The Federal Reserve Board has proposed a dangerously inadequate system to measure the interest rate risk component of the risk-based capital guidelines.

Bankers already use and understand simulation analysis, a more accurate methodology for measuring, managing, and regulating interest rate risk.

The Fed's plan is much inferior, with serious conceptual and technical flaws. It is not a workable tool for measuring and managing interest rate risk.

Led Astray

Nevertheless, some bankers -- particularly less sophisticated bankers and some at smaller institutions -- will adopt the methodology for measuring and managing interest rate risk.

This would improve neither the industry's ability to measure and manager interest rate risk nor the level and stability of earnings.

Simulation analysis has been refined by the banking industry and the asset-liability management software industry during the past 20 years.

A Step Backward

The Federal Reserve's proposed measurement system, which uses gap and duration analyses, is significant step backward.

Bankers understand the regulators' concerns and generally agree with the need for oversight in this area. And they support the agencies' efforts to develop regulations that enhance the safety and soundness of the industry.

Bankers are also very willing to share their expertise with the regulatory agencies to develop regulations to ensure the safety and soundness of the banking industry.

The danger of the proposed regulation is that some bankers will adopt the proposal's measurement system.

Past Misstep

The Office of Thrift Supervision's Thrift Bulletin 13 is a perfect example of this phenomenon.

It led thrift executives to shift most of their asset-liability management analysis activities from measuring and managing the level of interest rate risk to complying with the requirements of the regulation.

Coordination and cooperation between bankers and the regulators can produce a better risk-based capital regulation.

A recent survey of 49 of the country's 100 largest banking companies revealed that 76% regularly use simulation analysis to measure and manage rate risk.

The use of simulation analysis will provide a more accurate methodology for monitoring and controlling the risks regulators seek to control.

Government's Misapprehension

The regulatory agencies' argument in support of their proposed measurement system centers on a belief that smaller institutions cannot perform simulation analysis.

The agencies' concerns that a regulations requiring the use of simulation analysis for all banks would create an undue burden is unfounded.

There already exists at least 10 well-known firms that provide accurate and timely simulation analysis for smaller banks, and at very reasonable rates.

The regulator's proposal would create another burden for the banking industry, as well as being potentially harmful. Since interest rate risk management is as much an art a science, a flexible approach of allowing banks to use their own simulation systems is preferable to a rigid approach.

Banks would of course provide regulators with documentation to back up claims and predictions based on simulation analysis.

The proposed interest rate risk measurement and monitoring system should be eliminated and risk-based capital calculations should be based on bank-developed, or out-source developed, simulation analysis.

Risk-based capital requirements should be based on a percentage change in net interest income.

Proven System in Place

Simulation analysis could be implemented into the risk-based capital guidelines.

The regulatory agencies would be responsible for defining guidelines such as:

* The time frame of the simulation analysis -- for example 12 months.

* Three standard interest rate forecast scenarios and accompanying yields curves, which should include flat, rising, and declining interest rate scenarios.

* The method for calculating the percentage change in net interest income.

* Risk-based capital requirements based on a percentage change in net interest income. (Additional capital requirements would be calculated using the percentage and the actual dollar difference between the rising or declining rate scenario's simulation results and the flat rate scenario's simulation results.)

Information from Banks

Financial institutions would be responsible for providing specific simulation analysis information such as:

* Listing the assumptions.

* Documenting the process followed and the technology used to develop the assumptions.

* Validating the accuracy of their analysis.

The proposed measurement and monitoring system has problems in three areas: data collection assumptions, calculation methodology, and false assumptions.

The government's proposed interest rate risk measurement system requires only six maturity buckets for all maturities.

Most commercially available models for asset liability management provide over 40 buckets that can accurately simulate 360 buckets using prepayment calculation options.

The proposed system also ignores the actual rates for each of the maturities and total balances.

Other important areas of data requirements that are not included in the measurement system are interest rate caps, floors, and ceilings.

And accurate simulation analysis, calculation of the market value of portfolio equity, and measuring the exposure to an interest rate shock are all impossible without this information.

Flawed Calculations

The proposed measurement system is based on gap analysis and modified duration analysis calculations to produce its results.

By using gap analysis calculations, the system ignores basis risk, pricing spreads, the existence of a yield curve, customer options (prepayments and early withdrawals), and repriceable products.

By using modified duration analysis calculations, the system is developing a linear relationship between changes in rates (yields) and prices (market value) for all items the balance sheet.

A linear relationship exists only for small changes in interest rates of five to 10 basis points. The proposed system inaccurately calculates changes of 100 basis points.

Interest rate changes in excess of 15 to 20 basis points require a quadratic relationship to accurately determine the prices of assets and liabilities. The development of a quadratic relationship requires a duration and convexity calculation.

False Assumptions

The proposed measurement system contains two very pivotal assumptions.

The first assumption concerns the agency developed interest rate risk weights. These risk weights have a very low probability of being accurate.

Actual information on a particular bank concerning its underlying interest rates, prepayment speeds, early withdrawals, level of principal reduction, and date of maturity for each of the bank's assets and liabilities, as well as the level of current interest rates and the shape of the current yield curve, will be drastically different from the assumptions used by the regulatory agencies.

The second pivotal assumption concerns the maximum limit on core deposit maturities or decay rates for demand deposits. NOW accounts, money market deposit accounts, and savings.

The proposal dictates that only 30% of these deposits can be placed in the one- to three-year bucket (which is the longest bucket for these accounts).

The proposal also sets a 40% limit on the amount of savings that can be placed in the three- to seven-year bucket (the longest bucket for this account).

Banks could easily dispute the accuracy of the proposal's decay rate assumptions by documenting their actual decay rate experience.

In short, simulation analysis accomplishes the proposed regulation's objectives in a more productive manner.

Therefore, let's scrap the regulatory agencies' proposed interest rate risk measurement and monitoring system and allow banks to use a system that they know works.

Mr. Kummerl is vice president and director of asset liability management advisory services at Sun Trust Banks Inc., Atlanta.

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