Communicator Archives: February 2002

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Model Validation
(Part 2 of 2)

The 1996 Joint Policy Statement requires a bank to annually assess their interest rate risk management process to ensure its integrity, accuracy and reasonableness. This in a nutshell is model validation. What specifically does this mean?

OCC Bulletin 2000-16 states that the person performing the model validation should be independent from the person who constructs the model. Fundamentally this is a form of checks and balances. The bank is responsible for model validation while ORA has constructed your A/L Benchmarks model. Further, we are not responsible for maintaining or updating any of your internal accounting or reporting systems and are entirely independent of your bank operations. We do not make your forecast assumptions and have no conflict of interest with your bank's other lines of business (securities, insurance or other financial services.)

Below is a list of the elements model validation should include.

1. An evaluation of the adequacy of and compliance with internal controls. ALCO policies for IRR should define a general philosophy about sensitivity, be written and specific, specify the measurable guidelines used to control the bank's IRR and identify who is responsible for monitoring each policy. ORA offers sample ALCO policies on our website at: http://www.olsonresearch.com.
2. An evaluation of the model's appropriateness. The bank's complexity and risk profile should determine the sophistication of its IRR model. Model appropriateness is also gauged by the credibility of the vendor. Olson Research has been in the asset/liability modeling business since 1969. Both the FDIC and the OCC have recognized Olson Research and the A/L Benchmarks model. Olson Research has also developed an online course entitled, "The Concepts of Interest Rate Risk" in conjunction with the Conference of State Bank Supervisors (CSBS).
3. A review of the data inputs and processing components. To verify the model's ability to perform accurate mathematical calculations, compare performance ratios to your internal reports. If they are not reasonably close, determine why.
4. A review of the model's methodologies and key assumptions. Determine if the methodologies and key assumptions used make sense for you institution. Make sure key personnel are familiar with the model's data sources, cash-flow assumptions, discount rate components and other standard assumptions used in the modeling process. A/L Benchmarks provides a section entitled, "Model Methodologies and Assumptions," in the Executive Report. Review this as well as the A/L Benchmarks Detail Reports package, which gives further details of cash flows, discount rates and forecasts.
5. A back test of the model's output. Because many IRR measures rely on forecasted information, you must be certain that the forecast is reasonable. Compare previous model estimates to actual outcome. If they are not comparable, did you supply additional inputs to the model to best reflect the uniqueness of the bank?

An independent review of your model is an option. While we may not perform this review for you, our analysts are available to help you understand your model better. Please don't hesitate to contact us whenever you have a question. ORA provides continuous customer support as part of you A/L Benchmarks service.

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"FDIC Alerts Banks to Subprime Woes"
National Mortgage News (02/11/02) Vol. 26, No. 20, P. 2

According to the Federal Deposit Insurance Co. (FDIC), Federal Housing Administration and other sub-prime loans are reporting significantly higher delinquency rates as the recession lingers. The FDIC does not see any improved sub-prime performance in the near future. Meanwhile, slightly less than one third of the 50 banks survey by the Federal Reserve Board did not meet their sub-prime expectations. However, standard residential mortgages were performing better than anticipated. The survey indicates that 30 percent of refinance borrowers spent the money on home improvements, debt repayments, and other purchases. Furthermore, 40 percent of commercial banks are charging higher interest rates on CRE loans; many are also lowering loan-to-value ratios and boosting mandatory debt-service coverage ratios. The survey also found demand for multifamily loans has held steady, while CRE loan demand has lagged over the past three months.

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However, with the sudden downward trend in rates, many banks have found out just how sensitive these accounts are and may consider some modifications in this area. A/L Benchmarks is capable of handling these situations. Contact an A/L Benchmarks analyst to discuss how to handle your situation in the most appropriate manner.

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