Why so sensitive? Just as failure to keep a grip on your emotional sensitivity can lead to interpersonal problems, experienced community bank executives know that failure to manage their bank's sensitivity to interest rate risk can cause financial troubles.
Uncle Sam (e.g., the Federal Deposit Insurance Corp.) is justifiably concerned about the effect that rising interest rates and rate volatility will have on community banks. The regulator is reminding us about the importance of managing interest rate risk in this new era of expected rising and volatile rates.
In its Oct. 8 letter "Managing Sensitivity to Market Risk in a Challenging Interest Rate Environment," the FDIC re-emphasizes the importance of bank interest rate risk oversight and risk management processes to ensure that community banks with less than $1 billion in assets are prepared for volatility and rising interest rates.
In the letter, the FDIC cites recent macroeconomic evidence that reinforces the importance of carefully managing banks' interest rate risk sensitivity. Namely, more banks are reporting liability-sensitive balance sheets, which could reduce their net interest income and earnings. Such banks could get double-whammied by resulting reductions in net interest income and simultaneous deposit runoff. And rate-sensitive liabilities may reprice faster than variable-rate loans.
So, the FDIC is concerned and accordingly, encourages both community bank boards and management to monitor balance sheet (and off-balance-sheet) exposure to interest rate risk and volatility and take action to reduce risk, if the situation requires it.
If interest rates spike, the FDIC reasons, long bonds could depreciate significantlyparticularly relative to capitaland banks holding them may not be able to meet short-term cash needs if other marketable assets are not available to liquidate. And even though unrealized losses on such bonds do not move to capital (if the bank in question chooses the Basel III opt-out provision), FDIC examiners nonetheless look at these unrealized losses when determining a bank's capital adequacy and liquidity. Furthermore, these unrealized losses can act to reduce equity capital under generally accepted accounting principles.
So, the FDIC suggests the following general steps for a community bank's comprehensive asset-liability and interest rate risk management process:
- Board and management oversight of the asset/liability process. Boards should always be aware of their bank's interest rate exposure and understand how it can affect earnings and capital so they can take action if required. The FDIC reminds us that its safety and soundness standards require state-chartered nonmember banks to manage their interest rate risk appropriately and provide periodic reports to the banks' board of directors that enable the board to assess the risk.
- Policies and exposure limits. The FDIC suggests reviewing your community bank's asset/liability and investment policies "at least annually" to ensure authority, risk tolerance and exposure limits are prudent. Policies should include risk philosophy and provisions that protect capital from too much risk. Although the FDIC does not mention this in the letter, it is also wise to not expand the policies too much (or expand any other bank policies, including Human Resources policies) because regulators and other government agents (e.g., the Equal Employment Opportunity Commission) will generally require bank adherence to all policy provisions, whether the provisions are legally required or not. So, if you put it in the policy, be prepared to adhere to it regardless of its increased administrative burden.
- Effective IRR measuring and monitoring. Community banks should use a variety of modeling techniques to measure interest rate risk. Examples include gap analyses, earnings simulations, economic value of equity estimates and stress tests. They recommend a holistic approach in addition to 300- and 400-basis-point rate shocks to determine the result on earnings and capital.
- Risk mitigation. Finally, the FDIC reminds us that community banks have a number of techniques at their disposal to mitigate interest rate risk, including rebalancing earning asset and liability durations, proactively managing nonmaturity deposits, increasing capital (which may be easier said than done) and hedging (which we believe can be complicated, require much attention and potentially unsuccessful in mitigating interest rate risk).
The FDIC wraps us the letter by reminding us that "effectively managing interest rate risk is part of the business of banking" and that too much interest rate or market risk can lead to bank losses and lack of liquidity when rates change significantly. They conclude by writing of their intent to continue reviewing bank interest rate risk in the normal course of their business and offer feedback. This letter is a worthwhile read for any community banker.
As the French philosopher Blaise Pascal wrote, "The sensitivity of men to small matters, and their indifference to great ones, indicates a strange inversion." So don't be so sensitive already!
David G. Barnes is chairman, president and CEO of Heber Fuger Wendin Inc., an institutional investment advisory firm in Bloomfield Hills, Mich. He can be reached at firstname.lastname@example.org.