Financial Update (First Quarter 2010)

Fed Vice Chairman Kohn Cautions Banks on Interest Rate Risk

The nation's banks, thrifts, and credit unions must be particularly mindful of interest rate risk, Federal Reserve System Vice Chairman Donald Kohn said in a January 29 speech on interest rate risk management at a symposium sponsored by the Federal Deposit Insurance Corporation. Noting the difficulty in predicting how interest rates will respond to monetary policy in normal times, Kohn warned that the task has become even more challenging under current circumstances.

photo of Fed Vice Chairman Kohn

"The usual uncertainty about changes in policy interest rates is compounded by uncertainties related to the possible special effects of the historically low levels of interest rates in the current recession, as well as the unprecedented increase in the size of the Federal Reserve's balance sheet and bank reserves as a result of our credit programs and large-scale asset purchases," he said.

Other elements could influence rates
A number of factors outside of monetary policy could affect intermediate- and longer-term interest rates, Kohn said, including increased competition for funding as a large amount of debt matures over the next few years and large projected federal budget deficits, which could crowd out private-sector investment.

Foreign demand for U.S. dollar–denominated assets could also influence longer-term rates. Prior to the crisis, the United States drew large inflows of foreign capital seeking higher returns. According to Kohn, this inflow helped push down long-term rates. However, the Group of 20 leaders' commitment to more balanced global growth could affect the amount of foreign capital made available to the United States, with a possible impact on long-term rates.

Robust interest rate risk management is key
Many banks, thrifts, and credit unions may be exposed to an eventual increase in short-term rates, said Kohn, who urged banks to "have in place sound practices to measure, monitor, and control this risk."

The unusually high level of uncertainty with respect to the future path of interest rates could pose challenges to banks as they manage their interest rate exposure. Echoing a recent interest rate risk advisory issued by financial regulators, Kohn discussed the importance of appropriate corporate governance and strong internal controls as well as robust risk measurement and reporting systems that focus on stress testing of alternate-interest rate scenarios.

February 26, 2010