January 30, 2019
It’s true. It’s uncommon for interest rate risk (IRR) to be the main driver underlying a bank’s failure. Even more so for community banks, whose balance sheets share the same characteristics with vanilla ice cream. Nonetheless, the regulation side of the industry equates a dynamic interest rate environment with risk, and as a result, examination findings surrounding having an independent IRR review performed are running rampant. The results of the steadily increasing number of these reviews we performed over the last year have yielded some trends. Take a look and consider implementing these common suggested enhancements to boost the value of your bank’s IRR management program, if you haven’t already.
Incomplete or Outdated Policies
This one is essential. Even more so given the true purpose of a bank policy, which is to communicate the directorate’s risk tolerance and guidance to the bank’s senior management team. It’s challenging to perform an audit, a directors’ exam or an IRR review when the bank’s IRR policy hasn’t truly been updated to reflect its IRR management practices. Let’s use the Gap measure as an example. Many banks still use Gap to measure IRR, and many have transitioned away from this tool to using earnings-at-risk and economic value of equity simulations. Is your bank in the latter category? If so, does your policy still include a few paragraphs about Gap? It probably shouldn’t.
Bonus tip. There’s been a great deal of chatter in the industry about the regulatory agencies requiring banks to have an independent review of their IRR management practices performed annually. Interagency guidance, does not explicitly specify the frequency for these reviews, however. Those who know me well know I’m not an advocate of the one-size-fits-all approach to regulation. I believe some banks truly need an independent IRR review at least annually because of their IRR profile or the amount of customization allowed by their IRR model. If your institution doesn’t fit into this category, try formalizing the frequency in which the bank will have an IRR review performed in the bank’s IRR policy. What frequency is the board comfortable with? 18 months? Every two years with a caveat for an increased frequency if the bank’s IRR profile changes? I suggest formally documenting this in policy and then following policy.
Model Results Versus Established Risk Parameters
Do you know how many IRR models there are available on the market today? Yeah, neither do I. What I do know is that some models do a stellar job at comparing the results for the various scenarios simulated against board-approved risk tolerances outlined in policy, while others don’t. What does your model do? What is your model capable of? Given the board’s overarching responsibility for the bank’s risks, they should be regularly reviewing this comparison quarterly, at minimum.
Some IRR models are so customizable, that a bank can change the key driver rate assumption for each general ledger account. Other models request a few simple inputs each quarter to run. And some models fall in between the two extremes. When was the last time your ALCO review model inputs and assumptions? Has it been a few years, perhaps prior to when rates began to climb? If so, it’s time to revisit these to ensure they still make sense and mirror your bank’s characteristics. After all, as we’ve all heard before, “garbage in, garbage out.”