WASHINGTON — Federal regulators issued an advisory Thursday prodding banks to beef up interest rate risk management, including stress testing and computer modeling.
With interest rates at record lows, the regulators said many banks are funding longer-term assets with shorter-term liabilities, which "poses risks to an institution's capital and earnings" when rates rise. Regulators appear increasingly worried that many institutions have forgotten how to properly manage interest rate risk.
"The regulators expect all institutions to manage their IRR exposures using processes and systems commensurate with their earnings and capital levels, complexity, business model, risk profile and scope of operations," the advisory said. The advisory updates and expands on guidance released by regulators in 1996. The updated version specifically recommends extensive computer modeling and stress testing of potential threats to an institution if interest rates rise rapidly.
Regulators said that stress scenarios should include "instantaneous and significant changes" in interest rates, substantial changes in rates over time, changes in the relationships between key market rates and changes in the slope and shape of the yield curve.
Although regulators said that non-complex institutions with limited structured products on their balance sheet do not need to run as many tests, they emphasized that all institutions must apply at least some tests.
"Interest rate shocks of sufficient magnitude should be run, regardless of the institution's size or complexity" the advisory said.
It also emphasized that most institutions should be able to conduct computer modeling of interest rate risks.
"Current computer technology allows even some smaller, less sophisticated institutions to perform comprehensive simulations of the potential impact of changes in market rates on their earnings and capital," according to the advisory.
Regulators said stress testing must include a sensitivity analysis to help determine which assumptions have the most impact on the bank's risk measurement. This "can be used to determine the conditions under which key business assumptions and model parameters break down or when IRR may be exacerbated by other risks or earnings pressures."
Regulators said institutions must document, monitor and regularly update key assumptions used in their models.
"At a minimum, institutions should ensure the reasonableness of asset prepayments, non-maturity deposit price sensitivity and decay rates and key rate drivers for each interest rate shock scenario," the advisory said.
Regulators also advised banks to build in controls to ensure that when systems flag a problem they receive prompt management attention.
"An appropriate limit system should permit management to identify IRR exposures, initiate discussions about risk and take appropriate action as identified in IRR policies and procedures," the advisory said.
Should interest rate risk increase, institutions will be expected to mitigate the risk through balance sheet changes and hedging. Although regulators said the most common way to handle interest rate risk is through a balanced mix of assets and liabilities, they said institutions can also use certain derivatives.
Regulators said that both the board and senior management of a bank must ensure the institution is paying proper attention to interest rate risk, including ensuring that appropriate policies, procedures and internal controls are in place and that there are comprehensive systems and standards for measuring risk.
The advisory made it clear that examiners view interest rate management as a critical part of a bank's safety and soundness.
"Material weaknesses in risk management processes or high levels of IRR exposure to capital will require corrective action," the advisory said.
Such actions include requiring an institution to raise capital, reduce levels of interest rate expodure, strengthen risk management or improve measurement systems.
"IRR management should be an integral component of an institution's risk management infrastructure," the advisory said.