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RISK DOCTOR

Has OCC's Ability to Monitor Interest Rate Risk Been Compromised?

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As Hurricane Sandy bears down on much of the eastern seaboard this week, there are important lessons for bank regulation. 

Forecasters at the National Hurricane Center were quick to point out that just because Hurricane Sandy was rated only a Category 1 storm people should not underestimate its potentially damaging effects given its unusual combination of meteorological events.  So too must organizations like the Office of the Comptroller of the Currency avoid the danger of ignoring potentially devastating risk events simply because the financial tsunami of 2008-2009 continues to weigh heavily on the minds of OCC management.

Imagine that in the aftermath of the Halloween Nor'easter of 1991 (the so-called Perfect Storm), the National Weather Service and decided to consolidate the National Hurricane Center with its National Storm Center and after its review of both organizations had decided to adopt the latter's hurricane forecasting system and abandon the former's models even though the NHC's hurricane monitoring capabilities were significantly more robust. Something similar has happened as a result of the consolidation of the Office of Thrift Supervision with the OCC as mandated by the Dodd-Frank Act. 

The financial crisis exposed a significant number of missteps by OTS, to be sure, in reining in excessive risk-taking by some of the largest thrifts under its supervision. There is little doubt that restructuring the OTS was required.

However, in merging it in with the OCC, a little known but critically important activity being conducted by the OTS was abandoned, leaving the OCC virtually blind in assessing the impact of a major risk event for the industry. 

In response to the thrift crisis of the 1980's, a comprehensive set of regulations in the form of Financial Institutions Reform, Recovery, and Enforcement Act also created a new agency to regulate the thrift industry, the OTS.  It then embarked on a project to radically change the way it monitored thrifts' interest rate risk exposures.  While a number of factors contributed to the thrift crisis, a severe mismatch in assets and liabilities gave rise to significant interest rate risk exposure during the period for much of the industry. 

The OTS set out to construct its Net Portfolio Value model as part of Thrift Bulletin 13a, which required periodic reporting by thrift institutions of detailed aspects of their balance sheet under a variety of interest rate shock scenarios.  The NPV model for its time was one of the more advanced regulatory efforts focused on assessing interest rate risk to come out of a U.S. bank regulator, and was unique among regulatory efforts of this kind due mostly to the fact that the thrift charter's focus on mortgage-related assets was prone to interest rate risk.

The NPV framework entailed modeling the cash flows of all assets and liabilities of the thrift balance sheet, including derivative instruments.  The model was able to incorporate a wide variety of complex financial instruments and provide the OTS with detailed information on the sensitivity of changes in the economic value of a thrift institution to interest rate changes.  Each thrift was required to submit information on each asset and liability on Schedule CMR, a companion to the Thrift Financial Report each thrift was required to submit quarterly.  No other regulator adopted the OTS interest rate risk requirements, including the OCC, which was foretelling.

As of March 31 of this year, the OCC formally rescinded TB 13a and associated reporting requirements by thrifts and monitoring of interest rate risk exposure via the NPV framework. Currently, the OCC's official policy is to rely on a variety of handbooks and other bulletins to manage interest rate risk exposure of thrifts and banks. 

Handbooks. Think about it. If the NWS relied on forecasting hurricanes using handbooks, the East Coast would be in bigger trouble than it is.

It is interesting that just last week the OCC issued supervisory guidance regarding community bank stress testing.  The OCC provides a considerable amount of detail about how community banks should go about assessing the impact of credit events on their portfolios.  In that announcement the OCC acknowledges that banks regularly perform interest rate risk assessments. But other than the regularly scheduled examinations, which occur every 12 to 18 months (leaning toward 18 months for smaller institutions), insight into exactly how institutions and the industry are faring in their interest rate risk management activities is limited.  In other words, OCC has no ability to assess each bank's sensitivity to interest rate risk in a consistent fashion so that it can anticipate potential industry problems.

In an era where more attention, not less, to gathering transaction-level information on various risk positions is warranted, the OCC abandoned a comprehensive and sophisticated approach to monitoring interest rate risk. The Federal Reserve may continue for a while to pursue its policies aimed at holding interest rates down to support economic recovery, but at some point interest rates will inevitably rise.  At this point it would be impossible for the OCC to quantify what impact that scenario would have for banks and thrifts under varying interest rate scenarios.  It is time that the OCC reassess its capabilities to evaluate these risks before the next financial hurricane hits.

Clifford V. Rossi is the Executive-in-Residence and Tyser Teaching Fellow at the Robert H. Smith School of Business at the University of Maryland. 

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Comments (5)
I guess Mr. Rossi is unaware of the work of each banks Asset and Liability Committes where externally prepared reviews are made quaterly of the impact on the banks capital and earnings of 0-3% up and down interest rate changes. Such analysis considers both investments and loans. And to be sure its right the assumptions to the analysis are reviewed by a second independent outside source.
Posted by Rhsmith999 | Tuesday, October 30 2012 at 11:57AM ET
The OTS model was not as reliable as Mr. Rossi thinks it was. It was antiquated and a complicated process producing less than marginal data that only Thomas Ho really understood. I agree that industry averages could be useful, but until someone comes up with a better barometer, banks are better off benchmarking against themselves through their own ALM processes.
Posted by kksays | Tuesday, October 30 2012 at 12:28PM ET
Actually, I am quite aware that the ALCO committees of banks do make such assessments and you will note my reference to same by the OCC in their Community Bank Stress Test announcement. Just because a bank performs such an analysis doesn't mean they are not willing to take excessive interest rate risk. We saw many instances during the housing boom for example where significant efforts were made to model credit risk, but that didn't mean firms weren't taking significant risks that were in some cases excessive.

As to the other comment that the OTS models were not as reliable as they might be, it sure beats not having anything to go by and if the OTS, now OCC made an investment in collecting better and more timely information, it would go a long way to providing OCC with insights into industry interest rate risk exposures that otherwise are not available at this time. Ignoring the problem simply because a model may not be as reliable as you would like is not a good reason to not focus on enhancing that capability.
Posted by crossi@rhsmith.umd.edu | Tuesday, October 30 2012 at 1:33PM ET
I worked as a CFO for a savings and loan from 1980 through 1990. This was during the meltdown of the savings and loan industry. Our institution acquired 3 failed savings and loan during the decade and sold to a community bank in 1990. I have worked for this community bank since 1990 and have been CFO for the past 15 years. The OTS did a nice job collecting interest rate risk information on the savings and loan industry in the late 1980s. I was surprised that the OCC was not doing this with the banking industry and essentially is not doing this today in our regulatory reports. However, I must emphasize the OCC examiners that we have examine us on interest rate risk are extrememly knowledgeable and do an excellent job. These examiners certainly have created their own data base of information on peer banks and share this with us during our ezaminations or any time we ask for their help. I am very impressed with the way the OCC examines interest rate risk at banks.
Posted by JKozak | Tuesday, October 30 2012 at 3:02PM ET
Someone needs to call the question on how revelant is community banking. The QE easing program of past several y
Posted by Rdo | Tuesday, October 30 2012 at 7:59PM ET
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