The Office of the Comptroller of the Currency followed up a February advisory letter on interest rate risk last week by issuing details in a question-and-answer format. Senior Deputy Comptroller Douglas E. Harris, whose office supervised the advisory, said most banks are doing a good job with interest rate risk. But he cautioned that "interest rate risk is one of the fundamental risks banks face." Here are excerpts from the Q&A:

Q.: Is interest rate risk the most significant risk facing banks today?

HARRIS: Because the primary business of banking is lending money, credit risk traditionally has been, and continues to be, considered the most significant risk. However, changes in the structure of bank balance sheets and the use of more complex on- and off-balance-sheet products to manage interest rate exposures has increased the importance of interest rate risk.

Q.: Is the OCC's concern about interest rate risk focused mostly on big banks or small banks?

HARRIS: The OCC's concern about interest rate risk is not limited to any particular size or group of banks. Interest rate risk is inherent in a bank's role as a financial intermediary and, therefore, affects all banks.

However, some risk profiles can make a bank more vulnerable to a decline in earnings or the value of its capital because of interest rate risk exposure. For example, a bank with long-term fixed-rate assets funded by money market deposit accounts may not have a meaningful amount of short- term interest rate risk exposure because MMDA rate increases typically lag market rate increases.

If interest rates increase over the next 12 months, MMDA rates may not increase (or may increase at a slower rate) and the net interest margin for a bank with that profile will not be materially affected.

If such a bank, at some point, is forced to raise MMDA rates or replace lost deposits with market rate products (e.g., certificates of deposit, fed funds purchased, etc.), its net interest margin will begin to decline. The cost of funding below-par assets (i.e., higher interest rates will result in fixed-rate loans being valued at a discount because their yields are not consistent with current market rates) with par liabilities will erode the economic value of equity. A bank with short-term (i.e., two-years and under) assets funded by long-term liabilities will be similarly exposed to a falling rate environment.

Q.: What are the implications of noncompliance with the standards set forth in the advisory letter?

HARRIS: If the OCC identifies a situation in which a bank has taken a material amount of interest rate risk and is not able to identify, measure, monitor, and control that risk, the OCC will require the bank to take corrective action. The OCC will use its standard procedures for ensuring that the bank takes the action necessary to address issues of safety and soundness. Those procedures range from securing voluntary board commitments assuring corrective action to issuing cease-and-desist orders or entering into other formal actions.

Q.: What are the primary products/activities that the OCC is concerned about with respect to interest rate risk?

HARRIS: The OCC believes that many national banks have risk management systems that adequately capture short-term earnings exposures. Hence, our primary concern is with products or activities that cannot be effectively measured using short-term analysis. Generally, these are products with embedded options risk (e.g. credit cards, real estate mortgage products, structured notes, etc.) and activities that result in significant long-term repricing mismatches (e.g. funding a portfolio of 30-year fixed-rate mortgages with 18-month certificates of deposit).

Q.: How will the OCC decide which banks will need to assess interest rate risk from an economic perspective?

HARRIS: The OCC will evaluate significance of interest rate exposures using criteria such as: capital, liquidity, asset and liability mix, earnings, and management's ability. Examiners will determine which banks need systems that identify and measure risk from medium- and long-term positions on a case-by-case basis.

The OCC believes that banks with significant interest rate exposure should adopt value-at-risk measurements (i.e., measures of the potential decline in economic value of equity as a result of movements in interest rates) to complement earnings-at-risk measurements. With few exceptions, the complexity of on- and off-balance sheet activities at larger national banks supports their need for an interest rate measurement system that adequately captures these exposures. The OCC encourages smaller banks to assess their medium- and long-term structural imbalances. If the board and senior management believe that the level of exposure to changes in longer- term rates is significant, the board should adopt a measurement system that can quantify that exposure.

Whether a smaller bank needs a system that measures the impact of longer-term positions from an economic perspective depends on the bank's balance sheet structure and exposure to products with options risk. For example, a bank with more than 25% of total assets in long-term, fixed-rate securities (five years or more) and comparatively little in nonmaturity deposits and/or long-term funding is likely to need to measure the longer- term impact to the economic value of equity. Conversely, a bank principally invested in short-term securities and working capital loans, funded by short-term deposits, probably would not.

During the normal supervisory process, in conjunction with their overall assessment of interest rate risk management, OCC bank examiners will evaluate the adequacy of interest rate risk measurement systems.

Q.: For banks with significant medium- and long-term exposures, does the advisory letter require an economic value of equity (EVE) calculation?

HARRIS: No. Banks can measure the volatility of longer-term interest rate risk exposure using a variety of methods. For example, a bank which has large exposures to medium-term interest rate risk may elect to expand the earnings-at-risk analysis beyond the traditional one-to-two-year time period, to capture longer-term mismatches.

Alternatively, a bank may control exposure to longer-term mismatches by limiting interest rate risk positions to products or portfolios with certain repricing characteristics. Such limits are usually developed based on analysis of the volatility of the instruments in question under various scenarios.

The results of such analyses can be used to estimate the potential impact on capital due to earnings changes analyzed over a longer time period. Gap reports that reflect a variety of rate scenarios may also be used to measure longer-term interest rate risk exposure.

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