On December 20, 1996, the FDIC adopted the revised Uniform Financial Institutions Rating System (UFIRS). The UFIRS was amended to include a sixth component: Sensitivity to Market Risk. That "S" component rates the degree of market risk taken, management's ability to identify, measure, monitor, and control that risk, and the financial support provided by earnings and capital.
Primarily, market risk results from interest rate, foreign exchange rate, commodity price, and equity price volatility. Clearly, most banks' principal market risk exposure is interest rate risk (IRR). The IRR examination procedures guide examiners toward a qualitative assessment of a bank's IRR management and exposure. In addition, examiners may use these examination procedures for general guidance when evaluating foreign exchange, commodity, or equity price risk.
Subsection VII, Other Market Risk Factors, provides additional guidance regarding activities that alter banks' market risk exposure. Subsection IX, Rating Sensitivity to Market Risk, provides guidance for assigning the "S" component rating.
The Office of the Comptroller of the Currency, Board of Governors of the Federal Reserve System, and the FDIC have issued the Joint Agency Policy Statement on Interest Rate Risk (Policy Statement). The Policy Statement provides guidance to bankers on sound IRR management practices.
FDIC examination procedures follow a multi-level framework that incorporates the Policy Statement's guidelines and efficiently allocates examination resources. Examination scope will vary depending upon each bank's IRR management and exposure. The procedures guide examiners towards a qualitative IRR assessment, rather than a uniform supervisory measurement.
IRR is the exposure of a bank's current or future earnings and capital to interest rate changes. Interest rate fluctuations affect earnings by changing net interest income and other interest-sensitive income and expense levels. Interest rate changes affect capital by altering banks' economic value of equity (EVE).
EVE represents the net present value of all asset, liability, and off-balance sheet cash flows. Interest rate movements change the present values of those cash flows. EVE estimates the long-term, expected change to earnings and capital that will result from an interest rate movement.
As financial intermediaries, banks can not completely avoid IRR. However, excessive IRR can threaten banks' earnings, capital, liquidity, and solvency. IRR has many components, including repricing risk, basis risk, yield curve risk, option risk, and price risk.
Repricing Risk results from timing differences between coupon changes or cash flows from assets, liabilities, and off-balance sheet instruments. For example, long-term fixed rate securities funded by short-term rate deposits may create repricing risk. If interest rates change, then deposit funding costs will change more quickly than the securities' yield.
Basis Risk results from weak correlation between coupon rate changes for assets, liabilities, and off-balance sheet instruments. For example, LIBOR-based deposit rates may change by 50 basis points, while Prime-based loan rates may only change by 25 basis points during the same period.
Yield Curve Risk results from changing rate relationships between different maturities of the same index. For example, a 30-year Treasury bond's yield may change by 200 basis points, but a three-year Treasury note's yield may change by only 50 basis points during the same time period.
Option Risk results when a financial instrument's cash flow timing or amount can change as a result of market interest rate changes. This can adversely affect earnings or EVE by reducing asset yields, increasing funding costs, or reducing the net present value of expected cash flows.
For example, assume that a bank purchased a callable bond, issued when market interest rates were 10 percent, that pays a 10 percent coupon and matures in 30 years. If market rates decline to eight percent, the bond's issuer will call the bond (new debt will be less costly).
At call, the issuer effectively repurchases the bond from the bank. As a result, the bank will not receive the cash flows that it originally expected (10 percent for 30 years). Instead, the bank must invest that principal at the new, lower market rate.
In addition, many loan and deposit products contain option risk. For example, many borrowers can prepay part or all of their loan principal at any time. Also, savings account depositors may withdraw their funds at any time.
Price Risk results from changes in the value of marked-to-market financial instruments that occur when interest rates change.
For example, trading portfolios, held-for-sale loan portfolios, and mortgage servicing assets contain price risk. When interest rates decrease, mortgage servicing asset values generally decrease. Since those assets are marked-to-market, any value loss must be reflected in current earnings.
The board of directors (board) must ensure that management effectively identifies, measures, monitors, and controls IRR. The policies, procedures, and systems used to achieve those goals comprise the IRR management program.
Although many methodologies effectively guide IRR management, all programs should address:
The bank's complexity and risk profile should determine its IRR management program's formality and sophistication. Banks that do not employ complex strategies, maintain basic balance sheet structures, and exhibit low IRR may rely on less intricate programs. However, all procedures should be clearly documented and senior management should actively supervise daily operations.
More complex banks will likely need more formal, detailed IRR management
programs. In such cases, management should establish specific controls and
produce cogent analysis that addresses all major risk exposures. At those banks,
internal controls should include an independent review process for IRR analysis
and requirements for reasonable separation of duties.
Board Oversight
Effective board oversight is the cornerstone of sound risk management. The board must understand the bank's risk exposures and how those risks affect current operations and strategic plans. The board's three primary IRR responsibilities are to:
Senior management's responsibilities include both long-range and daily IRR management. Senior management should:
Effective board and senior management oversight requires reasonable strategies, prudent risk limits, and clear internal controls. Internal controls should address management authority and responsibility, permissible activities, and staffing needs.
Strategies should address all relevant IRR factors, such as capital, earnings, balance sheet structure, economic and interest rate forecasts, and long-term business plans. Management should develop strategies that address the board's policies and risk limits. Those strategies may incorporate off-balance sheet activities, balance sheet structure changes, product pricing guidelines, or other management tactics.
Strategy detail and formality should depend upon the bank's size, complexity, and management expertise. All related activities, including lending, deposits, and investments, should be coordinated. Generally, the management committee responsible for IRR should include a representative from each major product area.
Risk Limits should establish the board's IRR tolerance by restricting earnings and capital volatility for given interest rate movements. The board should document and approve risk limits that guide management's activities and do not create safety and soundness concerns.
Limits should reflect the bank's complexity and capital strength. Further, they should relate directly to the internal measurement system's methodology. In addition, limits should specifically address IRR effects on reported earnings and capital.
Management should maintain IRR exposure within the established limits. Internal controls should ensure that when exposures exceed the risk limits, management promptly reviews the exception and reports it to the board. The board should review all policy and risk limit exceptions. However, effective limits should provide management with the flexibility to respond to changing economic conditions.
Earnings-based risk limits may include volatility restrictions on:
Capital-based risk limits may include volatility restrictions on:
Authority And Responsibility should clearly delineate management's duty to identify, measure, monitor, and control IRR.
Permissible Activities should identify the strategies and instruments that management can use to control IRR. Policies should specifically describe the instruments and activities that the board authorizes and those that management may not use without prior board approval.
Staffing resources should permit effective IRR management, including:
Risk Identification And Measurement
Prudent risk management demands accurate, timely IRR quantification. Although many measurement methods exist, an effective system must clearly identify, quantify, and report the bank's risks.
When evaluating IRR, well-managed banks should consider both earnings and economic approaches. Reduced earnings, or losses, can harm capital, liquidity, and even marketplace perception. EVE measurements provide longer-term earnings and capital analysis.
The Level Three Examination Procedures subsection details measurement system
methodologies and examination procedures.
Risk Monitoring And Reporting
Banks should maintain systems that concisely report IRR. At least quarterly, senior management and the board should review those reports. However, banks that engage in complex activities or take greater risks should assess IRR more frequently. IRR reports should contain sufficient detail to permit management and the board to:
The board should subject its IRR management program to periodic independent review. Independent review may encompass external audit, internal audit, or simply evaluation by personnel independent of IRR management. Independent review considerations should include:
The independent review program's scope and formality should correspond to the bank's size, complexity, and IRR profile. Larger, more complex banks may use internal or external auditors. Banks that operate complex IRR measurement systems should subject those systems to independent testing and validation. Smaller, less complex banks may rely upon less formal independent review. Regardless, independent review findings should be reported directly to the board at least annually.
IRR measurement systems range from simplistic to extremely complex. Despite
that variety, all systems require verifiable account data, rely heavily on
assumptions, and lose precision when analyzing complex instruments or volatile
markets. Most important, measurement systems are only a forecasting tool and can
not flawlessly predict cash flows, earnings, or capital.
Measurement System Approaches
IRR measurement systems use an earnings approach, an economic value approach, or a blend of those two approaches. Each approach provides a different, but not necessarily contradictory, view.
The Earnings Approach focuses on risks to reported earnings, usually over a shorter-term time horizon. Typically, earnings systems estimate risk for up to two years. In addition, estimating future earnings permits regulatory capital forecasts.
The earnings approach traditionally focus on net interest income. However, many systems now incorporate components that measure the price risk from instruments accounted for at market value or lower-of-cost or market value. Those systems estimate gains and losses from assets that include loans held for sale, trading portfolios, and mortgage servicing rights.
The Economic Value Approach estimates the bank's EVE for forecasted interest rate changes. This method assumes that all financial instruments will be held until final payout or maturity. The economic value approach might provide a broader scope than the earnings approach, since it captures all anticipated cash flows.
The economic value approach best suits banks that mark most instruments to market. At banks that value most instruments at historical cost, economic value measurements can also effectively estimate IRR. However, in those banks, EVE changes might be recognized over a longer time frame (through reported earnings).
As a result, banks often blend the two approaches. Management may use an
earnings approach to evaluate short-term performance and an economic approach to
monitor the bank's long-term viability. Despite using different methodologies,
the two approaches should not report conflicting IRR exposures.
Gap Analysis
Gap systems use an accrual approach to identify risk to net interest income. Typically, gap systems identify maturity and repricing mismatches between assets, liabilities, and off-balance sheet instruments. Gap schedules segregate rate-sensitive assets, rate-sensitive liabilities, and off-balance sheet instruments according to their repricing characteristics. Then, the analysis summarizes the repricing mismatches for each defined time horizon. Additional calculations convert that mismatch into risk to net interest income. Gap analysis may identify periodic, cumulative, or average mismatches.
The most common gap ratio formula is:
Occasionally, average assets or total assets may be used in place of average earning assets. However, those denominators can underestimate IRR.
The gap ratio should also be expressed as the percentage risk to net interest income. Multiply the gap ratio by the assumed rate change. The result estimates the change to the net interest margin.
For example, a bank has a 15% one-year average gap. If rates decline 2%, then the net interest margin will decline by 30 basis points (15% x .02). This estimate assumes a static balance sheet and an immediate, sustained interest rate shift.
Gap analysis has several advantages. It:
However, gap's weaknesses often overshadow its strengths, particularly for larger, more complex banks. For example, gap analysis:
Some gap systems attempt to capture basis, yield curve, and option risk. Multiple schedules (dynamic or scenario gap analysis) can show effects from nonparallel yield curve shifts. Additionally, sensitivity factors may be applied to account categories. Those factors assume that coupon rates will change by a certain percentage for a given change in a market index. That market index is designated as the driver rate (sophisticated systems may use multiple driver rates). Those sensitivity percentages, also called beta factors, may dramatically change the results.
Banks often use sensitivity factors to refine non-maturity deposit gap analysis. For example, management may determine that its MMDA cost of funds will increase 25 basis points whenever the six-month Treasury bill rate increases by one percent. Thus, management might consider only 25% of MMDA balances rate-sensitive for gap analysis. Management may expand its analysis by preparing gap schedules that assume different market rate movements and changing customer behaviors.
Gap analysis may provide sufficient IRR measurements for some banks. However,
gap analysis may be ineffective for banks with complex structures or activities.
Duration Analysis
Macaulay Duration, duration's simplest form, calculates the weighted average term to maturity of a security's cash flows. Duration always:
| Year | Payment | PV | T | PV * T |
| 1 | $100 | $90.9 | 1 | 90.9 |
| 2 | $100 | $82.6 | 2 | 165.2 |
| 3 | $1,100 | $826.4 | 3 | 2,479.3 |
| $1,000.0 | 2,735.4 |
T = Time period payment is received
Macauley Duration = 2,735/1,000 = 2.74
years
Modified duration, calculated from Macauley duration, estimates price
sensitivity for small interest rate changes. An instrument's duration represents
its percentage price change given an assumed parallel yield curve shift. Thus,
it serves as a proxy IRR measure.
For modified duration, assume that interest rates increase one percent (an
instantaneous 100 basis point parallel yield curve increase). Then, divide the
bond's Macauley duration by one plus its yield. As shown below, price decreases
by approximately 2.5 percent.
Modified Duration Calculation Macauley Duration = 2.74 years
3
year bond, 10% coupon, 10% yield
| Modified Duration | = Macauley Duration |
| (1 + Yield) | |
| = (2.49%) |
However, modified duration assumes that interest rate shifts will not change an instrument's cash flows. As a result, it does not accurately estimate price sensitivity for instruments with embedded options (for example, callable bonds or mortgages). Banks with significant option risk should not rely upon modified duration to measure IRR.
Effective Duration estimates price sensitivity more accurately than modified duration for instruments with embedded options. However, effective duration is calculated using valuation models that contain option pricing components. First, management must determine the instrument's current value. Next, the valuation model assumes an interest rate change (usually 100 basis points) and estimates the instrument's value. The percentage change between the current and forecasted values represents the instrument's effective duration.
All duration measures assume a linear price/yield relationship. However, that relationship actually is curvilinear. That is, beyond 100 basis point interest rate changes, the mathematical relationship between price and yield does not remain constant. Therefore, duration may only accurately estimate price sensitivity for rather small (up to 100 basis point) interest rate changes.
Convexity describes the nonlinear price/yield relationship. Option-free instruments display positive convexity. When rates decline, a positively convex instrument's price increases at an increasing rate. When rates rise, a positively convex instrument's price decreases at a decreasing rate.
Instruments that contain embedded options demonstrate negative convexity. When rates decline, a negatively convex instrument's price increases at a decreasing rate. When rates rise, a negatively convex instrument's price declines at an increasing rate.
Convexity-adjusted duration should be used to more accurately estimate price sensitivity for larger interest rate changes (over 100 basis points).
EVE may be calculated using duration. For example, assume that a bank has rate sensitive assets (RSA) valued at $10,000 with a duration of 4 years and rate sensitive liabilities (RSL) valued at $9,000 with a duration of 4 years. For a 1% interest rate change, the following will occur:
Despite maintaining matched duration percentages for assets and liabilities, the bank's EVE changes by four percent when rates change by one percent. This results from the dollar duration gap created by the difference between RSA and RSL volume. Thus, banks that use duration to manage IRR should maintain asset and liability durations based on dollar value changes, not raw duration.
Duration analysis provides significant advantages over gap analysis. Duration analysis yields a single IRR number and considers all expected cash flows. Thus, duration generates a more comprehensive IRR measurement. Duration analysis can provide more accuracy than maturity gap analysis for measuring and managing IRR.
Despite those advantages, duration analysis contains weaknesses that limit
its practical applications. Accurate duration calculations demand sophisticated
accounting and information systems. Further, duration accurately measures value
changes for only relatively small interest rate fluctuations. Therefore, banks
must frequently update duration measures during volatile interest rate
environments.
Simulation Analysis
Simulation analysis determines the effect of interest rate changes on short-term net interest income, net income, and, in some cases, EVE. Simulation models generate results for a range of probable interest rate environments and risk exposures.
Banks may vary simulation rate scenarios based on factors such as pricing strategies, balance sheet composition, and hedging activities. Simulation may also measure risk presented by non-parallel yield curve shifts. Any simulation system's accuracy, though, depends on the assumptions and data used. Inaccurate data or unreasonable assumptions render simulation results meaningless. Simulation models are often not "user friendly" and may require more data and expertise than other IRR measurement systems.
Simulation systems vary greatly, both in methodology and sophistication. Some systems focus on short-term earnings, some concentrate on EVE, and others blend those views. Despite those differences, most simulation systems share two characteristics: They require advanced information systems and technical expertise.
The three primary goals require that examiners:
The IRR examination procedures accomplish those goals and:
Although IRR is the principal market risk taken by most banks, other activities can dramatically increase (or reduce) market risk exposure.
Foreign Exchange activities expose banks to the price (exchange rate) risk that results from volatile currency markets. Exchange rates depend upon a variety of global and local factors that are difficult to predict, including interest rates, economic performance, and political developments.
Commodity activities involve using contracts (including futures and options) for fungible, bulk goods to speculate or hedge. Commodity prices depend upon many factors, including weather, economic conditions, and political developments that are exceptionally difficult to forecast.
Generally, banks should only use foreign exchange or commodity activities to control specific market risks. Management, independent of the broker/dealer, should demonstrate expertise commensurate with the activities undertaken. In addition, management should produce documented analysis that clearly details the effectiveness of all foreign exchange and commodity activities. That analysis should be prepared at least quarterly and presented to the Board for review.
Equity Trading And Investing creates market risk exposure, since changes in equity prices can adversely affect earnings and capital. The board and management have a responsibility to identify, measure, monitor and control trading activity risks. Management should carefully monitor all equity investments, regularly evaluate the resulting market risk exposure, and provide timely reports to the Board.
Certain restrictions on this activity are contained in Part 362 of the FDIC Rules and Regulations, "Activities and Investments of Insured State Banks" which implements section 24 of the Federal Deposit Insurance Act. Section 24 prohibits an insured state bank from directly, or indirectly, acquiring or retaining any equity investment of a type that is not permissible for a national bank. National banks are generally prohibited from owning equity securities and, by extension, insured state banks are also enjoined from this activity. However, there are three exceptions to the referenced section 24 prohibition. One of these exceptions enables certain insured state banks (grandfathered banks) to retain and continue to invest in common or preferred stock, or shares of investment companies. The FDIC has extended this exception by regulation to enable banks having the grandfathered authority to hold the subject investments through majority-owned subsidiaries provided the bank is well-capitalized.
Foreign exchange, commodity, or equity speculation may be considered an unsafe and unsound practice. However, well-capitalized banks with sophisticated, effective management may safely engage in prudent foreign exchange, commodity, and equity trading. When necessary, contact a designated Capital Markets Specialist for additional guidance.
Determine if the bank's IRR measurement system enables management to measure and monitor IRR. Focus on:
The IRR measurement system must capture and measure all material risk exposures. Therefore, any measurement system review should begin by identifying the bank's exposures. Use all available information, including:
Long-term, Fixed-rate Assets may create repricing risk in banks that have traditional, shorter-term funding structures.
Embedded Options within assets, liabilities, and off-balance sheet derivatives create significant risks. Embedded options include any feature that can alter an instrument's cash flows when interest rates change. Many instruments contain various embedded options, including:
For example, mortgage loans contain prepayment options. Borrowers may prepay loan principal at any time, which alters the mortgages' cash flows and creates material IRR considerations.
Funding Sources may create repricing risk, basis risk, yield curve risk, or option risk. Evaluate the fundamental relationship between funding sources and asset structure. Potentially volatile or market-based funding sources may increase IRR, especially when matched to a longer-term asset portfolio.
For example, fixed-rate mortgages funded by purchased federal funds create repricing risk. Funding costs may increase substantially, while asset yields remain fixed.
Nonmaturity Deposits may mitigate some IRR. Nonmaturity deposit funding costs generally demonstrate less volatility than market interest rates. As a result, high nonmaturity deposit volumes may actually reduce repricing risk and moderate overall IRR. However, significant interest rate or economic changes can rapidly alter customers' nonmaturity deposit behavior.
Nonmaturity deposit assumptions are crucial components of any IRR measurement system. Carefully review management's nonmaturity deposit assumptions. Those assumptions should be reasonable and well supported. In addition, IRRSA provides nonmaturity deposit interest rate sensitivity analysis.
Off-balance Sheet Derivatives may introduce complex IRR exposures. Depending on the specific instrument, derivatives may create repricing, basis, yield curve, option, or price risk.
Mortgage Banking operations create price risk within the loan pipeline, held-for-sale portfolio, and mortgage servicing rights portfolio. Interest rate changes affect not only current values, but also determine future business volume.
Fee Income businesses may contain IRR, particularly trust, credit card servicing, and non-deposit investment sales. Changing interest rates may dramatically affect such activities.
Product Pricing Strategies may introduce IRR, particularly basis risk or yield curve risk. If funding sources and assets are ed to different market indices, then basis risk exists. If funding sources and assets are ed to similar indices with different maturities, then yield curve risk exists.
Management should clearly identify and document the bank's material IRR
exposures. That analysis should address how the IRR management program measures,
monitors, and controls those risks.
Determine System Capabilities
The IRR measurement system must capture and reliably estimate the bank's material risk exposures. Therefore, the system should consider all significant risk factors. For example, if the bank holds material mortgage loan or mortgage-backed security assets, then the system should incorporate prepayment projections.
Management should fully understand the measurement system, including its:
System Documentation should provide complete information regarding the above factors. Both models purchased from vendors and internally developed systems should be supported by complete documentation. Management should read and retain all system documentation.
In addition, vendor systems often require additional components (for example, an option pricing module) or periodic updates. Without the needed components, the system may not calculate accurate results. Verify that the system contains the components and updates needed to generate accurate measurements.
Discuss the system's capabilities, limitations, and assumptions with
management. If the system ignores significant risks or relies on incorrect
methodology, then management should correct the deficiencies and produce
reliable IRR measurements.
Evaluate Objective Data
The system's objective data should reflect the bank's current condition. Management may enter data into the system manually or employ a computerized data extract program. Independent review should ensure that the system contains accurate objective data.
Account Data should accurately describe each category or instrument, including:
Review the account data for larger and more complex account categories. For example, adjustable rate mortgages' (ARMs) account data should include rate indices, coupon formulas, periodic coupon caps and floors, lifetime caps and floors, and coupon reset dates.
Often, detailed account data resides in subsidiary systems. The deposit, commercial loan, mortgage, and investment systems usually contain account data needed for the IRR measurement system.
If management uses a data extract program, then review the program's output and verify that it transfers accurate data to the IRR measurement system. Otherwise, verify account data accuracy using the general ledger, subsidiary ledgers, and any other available information.
Data Aggregation processes should reasonably group individual instruments into categories according to their types and cash flow characteristics. Most banks aggregate data to increase efficiency. Management should carefully consider this process and should develop an aggregate account chart that accurately represents the bank's cash flow characteristics. Aggregation varies greatly and depends upon the bank's size, complexity, and measurement system.
Review the data aggregation process and ensure that it reasonably portrays the bank's cash flow characteristics. Management should not aggregate material volumes of dissimilar instruments, including:
Management should more precisely stratify accounts whenever cash flow characteristics create material differences within a category. For example, banks with large fixed-rate mortgage and ARM volumes generally must stratify those assets more exactly.
Base Case Interest Rates should
accurately illustrate the current rate environment (as of the analysis date).
Verify that the base case interest rates and market values are accurate. Most
systems, particularly duration and simulation models, can not generate accurate
results using incorrect current market rates.
Assess Key Assumptions
All measurement systems rely upon assumptions. Unreasonable assumptions render even the most sophisticated system's results unreliable. As a result, management must carefully develop and support all key measurement assumptions.
Review available information regarding all key assumptions, including:
Each IRR measurement system relies upon unique assumptions. However, most systems incorporate several key assumptions.
Projected Interest Rate Forecasts must be used in many systems (particularly duration and simulation models). Banks may generate internal forecasts based on supported analysis. For example, internal rate forecasts might rely on implied forward yield curves, economic analysis, or historical regressions.
Banks might also incorporate forecasts from external sources. Regardless of the source, rate forecasts should be consistent with other forecasts used throughout the bank's planning processes (for example, forecasts used to estimate loan demand).
Rate forecasts should include increasing and decreasing rate environments that provide meaningful stress scenarios and address the bank's risk exposures. Simulation system forecasts may also consider nonparallel yield curve shifts.
Driver Rate Relationships must specifically and reasonably dictate changes in all material interest rates for given changes in the driver, or primary, rates. For example, management might specify that NOW account funding costs will increase 25 basis points when the six-month Treasury bill yield increases 100 basis points.
Most systems maintain static rate relationships, but more sophisticated systems can alter the relationships for different rate environments. Review the driver rate relationships and ensure that they are supported and accurately applied.
Reinvestment Rates determine the yields earned by projected future cash flows (after the bank receives and reinvests them), primarily in simulation models. Many systems simply assume that all future cash flows will be reinvested at one rate (for example, federal funds). More sophisticated systems use multiple reinvestment rates for cash flows from different sources. All reinvestment rates should be reasonable and consistent with other bank forecasts. Unrealistic reinvestment rates render IRR simulations meaningless.
Nonmaturity Deposit Sensitivity Factors estimate volume and funding costs for those deposits. Management should determine nonmaturity deposit interest rate sensitivity and support those conclusions with documented analysis. IRRSA provides nonmaturity deposit analysis measures for examiner review.
Prepayment Forecasts should reasonably estimate unscheduled principal cash flows from amortizing instruments. Dealer median prepayment forecasts may serve as an acceptable assumption. Should management use prepayment assumptions that differ substantially from the dealer median forecasts, those differences should be explained and supported.
Growth Estimates should reflect the
strategic goals and forecasts used in the strategic planning process.
Unrealistic asset or deposit growth assumptions will invalidate the system's
results.
Review System Reports
Measurement system reports must provide clear information to management and the board. Reports should:
Carefully review all system output and ensure that the board and management
receive timely, accurate, and clear IRR measurement reports.
Verify Measurement System Validation
Verify that management periodically evaluates and validates the measurement system's adequacy and accuracy. Determine if the system's prior forecasts reasonably estimated actual performance. Focus on evaluating:
Determine if the internal measurement system produces reliable IRR results. Minor system deficiencies should not invalidate the results. However, material flaws may render the results unreliable. If the system's results can not be used as a basis for the examination's IRR assessment, then the system is not satisfactory.
Rating Sensitivity To Market Risk
The UFIRS "S" component rates the market risk taken, management's ability to identify, measure, monitor, and control that risk, and the financial protection provided by earnings and capital. After completing the examination procedures, assign the Sensitivity to Market Risk rating. When assigning the component rating, consider both qualitative and quantitative factors. Focus on the risk management process, especially management's ability to measure, monitor, and control market risk. In addition, evaluate the potential for market risk to adversely affect earnings and capital.
Banks Rated "1" have well controlled market risk and minimal potential that market risk will adversely affect earnings or capital. Relative to the bank's size, sophistication, and market risk taken, risk management practices are strong. Earnings and capital provide substantial support for the degree of market risk taken.
Banks Rated "2" have adequately controlled market risk and only moderate potential that market risk will adversely affect earnings or capital. Relative to the bank's size, sophistication, and market risk taken, risk management practices are satisfactory. Earnings and capital provide adequate support for the degree of market risk taken.
Banks Rated "3" need to improve market risk control or there is significant potential that market risk will adversely affect earnings or capital. Relative to the bank's size, sophistication, and market risk taken, risk management practices need improvement. Earnings and capital may not provide adequate support for the degree of market risk taken.
Banks Rated "4" have unacceptable market risk control or high potential that market risk will adversely affect earnings or capital. Relative to the bank's size, sophistication, and market risk taken, risk management practices are deficient. Earnings and capital provide inadequate support for the degree of market risk taken.
Banks Rated "5" have unacceptably controlled market risk or market risk presents an imminent threat to the bank's viability. Relative to the bank's size, sophistication, and market risk taken, risk management practices are wholly inadequate.
The IRR examination procedure levels indicate only the examination's scope and do not correspond to a Sensitivity to Market Risk component rating. Consider the following examples:
Examination Procedures
Examination procedures for Market Risk are
included in the Examination Modules Handbook. Refer to that Handbook for
specific examination procedures and other information.