The FDIC’s Division of Risk Management Supervision’s Winter 2013 issue of Supervisory Insights includes an article (the “Article”) that discusses how the banking industry’s asset mix and funding profile have shifted during the recent five-year period of historically low interest rates and how this shift has resulted in increased interest rate risk (“IRR”) exposure for many banks. The FDIC notes that the concerns center on lengthened asset maturities and a potentially more rate-sensitive mix of liabilities. The Article also provides a discussion of supervisory expectations as to how banks should address IRR management and the FDIC suggests certain IRR management strategies that can be used by banks to assess and mitigate their respective IRR exposure. In the Article, the FDIC identifies certain common pitfalls in IRR management that have been identified by FDIC examiners:
- The Board and senior management do not regularly review or approve policies, procedures, risk limits, or strategies.
- Risk limits are not defined or not appropriate for risk tolerance of the institution.
- Policies and procedures do not specify oversight responsibilities for measuring, monitoring, or controlling IRR.
- Assumptions are not regularly updated or are not reasonable for a given interest rate shock scenario (e.g., specified asset prepayments or non-maturity deposit price sensitivity and decay rates) or do not take into account specific characteristics of certain assets and liabilities (e.g., influence of loan floors and caps on rate exposure).
- Stress tests do not incorporate significant rate shocks (for example, 300- and 400-basis point shocks) and other severe but plausible scenarios specific to the particular risks of the bank. Results of stress tests are not compared to internal risk limits.
- Models used to measure and manage IRR are not adequate given the complexity of the institution’s balance sheet (i.e., the model cannot accurately measure embedded options).
- An imbalance in the duration of assets and liabilities presents a marked exposure to changes in interest rates.
- The potential exists for significant securities portfolio depreciation in relation to capital in the event of a significant increase in interest rates.