Articles & E-Books


Regulator expectations for managing liquidity and interest rate risk

Aug 29, 2019

By Janeen Bradshaw

In the years since the financial crisis of 2008, small financial institution management teams have struggled to keep up with increased statutory regulations and supervisory guidance while continuing to manage their bottom lines under an unusually sustained low interest rate environment. Contracted net interest margins (NIM) have led some management teams to pursue alternative strategies to boost earnings and maintain adequate capital levels. According to the Federal Reserve Economic Data (FRED) website of the Saint Louis Federal Reserve Bank, small financial institutions are showing increased concentrations of higher yielding, longer-term assets often funded by potentially volatile surge deposits.[1]

Regulatory guidance expects a financial institution’s board of directors (board) to oversee the implementation of prudent policies and procedures for both liquidity and IRR, establish lines of authority and responsibility, establish comprehensive measuring and monitoring systems including appropriate risk limits commensurate with the risk profile of the institution, outline risk mitigation strategies that will be implemented if risk limits are breached, and establish an independent review process for each area. Management typically utilizes various internal reports as well as outsourced vendor models to measure and monitor IRR and liquidity risks and report these risks to the board. Report detail will vary with the size and complexity of the institution but should be comprehensive enough to capture institution-specific behaviors of assets and liabilities with varying maturities and repricing behaviors. Even when the measurement and reporting process is outsourced, regulators expect management to have a sufficient understanding of the inputs and assumptions and be able to tailor them to best reflect institution-specific behaviors. However, management must also consider how the current sustained low rate environment may have a very different impact on future customer or member behaviors as compared to historical information and should make any necessary adjustments based on qualitative factors.

According to the 2010 Interagency Policy Statement on Funding and Liquidity Risk Management, liquidity reports should contain cash flow projections that include discrete and cumulative cash flow mismatches or gaps over specified future time horizons under both expected and adverse business conditions and target amounts of unencumbered liquid asset reserves. Pro forma cash flow projections are a critical tool for adequately managing liquidity risk. Periodically review assumptions used in cash flow projections for reasonableness and adequately document these reviews. An institution should also conduct regular liquidity stress testing to assess a variety of internal and external events across multiple time horizons. The board and management are required to have a contingency funding plan (CFP) in place that outlines strategies for addressing liquidity shortfalls in emergency funding situations.  Base strategy implementation and escalation procedures outlined in the CFP on trigger values of quantitative projections and the evaluation of expected funding needs and funding capacity calculated in the various stress test scenarios.

Interagency guidance also states that “appropriate internal controls should address relevant elements of the risk management process, including adherence to policies and procedures, the adequacy of risk identification, risk measurement, reporting, and compliance with applicable rules and regulations. Management should ensure that an independent party regularly reviews and evaluates the various components of the institution’s liquidity risk management process. These reviews should assess the extent to which the institution’s liquidity risk management complies with both supervisory guidance and industry sound practices, taking into account the level of sophistication and complexity of the institution’s liquidity risk profile”.[2]

IRR models range in complexity from call report-based inputs to very comprehensive models with granular account level detail. IRR reports should include sufficient account level input detail and assumptions to adequately reflect institution-specific product behaviors. Regulatory guidance indicates management should incorporate both net interest income (NII) and economic value of equity (EVE) scenario analyses in the IRR measurement process. To capture exposures that may not be immediately apparent, project NII over at least one- and two-year periods. EVE analysis incorporates longer term net present value measures of balance sheet exposures but does not predict when those exposures will occur. Some institutions may choose to run NII scenarios beyond two years to help capture the timing of the projected exposure. Management should run parallel scenarios (all rates change by the same amount) as well as nonparallel scenarios that capture yield curve risk (short-term rates may rise or fall faster than longer-term rates). Models should also contain instantaneous rate shocks of sufficient magnitude to adequately monitor the effects of potential rate movements. Even though the federal funds rate has remained relatively flat over the last decade, it has changed by 200 basis points or more within a year’s time in at least one third of the previous 50 years as noted in the Federal Reserve Economic Data website’s statistics. [3]

Management should ensure the IRR model reasonably captures the volatility of income and cash flows from assets, liabilities, and off-balance sheet items and ensure that assumptions are understood, documented, updated regularly, and reported to the board. Common assumptions include product pricing, loan prepayments, deposit repricing (betas) and decay rates, embedded options, driver rates, and growth rates. Whenever practicable, management should perform assessments of historical institution-specific behaviors to calculate loan prepayment rates and non-maturity deposit behaviors. Compare these institution-specific results to industry or peer averages and adjust as necessary using internal or external qualitative factors to best reflect anticipated future customer or member behaviors. The institution should review the appropriateness of assumptions used at least annually or whenever any material changes occur and then document that review. Sensitivity analysis should also be conducted on each of the major assumptions, holding all other variable inputs constant within the model, to assess the impact of varying levels of that particular assumption on overall risk exposure.

The board and senior management should establish a system of internal controls to ensure the adequacy of corporate governance, compliance with policies and procedures, and the comprehensiveness of IRR measurement and management information systems. An essential component of the internal control process is an independent review and validation to test the integrity, accuracy, and reasonableness of the measurement system and of the IRR management process in accordance with the complexity and risk profile of the institution. The review should assess the adequacy of and compliance with the internal control system, the accuracy of data inputs and adequacy of assumptions, and the validity of model calculations including backtesting of model results. The findings of the independent review and validation should be reported to the board annually. The report should provide a summary of the measurement techniques and practices used by management, identify critical assumptions and the process used to drive those assumptions, and provide an assessment of the impact of those assumptions on the levels of IRR exposures. Board members and management may refer to the FDIC website, Directors’ Resource Center page, which provides helpful videos that summarize many of the major supervisory expectations for IRR management outlined above.[4]


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