Pub. 5 2016 Issue 6

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 14 A DECLARATION OF INDEPENDENCE FOR IRR REVIEW By Lester F. Murray, Associate Partner, The Baker Group LP T HERE’S BEEN SOME confusion (and perhaps misinformation) among many community bankers about the best way to achieve the appropriate degree of independence when reviews of interest rate risk systems and practices are performed. It has been the perception of many that to satisfy regulatory requirements, independence must be outsourced. While hiring an outside entity to perform such an exercise is certainly an option, it is not mandatory. Part of the puzzlement may be because third-party involvement is necessary to satisfy the regulatory decree of interest rate risk (IRR) software validation. The third party providing that proof of software integrity is generally the model's vendor. If not provided as a matter of course, an independent review should be easily attainable. Validating Is Not the Same as Reviewing As the authorities are quick to remind us, a vendor’s authentication of a computer model’s conceptual soundness and mathematical accuracy is a whole different kettle of fish than what they have in mind for an acceptably thorough and independent review of a community bank’s IRR processes. The utilization of an Asset/Liability Management (ALM) model is only part of those processes. Having a letter on file attesting to a model’s accuracy is part of a review, but it’s just the tip of the iceberg when it comes to a community bank’s IRR processes. Those processes include everything from director oversight to assumptions development to data verification to internal controls and more. And unlike model validation, an independent review does not require a third party—just independence. As previously mentioned, that independence can be had, at a price, by hiring a qualified outsider to conduct an independent review, but most banks probably have a qualified insider they’re already paying. The trick is to make sure the qualified insider has unqualified independence. Separation of Powers To display a sufficient degree of independence, the qualified employee should neither be directly involved in the ALM risk measurement process nor be supervised by personnel responsible for IRR oversight. And while regulators appreciate that there is no one “right” way to perform an independent review, they have been pretty specific about what needs to be reviewed. One need only refer to the Joint Agency Policy Statement on Interest Rate Risk (1996) to discover the “Five Elements” that represent the essence of what a review should include. The afore-mentioned model validation is one of them. The other four general areas of review address the adequacy of internal controls, the appropriateness of a bank’s risk measurement systems and/or modeling capabilities, the accuracy of data inputs including assumptions, and the reasonableness and validity of risk scenarios. The intricacy and depth of these reviews depend to a large degree on the size and complexity of the institution, and, for that reason, can vary significantly from one bank to the next. What shouldn’t vary from bank to bank is what the board of directors does with the findings. The need for the review process to take place in the first place is really to answer these two questions: 1. Does the process function within policy guidelines and prudent standards? 2. Does the risk measurement system reasonably estimate risk exposure to earnings and capital based on reasonable and well-supported assumptions? Sounds simple, right? Well, we all know performing an independent review is not quite as simple as it sounds, but it may not be as hard as what some might think either. Bankers and regulators alike want to be confident that the information management and directors use, as part of their decision-making process, is accurate and reliable. An independent review helps to assure that is the case. So, regardless of who does it, declare someone’s independence and get it done! Lester F. Murray, Associate Partner of The Baker Group LP, came to the Baker Group in 1986 following his work with the OCC as an assistant National Bank Examiner. His focus is on devel- oping community bank portfolio and interest rate risk management strategies. Contact: 800-937- 2257, lester@GoBaker.com .