The Federal Reserve Board's proposal for monitoring interest rate risk met cautious approval from some bankers and analysts on Thursday.

Although many in the industry had not yet seen the proposal, some who had said it would help the Fed to better gauge interest rate risk at individual banks.

"My sense is that the proposal will work - it has intuitive appeal based on the industry standards for risk that the Fed has set," said Craig Wood, senior vice president at Olson Research Associates in Greenbelt, Md.

"But there are a lot of soft areas to the proposal and there will be a lot of debate over how it will work in practice."

Disagreement on Core Deposits

For example, the Fed's treatment of core deposits in the proposal is at odds with the bankers' view.

The Fed's proposal, released Wednesday, aims to identify the 20% of banks that it believes are taking excessive interest rate risk, based on its study of individual banks for the past two years. The Fed wants to identify banks whose earnings and capital are at risk if interest rates shift one percentage point in either direction.

Capital requirements will go up for banks in the high-risk category in June 1993, as required by the Federal Deposit Insurance Corporation Improvement Act.

Off-Balance-Sheet Components

"I think it will help identify who might be at risk," said Joseph M. Vayda, senior vice president with CoreStates Financial Corp. in Philadelphia.

It is not clear which banks will be affected most by the proposals. Analysts say published reports do not include a full picture of off-balance-sheet instruments, such as hedges and swaps, which can affect a bank's overall rate risk.

"Public disclosure is not adequate to make anything more than an educated guess about who is taking a big risk," said Arthur P. Soter, an analyst with Morgan Stanley & Co.

Under the Fed's proposal, banks will disclose quarterly the risk associated with all assets, liabilities, and off-balance-sheet instruments.

Most banks detail the risk only over five years. The Fed wants banks to break out those risks into two additional categories: seven years and over 15 years. Few banks calculate their risks that far out and therefore ignore the exposure of long-term fixed-rate assets, according to regulators.

Complying with the Fed's proposal will likely take banks six to eight months to analyze their risk exposures and reprogram financial-information systems, say bankers.

Debate on Core Deposits

Bankers question the assumption that core deposits have a duration of less than three years. They say core deposits are more stable, and can stay at a bank for up to 10 years.

"There are no explicit maturities associates with savings accounts or demand deposit accounts," Mr. Wood said. "But the Fed is imposing limits on how a bank can assume these are being repriced."

Mr. Vayda of CoreStates added: "The problem that we have with the Fed is that we have with the Fed is that it is taking a standardized approach.

"But each bank has unique risk positions, and banks measure their risk with different methods that are valid."

Fed's Net Would Catch Banks with Abnormal Exposure

The Federal Reserve's rate-risk proposal may be complex, but it's not without some basic logic.

The Fed is trying to make sure that banks, in working to control credit risk, do not overlook the danger that swings in interest rates will hurt profits and capital.

Many banks, for example, have been loading up on home mortgages, one of the safest of all credits.

But, as the thrift industry knows all too well, mortgages can be big money losers when market rates soar. Scores of thrifts were crippled in the early 1980s when deposit rates rose above the yields on holdings of 30-year, fixed-rate mortgages.

Pinpointing Vulnerable Banks

The Fed's approach is to establish a "normal" level of rate risk for all banks, and to then zero in on banks with higher than normal risk.

Those banks - probably about 20% of the industry - would be required to meet higher capital requirements. Typically, the extra requirement would amount to 0.55 of assets, Fed staffers estimate.

What is normal rate risk? The Fed would set the level based on both its own view of what is acceptable and the existing distribution of risk across the industry, according to the proposal.

"It's basically a level of forgiveness," said a Fed official. "Until you get out there, there's no capital charge."

To get a handle on the rate risk at a specific bank, the Fed would group the bank's assets and liabilities into six categories, based on remaining years to maturities or repricing dates. The groups would start with zero to three months and go up to 15 years and over.

Each of the six asset buckets would then be subdivided by payment characteristics.

For example, instruments that entail periodic payments of both principal and interest would make up one subgroup; instruments that call for the payment of principal only at maturity would go into another subgroup.

Ultimately, the Fed would seek to establish how each of the asset subgroups and each of the six liability buckets would respond to a 100-basis-point shift in interest rate, up or down.

This would be done by multiplying each group by a "risk factor." The Fed as developed a series of risk factors for each group and subgroup to reflect their approximate rate sensitivity.

The Fed would then tote up the risk-weighted assets, and subtract risk-weighted liabilities. This, along with consideration of off-balance-sheet items, results in a dollar sum called the net risk-weighted position.

Fed staffers expect the sum to equal less than 1% of assets at most banks, 1.55 for a typical higher-risk bank.

System Could Be Deceived

Experts in asset and liability management say that the approach, for all its steps, is not nearly as elaborate of some of the alternatives.

Paul DeRosa, managing director of Eastbridge Capital, New York, called the method "crude" but said it should help the Fed catch banks that are unknowingly sitting on rate risk. "If a bank wants to hide rate risk, it could deceive this system," he said.

Meanwhile, a lively industry debate is expected to soon begin over which maturity bucket to use for checking accounts and other core deposits.

"Some people will say these belong in the shortest-term group, and others will say they should go in the longest-term category," said Dennis Bennett, president of Bennett Management Services, Phoenix.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.