Pub. 4 2013 Issue 4

www.wvbankers.org 18 West Virginia Banker T he FDIC issued a new Financial Insti- tution Letter (FIL) on October 8 enti- tled “Managing Sensitivity to Market Risk in a Challenging Rate Environment.” Their concern, of course, is that many banks are not adequately prepared for, or equipped to manage, the risks to earn- ings and capital that would accompany a sustained rising rate environment. This FIL follows several other advisories and joint statements from the FFIEC regarding interest rate risk and liquidity risk manage- ment. In the letter, FDIC points to their concerns about recent trends in bank balance sheets. For example, there has been a notable increase in long-term assets funded by liabilities that may be more rate sensitive than commonly thought. The FIL notes that: “For a number of FDIC-supervised insti- tutions, the potential exists for material securities depreciation relative to capital in a rising interest rate environment,” … and… “Moreover, rate sensitive liabilities- may re-price faster than earning assets as coupons on variable rate loans and invest- ments remain below their floor.” Among other things, banks are reminded of the importance of having a sufficiently detailed reporting system to keep manage- ment and directors informed of interest rate risk exposures. Banks should have access to simulation models that produce stress tests on the overall balance sheet and particularly on high duration assets. Re- pricing assumptions for liabilities should be stressed as well. The FIL outlined four specific points: • Board and Management Oversight – Directors are charged with the responsibility of policy development, and should have a clear understand- ing of the interest rate risk manage- ment processes in place at their bank. Management is expected to provide the reporting tools and other resourc- es necessary to carry out policy. • Policy Framework and Prudent Ex - posure Limits – Boards of directors should “formalize” risk philosophy with sound policies and exposure limits that give management guid- ance on appropriate risk manage- ment strategy. • Effective Measurement and Moni - toring of Interest Rate Risk – Man- agement should utilize a variety of tools and techniques for assessing risk exposures. These should include earnings simulations, stress tests, and EVE analysis among others. • Risk Mitigation Strategies – Use of hedging off-balance-sheet derivatives are only appropriate for institutions that have the knowledge, expertise, and resources to understand and manage the potential risks and unin- tended consequences. Interest rate risk has been a priority for regulatory agencies for several years now. Much has changed with respect to examiner expectations of bank manage- ment teams and directors. Since the end of 2009, banks are required to build a more thorough ALCO process within a sound risk management framework. Banks must now have an interest rate risk reporting system that allows for multiple stress sce- narios, assumptions testing, and dynamic processing of cash flows among other things. The release of this FIL is one more helpful reminder of the fact that these interest rate risk processes will remain a top-of-mind issue as we move forward. n Bank regulators have again made clear their intention to highlight interest rate risk management as a point of focus. Managing Sensitivity to Market Risk FDIC Amplifies the Importance of Interest Rate Risk Management By Jeffrey F. Caughron Jeffrey F. Caughron Associate Partner The Baker Group LP Since 1979, we’ve helped our clients improve decision-making, manage interest rate risk, and maximize investment portfolio performance. Our proven approach of total resource integration utilizing software and prod- ucts developed by Baker’s Software Solutions* — combined with our solid investment experience and advice — makes us the investment firm of choice for many community financial institutions. For more information, contact Jeff Caughron at The Baker Group: 800-937-2257, www.GoBaker. com, or email: jcaughron@GoBaker.com. *The Baker Group LP is the sole authorized dis- tributor for the products and services developed and provided by The Baker Group Software Solutions, Inc.