Independent Review of the Interest Rate Risk Management Process

Most of us are familiar with assessing a bank’s safety and soundness using the acronym “CAMELS”. The last letter, “S” represents the bank’s “Sensitivity” to changing interest rates. The interest-rate risk management process encompasses a myriad of assumptions (re-investment rates, volumes, driver rate models, prepayments, repricing betas, decay terms, hedges, etc.) from every component of the balance sheet. The fact that banks’ earnings can be significantly impacted by interest rate risk and the complexity of the process are the two main reasons why regulatory guidance has mandated performing independent reviews of the interest rate risk management process. This eBrief will describe what examiners look for in these reviews, common drawbacks, and best practices.

Background

One of the most comprehensive regulatory documents published regarding IRR was the 1996 Joint Agency Policy Statement. This was a collaborative effort by the OCC, FDIC, and Federal Reserve that described methods to manage, monitor, and control IRR. The goal of the publication was to deliver a framework to financial institutions on sound interest rate management practices, noting that each institution will have its own unique methods based on its balance sheet and business strategy.

After describing various aspects of the IRR management process, the policy statement said “The bank should conduct periodic reviews of the IRR management process to ensure its integrity, accuracy, and reasonableness.” Five major areas examiners expect to be examined and validated in the scope of the IRR review are:

• Internal controls (governance)
• Appropriateness of the IRR model for the bank
• Data inputs and assumptions
• Scenarios simulated in the model
• Risk measurement calculations (which generally includes back-testing analysis)

Necessary Documentation

As can be seen from the above list, examiners are expecting a wide-ranging review of the IRR management process. Completing this report requires institutions to maintain documentation of each forecast of the interest rate risk model, assumptions used in the model (and changes to the assumptions), documentation supporting bank-specific estimates, periodic back-testing, the IRR/ALM Policy, and ALCO meeting minutes discussing the bank’s risk profile and risk management strategies. Depending on how in-depth the review is, even more information may be necessary.

Content of the Report

There is no set format for what the IRR management process review report should look like. In general, it needs to address the five items listed in the Background section, and upon completion, needs to be reviewed by the Board of Directors. Submitting the report to the board ensures oversight by reviewing recommendations that can be acted on or
improved before the next review.

When examining the internal controls of the bank, one of the most important aspects is ensuring that there is proper communication between management and the Board. Roles and responsibilities should be outlined, and it should be noted how information is disseminated among all parties. Secondly, the appropriateness of NII and EVE policy risk limits should be evaluated and compared to the output of the interest rate risk model for compliance testing.

After this, a meaningful part of the report is spent examining the model itself. Is it appropriate for the size and complexity of the bank? Are the assumptions reasonable? An institution with off-balance sheet hedges or significant optionality will require a more complex model than a bank with a “plain vanilla” balance sheet. Assumptions such as deposit betas, deposit decay rates, and loan prepayment speeds should be examined closely.

Validating the risk measurement calculations can often be satisfied by obtaining certifications provided by IRR model vendors. This will give confidence that the mechanics of the model are sound, but does not provide any analysis as to how useful the model is in forecasting future results. This is where a back-testing analysis is very useful. It will show how the bank’s actual performance differed from what was predicted, and this information can be used to find the source of the variance and improve the model going forward. With this type of analysis, it is possible to show if the variance in a given category was due to rate or volume assumptions.

Challenges

After completing the review and submitting it to the Board, examiners will look to make sure it is comprehensive and covers all the major areas of the guidance. Whether the review is performed internally or externally, there are a few common drawbacks that often show up. Many relate to the assumptions or scenarios used in the modeling process. If the reviewer does not have the necessary expertise, it will often be apparent in these sections. For example, some legal firms claim to perform these types of reviews with virtually no knowledge of interest rate risk management mechanics.

A second set of issues sometimes arise when trying to find an independent party to perform the review. As the regulatory guidelines note, it is perfectly acceptable for institutions to complete the review internally, provided the reviewer is independent from the IRR process and has the necessary expertise. However, at many institutions it can be difficult to find personnel with IRR expertise who are not already involved in the IRR process. For this reason, many community banks turn to a credible third party for an independent and objective report.

Conclusion
While conducting an interest rate risk management review can be a substantial undertaking, it can also be an opportunity to improve your institution’s IRR management function, especially in regards to forecasting accuracy and strategy formation. An independent third party should be able to add value to the process by including industry best practices for areas ranging from assumptions development to policy verbiage. The goal should be to make this more than just a regulatory exercise by actively looking at ways to improve your process and incorporating best practices to manage, monitor, and control interest rate risk.

Taylor Advisors, Inc. is a balance sheet consulting firm and a registered investment advisor based in Louisville, Kentucky. We help banks improve or maintain profitability while managing interest rate risk – what we call Balance Sheet Management (BSM). Additionally, Taylor Advisors’ investment consulting/advisory services assist with strategy formation, portfolio diversification, credit monitoring, and tax minimization strategies, including municipal bonds and investment subsidiaries.