategies

Model reliability

Independent Review


Resources

Joint Agency Policy Statement on Interest Rate Risk (FIL-52-96)

Advisory on Interest Rate Risk Management (FIL-2-2010)

Interagency Advisory on IRR Management: Frequently Asked Questions (FIL-2-2012)

Managing Sensitivity to Market Risk in a Challenging Interest Rate Environment (FIL-46-2013)

Winter 2014 Supervisory Insights (FIL-61-2014)


Resources

www.fdic.gov

Technical Assistance Video Program: www.fdic.gov/regulations/resources/director/video.html

Directors’ Resource Center: www.fdic.gov/resourcecenter

Regional Senior Capital Markets and Securities Specialists

Mailbox: [email protected]

managing interest rate risk - fdic: federal deposit ... · pdf filetypes of interest rate risk...

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