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Regulatory Alert – Examiners are Taking a Close Look at Interest Rate Risk

The news is rolling in from both banks and regulators — interest rate risk (“IRR”) will be a primary focus of upcoming safety and soundness examinations.  In the current market of tight net interest margins and slow loan growth, regulators are concerned that banks may begin reaching for higher yields in the form of longer-term assets.  This concern could be well-founded given the strong forces that are creating incentives on both sides of the closing table.  In the current low interest rate environment, borrowers believe that rates can only go up, and so there is a strong incentive to lock in the low rates for a longer term.  To obtain the longer-term lock, borrowers are typically willing to pay a premium.  On the other side of the table, lenders are feeling pressure of tight net interest margins and tough loan competition.  Consequently, they also have an incentive to target longer-term, higher-yielding returns. While these incentives may temporarily alleviate the pressure of declining net interest margins, regulators are concerned that they may also expose banks to additional risks.  When rates eventually increase, regulators predict that lenders will ultimately be forced to fund their new long-term assets with higher-priced liabilities.

Both state and federal regulators have recently and repeatedly emphasized that banks must have a robust process for measuring, and where necessary, mitigating their exposure to increasing interest rates.  While this recommendation is certainly not new, the intensity of the recent regulatory scrutiny strongly suggests that bankers should be conducting internal reviews and updates of their IRR management function prior to the time that examiners walk in the door.

At a minimum, banks should revisit their IRR policies, procedures, controls and simulation models.  Even if your bank’s IRR profile is relatively simple, make sure that your simulation model is current and that its assumptions are consistent with your institution’s IRR profile.  Even if your bank’s model is prepared by a third-party processor, management should understand and be able to discuss the model’s assumptions (e.g., rate changes, prepayment estimates, cost of funds, etc.), as well as the implications of its results with respect to your bank’s current and projected balance sheet.  This will be especially critical for banks that have recently repositioned their balance sheet to include more long-term, higher-yielding assets.

As your bank begins the process of reviewing and updating IRR policies, procedures and controls, you should do so with the appropriate regulatory guidance in hand.  This guidance is publicly available, and it is the same guidance that will be used by examiners in assessing the adequacy of your IRR management function.  A link to each of the three primary IRR guidance documents is included below:

In addition, the FDIC recently issued a series of technical assistance videos on the IRR management function.  Click here to access those videos.

Again, IRR management is not a new issue but the pressures and incentives of the current lending market are giving it a new life in bank safety and soundness examinations.  Bankers should steps now to review and update IRR management processes so that they will be prepared to successfully respond to this type of inquiry at the next exam.