Comment: How to Balance Rate Risk and Performance

As interest rate risk management for community banks has become both more important and more complex, the need to properly review rate-related performance and transmit that information to the board and regulators has increased.

Many banks are handicapped in doing these functions, however, because they mix business plan evaluations with rate risk assessments and define rate risk exposure limits that are too simplistic.

In a recent consulting engagement with a leading East Coast community bank, solutions for these handicaps were developed that will be useful to all institutions struggling with rate risk management. These solutions, key components of a larger comprehensive process designed to monitor and control performance and rate risk, provided management with ways to bring the board and regulators into focus on the bank's current rate risk, maximum and acceptable levels of rate risk, as defined by the bank, and the importance of these two concepts taken together.

Business plan evaluation reviews performance from the perspective that the bank is a going concern. This is the view that the board normally takes in its oversight activities, and it by necessity incorporates all of the complexities of the bank's business plan, its local markets, etc. Rate risk assessment reviews performance from a liquidation perspective. This is the view that the regulators typically take in their oversight activities, and it by necessity ignores information other than that contained in the bank's current balance sheet.

While the two approaches are not entirely independent, distinguishing between them can pay big dividends when communicating performance and rate risk data, because doing so separates the probable from the hypothetical in the eyes of the board and regulators.

Business plan evaluation provides a management-oriented review of the bank's expected future performance. Use of it by the bank should thus be analogous to using a speedometer in an automobile - something to be checked often for accurate guidance. By emphasizing business plan evaluation as this type of a conceptually distinct process, the focus of the board and regulators is directed to performance review and decision-making in a realistic - not regulatory-oriented - context.

Rate risk assessment provides an exposure-oriented review of the bank's hypothetical future performance. It's independence from the business plan and use of extreme rate tests results in performance projections that are sharply focused on just rate risk. Use of it by the bank should thus be analogous to using an oil or water temperature gauge in an automobile - something to be checked regularly for specific reference. By emphasizing rate risk assessment as this type of a conceptually distinct process, the focus of the board and regulators is directed to rate risk review and decision-making in its proper regulatory - not realistic - context.

Distinguishing business plan evaluation from rate risk assessment draws the line that the board and regulators need to see between what is probable and what is only hypothetical. Better understanding of the bank's expected performance, separate from its rate risk exposure, is one outcome of this. Better decision-making, and resulting higher performance, is another.

Commonly seen rate risk exposure limits specify only regulatory-oriented maximum allowable exposures. They are typically not understood by the board, either when adopted or when used in context with indicators of the bank's rate risk position. This clearly limits their value as evaluation and decision tools and weakens their regulatory defensibility. Defining rate risk exposure limits as green light/yellow light/red light zones remedies these problems and adds other important value as well.

Rate risk exposure zones are defined based on accepted estimates of exposure (for example, percentage losses in net interest income or market value for defined rate changes). They are thus similar to current commonly defined rate risk limits in this respect. In addition to establishing maximum allowable rate risk exposure, however, green light/yellow light/red light zones give guidance regarding what the board feels are normal and temporarily acceptable ranges of rate risk exposure.

The green light zone and its upper limit clearly define the board's normal operating tolerance to rate risk. This offers management firm guidance in this often illusive area. The yellow light zone, within its lower and upper limits, provides a rate risk buffer. By having a yellow light zone, management is empowered by the board to take rate-related risks that are in the best interest of the institution but that may temporarily place rate risk exposure outside normal tolerance limits.

Additional reporting and control mechanisms are required in the yellow light zone, of course, to check unwarranted risk taking in a proactive fashion. The red light zone is similar to current commonly defined rate risk limits. Rate risk above the red light zone's lower limit is out of compliance with board and asset-liability committee policies.

Separate green light/yellow light/red light zones need to be defined for each rate test used in the bank's business plan evaluation and rate risk assessment process. Zone limits should be tailored to each specific rate test situation. Relatively tight zone limits, for example, would be expected for the performance variations expected among business plan rate forecasts compared with the broader zone limits defined for the more exaggerated rate risk assessment stress tests. Defining rate risk limits in this way extends the bank's exposure review to more performance situations, both realistic and regulatory, and clearly demonstrates the board's full range of rate risk preferences.

Board understanding of the bank's rate risk limits relative to its current rate risk position is also enhanced by adoption of green light/yellow light/red light zone limits. When placed in the zone context, the red light zone limit clearly transmits to the board the bank's maximum allowable rate risk exposure. Likewise, the yellow light and green light zone limits define readily understood references for normal and temporarily acceptable rate risk exposure.

Green light/yellow light/red light zones have been positively received by regulators. This is largely because of the greater information they quickly transmit to examiners. The zones also show additional understanding and involvement by the board with respect to the rate risk position of the bank, compared with typical current rate risk limits. Further the yellow light zone limits define an area of early intervention and proactive management of rate risk. For most institutions, this demonstrates a process solution superior to any now in place.

Recent rate increases and changes in the relative attractiveness of selected loan, funding, and investment sectors presented management at a leading East Coast community bank with a strong performance motive and the opportunity to reengineer key elements of the bank's balance sheet. Concerns expressed by regulators regarding the rate risk exposure of the bank provided an additional incentive, and a regulatory perspective.

Board approval was required for balance sheet changes to alter the bank's rate risk exposure. These changes would also, of course, affect performance. In the past, consideration of such strategies has tested the understanding and patience of many board members. By separating the business plan evaluation and rate risk assessment aspects of the issue, however, and defining green light/yellow light/ red light zone limits for the bank, current and strategy-related performance and rate risk exposure was immediately apparent to the board. Because of this, action was able to be taken faster and with greater understanding.

Following a baseline (no strategy) evaluation of the bank's performance and rate risk exposure, each proposed strategy was hypothetically tested in both a business plan evaluation and rate risk assessment environment and presented to the board. The distinction of business plan evaluation versus rate risk assessment paid big dividends in the board's grasp of the probable versus hypothetical performance and rate risk exposure implications of the strategies.

In the process of evaluating proposed strategies, the green light/yellow light/red light zone limits were a valuable tool. Using them, management was able to clearly illustrate to the board the bank's progression towards lower rate risk through each strategy. This helped the board put the strategies in their complete context quickly, further facilitating decision-making.

The bottom line on the experience is that the bank was able to successfully define and, with board approval implement, a balance sheet strategy that reduced rate risk with limited impact on performance. Compared with previous experiences, applying two simple concepts made a major positive impact on both the decision process and the outcome.

Mr. McGuire, a consultant in Scottsdale, Ariz., was formerly with Sendero Corp. Mr. Massengill, in Philadelphia, heads a Wheat First Securities area that provides rate risk management and portfolio assistance, primarily to community banks.

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