03 Feb Regulators are Focusing on Community Bank Interest Rate Risk Assumptions
Regulators are Focusing on Community Bank Interest Rate Risk Assumptions
The message from prudential regulators in recent months: Make sure the key assumptions that your bank is using to assess interest rate risk (IRR) are reasonable, forward-looking and specific to your bank’s unique scenarios.
Community banks are often getting marked down in their Sensitivity to Market Risk portion of their FDIC exams for having “unsupported or stale” IRR assumptions, the FDIC reported in its latest issue of Supervisory Insights.
The FDIC said the common mistakes that banks are making include:
- Using peer averages without considering the bank’s unique circumstances.
- Failing to differentiate between rising and falling interest rate scenarios.
- Oversimplifying balance sheet categories.
- Forgetting to evaluate how IRR results would change if the assumptions also change.
- Using off-the shelf vendor assumptions that do not reflect the bank’s assets, liabilities and local markets.
- A lack of qualitative adjustment factors to historic data.
The Office of the Comptroller of the Currency, in its latest semi-annual risk perspective, reviewed IRR data from more than 1,500 community and mid-sized banks, finding a range of modeling practices and assumptions. The OCC concluded that “outliers in reported exposures and NMD assumptions may indicate diversity in balance sheet profiles or unrealistic or incorrect modeling assumptions.”
“They have essentially created a bell-shaped curve for all of the key assumptions in the models,” noted Invictus Consulting Group senior partner Adam Mustafa. “If you are on the more aggressive side of the curve, you had better be able to explain why.”
The OCC review found that most banks used Economic Value of Equity (EVE) to measure IRR, and the results ranged from a 44 percent loss in EVE to a 29 percent increase. The OCC noted that “banks reporting exposures below the median should carefully consider the risk to capital and ensure the board and senior management understand the potential exposure and are comfortable with the risk.”
The OCC reminded banks to conduct sensitivity analysis of non-maturity deposit assumptions “to identify the potential impact of depositor instability.” Banks should test assumptions by “applying subtle or significant variations to the repricing or decay rates” to analyze the impact on capital and earnings. The OCC wrote that repricing assumptions must be analyzed carefully to make sure they are realistic.
While the OCC said it was providing the data to show the wide range of practices used for IRR modeling, it did offer some guidance. For instance, the OCC found that the majority of banks used shock and ramp scenarios using up and down parallel rate movements ranging from 50 bps to 400 bps. However, the regulators said that stress scenarios using rate changes of plus 300 bps and plus 400 bps “are appropriate” in the low interest rate environment.
Banks used a wide range of data from Non-Maturity Deposit (NMD) assumptions, which are crucial because they are a “driver of earnings and capital exposures,” the OCC indicated. Banks should use assumptions that “reflect the bank’s unique profile in order to identify risk properly,” the OCC said.
In addition, the FDIC noted that “customer behavior may not reflect past behavior when market rates change in the future.”
Banks with large investments in longer-duration securities must develop rising-rate scenario assumptions “where bond depreciation may pose outsized or unintended risk to earnings and capital,” the FDIC said.
Tips to Managing Assumptions
- Be aware that historical data may not reflect future trends.
- Use your bank’s own historical information for deposit assumptions.
- Assume a minimal level of prepayments.
- Measure the interest rate risk of your current balance sheet.
- If you use a growth assumption, also use a ‘no growth” analysis.
- Perform an independent review of your bank’s IRR measurements.
- Source: FDIC Supervisory Insights