INTEREST RATE RISK MAKING YOUR MODEL UNDERSTANDABLE AND RELEVANT

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2 INTEREST RATE RISK MAKING YOUR MODEL UNDERSTANDABLE AND RELEVANT Scott J. Hopf, CPA Senior Manager BKD, LLP 375 North Shore Drive, Suite 501 Pittsburgh, PA

3 AGENDA The Basics How to Measure Interest Rate Risk (IRR) Types of IRR Models Stress Testing Model Assumptions Model Backtesting Internal Controls Regulatory Guidance Example Exam Comments 3

4 THE BASICS Sensitivity to market risk reflects the degree to which changes in interest rates can affect earnings or capital Understanding interest rate risk requires the following: Policies, procedures, controls Reporting processes Measurement systems Internal controls 4

5 THE BASICS Responsibility of management to develop Interest Rate Risk Strategies and resulting program that consider: Size, nature and scope of risk activities Board of Directors approved risk tolerances Board of Directors strategies Limiting the risk to earnings and capital of the institution 5

6 HOW TO MEASURE IRR Three prevalent types of measurement methods capture and quantify exposure to earnings and capital Gap Analysis Earnings Simulation analysis Economic value of equity 6

7 TYPES OF IRR MODELS Gap analysis Identifies pricing mismatches between assets, liabilities and other instruments Positive gap rate sensitive assets (e.g., loans) exceed rate-sensitive liabilities (e.g., shares) during a specified period Negative gap rate-sensitive liabilities exceed rate-sensitive assets during a specified period 7

8 TYPES OF IRR MODELS Gap analysis continued Advantages Simple Does not require sophisticated technology Clear, easily interpreted guidance Disadvantages Captures only repricing risk Assumes parallel rate movements Does not measure impact to economic value of equity 8

9 TYPES OF IRR MODELS Earnings Simulation Analysis Utilizes balance sheet and income statement projections Projects over a time period, e.g., 24 months Can utilize static or dynamic models Static assumes a constant balance sheet Dynamic assumes asset growth, changes in business lines, etc. Highly dependent on management assumptions 9

10 TYPES OF IRR MODELS Economic value of equity Represents present value of expected cash flows of assets and liabilities Projects economic capital on a base-case scenario and typically to a stressed scenario Broader in scope to Gap and Earning Simulations as it measures all estimated changes to balance sheet and earnings Provides most consistent view of IRR 10

11 STRESS TESTING Integral part of IRR management Should assess a range of scenarios Instantaneous rate change (rate shock) 100 to 400 basis point increase and decrease Significant rate changes over time (rate ramp) 300 basis point risk over 24 months Substantial rate changes over time Changes in key market rates (e.g., prime) Changes in shape or slope of yield curve 11

12 MODEL ASSUMPTIONS Most critical part of your model Must accurately reflect management s expectations regarding: Interest rates Consumer behavior Local and macro-economic factors Must be regularly updated and supported through analysis and documentation 12

13 MODEL ASSUMPTIONS Key assumptions to consider: Projected interest rates Derived from yield curves, economic analysis or historical regressions Driver rates (primary market rates) relationships Institution rates are typically set to move in relation to driver rate Rate spread Beta 13

14 MODEL ASSUMPTIONS Key assumptions to consider continued: Non-maturity shares Most critical and difficult assumptions that management makes Decay rates amount of non-maturity shares that may be withdrawn or closed in a given rate environment Must reflect institution-specific factors and overreliance on industry estimates or default assumptions Loans and securities repayments 14

15 MODEL ASSUMPTIONS Important keys for assumptions Process for developing material assumptions should be formalized and periodically assessed Assumption summary reports are an important tool your model should be able to provide 15

16 MODEL BACKTESTING Identifies material differences between actual and forecasted income statement and balance sheet amounts Complete no less than annually Document reasons for material variances Primary cause Proposed/implemented corrective actions Key assumptions should be checked against actual behaviors on a regular basis 16

17 INTERNAL CONTROLS Clearly define management authorities and responsibilities Ensure adequate separation of duties to avoid potential conflicts of interest IRR exposure should be reported directly to senior management and the board of directors 17

18 INTERNAL CONTROLS Independent reviews Performed at least annually Scope defined by internal audit staff and approved by supervisory committee Tailored to type and complexity of activities Findings reported to board of directors no less than annually Summary of IRR measurement techniques and practices reported to board no less than annually 18

19 INTERNAL CONTROLS Scope of Independent Review System input review Knowledge/skills of individuals Reconciliation of data to general ledger Source, completeness, accuracy and procedures used on external data Assumption Review Process for development assumptions Process for reviewing and approving key assumptions Periodic review of assumptions for relevance, applicability and reasonableness Completeness of assumption analysis 19

20 INTERNAL CONTROLS Scope of Independent Review continued System output and reporting Sufficient scenarios Accuracy of IRR measurement Timeliness and frequency of reporting to management and the board Compliance with operating policies and risk limits Backtesting Understandable reports that support decision making 20

21 INTERNAL CONTROLS Model validation Ensures that software and mathematics of IRR model functions as intended Management should periodically discuss with vendors what validation and internal control procedures have been conducted Validation provided by vendors for largely standardized, vendor-provided models can be used to support accuracy 21

22 REGULATORY GUIDANCE Joint Agency Policy Statement on Interest Rate Risk (1996) Advisory on Interest Rate Risk Management (2010) Interest Rate Risk Management: Frequently Asked Questions (2012) Interagency Policy Statement on Funding & Liquidity Risk Management 22

23 EXAMPLE EXAM COMMENTS The person responsible for conducting the annual independent review is not independent of the control of the model as this person is responsible for monthly data inputs, reconciliations & assumption changes. 23

24 EXAMPLE EXAM COMMENTS Only two formal Asset/Liability Committee (ALCO) meetings have been held since the last examination, although bank policy calls for quarterly meetings. Management meets informally outside of ALCO meetings to discuss IRR & maintains notes of those meetings; however, the notes are not presented to the Board for review. Further, while management stated IRR matters are discussed at the Board meetings in the absence of ALCO meetings, Board minutes lack sufficient detail of those discussions. 24

25 EXAMPLE EXAM COMMENTS Guidelines in the Asset Liability Management Policy remain liberal, as was noted at the prior examination. Management should narrow the risk parameters which continue to allow for NII changes of 10, 15 & 20 percent for 100, 200 & 300 basis point rate shocks, respectively. 25

26 EXAMPLE EXAM COMMENTS Though the institution s sensitivity to market risk is satisfactory, many parameters established in the policy are liberal & allow for an inordinate amount of risk. The policy should be amended to incorporate parameters that minimize risk & establish limits for the level of risk the institution is willing to accept. 26

27 QUESTIONS?

28 THANK YOU! FOR MORE INFORMATION Scott J. Hopf, CPA Senior Manager BKD, LLP Pittsburgh

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