Expert Byline: Rate Risk Watch

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FDIC market guidance calls on banks to assess—and act

By Mark Evans

Over the past several years, amid earnings pressures and persistently low interest rates, many community banks have added interest rate risk to their balance sheets by lengthening the durations of their investment assets and by shortening liabilities. The updraft in interest rates that occurred this past spring and summer provided a wake-up call to many institutions by exposing them to the market volatility in their securities’ portfolios.

For most community banks, the decline in market values from mid-May through August illuminated market risk in their investment portfolios. What became visible was expected and tolerable for many, but was concerning to others. A number of banks have, since then, sought to reduce their interest rate risk exposure by selling more volatile bonds or by initiating a hedge.

In October, the FDIC entered the fray by publishing a Financial Institution Letter titled “Managing Sensitivity to Market Risk in a Challenging Interest Rate Environment.” The letter reminds banks of the importance of prudent interest rate risk oversight and expresses concerns about exposures to rising rates.

In addition, the letter specifically cautions banks about the price volatility exposure that could be within their investment portfolios, saying:

Examiners will continue to consider the amount of unrealized losses in the investment portfolio and the degree to which institutions are exposed to the risk of realizing losses from depreciated securities when qualitatively assessing capital adequacy and liquidity and assigning examination ratings.

They will also consider net unrealized losses on available-for-sale debt securities, which flow through to equity capital as reported under U.S. generally accepted accounting principles (GAAP). Adverse trends in an institution’s GAAP equity can have negative market perception and liquidity implications.

In the first of those two bullet points, by specifically focusing on the exposure from unrealized losses (without differentiating between available-for-sale and held-to-maturity securities), the FDIC indicates that it is focusing on overall risk without regard for any perceived shelter from a held-to-maturity classification.

Assessing Exposure Reducing Exposure
myPortfolio’s portfolio value at risk screens What-if analysis on portfolio
Performance Profile’s portfolio value at risk report Identify securities with greatest price volatility
Risk Manager’s earnings-at-risk and economic-value-of-equity simulations Identifying interest rate swap to offset exposures and quantify the impact

The Financial Institution Letter is important for a number of reasons. First, it is a reminder to banks to be aware of their portfolio investment risk and manage it. The reminder comes not from a crystal ball showing the future, but instead from observations of concerning risk from exam reviews. Second, this appears to be the first time that the FDIC has departed from the definitions of capital requirements, including Tier 1 capital, to specifically say it is focusing on the exposure to capital from securities’ market exposure, irrespective of a bank’s overall asset/liability exposure and irrespective of the accounting classification of its securities.

Two-Step Reviews

ICBA Securities can assist community banks by both assessing the interest rate risk exposures in their investment portfolios and by developing strategies to manage the risk. The steps to evaluate each are listed in the chart below.

Community banks should be proactive in assessing their exposure to changing rates. Doing so requires community banks to take action on a number of fronts:

  1. They must ensure that they are robustly modeling their exposure to changing rates. This should include realistic assumptions about deposit repricing in rising rate scenarios in which competition for funding will be more aggressive.
  2. They should consider not only earnings simulations but also EVE (economic value of equity) exposures which may identify structural, longer-term mismatches between assets and liabilities.
  3. In addition to regulatory capital ratios (which excludes the accumulated other comprehensive income adjustment), institutions should consider GAAP capital under changing rate scenarios.
  4. Finally, the FDIC guidance suggests banks consider the overall expected mark-to-market exposure on investments and the impact of that exposure on capital adequacy and liquidity.

Given the FDIC’s new focus on GAAP capital, as well as the capital adequacy and liquidity implications of unrealized losses in securities (available for sale or held to maturity), institutions that find they have too much exposure to rising interest rates will likely need to concentrate on the following two options to mitigate that exposure:

  1. Reduce the risk in the investment portfolio directly by selling more volatile securities. Such a move will undoubtedly result in an income sacrifice as longer, more price volatilities bonds are sold and the proceeds are invested in securities with less price risk.
  2. Offset the mark-to-market risk in the investment portfolio by using interest rate swaps. Obtaining hedge accounting treatment by tying the swaps to carefully selected balance sheet items can mitigate earnings volatility while achieving desirable accumulated other comprehensive income and market value impacts.

Using interest rate swaps, community banks can employ two alternative strategies, either a direct or indirect hedge of their investment portfolio, to protect the value of their investment portfolios and create balance sheet flexibility.

Research on Recent FDIC GuidanceICBA Securities issued a Strategic Insight report, titled “FDIC Issues Caution on Market Risk,” that analyzes the agency’s Letter, and provides a link to the actual document. To access the research report, contact your ICBA Securities representative.
Read the FDIC guidance online at www.fdic.gov/news/news/financial/2013/fil13046.html.

A direct hedge of the investment portfolio is one in which the bank uses an interest rate swap and designates specific investment securities in a hedge accounting relationship. By carefully selecting available-for-sale securities and matching them to the interest rate swaps, banks can hedge their interest rate risk (designated as the changes in value caused by changes in the underlying interest-rate-swap rate, a proxy for market rates) in the selected securities. The change in value of the interest rate swap that is a result of the change in the underlying interest-rate swap rate offsets the accumulated other comprehensive income impact.

An indirect hedge is one in which the bank uses an interest rate swap and designates assets (other than bonds) or liabilities in a hedge accounting relationship. The economic and accounting outcomes of both strategies are similar.

Community banks must now be proactive in quantifying their exposure to market risk, reviewing their overall interest rate risk exposures, assessing capital adequacy in shocked-rate scenarios and acting to reduce or hedge risk, if necessary. While community banks are already modeling their interest rate risk position and seriously assessing exposures, the new FDIC guidance, along with the current market environment, necessitate a redoubling of those efforts.


Mark Evans (mevans@icbasecurities.com) is executive vice president and director of investment strategies for ICBA Securities, ICBA’s fixed-income broker-dealer for community banks. For more than 20 years, he has worked with community banks on their investment strategies, loan trading, wholesale funding, balance sheet management and interest rate risk management.