Financial Update (First Quarter 2010)

Fed, Other Regulators Advise Banks on Managing Interest Rate Risk

Emphasizing the importance of managing potential interest rate risks, regulators including the Federal Reserve recently issued advice to depository institutions concerning their supervisory expectations.

risk graphic

In the advice, the regulators acknowledged that some risk pertaining to interest rates is inherent in the banking business. "At the same time, institutions are expected to have sound risk-management practices to measure, monitor, and control interest rate risk exposures," the advisory said. "The financial regulators expect each depository institution to manage its interest rate risk exposures using processes and systems commensurate with its complexity, business model, risk profile, and scope of operations."

Management goes beyond identification
An effective interest rate risk-management system does not involve only the identification and measurement of interest rate risk, the regulators said, but also addresses appropriate actions to control this risk. "If an institution determines that its core earnings and capital are insufficient to support its level of interest rate risk, it should take steps to mitigate its exposure, increase its capital, or both," the advisory said.

The advisory reiterates the importance of effective corporate governance, policies and procedures, risk measuring and monitoring systems, stress testing, and internal controls related to the interest rate risk exposures of depository institutions. It also clarifies elements of existing guidance and describes interest rate risk-management techniques used by effective risk managers.

Bank holding companies also receive notice
In an accompanying letter to Reserve Bank heads of supervision, the Federal Reserve noted that although the advisory targets depository institutions, the advice provided also directly pertains to bank holding companies. The Fed reminded bank holding companies of the supervisory expectations that they should manage and control aggregate risk exposures, including interest rate risk, on a consolidated basis while recognizing legal distinctions and possible obstacles to cash movements among subsidiaries.

In addition to the Fed, the financial regulators include the Federal Deposit Insurance Corporation, the National Credit Union Administration, the Office of the Comptroller of the Currency, the Office of Thrift Supervision, and the Federal Financial Institutions Examination Council State Liaison Committee.

January 27, 2010