Summary: | The FDIC is re-emphasizing the importance of prudent interest rate risk oversight and risk management processes to ensure FDIC-supervised institutions are prepared for a period of rising interest rates. Statement of Applicability to Institutions With Total Assets Under $1 Billion: This Financial Institution Letter applies to all FDIC-supervised banks and savings associations, including community institutions. |
Highlights:
Continuation of FIL-46-2013 Distribution: Suggested Routing: Note: |
Financial Institution Letters FIL-46-2013 October 8, 2013 |
Managing Sensitivity to Market Risk in a Challenging Interest Rate Environment The FDIC has identified industry trends that highlight the importance of careful management of sensitivity to interest rate risk. Nationally, a number of institutions report a significantly liability-sensitive balance sheet position, meaning that a marked increase in interest rates could adversely affect net interest income and, in turn, earnings performance. For a number of FDIC-supervised institutions, the potential exists for material securities depreciation relative to capital in a rising interest rate environment. Interest rate risk at most banks arises from traditional activities; however, institutions may have hedging positions, embedded optionality, or other strategies that can moderate this sensitivity. This Financial Institution Letter re-emphasizes the importance of prudent interest rate risk oversight and effective risk management processes to ensure all state nonmember institutions are prepared for a period of rising interest rates. On January 6, 2010, the FDIC joined the other financial regulators 1in issuing guidance titled Advisory on Interest Rate Risk Management (the 2010 Advisory). This guidance was issued when interest rates were trending toward historic lows and the more attractive asset yields were becoming concentrated in longer-duration assets. The issuance was intended to remind institutions of supervisory expectations for managing interest rate risk and that the declining trend in interest rates would not continue indefinitely. The fundamental risk management processes outlined in the 2010 Advisory continue to be relevant today. Institutions that embraced its tenets should have an effective interest rate risk management framework in place to handle potential market volatility. The FDIC is increasingly concerned that certain institutions may not be sufficiently prepared or positioned for sustained increases in, or volatility of, interest rates. For example, institutions with a decidedly liability-sensitive position could experience declines in net interest income and potential deposit run-off in a rising rate environment. Moreover, rate sensitive liabilities may re-price faster than earning assets as coupons on variable rate loans and investments remain below their floor. Accordingly, the FDIC believes that asset-liability management should be viewed as an ongoing process that requires effective measurement and monitoring systems, clear communication of modeling results, evaluation of exposures relative to established policy limitations, and consideration of risk mitigation options as appropriate. As economic and interest rate cycles evolve, asset-liability management processes should be revisited to confirm that the institution has avoided a speculative position and reduced the likelihood of adverse outcomes. Boards of directors and management are strongly encouraged to analyze on- and off-balance sheet exposure to interest rate volatility and take action as necessary to mitigate potential financial risk. If interest rates were to rise markedly, institutions that have concentrated bond holdings in long-duration issues could experience severe depreciation of a magnitude that could be material relative to their capital position. Institutions that rely primarily on a long-duration fixed-income portfolio for liquidity could have difficulty meeting short-term cash needs if other marketable assets or funding sources are not readily available. Although net unrealized losses on securities may not flow through to regulatory capital under certain circumstances, 2examiners consider the amount of unrealized losses in the investment portfolio and an institution's exposure to the possibility of further unrealized losses when qualitatively assessing capital adequacy and liquidity and assigning examination ratings. Unrealized losses on securities also may reduce equity capital under U.S. generally accepted accounting principles (GAAP) 3. Specifically, net unrealized losses on trading and available-for-sale securities are reflected in GAAP equity. Under certain circumstances, principally credit impairment, unrealized losses on held-to-maturity debt securities can also reduce GAAP equity. Adverse trends in an institution's GAAP equity can have negative market perception and liquidity implications. The FDIC is re-emphasizing these practices to ensure state nonmember institutions have adopted a comprehensive asset-liability and interest rate risk management process:
Effectively managing interest rate risk is part of the business of banking, and many institutions have effectively measured, monitored, and controlled exposures to achieve earnings goals. However, significant, unmitigated levels of interest rate or market risk can lead to losses and liquidity constraints when prevailing rates change significantly. The FDIC will continue to review interest rate risk in the normal course of its supervisory activities and offer feedback as appropriate on institutions' risk measurement and mitigation processes to sustain earnings and preserve capital. |
Additional Related Topics:
- Advisory on Interest Rate Risk Management, January 6, 2010
- Managing Sensitivity to Market Risk in a Challenging Interest Rate Environment
- 1
The financial regulators that issued the 2010 Advisory are the Board of Governors of the Federal Reserve System, FDIC, National Credit Union Administration, Office of the Comptroller of the Currency, former Office of Thrift Supervision, and Federal Financial Institutions Examination Council State Liaison Committee.
- 2
The Basel III Interim Final Rule, adopted by the FDIC’s Board of Directors on July 9, 2013, provides a prospective option for all institutions, other than institutions subject to the rule’s advanced approaches, to make a one-time irrevocable election to continue to neutralize accumulated other comprehensive income in a manner consistent with existing rules and financial reporting standards.
- 3
Accounting Standards Codification (ASC) Section 320-10-35, Investments-Debt and Equity Securities – Overall – Subsequent Measurement, requires that any unrealized holding gains or losses on trading securities be reported in earnings and unrealized holding gains and losses on available-for-sale (AFS) securities generally be reported in other comprehensive income. Held-to-maturity (HTM) securities are measured at amortized cost; therefore, unrealized losses are generally not recognized in the financial statements. However, unrealized losses on HTM securities must be recognized if there is other-than-temporary impairment (OTTI). In general, for AFS and HTM debt securities, the portion of OTTI representing credit loss must be reported in earnings, while the remainder is reported in other comprehensive income. However, unrealized losses on AFS and HTM debt securities that an institution intends to sell or more likely than not will be required to sell before recovery of their amortized cost basis less any current-period credit loss are deemed OTTI, and therefore must be fully reported in current period earnings.