Communicator Archives: July 2001

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Interest Rate Risk
Evolution of Risk

In order to understand all of the types of risk involved in managing a bank's balance sheet in the current environment (asset quality, liquidity and interest rate risk), it is worthwhile to take a backward glance at how this risk evolved.

The Great Depression of the 1930's and its ensuing bank failures due to liquidity issues forced the formation of the FDIC.  The FDIC Act of 1933 clearly spelled out control procedures that must be in place prior to the issuance of deposit insurance.

The 1939-1943 wartime balance sheet was characterized by assets invested in Treasury Bonds (75%) and liabilities consisting of checking and savings accounts (95%).  Liquidity issues solved.

The growth in the post war period of the 1940s and 1950s caused a shift in balance sheet management.  Treasury bonds were replaced with loans on the asset side and banks began to wrestle with an animal previously unknown to them…assets quality.

The balance sheet of the 1960s and 1970s saw tremendous changes again due to growth and an added economic condition known as inflation.  Interest rates began to climb and in 1962 Negotiable Certificates of Deposit were introduced.  NOW accounts followed in 1967.  Loan participations and forward and futures contracts on securities were the latest buzz.  Regulatory changes ensued with de-regulated interest rates on deposits and new tax rules for mortgage backed securities.  In addition to liquidity and assets quality, bank management was faced with interest rate risk.

During the 1980s alone more than 1000 new financial contracts were invented.  Swaps and options further increased the complexity of the balance sheet.  Numerous Savings and Loan and bank failures increased deposit levels for FDIC insurance and brought the formation of the (FASB's) Financial Instruments Project and risk-based capital legislation.  From the 1980s on, interest rate risk has received the most regulatory attention.

Managing the balance sheet in today's banking environment has become an infinitely complex task.  However, assets quality, liquidity and interest rate risk must be managed in order to maximize profits and preserve equity value.

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In testimony this week before the Senate Banking Committee, federal regulators said the banking and thrift industries generally are well positioned to weather the current economic slowdown, especially in terms of capital and risk-management procedures. However, emerging problem areas were commented on.

Chairman Greenspan said there were two "salient points" to be made about the condition of the banking system. First, both quantitative and qualitative indicators suggest that "bank asset quality is deteriorating and that supervisors need to be more sensitive to problems at individual banks, both currently and in the months ahead."

Greenspan's second point was that the "banking system entered this period of weak economic performance in a strong position." He emphasized that over the last decade banks have improved their risk management and control systems, which "may have both strengthened the resultant asset quality and shortened banks' response time to changing economic events."

Greenspan cautioned against overreaction, noting that loan standards tend to "belatedly tighten" in downturns. He said loan applications that earlier would have been judged creditworthy are rejected "when in retrospect it will doubtless be those loans that would have been the most profitable." He added that such policies "are not in the best interests of banks shareholders or the economy [and more importantly] contribute to increased economic instability."

Comptroller Hawke said the national banking system is in "a solid position to bear the stresses of any economic slowdown." Hawke added, however, that there are trends that concern the OCC, most notably in the areas of credit and liquidity. He said that since 1997 there has been "a lowering of underwriting standards at many banks [stemming] from competitive pressure to maintain earnings in the face of greater competition for high- quality credits, particularly from non-bank lenders."

Like Hawke, FDIC Chairman Tanoue and OTS Director Seidman said banks and thrifts continue to show signs of strength. Nevertheless, Chairman Tanoue expressed concern about "decreased liquidity and continued credit availability, especially at community banks." For banks under $1 billion in assets, the environment of strong loan demand has produced balance sheet shifts that have increased community bank exposure to interest-rate risk, credit risk and liquidity risk. As a result, "many small banks appear to be liquidating securities to fund loan growth, and increasing the proportion of higher yielding, higher-risk loans in their portfolios to offset the increased cost of funding." Tanoue observed that while this may have limited the erosion of community bank profitability in recent years, these "changes have left many small banks more vulnerable to rising interest rates and a slowing economy."

While OTS Director Seidman said the thrift industry is "strong and growing," she noted that small thrift earnings have lagged overall industry earnings for the last three years. She said that part of the reason for this lag in earnings is that small thrifts hold higher than average proportions of lower yielding assets. On the funding front, Seidman noted that the industry has become "somewhat more dependent on wholesale funding as deposit growth has slowed due to changing savings and investment patterns and strong competition from mutual funds." Seidman said FHLBank advances are the primary form of wholesale lending now used by thrifts. At the end of the first quarter, these advances funded 22.8 percent of thrift assets, compared to just 7.4 percent in 1991.

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The economic environment is completely out of our control but bankers must be prepared to respond to it immediately.  Falling rates, rising rates, depression, recession, etc. all have an impact on the balance sheet and touch and/or create each type of risk.

The structure of the balance sheet in each bank is as individual as a fingerprint, carrying differing levels of risk in each of the categories.  Community banks and large commercial banks have very different risk profiles.  Banks located in rural areas and large money center banks again carry very different types of risk.

Finally the process in place that has been designed to control the various types of risk has a tremendous impact on the types of risks facing bank management.  How tight are the controls?  How often is the risk position reviewed and by whom?  How likely and how quickly will bank management respond when an area of risk is "out of control?"

Although interest rate risk has been in the spotlight since the 1980s, liquidity and assets quality have also caught many banks by surprise when not managed effectively.

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Summit Bancshares   
Fort Worth, TX