OCC 95-28 Subject: Interest Rate Risk Management Description: Questions and Answers To: Chief Executive Officers of National Banks, General Managers of Federal Branches and Agencies, Deputy Comptrollers, Department and Division Heads, and Examining Personnel On February 8, 1995, the Office of the Comptroller of the Currency (OCC) issued Advisory Letter 95-1 to provide guidance on interest rate risk management. Since that time, the OCC has received numerous questions about that guidance. The attached document answers the most frequently asked questions and provides greater detail on the guidance in Advisory Letter 95-1. For additional information, please contact the Senior Deputy Comptroller for Capital Markets' staff at (202) 874-5670 or the Office of the Chief National Bank Examiner at (202) 874-5070. Douglas E. Harris Senior Deputy Comptroller for Capital Markets Attachment Date: June 20, 1995 Questions and Answers For Advisory Letter 95-1: Interest Rate Risk BACKGROUND 1. Why did the Office of the Comptroller of the Currency (OCC) issue Advisory Letter 95-1 (AL 95-1)? The OCC issued AL 95-1 to help bankers understand what the OCC expects in interest rate risk management systems. AL 95-1 does not contain new policy statements, but rather reiterates OCC expectations about the prudent control of interest rate risk. AL 95-1 was designed to remind bankers that effective interest rate risk management includes risk identification, measurement, monitoring, and control. 2. How does the OCC define interest rate risk? The OCC defines interest rate risk as, "the risk to earnings or capital arising from the movement of interest rates." In this definition, earnings refers to accrual or reported earnings on financial statements. Capital refers to the economic value of equity (i.e., the present value of expected cash flows to be received from assets minus the present value of expected cash flows to be paid to liabilities, adjusted by the present value of expected cash flows of off-balance sheet instruments). The OCC has identified four primary ways that interest rate risk arises: Repricing risk results from differences between the timing of rate changes and the timing of cash flows. The contractual repricing of an asset, liability, or off-balance sheet product is the critical consideration when evaluating repricing risk. For example, if a 3-year fixed-rate certificate of deposit is used to fund a 3-year corporate loan with interest rate resets every 90 days, the bank is exposed to repricing risk every 90 days. Basis risk arises from changing rate relationships between yield curves and markets. For example, a one-year loan, priced at prime plus a spread, may be funded by a one-year CD priced at LIBOR plus a spread. Although both the asset and liability have adjustable rates of interest and thus may reprice at the same time, the spread between prime and LIBOR may change, which would cause the earnings from this position to change. The potential exposure arising from this spread changing is referred to as basis risk. Options risk arises when a bank customer has the right, but not the obligation, to alter the level and/or timing of the cash flows of an asset, liability, or off-balance sheet instrument. Such options often result in an asymmetrical risk/reward profile for the bank. Generally, customers exercise embedded options (as opposed to explicit options which are purchased and sold as distinct products) for their advantage, when it is disadvantageous to the bank. For example, bank customers with fixed-rate real estate mortgages typically exercise their options to prepay when rates are falling. Therefore, the bank loses fixed-rate assets which have to be replaced in a lower rate environment. Yield curve risk results from changing rate relationships across the spectrum of maturities. For example, consider a structured note that reprices every quarter, but pays a formulaic rate based on the spread between 5-year U.S. Treasury bonds and 3-month Treasury bills. If the slope of the U.S. Treasury yield curve changes, the earnings stream and value of this structured note will change. 3. Is interest rate risk the most significant risk facing banks today? Because the primary business of banking is lending money, credit risk traditionally has been, and continues to be, considered the most significant risk. However, changes in the structure of bank balance sheets and the use of more complex on- and off-balance sheet products to manage interest rate exposures has increased the importance of interest rate risk. 4. Why is the OCC concerned about interest rate risk? The OCC is concerned about interest rate risk because bank products and activities are changing and interest rates are increasingly volatile. Bank products and activities have changed in four major ways that impact the effects of interest rate risk exposures. First, commercial banks now hold more long-term (i.e., 5-years or more) products with embedded options (mostly residential real estate products) than ever before and the options features on some of those products can be very difficult to measure and control. Second, transactional interest rate risk measurement tools, such as gap reports, typically do not capture the interest rate risk arising from options exposure. Third, the use of off-balance sheet derivatives to manage interest rate risk positions has increased dramatically in the last 10 years and some derivatives can complicate interest rate risk measurement because their cash flows are less certain than those of traditional bank products. Fourth, nonbank competition and below market pricing have constrained the growth of non-maturity deposits (i.e., accounts from which a customer can withdraw funds at any time, such as demand deposit accounts (DDA), negotiable order of withdrawal (NOW) accounts, money market deposit accounts (MMDA), and savings accounts) in the commercial bank system. Because non- maturity deposits are less sensitive and more stable sources of funds, when a bank relies on other sources of funding to match asset growth, it may increase its interest rate risk. In 1994, interest rates rose by more than 200 basis points across the entire maturity spectrum. More recently, yield curve relationships have shifted dramatically as long-term rates have fallen and short-term rates have remained fairly constant. While the rate movements of late are not unprecedented, the recent volatility of rates has heightened the need for bankers to have the ability to identify, measure, monitor, and control their risk exposures. 5. Is the OCC's concern about interest rate risk focused mostly on big banks or small banks? The OCC's concern about interest rate risk is not limited to any particular size or group of banks. Interest rate risk is inherent in a bank's role as a financial intermediary and, therefore, affects all banks. We expect all national banks to comply with the guidance set forth in AL 95-1. However, some risk profiles can make a bank more vulnerable to a decline in earnings or the value of its capital because of interest rate risk exposure. For example, a bank with long-term fixed-rate assets funded by MMDA may not have a meaningful amount of short-term interest rate risk exposure because MMDA rate increases typically lag market rate increases. If interest rates increase over the next 12 months, MMDA rates may not increase (or may increase at a slower rate) and the net interest margin for a bank with that profile will not be materially affected. If such a bank, at some point, is forced to raise MMDA rates or replace lost deposits with market rate products (e.g., certificates of deposit, fed funds purchased, etc.), its net interest margin will begin to decline. The cost of funding below-par assets (e.g., fixed-rate loans that are valued at a discount to par because their coupon payments are below current market rates) with par liabilities will erode the economic value of equity. A bank with short-term (i.e., 2-years and under) assets funded by long-term liabilities will be similarly exposed to a falling rate environment. Banks with high interest rate exposure are not all the same. Some banks are very small and others quite large. Through analysis of call report data, the OCC has developed filters to identify banks that may have significant structural imbalances. It is critical to understand that although such a "snap shot" view of the balance sheets may suggest that earnings and/or capital may be jeopardized by long-term interest rates changes, many other factors affect interest rate risk. For example, stable low-cost core deposit accounts and/or well designed off- balance sheet hedges may mitigate high interest rate risk. The OCC will review and update filters as better information becomes available. 6. In view of the OCC's concern about interest rate risk, will the agency conduct targeted examinations of interest rate risk? AL 95-1 did not change supervisory strategies or bank examinations. When the OCC issued AL 95-1, we instructed our bank examiners to consider the risk profiles of their assigned banks and to ensure that supervisory strategies were appropriate for the level and complexity of interest rate risk. When a bank's circumstances had changed, or the current strategy was otherwise inappropriate, examiners were directed to follow standard OCC policy for adjusting strategies. The OCC does not plan the widespread implementation of targeted interest rate risk examinations, outside of normal supervisory activities. Rather, as we identify banks that exhibit a potential for significant interest rate risk exposure, our bank examiners will adjust the strategy for supervising the bank accordingly. 7. When are the standards of AL 95-1 effective and what does the OCC expect bankers to do to demonstrate compliance with this policy guidance? The standards in AL 95-1 became effective when it was issued on February 8, 1995. The OCC expects the senior managers and board members of national banks to consider whether or not their existing interest rate risk management process adequately identifies, measures, monitors, and controls interest rate risk. This exercise does not need to involve a special study, but rather it should become an integral part of board and senior management oversight. When management or the board identifies weaknesses in the risk management process, management should consider alternatives and take steps to strengthen that process. As noted in AL 95-1, the OCC expects a bank's risk management systems to be commensurate with the level and complexity of its risk profile. 8. What are the implications of non-compliance with the standards set forth in AL 95-1? AL 95-1 is designed to help bankers develop a risk management framework that provides for prudent risk-taking. As noted in AL 95-1, the OCC believes that "an effective interest rate risk management process is an essential component of safe and sound banking practices." If the OCC identifies a situation in which a bank has taken a material amount of interest rate risk and is not able to identify, measure, monitor, and control that risk, the OCC will require the bank to take corrective action. The OCC will use its standard procedures for ensuring that the bank takes the action necessary to address issues of safety and soundness. Those procedures range from securing voluntary board commitments assuring corrective action to issuing cease and desist orders or entering into other formal actions. RISK IDENTIFICATION 9. What are the primary products/activities that the OCC is concerned about with respect to interest rate risk? The OCC wants to ensure that national banks have risk management systems that can identify, measure, monitor, and control their major sources of interest rate risk on a timely and comprehensive basis. The OCC believes that many national banks have risk management systems that adequately capture short-term earnings exposures. Hence, our primary concern is with products or activities that cannot be effectively measured using short-term analysis. Generally, these are products with embedded options risk (e.g. credit cards, real estate mortgage products, structured notes, etc.) and activities that result in significant long-term repricing mismatches (e.g. funding a portfolio of 30-year, fixed-rate mortgages with 18-month certificates of deposit). 10. Is the OCC discouraging banks from traditional bank products such as consumer non-maturity deposits or residential real estate mortgages? Absolutely not. Non-maturity deposits and residential mortgages are fundamental financial products offered by many national banks to their retail customers. The OCC is simply emphasizing the importance of a bank having effective risk management systems that are commensurate with the level and complexity of risk it is assuming. In the case of options risk, some national banks may not have implemented an adequate risk identification process. Bank customers owning embedded options associated with non-maturity deposits (i.e., withdrawable) and residential mortgages (i.e., prepayable) are influenced by changes in interest rates as well as other factors. As a result, exercise of these options can be difficult to predict and, therefore, cash flows can be difficult to project. The OCC expects national banks to conduct their own assessment of the significance and sensitivity of these products in various rate environments. Such assessments should also be incorporated into the decision-making process for risk measurement, monitoring, and control. 11. Many banks claim that non-maturity deposits are a natural hedge for investment portfolio depreciation in a rising rate environment. Does the OCC agree, and what factors does the OCC believe a bank should consider when analyzing these products? The OCC believes that "appreciation" in the value of non-maturity deposits can be a natural offset to depreciation of fixed-rate assets in a rising rate environment. Historically, in rising rate environments, banks have been able to delay rate increases paid on non-maturity deposit accounts. That lagging of rate increases may allow a bank to constrain the cost of non-maturity deposits and cause them to depreciate more significantly than the fixed-rate assets they are funding. If the bank can do this without significant runoff, the higher depreciation in liabilities can be used to offset declines in, or even increase, the economic value of equity. The concept of off-setting fixed- asset depreciation with greater depreciation in the non-maturity deposit base is frequently referred to as deposit appreciation. Bank management should understand the option features embedded in non-maturity deposits. Because such deposits do not have contractual maturities, the depositor usually has the right to withdraw funds without delay or penalty. On the other hand, they also typically are not subject to contractual interest rate agreements, which allows the bank to change rates. Non-maturity deposit repricing can be affected by a number of factors other than interest rates, including competition, geographic location, demographic characteristics of the depositor base, etc. The relative value of non-maturity deposits varies from bank to bank and also within each bank when measured over time. The OCC expects banks to consider all of these factors when assessing how much of a "natural" balance sheet hedge such products provide. Bank management should consider the historical performance of these deposits and how increased competition and changing demographics may affect future performance. 12. The increase in interest rates in 1994 led to the depreciation of securities held by many banks for investment purposes. Some analysts have said that if such depreciation were recognized in bank capital, several banks would have been insolvent. Is this true? No. Saying a bank is insolvent because depreciation in its securities portfolio exceeds its capital is simply incorrect. Solvency is a function of the value of all of the bank's assets, liabilities, and off-balance sheet contracts. Focusing on depreciation in only one group of assets, therefore, gives an incomplete picture of a bank. Analysts can readily determine appreciation or deprecation of securities holdings because banks report the market value of those assets. However, it is much more difficult for them to accurately assess the economic values of all bank assets, liabilities, and off-balance sheet instruments -- particularly those that are not regularly bought and sold in the markets. Market value disclosures show that the rise in interest rates in 1994 reduced the value of securities portfolios. The deposit appreciation (particularly non-maturity deposits) in the banking system, however, is not so readily seen and unfortunately has received less attention. The increased value of non-maturity deposits has been validated in market-based transactions when banks have had to pay larger premiums to acquire deposits from other depository institutions (i.e., paid amounts in excess of the book values of deposits) than they did when market rates were lower. Analysts who fail to consider the economic values of non- maturity deposits (and other assets or liabilities), rather than book values, ignore material information and are likely to reach erroneous conclusions. Finally, it is important to note that the replacement cost, liquidation value, and the on-going fair value of less liquid financial instruments are generally different from each other. As a result, a bank can be viewed as solvent according to the on-going fair values of its assets, liabilities, and off-balance sheet instruments, but could become insolvent if it is forced to recognize low liquidation values ("fire sale" prices) for its assets, or if it must replace liabilities (locate new funding sources) at excessive costs. 13. Many of the banks that experienced significant investment portfolio depreciation in 1994 have recently seen their bank portfolio values move back toward cost as a result of rate changes in early 1995. Assuming that these banks hold a large number of securities in their held-to-maturity (HTM) portfolios, can they use this market rally to shift a portion, or all, of the HTM securities to available-for-sale (AFS), in an effort to provide more flexibility in portfolio management? Transfers of investment portfolio securities from HTM to AFS should be rare. They are permitted only in certain circumstances (e.g., credit risk, sale of a security 90 days before maturity, change in regulations, etc.). Further, if a bank transfers only a portion of its portfolio to AFS, regulators might question management's intention with respect to the remaining HTM securities. If, however, a bank transferred its entire HTM portfolio to AFS, it would experience gain or loss as a separate component of equity capital. Such a strategy could increase management's flexibility to use the securities portfolio as a risk management tool. Any bank contemplating a transfer on HTM securities to AFS should first obtain an accounting opinion from a qualified independent accountant. 14. How do derivatives factor into the OCC's concern about interest rate risk? Derivatives can be either a solution to excessive interest rate risk exposure or the cause of undesirable earnings and capital volatility when interest rates change. In Banking Circular 277, the OCC encouraged national banks to use derivatives to efficiently reduce undesirable exposures to interest rate changes. Standard products such as interest rate swaps, futures, forwards, caps, and floors have been used by banks to limit earnings and capital volatility. For example, a bank with fixed-rate loans funded by rate-sensitive CDs that anticipates interest rate increases might choose to buy an interest rate cap to limit the potential negative earnings impact. Clearly, before entering into such a transaction, management should understand the nature of a derivative product being considered and whether and to what extent that product can reduce the bank's interest rate risk exposure. Derivatives also can be a source of interest rate risk for a bank. Embedded derivatives such as mortgage or deposit options can increase a bank's vulnerability to rate changes. Some banks also use both on- and off-balance sheet derivatives to take interest rate risk positions. For example, a bank that believes interest rates are going to fall can enter into a receive fix/pay floating interest rate swap transaction or purchase an inverse floater-type of structured note. Banks may use derivatives for risk management but the OCC expects any bank that does to have systems and controls over those activities commensurate with the level and complexity of risk. RISK MEASUREMENT 15. How can a bank measure/evaluate interest rate risk? Interest rate risk can be evaluated from two different perspectives: the earnings (accounting) perspective and the economic (capital) perspective. The accounting and economic perspectives are complementary and both should be considered when assessing the full scope of a bank's interest rate risk exposure. The earnings perspective considers how interest rate changes will affect a bank's accrual or reported earnings. The impact on earnings is significant because reduced earnings or outright loses can affect liquidity and capital adequacy. Earnings-at-risk (i.e., the potential decline in future reported earnings as a result of movements in interest rates) is generally determined over a 1- to 2-year timeframe under various interest rate scenarios. Measuring earnings-at-risk alone may not be sufficient if a bank has significant medium- (i.e., between 2- and 5-years) or long-term positions, because the earnings-at-risk measurement is usually limited to measuring the impact of rate changes over a short time horizon. The economic perspective considers the value of all bank assets, liabilities, and off-balance sheet instruments. Since this perspective considers the potential impact of interest rate changes on the present value of all future cash flows it is a more comprehensive measure of interest rate risk than the earnings perspective. Such assessments typically include an evaluation of the economic value of equity in the current interest rate environment as well as how that value may change under various interest rate scenarios. An adverse current posture or potential adverse change in a bank's economic value of equity under reasonable scenarios can be an indicator of future earnings and capital problems. For those banks with significant medium- or long-term positions, it is also important to know the current and potential economic value or equity because of the potentially prohibitive cost of selling assets that are depreciated, or accessing new high cost funding sources, to meet liquidity needs. Recently, some banks have found this type of analysis to be very useful in identifying portfolios with either current or potentially significant depreciation. Management at these banks have been able to identify and measure other portfolios that have experience substantial appreciation which wholly or partially mitigates concern. Banks have also found this information has also been useful in explaining risk levels and strategies to internal and external constituents. 16. What does the OCC standard requiring an earnings-at-risk assessment mean? Banks normally compute earnings-at-risk relative to one of the following: net interest income (NII), pre-provision net income (PPNI), net income (NI) or earnings per share (EPS). The choice and propriety of a selection depends on which method best conveys risk levels to appropriate parties. Many banks select NII as a target account because most of their earnings volatility occurs in this account. Such banks typically do not have significant fee income or other non-interest income and expense sensitive to changes in interest rates. Other banks elect to use PPNI, NI or EPS as the target account because they rely on non-interest income and expense items that are sensitive to interest rates (e.g., mortgage servicing, credit card securitizations, etc.). At a minimum, the OCC expects all national banks to understand the impact of interest rate changes on earnings. To ensure that the board and senior management realize the significance of the exposures, a bank that measures interest rate risk relative to NII, should still consider the exposure to PPNI, NI, or EPS. Consider a situation where a bank board of directors approves an earnings-at-risk limit of 5 percent of NII as projected over the next four quarters. This limit appears quite conservative but, depending on the contribution and composition of non-interest income and non-interest expense, the 5 percent of NII limit may translate into a much larger percent of NI. During the regular examination process, OCC bank examiners will review the earnings-at-risk assessment conducted by bank management. If management does not measure or limit bottom-line exposure they should be prepared to justify that decision by demonstrating the insignificance of assessing PPNI, NI, or EPS exposure. 17. When measuring interest rate risk, what rate scenarios does the OCC consider acceptable? A bank should determine what rate scenarios it will use to measure interest rate risk based on factors such as: level of current interest rates, historical and implied volatility of interest rates, the time that bank management would need to take actions to reduce or unwind unfavorable positions, and the maturity and repricing characteristics of its assets, liabilities, and off-balance sheet instruments. Banks should select scenarios that provide meaningful estimates of risk. The forecasts should include sufficiently wide ranges to allow management to understand the risks inherent in the bank's products and activities. In periods of higher rate volatility, management should consider altering the basis point change to reflect the increased likelihood that rates may change by a wider variance. Banks with significant options exposure (explicit and embedded) should include scenarios that capture the potential exercise of such options. Based on historical analysis, the OCC believes that banks should consider, at a minimum, the impact of a 200 basis point interest rate change over a one- year time horizon. 18. What is meant by medium- and long-term interest rate risk positions? Medium- and long-term exposure generally refers to repricing intervals of longer than two years. The volatility of such exposures is often not captured in an earnings-at-risk analysis, which typically covers a 1- to 2-year timeframe. Therefore, the OCC believes that banks with significant medium- and long-term positions should identify, measure, monitor, and control the potential impact of interest rate changes over a longer time period. 19. How will the OCC decide which banks will need to assess interest rate risk from an economic perspective? The OCC will evaluate significance of interest rate exposures using criteria such as: capital, liquidity, asset and liability mix, earnings, and management's ability. Examiners will determine which banks need systems that identify and measure risk from medium- and long-term positions on a case-by-case basis. The OCC believes that banks with significant interest rate exposure should adopt value- at-risk measurements (i.e., measures of the potential decline in economic value of equity as a result of movements in interest rates) to complement earnings-at-risk measurements. With few exceptions, the complexity of on- and off-balance sheet activities at larger national banks supports their need for an interest rate risk measurement system that adequately captures these exposures. The OCC encourages smaller banks to assess their medium- and long-term structural imbalances. If the board and senior management believe that the level of exposure to changes in longer-term rates is significant, the board should adopt a measurement system that can quantify that exposure. Whether a smaller bank needs a system that measures the impact of longer-term positions from an economic perspective depends on the bank's balance sheet structure and exposure to products with options risk. For example, a bank with more than 25 percent of total assets in long-term, fixed-rate securities and comparatively little in non-maturity deposits and/or long-term funding is likely to need to measure the longer-term impact to the economic value of equity. Conversely, a bank principally invested in short-term securities and working capital loans, funded by short-term deposits, probably would not. During the normal supervisory process, in conjunction with their overall assessment of interest rate risk management, OCC bank examiners will evaluate the adequacy of interest rate risk measurement systems. 20. For banks with significant medium- and long-term exposures, does AL 95-1 require an economic value of equity (EVE) calculation? No. Banks can measure the volatility of longer-term interest rate risk exposure using a variety of methods. For example, a bank which has large exposures to medium-term interest rate risk may elect to expand the earnings-at-risk analysis beyond the traditional 1- to 2-year time period, to capture longer-term mismatches. Alternatively, a bank may control exposure to longer-term mismatches by limiting interest rate risk positions to products or portfolios with certain repricing characteristics. Such limits are usually developed based on analyses of the volatility of the instruments in question under various scenarios. The results of such analyses can be used to estimate the potential impact on capital due to earnings changes analyzed over a longer time period. Gap reports that reflect a variety of rate scenarios may also be used to measure longer-term interest rate risk exposure. 21. If banks do not have to use EVE to measure long-term interest rate risk exposures, why is the OCC encouraging banks to adopt this type of risk measurement system? Every risk measurement system has limitations. For example, an expanded earnings-at-risk analysis will not capture interest rate risk exposures which occur in positions beyond the expanded timeframe. Gap reports and duration analyses generally do not capture the risk exposure generated by complex options products. The OCC believes the ability of a risk measurement system to accurately and understandably reflect risk positions should be of primary importance in deciding on what system is appropriate for a particular bank. The EVE risk measurement system uses discounted cash-flow analysis to determine the economic value of equity at any given point in time, in addition to assessing the potential risk to that value under a variety of interest rate scenarios. An EVE discounted cash-flow analysis involves calculating the present value of all assets, liabilities, and off-balance sheet contracts, and solves for the present value of equity. The sensitivity of the economic value of equity can be measured by adjusting the discount rate (as well as cash flows where appropriate) to reflect various rate scenarios. An EVE measurement system can help a bank's board and management assess the impact of a wide variety of projected rate changes on the economic value of their bank. Because an EVE analysis can capture exposures across the entire maturity spectrum under a wide variety of interest rate scenarios, as well as measure the value changes of complex options products, the OCC encourages banks to consider such a system. 22. What does the OCC expect with respect to assumptions? Does the OCC endorse a particular set of assumptions or source for obtaining assumptions (e.g., mortgage prepayment speeds)? The OCC expects banks to conduct their own analyses when determining appropriate assumptions for their internal risk measurement. The bank's vulnerability to customers exercising embedded options in retail assets and liabilities will typically vary from bank-to-bank because account holders are influenced by factors other than interest rates (e.g., demographics, competition, pricing philosophy, economic considerations, etc.). Thus, a standard set of assumptions or data sources may not be appropriate for all banks. When evaluating assumptions for non-maturity deposit accounts, banks should consider: historical account behavior, projected pricing strategies, anticipated actions by competitors, the general level and trend in interest rates, market interest rate spreads, and any economic factors which may otherwise influence the behavior of deposit account holders. They should perform similar analyses for residential real estate-related products. Market prepayment speeds may be a starting point for developing interest rate risk assumptions, but bank management should also consider other factors that may be unique to their bank customers. The determination of the prepayment speeds included in a bank's risk measurement system should reflect those considerations. Because the results of any interest rate risk measurement system depend on the associated assumptions, senior management should understand the significance of the key assumptions used. Management should document the analysis conducted to determine appropriate assumptions. The volume and detail of that documentation should be consistent with the significance of the risk and the complexity of analysis. For a small bank, the documentation typically will include an analysis of historical account behavior and additional comments about pricing strategies, competitor considerations, and any relevant economic factors. As noted in AL 95-1, banks should review the major assumptions underlying their risk management systems periodically to ensure timely identification of significant changes. They should also assess sensitivity of measured exposures to key assumptions. At a minimum, the board of directors, or a committee thereof, should review and approve major assumptions annually. In evaluating a bank's interest rate risk measurement process, OCC examiners will assess the reasonableness of major assumptions used by bank management in quantifying interest rate risk. RISK MONITORING 23. Does the OCC recommend that reports to the board include specific types of information about interest rate risk? The OCC believes reports to the board should be concise, timely, and accurate. The types of reports prepared for the board will vary based upon a bank's risk profile and risk management activities. At a minimum, quarterly reports should include: Risk Exposure: Reports to the board should provide information about the bank's risk position. They should include trend information and risk exposures aggregated to a meaningful level. For example, an earnings-at-risk report might show the potential exposure to projected net income if interest rates go up or down 200 basis points over the next 12 months. Similarly, an economic value of equity report might show the economic value of the bank today and how much that value might change under projected rate scenarios. Compliance: Reports to the board should demonstrate compliance with internal limits and controls and should note any exceptions and how they were approved. Risk/Return: Reports to the board should address the tradeoffs between risk levels and performance. When management considers major interest rate risk strategies (including a no-action strategy), they should assess the potential risk (impact of adverse rate movement) versus the potential reward (impact of favorable rate movement) and summarize that in reports to the board. Board reports should also compare performance to plans and strategies. Risk Control: Reports to the board should cover control activities, as conducted. Such reports include, but are not limited to audit reports, independent valuations of products used for interest rate risk management (e.g., derivatives, investment securities, etc.), model validations comparing model predictions to actual performance, and descriptive information on major assumptions (e.g. non-maturity deposit repricings, mortgage-related product prepayments, etc.) used in risk measurement. 24. Will the OCC use the FDICIA capital regulation on interest rate risk to monitor interest rate risk at national banks? Will this regulation replace the need for banks to implement additional interest rate risk measurement tools? The federal banking agencies (OCC, Federal Deposit Insurance Corporation, and the Federal Reserve) are finalizing revisions to the September 1993 proposal to address various concerns raised by the industry and other interested parties. The supervisory model the OCC and the other bank regulatory agencies are developing is not designed to prevent banks from being exposed to interest rate risk but rather, to identify those banks with high interest rate risk exposures. The model the agencies are considering will enhance the agencies' ability to monitor risk exposures and to identify banks that may need closer supervisory attention or additional capital to cover interest rate risk. However, the model is not designed to remove the need for banks to have effective risk identification, measurement, monitoring, and control tools. For some banks, the supervisory model may be sufficient to assess value-at-risk and may supplement the bank's earnings-at-risk analysis. For other banks, the supervisory model will be too simplistic to serve as an effective internal risk management tool. RISK CONTROL 25. Does the OCC standard on board communication with senior management regarding risk tolerance require a formal interest rate risk policy? The OCC does not require that each national bank have a formal, written interest rate risk policy. However, at all banks, the board and senior management should have a clear understanding of the institution's tolerance for risk. The form that communication takes will be assessed on a case-by-case basis. When management has a proven understanding and acceptance of the board's risk tolerance, informal guidelines may be appropriate. However, most large banks and banks involved in complex products or activities will need the discipline of implementing formal, written policies. As part of the normal supervisory process, OCC examiners will evaluate a bank's need for written interest rate risk policies based on its individual situation. 26. AL 95-1 requires bank management and directors to ensure that sufficient capital is maintained to support interest rate risk exposures. How should a bank determine capital adequacy? To evaluate the adequacy of its capital, a bank should assess its risk levels and the quality of its interest rate risk management process. Risk level should be assessed based on the bank's existing and projected exposures. For example, a bank with significant on- or off-balance sheet depreciation caused by changes in interest rates would consider the existing position, in addition to potential exposure that could arise if rates continued to move adversely. The evaluation of risk level should also consider the potential impact on capital of risk profiles for credit, liquidity, operations, and other relevant risks. The quality of risk management also affects capital adequacy. Factors that the board should consider include: Management: Does management take appropriate actions to maintain a risk profile consistent with board objectives? Can management explain the reasons for strategy changes or deviations from plan? Is the bank's interest rate risk profile understood by more than a small, controlled group? Risk Measurement: Does the existing risk measurement system(s) provide valid, reliable, and timely information? Are all significant products and activities included in the risk measurement system? Are major assumptions reasonable and periodically validated? Controls: Does the bank have limits that control the amount of interest rate risk it is taking? Does management have the necessary flexibility and tools to adjust risk exposure as needed? Are individuals who perform basic control functions such as risk computation and reporting, market valuations, risk measurement validations and limit monitoring sufficiently experienced and independent of risk-taking activities? Are there any outstanding control deficiencies that might jeopardize bank capital? Similarly, when assessing the adequacy of bank capital relative to its interest rate risk, examiners will consider the adequacy and effectiveness of senior management and board oversight; adequacy of and compliance with policies, procedures and internal controls; management's knowledge and ability to identify, measure, monitor, and control interest rate risk; the adequacy of internal risk measurement and monitoring systems; and the existence of and adherence to specific risk limits.