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Managing Interest Rate Risk
FEDERAL DEPOSIT INSURANCE CORPORATION
Scope of Discussion
Industry Trends
Board Responsibilities
Types of IRR
Measurement Systems
Critical Assumptions
Internal Control and Review
Resources
FEDERAL DEPOSIT INSURANCE CORPORATION
Earnings Have Begun to Recover, but Lower Margins Continue to Hamper Performance
Source: Call / TFR Reports. Insured institutions under $1B in total assets only. Unless otherwise noted, figures illustrated represent year‐end figures.
3.0
3.5
4.0
4.5
0.0
0.5
1.0
1.5
2.0
2000 2003 2006 2009 2012 2Q15
Pre‐tax ROAA, %
Net Interest Margin (right axis)
Pre‐tax ROAA (left axis)
Net Interest Margin, %
FEDERAL DEPOSIT INSURANCE CORPORATION
Long-Term Asset Exposures Have Risen
0
10
20
30
40
50
2Q91 2Q94 2Q97 2Q00 2Q03 2Q06 2Q09 2Q12 2Q15
Long‐term Earning Assets* to Total Earning Assets %
Over 50%
40% to 50%
30% to 40%
% of Community Banks
Source: Call Reports. Quarterly data. Banks with assets under $1B, excludes former TFR filers. *Assets maturing / repricing > 5 years.
FEDERAL DEPOSIT INSURANCE CORPORATION
Long-term Concentrations Led to Lower Margins During the Last Rate Cycle
Source: Call Reports, based on median figures. *Earning assets maturing / repricing > 5 years. Consistent sample of Call Report filers under $1B in assets as of 2Q04 only.
3.0
3.4
3.8
4.2
4.6
2Q04 3Q04 4Q04 1Q05 2Q05 3Q05 4Q05 1Q06 2Q06 3Q06 4Q06 1Q07
Under 30% 30‐40% 40‐50% Over 50%
‐2 bps
‐16 bps
‐32 bps
‐43 bps
Net Interest Margin, %
Median NIMs grouped by long‐term earning assets* as of June 30, 2004Federal funds rate increased 425 bps between June 2004 and July 2006
FEDERAL DEPOSIT INSURANCE CORPORATIONSource: Call Reports. Based on consistent sample of active Call Report filers as of 2Q15 with assets <$1B. Excludes any former TFR filers.
Share of Banks with Long‐term Assets Representing 30% or More of Earning Assets
Increased Exposure to Long-term Assets
Share of Community Banks
0 to 10%10 to 25%25 to 50%50 to 75%75 to 100%
2006
FEDERAL DEPOSIT INSURANCE CORPORATION
Share of Community Banks
0 to 10%10 to 25%25 to 50%50 to 75%75 to 100%
Share of Banks with Long‐term Assets Representing 30% or More of Earning Assets
Increased Exposure to Long-term Assets
Source: Call Reports. Based on consistent sample of active Call Report filers as of 2Q15 with assets <$1B. Excludes any former TFR filers.
2007
FEDERAL DEPOSIT INSURANCE CORPORATION
Share of Community Banks
0 to 10%10 to 25%25 to 50%50 to 75%75 to 100%
Share of Banks with Long‐term Assets Representing 30% or More of Earning Assets
Increased Exposure to Long-term Assets
Source: Call Reports. Based on consistent sample of active Call Report filers as of 2Q15 with assets <$1B. Excludes any former TFR filers.
2008
FEDERAL DEPOSIT INSURANCE CORPORATION
Share of Community Banks
0 to 10%10 to 25%25 to 50%50 to 75%75 to 100%
Share of Banks with Long‐term Assets Representing 30% or More of Earning Assets
Increased Exposure to Long-term Assets
Source: Call Reports. Based on consistent sample of active Call Report filers as of 2Q15 with assets <$1B. Excludes any former TFR filers.
2009
FEDERAL DEPOSIT INSURANCE CORPORATION
Share of Community Banks
0 to 10%10 to 25%25 to 50%50 to 75%75 to 100%
Share of Banks with Long‐term Assets Representing 30% or More of Earning Assets
Increased Exposure to Long-term Assets
Source: Call Reports. Based on consistent sample of active Call Report filers as of 2Q15 with assets <$1B. Excludes any former TFR filers.
2010
FEDERAL DEPOSIT INSURANCE CORPORATION
Share of Community Banks
0 to 10%10 to 25%25 to 50%50 to 75%75 to 100%
Share of Banks with Long‐term Assets Representing 30% or More of Earning Assets
Increased Exposure to Long-term Assets
Source: Call Reports. Based on consistent sample of active Call Report filers as of 2Q15 with assets <$1B. Excludes any former TFR filers.
2011
FEDERAL DEPOSIT INSURANCE CORPORATION
Share of Community Banks
0 to 10%10 to 25%25 to 50%50 to 75%75 to 100%
Share of Banks with Long‐term Assets Representing 30% or More of Earning Assets
Increased Exposure to Long-term Assets
Source: Call Reports. Based on consistent sample of active Call Report filers as of 2Q15 with assets <$1B. Excludes any former TFR filers.
2012
FEDERAL DEPOSIT INSURANCE CORPORATION
Share of Community Banks
0 to 10%10 to 25%25 to 50%50 to 75%75 to 100%
Share of Banks with Long‐term Assets Representing 30% or More of Earning Assets
Increased Exposure to Long-term Assets
Source: Call Reports. Based on consistent sample of active Call Report filers as of 2Q15 with assets <$1B. Excludes any former TFR filers.
2013
FEDERAL DEPOSIT INSURANCE CORPORATION
Share of Community Banks
0 to 10%10 to 25%25 to 50%50 to 75%75 to 100%
Share of Banks with Long‐term Assets Representing 30% or More of Earning Assets
Increased Exposure to Long-term Assets
Source: Call Reports. Based on consistent sample of active Call Report filers as of 2Q15 with assets <$1B. Excludes any former TFR filers.
2014
FEDERAL DEPOSIT INSURANCE CORPORATION
Share of Community Banks
0 to 10%10 to 25%25 to 50%50 to 75%75 to 100%
Share of Banks with Long‐term Assets Representing 30% or More of Earning Assets
Increased Exposure to Long-term Assets
Source: Call Reports. Based on consistent sample of active Call Report filers as of 2Q15 with assets <$1B. Excludes any former TFR filers.
2Q15
FEDERAL DEPOSIT INSURANCE CORPORATION
Share of Community Banks
0 to 10%10 to 25%25 to 50%50 to 75%75 to 100%
Share of Banks with Long‐term Assets Representing 30% or More of Earning Assets
Increased Exposure to Long-term Assets
Source: Call Reports. Based on consistent sample of active Call Report filers as of 2Q15 with assets <$1B. Excludes any former TFR filers.
2006 2Q15
FEDERAL DEPOSIT INSURANCE CORPORATION
Types of Interest Rate Risk
INTEREST RATE RISK
Yield Curve Risk
Option RiskBasis Risk
RepricingRisk
FEDERAL DEPOSIT INSURANCE CORPORATION
Board Responsibilities
Oversee Policy Establishment
Ensure Prudent IRR Levels
Establish Risk Tolerances
Understand Impact of IRR Strategies
Establish Lines of Authority and
Responsibilities
Internal Control & Review
Monitor IRR Position
FEDERAL DEPOSIT INSURANCE CORPORATION
Policies Should Govern the IRR Process & Translate the Board’s Goals
Risk Limits on Earnings and Economic Value of Equity
Lines of Authority and Responsibilities
Reporting Standards
Independent Review Process
Types of Instruments and Activities that may be used to Manage IRR
FEDERAL DEPOSIT INSURANCE CORPORATION
How to Establish Appropriate Risk Limits
Reflect the Board’s Risk Tolerance
Consider Earnings and Capital, and Complexity
Change with Risk Profile
Trigger Appropriate Action
FEDERAL DEPOSIT INSURANCE CORPORATION
Evaluation of Risk Limits
Hypothetical impact to 2Q15 median pre‐tax ROAA (1.07%) for insured institutions under $1B in assets. Based on applying simple haircut to net interest income, holding all other income drivers constant.
Consider impact of net interest income declines on net income Consider impact of non-interest income on net income and establish net income limits
-16%
-31%
-47%
-62%‐80%
‐60%
‐40%
‐20%
0%5% Haircut 10% Haircut 15% Haircut 20% Haircut
Estimated Impact to Earnings if Net Interest Income DeclinesPercent Decline in Pre‐Tax ROAA
FEDERAL DEPOSIT INSURANCE CORPORATION
Board Oversight of the IRR Process
• Internal Controls• Independent Review• Annual Board Report
• Model Selection• Data Inputs• Assumptions• Documentation
• Policies & Procedures• Authority & Responsibility• Risk Limits• Risk Mitigation
• Management & Board Reporting
• Assess Reports• Risk Limit Compliance
Risk Controls &
LimitsIdentify & Measure
Monitor & Report
Internal Controls &
Audit
FEDERAL DEPOSIT INSURANCE CORPORATION
Types of Measurement Systems
Short-term Models
Gap AnalysisGap
Income SimulationIncomeSim
Long-term Models
Economic Valueof Equity (EVE)
ExtendedIncome Simulation
EVE
ExtendedIncomeSim
FEDERAL DEPOSIT INSURANCE CORPORATION
Income Simulation: Measures Income if Rates Change
Product Type Balance
Base Case +300 bps Scenario
Rate Income Rate Income
Fixed Rate Loans $1,000 4% $40 4% $40
15 Year Muni Bonds $1,000 4% $40 4% $40
Non‐maturity Deposit $1,500 1% $15 2% $30
Net Interest Income $65 $50
Assess Reports to Monitor IRR Levels Ensure Levels Comply with Policy Limits
Percent Change in Net Interest Income ‐ 23%
FEDERAL DEPOSIT INSURANCE CORPORATION
What is Economic Value of Equity?
Present Value (Assets) – Present Value (Liabilities) = EVE
Considers the difference between book yield and the market yield
LoanRate 5% Values
Decrease
Time DepositRate 1%
Rates Increase
FEDERAL DEPOSIT INSURANCE CORPORATION
Compare Base EVE to Shocked EVE
Rate Scenarios
‐100 bps Base Case +300 bps
PV (Assets), $ in millions $555 $550 $525
PV (Liabilities), $ in millions $465 $460 $450
Economic Value of Equity, $ in millions $90 $90 $75
% Change from Base 0% ‐ ‐17%
Asset values decreased more than liability values, resulting in a
net decrease in EVE
FEDERAL DEPOSIT INSURANCE CORPORATION
Combination of Income Simulation and EVE Provides a More Complete Picture of IRR EVE
• Captures All Cash Flows and Rate Sensitivity• Long-term
Income Simulation• Captures Cash Flows and Rate Sensitivity for Periods Measured• Can Point to “when” IRR Occurs
Use of Both Models Provides a More Complete Picture of an Institution’s IRR Exposure
FEDERAL DEPOSIT INSURANCE CORPORATION
Model Assumptions
Written documentation Review changes
Driver RatesAccount Aggregation
Static or DynamicBalance Sheet
Other Embedded Options
Prepayment Estimates
Rate Changes
Deposit Assumptions
FEDERAL DEPOSIT INSURANCE CORPORATION
Dramatic Rate Changes are Fairly Common
‐8
‐6
‐4
‐2
0
2
4
6
8
10
‐8
‐6
‐4
‐2
0
2
4
6
8
10
Jul‐59 Jul‐63 Jul‐67 Jul‐71 Jul‐75 Jul‐79 Jul‐83 Jul‐87 Jul‐91 Jul‐95 Jul‐99 Jul‐03 Jul‐07 Jul‐11 Jul‐15
Year‐Over‐Year Change in Fed Funds RatePercentage Percentage
+/‐200 bps Range
Source: Federal Reserve Board
FEDERAL DEPOSIT INSURANCE CORPORATION
Rate Changes: Yield Curve Shifts can beNon-parallel
Source: Federal Reserve Board / Haver Analytics
1Q 20041Q 2005
1Q 2006
0
1
2
3
4
5
6
7
8
3M 1Y 5Y 10Y 30Y
Yield Curve – 2004 to 2006Rate, %
Parallel +200 bpsBased on 1Q 2004
FEDERAL DEPOSIT INSURANCE CORPORATION
Deposit Assumptions
Price Sensitivity
(Beta)
Measures deposit rate changes relative to market rate changes
Example: 33%
Average LifeDecay Rates
Annual percentage of deposit run-off
Weighted average time (in years) until deposits are withdrawn
Track historical information and adjust for qualitative factors
FEDERAL DEPOSIT INSURANCE CORPORATION
Prepayment Speeds
0%
20%
40%
60%
80%
0
3
6
9
12
15
‐100 Stable +100 +200 +300
Rate Changes can have Considerable Impact on Prepayment SpeedsWAL, in Years Principal Repaid
Rate Scenario (bps)
Weighted Average Life (left axis)
Principal Cash Flow Repaid within 3 Years
(right axis)
FEDERAL DEPOSIT INSURANCE CORPORATION
Sensitivity Testing
Beta Assumption Net Interest Income Risk Limit
20% ‐5% ‐10%
25% ‐10% ‐10%
30% ‐15% ‐10%
Impact of beta assumption changes on model results
IncomeSim
FEDERAL DEPOSIT INSURANCE CORPORATION
Internal Control and Review
Internal Control System:
Roles, Responsibilities, and Lines of Authority
Separation of Duties
Adequacy of System Inputs and Measurement Systems
Policy Compliance
Corrective Action Procedures
Independent Review & Validation
Adequacy of Internal Control System Compliance
with Internal Control System
Adequacy of Measurement
System
Accuracy of Data Inputs
Adequacy of Assumptions
Validity of Calculations
Backtesting
Annual Report to Board
FEDERAL DEPOSIT INSURANCE CORPORATION
Questions to Ask Management
Problematic rate scenarios
Key assumptions / sensitivity analysis
New products / initiatives
Mitigation strategies
Model reliability
Independent Review
FEDERAL DEPOSIT INSURANCE CORPORATION
Resources
Joint Agency Policy Statement on Interest Rate Risk (FIL-52-96)
Advisory on Interest Rate Risk Management (FIL-2-2010)
Interagency Advisory on IRR Management: Frequently Asked Questions (FIL-2-2012)
Managing Sensitivity to Market Risk in a Challenging Interest Rate Environment (FIL-46-2013)
Winter 2014 Supervisory Insights (FIL-61-2014)
FEDERAL DEPOSIT INSURANCE CORPORATION
Resources
www.fdic.gov
Technical Assistance Video Program: www.fdic.gov/regulations/resources/director/video.html
Directors’ Resource Center: www.fdic.gov/resourcecenter
Regional Senior Capital Markets and Securities Specialists
Mailbox: [email protected]