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Subject: Embedded Options and Long-Term Interest Rate Risk
Date: July 1, 2004
To: Chief Executive Officers of All National Banks, Federal Branches and Agencies, and All Examining Personnel
Description: Interest Rate Risk
As of January 12, 2012, this guidance applies to federal savings associations in addition to national banks.*
This bulletin alerts banks to the importance of measuring the cash flow and valuation risks for assets and liabilities with embedded options.1 It emphasizes the steps banks should take in order to effectively manage interest rate risk, and repeats the caution provided in OCC Bulletin 2002-19 regarding the assumption of unwarranted levels of risk in the investment portfolio. The guidance in this bulletin is supplemental to the detailed supervisory expectations included in the "Interest Rate Risk" booklet of the Comptroller's Handbook.
The Office of the Comptroller of the Currency (OCC) is concerned that some national banks have not adequately identified, measured, and controlled the potential exposure to earnings and capital that may arise from a scenario of rising interest rates. Continued signs of strength in the U. S. economy raise the possibility of higher interest rates. Banks that have invested a significant portion of their earning assets in products with embedded options at the generational low for yields on fixed income assets may now be highly vulnerable to rising rates.
The OCC is concerned about the impact on earnings and economic equity for both rising and falling interest rates. However, given ongoing pressure on net interest margins and continued concerns about yield chasing in the investment portfolio, the OCC is particularly concerned about a repeat of the structural problems that faced a number of institutions during the last period of materially rising interest rates. Bank management and boards of directors should remember the lessons learned in 1994. Although many interest rate risk models incorporate scenarios with interest rate changes of 300 basis points or more, bank management too often focuses exclusively on scenarios deemed to be "most likely." Low probability events do occur and can have significant impact on asset values and projected net interest margins. Assets with long maturities, and assets expected to have short maturities but whose maturities are designed to extend significantly as rates rise, can deteriorate rapidly in value. Finally, the investor community looks at depreciation in fixed income portfolios when evaluating the financial health of a banking company. It is critical that bank managers fully understand their institution's interest rate risk exposures and ensure that their risk management framework incorporates the controls and tools necessary to conduct asset/liability management activities in a safe and sound manner.
Identifying and measuring interest rate risk exposures can be challenging due to the complexities of bank balance sheets and the processes used to measure risk. Banks incur interest rate risk as a natural consequence of managing the assets and liabilities that result not only from customer preferences but also management's own asset/liability management decisions. The OCC has a long-standing expectation that national banks with significant amounts of assets or liabilities with embedded options should have a robust interest rate risk measurement process that includes, among other things, an economic value of equity2 (EVE) model and appropriate systems for stress testing. It is not inherently unsafe or unsound for banks to have balance sheets with exposures to the risks of embedded options. It is unsafe and unsound, however, to materially increase positions in instruments with embedded options and/or higher sensitivity to interest rate changes without an adequate understanding of the existing vulnerability to rate changes and a meaningful process that identifies, measures, and controls such risks.
Faced with weak loan demand and the prospect of declining net interest margins, many banks have increased the size of their investment portfolio to absorb excess liquidity and to improve yields. In particular, many banks have increased their holdings of mortgage-backed and callable securities. The volume of mortgage-related assets in the banking system has increased from 10 percent of total assets in 1987 to 27 percent of total assets as of year-end 2003. Earnings pressures have also enticed bank management at some institutions to pursue aggressive investment strategies by using borrowed funds to finance its portfolio holdings (leverage programs). These leverage programs often result in an asset and liability management position in which the bank has sold options on both sides of the balance sheet. For example, these strategies typically involve the bank purchasing callable/prepayable securities, funded by liabilities that allow the funds provider to increase the rate as interest rates increase. The asymmetrical behavior of the options can leave the bank's net interest margin exposed to both rising and falling interest rates.
The sustained low interest rate environment has caused assets with embedded options to prepay rapidly. With prepayments at very high levels, and (until recently) expectations for a sustained period of low interest rates, many bankers have not adequately considered the long contractual lives of assets acquired with cash flows from prepayments, since they believed that the assets were simply serving as a temporary bridge until loan demand improved or the interest rate environment changed.
Since the increase in longer-term interest rates that began in the second half of 2003, some bank portfolios are now experiencing declining portfolio cash flows and an extension in the portfolio's average life. A security that an investment manager may have thought had a two-year maturity when purchased might now have a much longer maturity because rates have risen; the longer maturity results in heightened price sensitivity. This is the "negative convexity" effect of securities with embedded options. This extension risk can be especially problematic for structured securities such as CMOs and callable bonds. The OCC is particularly concerned that national banks may overlook the impact of interest rate increases on the economic value of their equity, given that for many banks the initial impact on earnings from a rise in short-term interest rates could be positive. Deterioration in the value of a bank's economic equity over time can have sharply negative consequences for earnings and capital adequacy. It is important that national banks with significant volumes of assets and liabilities with embedded options measure their interest rate risk from both short-term earnings, as well as a long-term economic value perspective.
RISK MANAGEMENT CONSIDERATIONS
Bank management should carefully consider the trade-off between actions taken to retain or improve net interest margin, and the long-term risks of building a significant position of assets or liabilities with embedded options. Banks should review their potential exposure to rising interest rates and implement risk control measures, as appropriate. Banks that wait to take action until rates rise further may find evaluating and implementing risk control measures, such as selling assets and/or implementing derivatives hedges, difficult and expensive, since many similarly positioned investors may be attempting to do the same. It is unsafe and unsound to expose the earnings and capital of a national bank to heightened levels of interest rate risk without demonstrating a thorough understanding of the risk and an ability to prudently manage the risk with an effective risk control process.
National banks should take a number of steps to ensure that they have properly identified, measured, and controlled interest rate risks. The following steps are important risk management actions that bank management should consider to ensure a disciplined approach to assuming interest rate risk.
The larger the institution, the more likely it is that day-to-day interest-rate risk management is separated from executive management. However, executive management remains responsible for setting the bank's business strategy and monitoring the implementation of that strategy. To accomplish this, a risk reporting system that effectively conveys the magnitude and sources of the institution's risk must be in place. Executive management should review key risk reports, e.g., earnings and economic value of equity at risk, at least quarterly.
National banks should consider the accounting requirements for evaluating and recognizing "other-than-temporary" impairment in securities, including recently issued guidance provided by the Financial Accounting Standards Board (FASB) in Emerging Issues Task Force Issue No. 03-01. This guidance is effective for reporting periods beginning after June 15, 2004. (Disclosure requirements for investment securities in an unrealized loss position were effective for annual financial statements issued after December 15, 2003.) Specifically, management is reminded that "other-than-temporary" impairment can result from changes in interest rates as well as downgrades in credit ratings.
National banks contemplating the transfer of securities from available-for-sale to held-to-maturity should obtain prior approval from the board of directors. Some institutions have considered such transfers in an effort to lower the visibility of deteriorating portfolio values from equity accounts in published financial statements. Given the significant loss of management flexibility associated with such a transfer, banks should not make such transfers without board approval. National banks are reminded that the OCC will consider depreciation in the securities portfolio when evaluating capital adequacy.
SUPERVISORY REVIEW OF INTEREST RATE RISK
In light of the highly uncertain interest rate environment, OCC examiners will evaluate how national banks have identified, measured, and controlled interest rate risk. Examiners will assess the appropriateness of the tools used to manage risk, the assumptions (and any changes) used in the interest rate risk measurement process, and banks' strategic responses to changes in the interest rate environment. Examinations of asset/liability management activities will assess how well and how accurately national banks have reported exposures to their boards of directors, changes to investment horizons for assets with embedded options, management's ability to operate within the board's risk tolerance, and whether policies adequately control risks. Examiners will also consider depreciation in investment portfolios in their assessment of capital adequacy.
Questions or concerns regarding this guidance should be directed to National Bank Examiner Kurt Wilhelm or National Bank Examiner Ray Diggs in the Treasury and Market Risk Division at (202) 874-5670.
Michael C. Drennan
*References in this guidance to national banks or banks generally should be read to include federal savings associations (FSA). If statutes, regulations, or other OCC guidance is referenced herein, please consult those sources to determine applicability to FSAs. If you have questions about how to apply this guidance, please contact your OCC supervisory office.
1 An embedded option is a provision in a financial instrument, such as a loan or a security, which allows one party to change the timing or amount of one or more cash flows associated with that contract or instrument. Examples include prepayment options on loans, early withdrawal options on certificates of deposit, annual and lifetime rate caps on adjustable rate mortgages (ARMs), and call options on bonds. Embedded options make both the projected return and the interest rate risk of a financial instrument difficult to evaluate because the probability that the option will be exercised must be evaluated and may vary with movements in rates.
2 The economic value of an instrument represents an assessment of the present value of the expected net future cash flows of the instrument, discounted to reflect market rates. A bank's economic value of equity (EVE) represents the present value of the expected cash inflows minus the present value of expected cash outflows.
3 Portfolio sensitivity refers to the changes in the investment portfolio's value over different interest rate/yield curve scenarios, and meaningful stress scenarios. OCC Bulletin 98-20, "Supervisory Policy Statement on Investment Securities and End-User Derivatives Activities."
4 A parallel yield curve change is one in which the rate on all tenors along the curve change by the same amount.
5 A nonparallel yield curve change is one in which short-term and long-term rates do not change by equal amounts.