Communicator Archives: June 2001

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Interest Rate Risk
Types of Risk

Banks' senior management faces three types of risk each day in making ALM decisions:  assets quality, liquidity and interest rate risk.  Each is a function of the current environment under which the bank is operating and the controls that have previously been and currently are in place.

Asset quality refers to the credit quality of the security and loan portfolios, concentrations of a particular type of instrument and fair market values of these portfolios.  What is the likelihood of repayment in your loan portfolio?  Are there concentrations of "riskier" loans or securities with volatile market values?  If the bank were up for sale today, what is the market value of the loan and security portfolio?  Typical measurements of asset quality include:  non-performing assets to total assets, allowance for loan losses to total loans, net charge-off to total loans, risk weighted assets total assets and security/loan/deposit present value premiums.

Liquidity risk refers to asset liquidity, funding liquidity and contingency plans for funding within the bank.  How liquid are the assets in the bank?  How have they been funded?  What plan is in place if you should lose the current source(s) of funding?  Common ratios used to measure liquidity risk are:  cash to deposits, loans to deposits, ST investments to total assets, purchased funds to earning assets, net borrowed funds to equity and volatile liability dependence.

Interest rate risk refers to the risk associated with changing interest rates and the effect of the change on future earnings and the economic value of equity.  Interest rate risk is typically measured by an instantaneous, parallel shift in the Treasury curve otherwise known a shock analysis.  In the case of earnings at risk, a base forecast of earnings MUST have been developed PRIOR to the shock. Both earnings and equity at risk are measured as a percentage change and/or dollar amount of potential loss due to a change in interest rates.  Measurement is commonly stated as net interest earnings at risk and equity value at risk as a percentage of the economic value of equity.

One of the main goals of asset/liability management is to minimize and control the risk inherent in doing business in financial markets.  It is important that senior management have the ability to identify, measure, monitor and control these risks.

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The Office of the Comptroller of the Currency, along with the Federal Reserve Board, the Federal Deposit Insurance Corp., and the Office of Thrift Supervision, recently released an advisory that cautioned banks on brokered deposits.  According, to Kathryn Dick, director of treasury and market research for the OCC, community banks are increasingly buying brokered deposits and should be able to make good use of the information.  With the advisory, regulators warn banks that the Internet has given investors who focus on yield to determine high-yielding deposit sources the power to change balance sheets almost immediately and ruin banks.  First National Bank of Keystone, W. Va., is an example of a bank that had problems with brokered deposits, which contributed to its failure in 1999.  [ORA note: take a look at Keystone's 2nd quarter 1999 Canary Report, specifically Net Noncore Funding Dependence]   The advisory includes guidelines for managing brokered money, which usually comes in the form of certificates of deposit.  The guidelines suggest having management information systems in place that allow banks to monitor and manage such non-relationship or higher-cost funding programs. Banks also are encouraged to have a contingency funding plan so that they will have a funding strategy in the event that brokered deposits do not 'roll over.'  Community banks held $16.8 billion of the $193.8 billion in brokered deposits last year, and have view brokered deposits as an alternative deposit source as traditional deposits have declined.

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It is our goal to make the supplemental forms as easy as possible to use.  We welcome suggestions on the presentation of instructions as well as additional information that could be included.

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Q. We received several calls from the FDIC and Olson Research regarding errors on the March 31, 2001 call report that were not picked up on our software. How does this affect my A/L Benchmarks reports?  Any tips on making this process easier?

A. The FDIC call report is the primary data source for your A/L Benchmarks reports.  As such, it is imperative that the data presented be accurate in order to assess your bank's performance.

The March 31, 2001 call report was particularly trying.  Most call report software programs will check that your balance sheet and income statement do in fact balance, but do not have the historical references to check for "reasonableness".  Or, in the case of schedule RC-K, where only portions of the balance sheet are represented, it may not balance at all. Your call report data goes through rigorous testing at Olson Research for accuracy and reasonableness.  Most of you heard from us this quarter concerning issues on the March 31, 2001 call report.  It was our experience that most errors on the call report occurred in the income and average balances associated with the loan portfolio.  Reporting on the different schedules is not always consistent.  Below you will find a chart that will help you identify corresponding categories when preparing these schedules.