IRR Measurement
Well-managed
banks have IRR measurement systems that measure the effect of rate changes on
both earnings and economic value. The latter is particularly important for
institutions with significant holdings of intermediate and long-term instruments
or instruments with embedded options because the market values of all these
instruments can be particularly sensitive to changes in market interest rates.
Institutions with significant noninterest income that is sensitive to changes
in interest rates should focus special attention on net income as well as net
interest income. Since the value of instruments with intermediate and long
maturities and embedded options is especially sensitive to interest-rate
changes, banks with significant holdings of these instruments should be able to
assess the potential longer-term impact of changes in interest rates on the
value of these positions—the overall potential performance of the bank.
IRR measurement systems should have the
following; assess all material IRR associated with an institution’s assets,
liabilities, and OBS positions; use generally accepted financial concepts and
risk measurement techniques; and have well documented assumptions and
parameters. Material sources of IRR including the mismatch, basis, and option
risk exposures of the institution. In many cases, the interest-rate
characteristics of a bank’s largest holdings will dominate its aggregate risk
profile. While all of a bank’s holdings should receive appropriate treatment,
measurement systems should rigorously evaluate the major holdings and
instruments whose values are especially sensitive to rate changes. Instruments
with significant embedded or explicit option characteristics should receive
special attention.
IRR measurement systems should use
generally accepted financial measurement techniques and conventions to estimate
the bank’s exposure. Examiners should evaluate these systems in the context of
the level of sophistication and complexity of the institution’s holdings and
activities. A number of accepted techniques are available for measuring the IRR
exposure of both earnings and economic value. Their complexity ranges from
simple calculations and static simulations using current holdings to highly
sophisticated dynamic modeling techniques that reflect potential future
business and business decisions. Basic IRR measurement techniques begin with a
maturity schedule, which distributes assets, liabilities, and OBS holdings into
time bands according to their final maturity (if fixed-rate) or time remaining
to their next reprising (if floating). The choice of time bands may vary from
bank to bank. When assets and liabilities do not have contractual reprising
intervals or maturities, they are assigned to reprising time bands according to
the judgment and analysis of the institution’s IRR management staff (or those
individuals responsible for controlling IRR).
Comprehensive Internal Controls
An
institution’s IRR management process should be an extension of its overall
structure of internal controls. Banks should have adequate internal controls to
ensure the integrity of their interest-rate risk management process. Internal
controls consist of procedures, approval processes, reconciliations, reviews,
and other mechanisms designed to provide a reasonable assurance that the
institution’s objectives for interest-rate risk management are achieved.
Appropriate internal controls should address all of the various elements of the
risk-management process, including adherence to polices and procedures, and the
adequacy of risk identification, risk measurement, and risk reporting.
An
important element of a bank’s internal controls for interest-rate risk is
management’s comprehensive evaluation and review. Management should ensure that
the various components of the bank’s interest-rate risk management process are
regularly reviewed and evaluated by individuals who are independent of the
function they are assigned to review. Although procedures for establishing
limits and for operating within them may vary among banks, periodic reviews
should be conducted to determine whether the organization complies with its
interest-rate risk policies and procedures. Positions that exceed established
limits should receive the prompt attention of appropriate management and should
be resolved according to approved policies. Periodic reviews of the
interest-rate risk management process should also address any significant
changes in the types or characteristics of instruments acquired, limits, and
internal controls since the last review.
Reviews of the interest-rate risk
measurement system should include assessments of the assumptions, parameters,
and methodologies used. These reviews should seek to understand,test, and
document the current measurement process, evaluate the system’s accuracy, and
recommend solutions to any identified weaknesses. The results of this review,
along with any recommendations for improvement, should be reported to the
board, which should take appropriate, timely action. Since measurement systems
may incorporate one or more subsidiary systems or processes, banks should
ensure that multiple component systems are well integrated and consistent with
each other. Banks, particularly those with complex risk exposures, are
encouraged to have their measurement systems reviewed by an independent party,
whether an internal or external auditor or both. Reports written by external
auditors or other outside parties should be available to relevant supervisory
authorities. Any independent reviewer should be sure that the bank’s
risk-measurement system is sufficient to capture all material elements of
interest-rate risk.
IRR
Scenarios
IRR
exposure estimates, whether linked to earnings or economic value, use some form
of forecasts or scenarios of possible changes in market interest rates. Bank
management should ensure that IRR is measured over a probable range of
potential interest-rate changes, including meaningful stress situations. The
scenarios used should be large enough to expose all of the meaningful sources
of IRR associated with an institution’s holdings. In developing appropriate
scenarios, bank management should consider the current level and term structure
of rates and possible changes to that environment, given the historical and
expected future volatility of market rates. At a minimum, scenarios should
include an instantaneous plus or minus 200- basis-point parallel shift in
market rates. Institutions should also consider using multiple scenarios,
including the potential effects of changes in the relationships among interest
rates (option risk and basis risk) as well as changes in the general level of
interest rates and changes in the shape of the yield curve.
The risk-measurement system should
support a meaningful evaluation of the effect of stressful market conditions on
the institution. Stress testing should be designed to provide information on
the kinds of conditions under which the institution’s strategies or positions
would bemost vulnerable; thus, testing may be tailored to the risk
characteristics of the institution. Possible stress scenarios include abrupt
changes in the term structure of interest rates, relationships among key market
rates (basis risk), liquidity of key financial markets, or volatility of market
rates. In addition, stress scenarios should include the conditions under which
key business assumptions and parameters break down. The stress testing of
assumptions used for illiquid instruments and an instrument with uncertain
contractual maturities, such as core deposits, is particularly critical to
achieving an understanding of the institution’s risk profile. Therefore, stress
scenarios may not only include extremes of observed market conditions but also
plausible worst-case scenarios. Management and the board of directors should
periodically review the results of stress tests and the appropriateness of key
underlying assumptions. Stress testing should be supported by appropriate
contingency plans.
