Interagency IRR Advisory Bulletin: Implications and Opportunities for Balancing Risk and Return

“Virtue is more to be feared than vice, because its excesses are not subject to the regulation of conscience.” Adam Smith

On January 6, 2010, an interagency advisory concerning management of interest rate risk was promulgated by the joint federal bank, thrift, and credit union regulatory entities. While we can acknowledge that many financial institutions have benefited from the “carry trade” accorded by the historically steep yield curve, those institutions are also aware that their returns come at a potential price, specifically, interest rate risk. That is the risk of funding long-term assets with variable-rate liabilities in a rising rate environment. Things would be all the more precarious in the event of a rapid rate rise. Sound familiar? The last time such a directive occurred was just prior to the Thrift Crisis of the 1980s; those who suggest that “credit risk kills and interest rate risk only injures” may have short memories!

In the advisory, the joint agencies suggested two courses of action, which are not necessarily mutually exclusive. First, taking specific measures to reduce interest rate risk and, second, increasing capital levels to cushion this potential source of risk. In this article, we make a few observations on the first approach: mitigating interest rate risk. We also encourage those members looking to the capital-raising angle to tune into the Seattle Bank Web seminar, “The Capital Dilemma: Resources and Alternatives,” on February 18.

Interagency Hot Buttons
In directing institutions to take specific measures to reduce interest rate risk, the agencies suggested employing such tactics and tools as: appropriate risk measuring and monitoring tools, interest rate stress testing, interest rate risk policies, and governance. Once effective measurement mechanisms are in place, it becomes important to recalibrate the balance sheet if short-term funding is too out-of-synch with longer-term assets. If funding and assets are too misaligned and an institution is unduly exposed to rising rates and is subject to additional asset sensitivity, a number of measures may be considered. These measures could include extending funding duration via longer-term borrowings or deposits, shortening asset maturities by purchasing shorter-term investments, or booking variable-rate, rather than fixed-rate loans. Pricing decisions on various loan and deposit products might also encourage the appropriate calibration of the balance sheet. For instance, if an institution wanted to increase asset sensitivity, it could price its longer-term deposits and loans with variable-rate features more aggressively.

Risk Measuring and Managing Tools
Institutions with well-developed interest rate risk measuring and monitoring tools go beyond the world of static analysis. It’s one thing to know your current risk position; it’s an entirely different thing to know your position at several points in the future, given prospective economic, rate, and yield curve scenarios. It’s best to develop a granular base model of a balance sheet, complete with the unique characteristics of each investment, loan, deposit, and funding bucket. There are multiple places on a balance sheet where options exist, ranging from loan pricing floors to deposit “bump” features. Such an analysis goes well beyond the world of asset/liability “gap” analysis and requires more detailed simulation that includes multi-year time horizons. The impact of interest rate changes is generally best measured against both the resulting key operating metrics such as earnings, as well as the resulting economic value of capital (also known as “economic value of equity”, “net economic value,” or “net portfolio value”). Irrespective of terminology, the regulatory community will likely continue to draw a closer connection between an institution’s economic value at risk due to potential rate changes, and minimum required capital ratios.

The regulatory community further underscored the importance of interest rate risk model validation. For larger institutions and those that conduct internal interest rate risk modeling, enhanced validation procedures could include “second opinion” modeling, assumption back-testing, or external auditing. The advisory further suggests that smaller institutions and those using vendor-supplied models are not required to test the underlying models. However, they are encouraged to document that “a credible third party has performed such a function.”

Projecting Stress Scenarios for Interest Rate Risk
Compared with the landscape of five years ago, there is a far more robust set of software tools and outside resources available to enhance the ability to measure and monitor an interest rate risk position. Now, it is much easier to run scenarios that incorporate static as well as dynamic shocks, pricing changes, leverage, and funding alternatives. Still, there is no substitute for human judgment as a basis for regularly reviewing whether model assumptions are appropriate. For instance, during the recent credit debacle, many institutions were surprised to see their actual interest rate risk increase beyond projected levels as rates declined. Why? Many models assumed that in the real world, interest rate floors that were embedded in their loan portfolios were not negotiable. In actuality, as many of us know, as credits deteriorated and the workout process evolved, many loan floors were negotiated away.

The interagency directive mentions something that many institutions have been aware of for some time: interest rate scenarios can no longer simply incorporate 200-basis-point, instantaneous parallel shifts in the yield curve. Appropriate scenarios include large rate shocks, graduated rate movements, varying yield curve scenarios, and asymmetrical yield curve shifts. Scenarios should also include changes in basis risk. For instance, if the bulk of an institution’s variable-rate loans are based on the Prime rate and they are being funded by LIBOR-based advances, potential changes in the spread between the two measurements should be monitored and hedged if necessary. Further, the directive advises incorporation of the unique embedded options that are present on every institution’s balance sheet. Even the simplest balance sheets have options (e.g., pre-payable mortgages or deposits with conversion features).

In addition to projected various interest rate and yield curve scenarios, an important component of proper interest rate risk assessment concerns assumed levels of asset prepayments, price sensitivity of non-maturity deposits, and other key variables. For instance, it might be wise to run scenarios that incorporate the impact of deposit decay in a stressed credit environment or one that assumes the elimination or new presence of a competitor in one’s market area.

Developing Policies and Keeping them in Alignment
While it’s good to know how your operating results and economic value of equity might fare in a variety of rate scenarios, it’s important to build a speedometer (or more appropriately, a stall indicator!) and have contingent measures in place should you find yourself going below acceptable policy limits. Pre-specified risk tolerance limits and an accompanying assessment of an interest rate risk profile should be regularly communicated to an institution’s ALCO or senior management team. Interestingly, the interagency directive encourages these groups to have “sufficiently broad representation across major functions.” This might be important, for example, from the perspective of a chief loan officer regularly apprising an ALCO group of any changes in loan demand or credit conditions that could prompt a change in prepayment or other balance sheet assumptions going forward.

Once measurement mechanisms are in place, the advisory mentions the need for taking appropriate actions to control a breach (even a prospective breach) of interest rate risk tolerance levels. These actions would include “balance sheet alteration and hedging.” Here, a variety of alternatives, depending on individual institution’s suitability, exist.

Let’s consider the case of a liability-sensitive institution that in today’s low rate environment might be understandably concerned about the impact of rising rates on earnings and capital. In an effort to increase asset sensitivity (via lengthening liability durations and shortening asset durations), one effective step might be a simple, gradual approach that involves becoming less price-competitive on long-term mortgage originations and more price-competitive on variable-rate loan originations. Similarly, this organization might choose to de-emphasize short-term CDs in favor of longer-term CDs. Or, they may wish to develop a program with the Federal Home Loan Bank to extend funding durations.

Taking the alignment process a step further, external derivate instruments could be appropriate tools, but only in instances involving suitable use and board and senior management understanding of the structures involved. Again, referring to the example of a liability-sensitive institution, one mechanism to consider would be a Capped Floating Rate Advance—a tool that could offer continued funding at the lowest point on the yield curve and, concurrently, offer protection in the event rates were to rise from their historic lows. Mechanically, a Capped Floating Rate Advance functions like an advance with a known spread over an index, most likely 3-month LIBOR, with the rate of the index capped at a pre-defined level. The floating rate advance contains an interest rate cap as a contractual feature and protects against increases in short-term interest rates by paying the holder when an underlying interest rate (i.e., the reference rate) exceeds a specified strike rate. Interest rate caps are frequently purchased by institutions that are funding with floating rates and wish to protect themselves from the increased financing costs associated with an increase in interest rates. By embedding these options in an advance or other source of funding, caps (or depending upon the circumstances, floors) can help manage interest-rate risk, fund loans in portfolio, and meet asset/liability objectives. With the interagency advisory also broaching basis risk, there are external measures that can be taken to bring policy back into alignment. Many loans are still originated using the Prime index for setting adjustable-rate loans. Still, most of these loans are inherently mismatched between the asset and the funding on the portfolio. As an example, this misalignment can be repaired via an adjustable rate advance program that is indexed to Prime. While an institution doesn’t necessarily need to match every Prime loan with Prime funding, the addition of some funding that is indexed to Prime is a good way to reduce portfolio basis risk.

Watching the Doughnut, Not the Hole
It’s good to convene an ALCO meeting and review interest-rate-risk projections, but it’s best to also step back and look at the big picture. For instance, a healthy ALCO discussion could include life after today’s low-interest, risk-averse environment―a period that has probably fostered an increase in transactional deposits. If rates increase, these deposits may decline as depositors look for alternative investments with higher relative yields. As a result, deposit balances could markedly shift from transactional to certificates of deposit. Transactional accounts, many of which are thought to have longer durations, tend to create asset sensitivity. If in the future they were to comprise a smaller portion of the funding base, the asset sensitivity that you counted on today might not be there tomorrow. To compensate for this possibility, you might want to look at the aforementioned realignment strategies in much the same manner as insurance. Just remember that the cost of interest rate risk insurance is always higher with a pre-existing condition. Moreover, insurance premiums aimed at protecting operating income and economic value of equity have a cost in the form of diminished short-term reported margins. Still, notwithstanding the new interagency advisory, it’s better to know that you have a pre-existing condition now, rather than finding out about it later! The downside could be a regulatory order to either reduce interest rate risk exposure, increase expertise and measurement tools, or raise additional capital to counteract undesirable levels of interest rate risk.