Pub. 2 2013 Issue 8

November 2013 29 l e a d i n g a d v o c a t e f o r t h e b a n k i n g i n d u s t r y i n k a n s a s B ANK REGULATORS HAVE AGAIN MADE clear their intention to highlight interest rate risk management as a point of focus. The FDIC issued a new Financial Institution Letter (FIL) on October 8 entitled “Managing Sensitivity to Market Risk in a Challenging Rate Environment.” Their concern, of course, is that many banks are not adequately prepared for, or equipped to manage, the risks to earnings and capital that would accompany a sustained rising rate environment. This FIL follows several other advisories and joint statements from the FFIEC regarding interest rate risk and liquidity risk management. In the letter, FDIC points to their concerns about recent trends in bank balance sheets. For example, there has been a notable increase in long-term assets funded by liabilities that may be more rate sensitive than commonly thought. The FIL notes that… “For a number of FDIC-supervised institutions, the potential exists for material securities depreciation relative to capital in a rising interest rate environment,” …and… “Moreover, rate sensitive liabilities may re-price faster than earning assets as coupons on variable rate loans and investments remain below their floor.” Among other things, banks are reminded of the importance of having a sufficiently detailed reporting system to keep management and directors informed of interest rate risk exposures. Banks should have access to simulation models that produce stress tests on the overall balance sheet and particularly on high duration assets. Repricing assumptions for liabilities should be stressed as well. The FIL outlined four specific points: • Board and Management Oversight – Directors are charged with the responsibility of policy development, and should have a clear understanding of the interest rate risk management processes in place at their bank. Management is expected to provide the reporting tools and other resources necessary to carry out policy. • Policy Framework and Prudent Exposure Limits – Boards of directors should “formalize” risk philosophy with sound policies and exposure limits that give management guidance on appropriate risk management strategy. • Effective Measurement and Monitoring of Interest Rate Risk – Management should utilize a variety of tools and techniques for assessing risk exposures. These should include earnings simulations, stress tests, and EVE analysis among others. • Risk Mitigation Strategies – Use of hedging off-balance- sheet derivatives are only appropriate for institutions that have the knowledge, expertise, and resources to understand and manage the potential risks and unintended consequences. Interest rate risk has been a priority for regulatory agencies for several years now. Much has changed with respect to examiner expectations of bank management teams and directors. Since the end of 2009, banks are required to build a more thorough ALCO process within a sound risk management framework. The release of this FIL is a helpful reminder that interest rate risk remains a top-of-mind issue as we move forward. Since 1979, we’ve helped our clients improve decision-making, manage interest rate risk, and maximize investment portfolio performance. Our proven approach of total resource integration utilizing software and products devel- oped by Baker’s Software Solutions* — combined with our solid investment experience and advice — makes us the investment firm of choice for many community financial institutions. For more information, contact Jeff Caughron at The Baker Group: 800-937-2257, www.GoBaker.com, or email: jcaughron@ GoBaker.com.*The Baker Group LP is the sole authorized distributor for the products and services developed and provided by The Baker Group Software Solutions, Inc. MANAGING SENSITIVITY TO MARKET RISK FDIC AMPLIFIES THE IMPORTANCE OF INTEREST RATE RISK MANAGEMENT By Jeffrey F. Caughron Associate Partner The Baker Group LP