Communicator Archives: October 2001

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Communicating Interest Rate Risk to Your Board

Interest rate risk may be defined as: "The possibility that interest rates will change in the future, and that such change will cause economic losses that were unexpected. Losses will be reflected as losses of earnings or losses of economic value of equity (EVE); or both."

The Board of Directors is responsible for establishing the bank's tolerance for interest rate risk. They also have a fiduciary responsibility for the process of identifying, measuring, monitoring and controlling the level of risk in the bank. Senior Management must supply directors with the tools to manage this risk.

Timely measurement of interest rate risk is essential so that all involved may identify where the risks lie in the bank so that they may be monitored and compared with policy established to control this type of risk. As we have seen over the past year, interest rates have fallen dramatically. However, this should not have held any surprises for banks with a tight system in place to identify, measure, monitor and control this risk.

The most common measurement system used to quantify a bank's interest rate risk is shock analysis also known as stress testing. Both the income statement and the balance sheet are subjected to an instantaneous, parallel, standardized basis point increase and decrease in the Treasury Curve and both the projected income and economic value of equity is measured against the "base case", or current position. From these scenarios, we can determine which scenario, rates up or rates down, causes the potential for greatest loss.

Specific measurements that the Board of Directors needs to monitor at least quarterly are:

  1. Earnings at Risk
    Net interest Earnings at Risk and Net Earnings at Risk are expressed as a negative difference between the base forecast simulation and either the rates up simulation or the rates down simulation. The figure is expressed as a percentage of the forecasted 12-month income.
  2. Equity at Risk
    % Of Economic Value of Equity and % of Total Assets represent the negative difference between the current economic value of equity (EVE) and the forecasted economic value of equity in either the rates up simulation or the rates down simulation. This figure is expressed as a percentage of the current economic value of equity or as a percentage of total assets.

Warning signs that directors can look for include:

  • Outdated reports that do not identify the major sources of the bank's interest rate risk.
  • Inability of senior management to communicate assumptions used in determining the bank's interest rate risk.
  • Risk figures that are greater than established ALCO policies regarding interest rate risk.
  • Changes in the level of risk reported.
  • Changes in historical trends of interest rate risk.
  • Significant changes in net interest income.

The Board of Directors is ultimately responsible for determining what level of risk is consistent with the bank's overall business philosophy. Accurate and timely reports are essential in managing this risk.

Regulatory Focus

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ICBA Weekly News October 3, 2001

"Account Screening a Small-Bank Issue?"
American Banker Online (09/28/01); Roth, Andrew
The reaction to the recent terrorist attacks on the United States has fueled scrutiny of bank accounts and questions about small banks' capacity to handle the technology investment required. Prior to the attacks, vendors of compliance systems and community banks believed that smaller institutions, particularly those in states with small immigrant populations, were at less risk of violating OFAC guidelines, and therefore minimized the value of investing in filter products. But that was then. Today, evidence suggests that community banks are becoming more considerate of OFAC rules and their need for filtering products. Research also shows that and some major software vendors have lowered the cost of OFAC filtering software to as low as $600; a considerable gesture considering that products that handle the range of OFAC compliance activities use to cost anywhere between $4,000 and $10,000. Banks not in accordance with guidelines issued by the U.S. Treasury Office of Foreign Assets Control (OFAC) guidelines can face up to $1 million in fines and 12 years in prison, plus civil penalties of up to $250,000 per violation.

Ask the Expert by Dr. Ronald L. Olson, Chairman ORA

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Q. When looking at my income shock analysis, I notice that my FHLB advance expense goes up dramatically in the UP scenario, but remains the same in the DOWN scenario. What is happening?

A. The model is taking into account the call provisions of the FHLB advances you supplied in the supplemental data. In a rates UP environment, the Federal Home Loan Bank would most likely exercise the call provision in the advance contract, allowing them to lend the money out to another borrower at the prevailing higher rates. Your bank in turn would then have to find alternative borrowings also at the prevailing higher rates (200 basis points in a standard shock analysis). Thus you seen an increase in the expense associated with this long-term borrowing.

Alternatively, in a rates DOWN scenario, the FHLB advance would not be called and the expense would stay the same for the modeling year.

Welcome Aboard

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The staff of Olson Research is pleased to welcome these institutions aboard:
 New Liberty Bank 
Plymouth, MI		  Sleepy Hollow National Bank 
Sleepy Hollow, NY
 Terrabank, N.A. 
Miami, FL		  The Stockmen's Bank 
Kingman, AZ
 
Our best referrals come from clients like you. Who do you know professionally that could benefit from A/L  Benchmarks®? Please contact us: info@olsonresearch.com or (888) 657-6680.

The staff of Olson Research extends their deepest sympathies to the families and friends of the victims of the September 11th terrorist attacks.