FDIC Guidance: Preparing for Rising Interest Rates
With rising interest rates looming somewhere on the horizon, the FDIC has re-emphasized the importance of appropriate interest-rate risk oversight and risk management processes to ensure that banks are positioned to avoid or mitigate risks inherently associated with rising rates.1
The FDIC is concerned that certain institutions may not be adequately prepared or positioned for sustained increases in interest rates and notes that many of them have liability-sensitive balance sheets. If interest rates were to rise markedly, institutions with concentrated bond holdings in long-duration issues could experience severe depreciation that could adversely impact their capital positions. The FDIC’s guidance notes that “institutions that rely primarily on a long-duration fixed-income portfolio for liquidity could experience difficulty meeting short term cash needs if other marketable assets or funding sources are not readily available.”2
The FDIC advises that a bank’s board of directors and management should know of the dangers that marked interest rates increases could have in the net interest income and earnings performance of their institutions. Moreover, they should be aware of interest risk exposure during the business cycle, not just in advance of volatile periods. The FDIC emphasizes that “interest rate management should be viewed as an ongoing process that requires effective measurement and monitoring, clear communication of modeling results, conformance with policy limits, and appropriate steps to mitigate risk.”3 As a result, the FDIC recommends that directors devise sound policies based on a complete understanding of their institution’s susceptibility to interest rate shifts and the corresponding impact on earnings and capital.
Risk Management Practices
The FDIC has outlined four practices to help mitigate potential problems associated with a continuous increase of interest rates:
1. Financial institution’s board of directors and management should have a clear understanding on how changes in interest rates could impact their institution’s earnings and capital. Based on analytical or modeling information, they should adopt adequate strategies to balance their exposure to interest rate increases.
2. Asset-liability management and investment policies must be reviewed at least once a year to ensure prudent exposure limits and risk tolerance levels.
3. Adequate risk measurement tools must be adopted to ensure the effective measurement and monitoring of risks due to changes in interest rates. The FDIC suggests that “management should not focus on a single measurement of interest rate risk, but instead review multiple types of data.”4 Also, the FDIC advises that financial institutions should be aware of the effect that interest rate changes between 300 and 400 points could have on earnings and capital. Furthermore, financial institutions with longer duration portfolios should accurately determine the sensitivity of their holdings to potential increases of interest rates.
4. Institutions can use different approaches to mitigate risks associated with interest rate increases, including managing non-maturity deposits, increasing capital and rebalancing earning asset and liability durations. Hedging also could be used to mitigate interest risk exposure; however, the FDIC considers that hedging should not be used unless institutions have the requisite knowledge and expertise to engage in those types of transactions.
Finally, the FDIC also suggested that banks should continue to follow the 2010 Advisory on Interest Rate Risk Management. Although the 2010 Advisory was issued when interest rates were decreasing to historic lows, it was meant to remind institutions that low rates would not continue forever. Therefore, the risk management processes described in the 2010 Advisory also remain relevant.
Although low interest rates seem to be the present norm, the FDIC has put banks on notice that a challenging interest rate environment could present challenges. Therefore, it is imperative that financial institutions take proactive measures to avoid or mitigate risks associated with marked interest rate increases, especially those institutions with long-duration fixed-income portfolios.
1 See FIL-46-2013, October 8, 2013