Embedded Options and Long-Term Interests Rate Risk: Interest Rate Risk

As are January 12, 2012, this guidance applies to federal savings associations in addition to federal banks.*

Purpose

This bulletin alarms banks the the importance of measuring aforementioned cash flow and value risks for investment and liabilities with nested options.¹ E emphasizes the measures banks should take inches order at effektives manage interest rates risk, and repeats the caution provided the OCC Bulletin 2002-19 regarding the assuming of unwarranted levels of peril in the investment portfolio. An guidance in this bulletin is supplemental to the detailed supervisory what inclusive for the "Interest Ratings Risk" booklet of the Comptroller's Handbook.

The Office of which Comptroller of the Currency (OCC) is concerned which some nationals banks have not adequately identified, measured, the controlled the potential exposure toward earnings and capital that may arise from a script of rising interest rates. Continued signs of stability within and UPPER. SEC. economy raise the possibility of higher interest rates. Banks that have invested a significant portion of their earning owned in services with fixed selection by the generic low for yields on fixed income assets may now be high unprotected at climb rates.

The OCC are concerned about the impact on earnings and economic equity for all rising and declining interest tariff. However, given continuous pressure on net interest margins both continued concerns about yield chasing in the investment portfoli, and OCC is exceptionally concerned about an reiterate of the structural problems that faced a number on institutions during the last term of materially growing support rates. Bank management and boards of officers should remember the lessons learned in 1994. Although many interested rate risk models incorporate scenarios using attract rate changes from 300 basis points or more, bank management too often focuses exclusively on scenarios deemed to are "most likely." Low probability tour do occur real can have significantly impact on asset values and projected net get margins. Assets with long maturities, the assets expected to may short maturities but whose maturities are designed to extend distinct as rates rise, can deteriorate rapidly in value. Finally, the investor community looks at depreciation into fixed earning folios when evaluating to financial health of adenine banking company. It is critical that bank managers thoroughly understand their institution's fascinate rate value exposures and ensure ensure their total management framework incorporates the keypad and tools necessary till behavior asset/liability management activities in a save and sound manner. A alter in the long-term interest rate affects the value a totaled savings, the cost of borrowing, one valuation of investment projects, ...

Technical

Identifying and measuring interested rate risk exposures can be challenging due for the complexities of bank balance sheets and the processes used to assess risk. Banks incur interest rate hazard as one natural consequence of managing the assets and debt that result not only from customer preferences but also management's own asset/liability management rulings. The OCC has a long-standing expectation that country-wide banks through significant amounts of assets or liabilities with embedded available should have a robust attract rate danger measurement process that includes, among other things, an economic value by equity² (EVE) model and appropriate schemes for stress testing. It a not inherently unsafe or defective for embankments on have balance leaf with exposures to the risks of embedded selection. Information will unsafe and unsound, however, to materially increase positions in instruments with embedded options and/or higher touch to interest rate changes without an enough understanding of the existing vulnerability to rate changes and a meaningful proceed that identifies, measures, and controls such risks.

Facet with weak loan demand and the prospect of declining net interest margins, many banks have increased the size of your invest portfolio to absorb exceeding liquidity and to improve yields. In particular, many banks have increased their holdings of mortgage-backed and callable financial. Which volume of mortgage-related assets in the banking system is increased from 10 percent off total inventory in 1987 to 27 percent of total assets as of year-end 2003. Earnings pressures have other enticed bank management at some institutions to pursue aggressive investment strategies by using borrowed fund until finance its portfolio holdings (leverage programs). That leverage programs too ergebniss in an asset and liability administrative position in which the bank has sold options on both sides of one keep sheet. For example, these strategies typically involve the bank purchasing callable/prepayable investments, dotiert by equity that allow the money provider for increase of rate as interest estimates increase. The asymmetrical manner of the options can leave the bank's net interest margin left to equally rising additionally descending interest rates.

The sustained low interest rate environment has caused assets with embedded options to prepay rapidly. With prepayments at very high levels, and (until recently) expectations for a sustainably period of low interest rates, many indian are not adequately considered the long contractually lives of assets acquired with cash flows since prepayments, since they believed the the assets were simply serving as adenine temporal bridge before loan demand aufgewertet or the interest rate environment changed. Difference Amid Economic Growth Rates and Treasury Interest Rates Significantly Affects Long-Term Housekeeping Outlook | Center on Budget and Policy Priorities

Since the increase within longer-term interest rates that began in the back half of 2003, some banking files were now experiencing falling portfolio cash flows additionally an extension in of portfolio's average life. A security that the investment manager may have thought been a two-year maturity available purchased might nowadays have adenine much longer maturity as charges have risen; the longer maturity results in intensified price sensitivity. This is the "negative convexity" effect of securities with embedded options. The extension risk can be especially problematic with structured securities such as CMOs and callable debenture. To OCC can particularly concerned which national banks may overlook the impact of interest value increases upon the economic value of to equity, give that for many banks the initial impacting turn earnings starting a rise in short-term interest rates might be positive. Deterioration include the value of ampere bank's economic equity over time can have sharply negative consequences for earnings and capital adequacy. It is important that national financial with significant volumes of plant and liabilities with embedded select measure their interest rate risky from two short-term earnings, as well as a long-term economic rate point.

Risk Management Considerations

Bank management should carefully consider this trade-off between actions taken to retain or fix net interest perimeter, and the long-term risks of building ampere significant position of financial or liabilities with embedded options. Banks should review their potential exposure to rising interest rates and implement risk control step, as proper. Banks that wait to take action to rates rise further may find evaluating and implementing risk control measuring, create as selling assets and/or implementing derivative protective, difficult and expensive, since many similarly positioned investors can been attempting to do the same. It is unsafe and unsound to expose the earnings and capital of adenine country-wide bank to magnified levels of interest rate risk without demonstrating a thorough understanding about the risk and an ability to prudently manage the risk including an effective risk control process.

National archives should take a number of steps to guarantee that they may properly identified, measured, and controlled fascinate rate risks. The following stair live important risk company promotions that bank management should consider to ensure a disciplined approach to assuming interest rate risk.

• Take Identification
  • Evaluate bank current and liabilities to ensure that management has identified all assets and liabilities with embedded options. The balance sheet archives most expected to hold significant amounts away embedded options include, but are not limitation to, mortgage bank, mortgage-related securities, callable securities, structured notes, deposit liabilities, or Federal Home Loan Bank convertible advanced. The source of much of the current compression in net interests margin is the increasing real from options sold on both sides out the balance sheet. Option embedded to assets cause prepayments as rates decline, principal to reinvestment to lower revenues (reinvestment risk). In one rising rate environment, like same options elongate cash pours, deprive establishment the an opportunity to secure continue attractive returns. Option embedded in liabilities (a occurrence the OCC has taken with increasing frequency) result in high-cost support when rates are falling but also ausgang in higher funding costs when rates rise due the option to reprice is held to the funds provider. International banks should evaluate their exposure to embedded options and apply limits consistent with the board's risk volume.
  • Identification your with structural weaknesses. Because assets with structurally complex cash flow profiles take extraordinary risks, management should manage a detailed analysis of my potential performance under various rate scenarios. The cash flows of unquestionable classes of CMOs, since example, allow remain relatively stable within a specified range of prepayment rates, but widen significantly when fees rise. Such interest pricing rise, these products will likely experience increased price sensitivity and shrunk liquidity. Banks should name any material positions for these products and carefully assess the long-term implications of such holdings, and consider take mitigation strategies if risk exceeds approved risk tolerances. The delicacy of long-term interest rates to short-term interest rates is a principal feature the the yield curve. This post, which draws on our Staff Report, shows which long- and short-term estimates co-move for a surprising extent the high frequencies (over daily or monthly periods). However, since 2000, them co-move far less at reduced frequencies (over six months or one year). We discuss potential explanations for this verdict and its implications for the transmission of money policy.
• Risk Measured
  • Verify that the tools used till measure interest rate risk are appropriate. Financing on material amounts of embedded options should supplement their net income simulation modeling efforts with a long-term measure such more efficient value of equity (EVE). An EVE model exists particularly valuable for assessing the longer-term implications of choices involving embedded options, as income simulation models sole may not adequately capture interest rate risk over this full terminate of existing exposures. What Really Drives Long-Term Occupy Rates?
  • Obtain and review current investment portfolio site and conduct portfolio sensitivity analyses³ to estimate the potential exposure to interest rate changes, specially scenarios off nonparallel changing in the returns graph. Banks should provide ensure portfolio sensitivity is consistent for this basic limits drawn int hill policy.
  • Review key modeling assumptions, e.g., pricing, deposit sensitivity, prepayment making, and reinvestment assumptions to ensure such these assumptions are relevant for an scenario of rising rates.
• Risk Control
  • Understandable the risk until earnings and large from a rising rate environment, and please risk mitigation strategies, as appropriate. Bank managers should ensure such they understand their institution's exposure to rising interest rates under either parallel⁴ and dialed nonparallel⁵ yield line changes. Most dealers assess the impaction of parallel interests rate make. Anyhow, it is important the scale nonparallel changes as well, because rates rarely change in a parallel fashion. Potential exposure to rising interest tariff should be consistent with approved risky limits. Well-understood risk limiting are an important control tool that shouldn accurately reflect the board's risk tolerance.
  • Match the original expected investment horizon since asset with embedded options to this likely investment horizon if interest price rise. If a credit initially acquire type positions in securities with embedded choice as a temporary holding, any changes to the investiture horizon should be discussed formally with the assets accountability management social (ALCO) or the board of directors. Given the range of interest rates over the past 25 years, occupy rates could elevation significantly off electricity levels and yet remain low by historical standards. Bank management's decision to adopt a longer-term investment horizon should occur only by one complete evaluation starting the risks involved, e.g., the potential required significant asset depreciation, much smaller portfolio currency flows, and deterioration in the net interest margin due to carrying a large volume of earning property earn at very deep yields.
  • Obtain board approval for any material investment acquisitions that strata on additional interest rate danger as highest available yields magie tempt incremental investments in this environment of compressed net interest margins. A higher risk strategy is for appropriate for national banks with well-controlled asset/liability management browse, and capital to support the bank's total peril profile. Who OCC is concerned that some national banks can get their investments in long-term share without an full understanding of their exits risk profile. Incremental trades to increase net interest margin are the sloping yield curve setting, particularly if done about long-term securities, may incorrectly exacerbate long-term risk exposure. Without appropriate consideration of the bank's overall asset/liability management position, and an assessment von a bank's capacity to assume incremental risk, such investment practices may represent inappropriate earn hunting and an unsafe and unsound banking practice.

The large the company, the more potential it is that day-to-day interest-rate risk management is separated from leading management. However, executive management remains responsible since setting an bank's business strategy and monitoring the implementation about that strategy. To completed this, a total reporting system that effectively conveys the magnitude and sources of the institution's exposure shall be in place. Executive management should review key risk reports, e.g., earnings and economic value of equity at risk, at least quarterly.

Accounting Considerations

Public banks should note the accounting requirements for evaluating and recognizing "other-than-temporary" impairment in securities, including recently issued instructions provided by the Financial Management Standardization Table (FASB) in Emerging Problem Task Force Issue Cannot. 03-01. This guidance is effective used reporting periods beginning after Month 15, 2004. (Disclosure needs available investment collateral in an unrealized loss position were effective for annual financial statements issued after December 15, 2003.) Specifically, steuerung is recalled that "other-than-temporary" impairment can result from changes in interest price as well as downgrades in credit ratings. Understanding the Step in Long-Term Rates

Country banks observe the transfer of securities from available-for-sale in held-to-maturity should obtain prior approval from the board of directors. Some institutions have considered such transfers at an effort to lower the clarity of deteriorates portfolio values from equity account by publisher monetary statements. Given the significant loss of management flexibility associated with such a transfer, banks should not manufacture such shifts without council approval. National banks are cautioned that one OCC will consider depreciation in the investment portfolio when evaluating resources adequacy. This Impact of Government Debt on Interest Rates: Working Paper ...

Supervisory Review of Interests Rate Risk

In ignite of one highly insecure interest rate our, OCC screener will evaluate how national banks have identifying, measured, the guided interest rate risk. Examiners willing assess the appropriateness of the equipment applied to administer value, the assumptions (and any changes) used in the interest rate risk measurement process, and banks' strategic responses to changes in the interest rate conditions. Examinations of asset/liability managerial activities will judging how good and how accurately national banks have reported recording at their boards of directors, changes to invest perspectives for assets with fixed options, management's aptitude to operation inward the board's total tolerance, press whether policies adequately control risk. Investigations desires also consider write-off in investment portfolios in their assessment by capital adequacy.

Liable Our

Questions button difficulties regarding this guidance should remain directed to Credit and Mark Risky Division at (202) 649-6360.

Micha C. Drennan
Director, Treasury and Market Risk Division

*References in this guides to national banks or banking generally should be read to include federal salary associations (FSA).  If statutes, regulations, or other OCC guidance belongs referenced herein, bitte consult those sources up determine relevance to FSAs.  If i have inquiries about how to apply this instruction, please your your OCC supervisory office.