Banks are warmly greeting a newly issued report on managing interest rate risk that encourages them to set their own standards.
In the draft report, "Principles for the Management of Interest Rate Risk," the Basel Committee on Banking Supervision acknowledges there are many roads to effective risk management. It suggests ways for banks to establish their own policies, rather than forcing them to comply with a prescribed regimen.
"The concept of principles is superior to mandating certain tests," said Tanya Styblo Beder, principal at Capital Market Risk Advisors, a New York consultancy. "It holds you to do the right thing, rather than to some calculation that can be manipulated."
Changes in bond prices, Treasuries, and other interest rates can drastically affect bank earnings. In the last 10 years, commercial banks have begun trading billions of dollars worth of instruments designed to mitigate the effects of interest rate changes.
Banks have derivatives contracts worth $19.8 trillion, according to the Office of the Comptroller of the Currency, and $13.3 trillion of these derivatives are in contracts tied to interest rates.
Although swapping interest rate risks with other parties has done much to strengthen bank balance sheets, banks have also learned the hard way the costs of unsupervised trading of instruments to bet on changes in interest rates and other indexes.
The Basel committee, comprised of national banking supervisors from the United States, Canada, Japan, and seven countries in Europe, spells out a 12-step approach to prevent catastrophes like the recent collapse of Barings PLC.
Such disasters prompted calls a few years ago for tighter government regulation. The report, however, indicates it is sufficient for banks to clearly state the amount of risk they believe they can handle and tell their boards and top management how they intend to control it.
The report says banks should have measurement systems that capture all material sources of interest rate risk. It says that risk managers and bank management should understand the systems' underlying assumptions.
Recognizing that new ways of hedging against interest rates may develop, the report says that any new risk management policies-like buying or selling a new kind of derivative contract-should be approved in advance by the bank board or appropriate committee.
The report says independent controls should be placed on the bank's trading desks and Treasury operations to review risk management practices. It also says banking supervisors should obtain "sufficient and timely information" to evaluate their level of interest rate risk.
Comments are being taken through April 15.