Examiner Guidance Bulletin 04-3 Federal Housing Finance Board Office of Supervision Introduction Background net interest income net portfolio value.

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1 Federal Housing Finance Board Office of Supervision Date: September 29, 2004 To: From: Subject: Federal Housing Finance Board Examiners Stephen M. Cross Director Office of Supervision Interest Rate Risk Limits Introduction The purpose of this examiner guidance is to stress the importance of reviewing the interest rate risk limits of the FHLBanks during the examination process. The guidance also provides a series of questions that can be asked during the course of an examination that relate to the implementation of Advisory Bulletin 04-5, Interest Rate Risk Management. Background Section 917.3(b)(2) of the Federal Housing Finance Board regulations requires each Federal Home Loan Bank (FHLBank) to set forth in its risk management policy its tolerance levels for market risk. A comprehensive set of interest rate risk limits is the primary mechanism for achieving that objective. Each FHLBank should have a set of risk limits to control aggregate, or bank-wide, interest rate risk exposures. Where appropriate, FHLBanks should also have limits for individual business activities or units, portfolios, traders, and positions. The primary objective of interest rate risk management should be to maintain the institution s risk exposures within prudent bounds that are understood and approved by the institution s board of directors. Interest rate risk limits can be based on any of a number of risk management targets or risk metrics. As discussed below, a common practice at financial institutions is to link risk exposure limits to one or more of the institution s target accounts, or focal points, for managing interest rate risk. The most common target accounts are net interest income (or net income) and net portfolio value. [1] Exposure limits can also be based on specific risk metrics such as the [1] Net portfolio value represents the underlying net economic value (or net present value) of an institution's portfolio of assets and liabilities, including any off-balance sheet items. Net portfolio value is defined as the present value of assets less the present value of liabilities plus the net present value of any off-balance sheet contracts. In contrast to the GAAP-based shareholders equity account, net portfolio value represents the shareholders equity account expressed in present value terms Examiner Guidance Bulletin 04-3

2 economic capital ratio, [2] duration of equity, duration gap, maturity gap, the ratio of market value of equity to book value of equity, and Value at Risk (VaR). Target Account Limits Net interest income. When net interest income is the focal point for analyzing risk and return, the management objective is to maintain the net interest earnings of the institution within an acceptable range over a specified time horizon. At most institutions, the time horizon over which interest rate risk is managed is relatively short usually three to 12 months. For example, the objective may be to ensure that the bank s net interest income will remain within certain parameters or not fall below pre-specified levels during that time horizon over a range of hypothetical interest rate scenarios. If net interest income is an institution s target account for managing risk and return, then it should establish risk exposure limits (e.g., maximum allowable loss or deviation [3] ) that are directly linked to that target. The advantage of using net interest income as a target account for managing interest rate risk is that this target account is consistent with the common objective of generating a growing, but relatively stable, stream of earnings. The disadvantage of using net interest income as the only target account for managing risk, however, is that it tends to focus attention on the risk to earnings over the near-term horizon while ignoring the risk to earnings in the years beyond the forecast horizon. Net portfolio value. When net portfolio value is the focal point for managing risk and return, the risk management objective is typically to keep the institution s net portfolio value from falling below specified limits over a range of interest rate scenarios. Accordingly, an organization might establish risk exposure limits that specify the maximum allowable loss (or deviation) it is willing to tolerate under selected hypothetical interest rate scenarios (e.g., parallel and nonparallel interest rate shocks as well as changes in other key risk factors such as spreads). The advantage of using net portfolio value as a target account for managing interest rate risk exposures is that this target account is consistent with the objective of maximizing shareholder value on a risk-adjusted basis. Because the net portfolio value of a firm represents the discounted net present value of the future earnings associated with the firm s existing book of business it is a long-term concept that highlights the risk to earnings over the long-term. Other limits [2] The economic capital ratio for a given interest rate scenario is calculated by dividing the bank s net portfolio value that would result in that scenario by the estimated market value of its assets (including the net effect of any off-balance sheet contracts) in that same scenario. The economic capital ratio is simply a capital-to-assets ratio measured in terms of economic values (or estimated market values) in a particular rate scenario. [3] Some institutions set limits in terms of variability of income or economic equity and thus the limits represent the maximum allowable gain or loss under a specified scenario. Examiner Guidance Bulletin

3 Economic capital ratio. When the economic capital ratio is the focal point for interest rate risk management, the objective is typically to keep the institution s economic capital ratio from falling below specified limits over a range of interest rate scenarios. The advantages of using the economic capital ratio to limit interest rate risk are: (1) it is an unambiguous means of communicating an institution s tolerance for risk; (2) it represents a floor that does not have to be linked to a specific time horizon; and (3) it addresses the loss to economic value from all key risk factors parallel rate shocks, non-parallel rate shock, prepayment risk, and so forth. Moreover, the focus on economic capital is consistent with the goal of maximizing risk-adjusted returns to shareholders over the long run. By focusing on economic value and the economic capital ratio, management is less likely to inadvertently sacrifice long-term economic earnings in pursuit of short-term gains. Duration of equity limits. Duration is a measure of the sensitivity of a financial instrument s value, or the value of a portfolio of instruments, to small, parallel shifts in interest rates. Duration of equity is a measure of the interest rate sensitivity of the net portfolio value of an institution. While useful, the limitations of duration as a risk metric are well known. It assumes instantaneous, small, parallel rate shocks. In reality, sizable yield shifts tend to occur over time, and parallel rate shocks are not likely. Moreover, duration does not describe an institution s exposure to other key risk factors such as changes in the shape of the yield curve and changes in spreads. Duration gap limits. Duration gap is simply the duration of an institution s assets less the duration of its liabilities. A portfolio with a longer (wider) duration gap will experience a greater relative change in value for a given change in interest rates because its cash flows reprice more slowly to the new rate structure than a portfolio with a shorter (narrower) gap. Unlike duration of equity, duration gap does not take into account the effects of financial leverage on risk exposure. An increase in leverage will magnify the impact of a given duration gap on the institution s duration of equity, and thus on the sensitivity of net portfolio value to changes in interest rates. Maturity gap limits. A maturity gap is the difference between the dollar volume of assets and the dollar volume of liabilities that mature or reprice within a specified time horizon. Some institutions use maturity gap limits to control the risk to earnings from changes in interest rates for specific time periods or time bands. Limits generally specify the maximum allowable maturity gap for each time band in the institution s planning horizon. Market value of equity to book value of equity (MVE/BVE). This ratio measures the market value of equity, or net portfolio value, of an institution relative to book value of equity. In general, an excess of market value of equity over the book value of equity is a positive sign. Hence, an institution might structure its portfolio in such a way that the market value of equity does not fall below some threshold, say 90 percent, over a range of scenarios. Retained earnings limits. Given the importance of retained earnings to the financial stability of an institution, it is appropriate to set risk limits in terms of retained earnings. For example, a Examiner Guidance Bulletin

4 Bank might limit the maximum dollar or percentage loss in retained earnings resulting from a +/- 200 basis point interest rate shock or from adverse movements in other risk factors. Value-at-Risk (VaR) limits. VaR is a statistical measure of potential portfolio losses over a given horizon at a given confidence level under normal market conditions. It does not provide a measure of worst loss. VaR answers the question: What is the maximum loss over a given period of time, for example one month, such that there is a low probability, say a one percent probability, that the actual loss over that time period will be larger? In principle, VaR can be used to measure market, credit, and operational risk. Hence it is a useful summary measure of risk for institutions that are exposed to multiple sources of risk. It can also be used to set risk limits for traders, business units, or the firm as a whole. [4] Guidance In assessing an FHLBank s policies, procedures, and practices with respect to interest rate risk limits, examiners should review all documentation of the FHLBank s interest risk limits, including reports provided to the FHLBank s board of directors and minutes of board discussions. In particular, examiners should consider the following: 1. Board and Senior Management Oversight. Assess the quality of oversight provided by the board of directors and senior management relative to their responsibilities for establishing and enforcing sound and prudent regime of interest rate risk limits. Have the FHLBank s aggregate interest rate risk limits and related policies been approved by the board of directors? Does the board of directors review interest rate risk limits and related policies at least annually? Is senior management informed promptly of any limit violations? Does senior management take appropriate and prompt follow-up action when limits violations occur and when policies and procedures are not followed? Is the board of directors provided with regular, accurate, informative, and timely reports on compliance with aggregate (i.e., institution-wide) exposure limits? Do the reports identify and explain limit violations? [4] VaR approaches for determining capital adequacy are consistent with provisions of the Gramm-Leach-Bliley Financial Modernization Act of 1999 pertaining to the FHLBank System. Examiner Guidance Bulletin

5 2. Adequacy of Policies and Procedures. Assess the adequacy of the FHLBank s policies and procedures governing interest rate risk limits. Are policies and procedures for limiting interest rate risk clearly defined? Does the policy clearly assign responsibility for managing the FHLBank s risk limits? Does the policy describe the corrective actions to be taken when limits are violated? Is there an internal control system that will promptly identify limits violations? Has the FHLBank changed its policies since the last examination? (Frequent changes to an institution s policies to accommodate policy exceptions may reflect ineffective board oversight and risk management.) 3. Selection of Limits. Assess the appropriateness of the limits selected by the FHLBank. Does the FHLBank have limits that specify the minimum allowable economic capital ratio that the FHLBank is willing to tolerate under different scenarios? Does the FHLBank have limits that specify the maximum allowable loss (or deviation) to the FHLBank s net portfolio value under different scenarios? Does the FHLBank have limits that specify the maximum allowable loss (or deviation) from to the FHLBank s net income or net interest income under different scenarios? Are the limits tied to a specific time horizon (e.g., monthly or quarterly)? Does the FHLBank have VaR limits? 4. Prudence of Limits. Assess the overall prudence of the FHLBank s risk limits in the context of the strength of the FHLBank s capital position, the adequacy of its retained earnings, and the overall quality of its risk management and risk measurement systems. Are the limits prudent given the FHLBank s capital position, the level of its retained earnings, and the quality of its risk management and reporting systems? 5. Adherence to Limits. Assess the FHLBank s adherence to its interest rate risk limits. Frequent exceptions to limits may indicate weak risk management practices. Similarly, recurrent changes to an FHLBank s risk limits to accommodate exceptions to the limits may reflect ineffective oversight and control. Does the FHLBank have a formal system to monitor risk exposures against established risk limits? Does staff that is independent of those authorized to take positions perform the risk monitoring function? Examiner Guidance Bulletin

6 Did the FHLBank experience any limit violations since the last examination? If so, what action did management take in response to limit violations? Were the violations reported to the board of director? Is management able to explain abnormal profits and losses given the size of the FHLBank s risk exposures? [1] Net portfolio value represents the underlying net economic value (or net present value) of an institution's portfolio of assets and liabilities, including any off-balance sheet items. Net portfolio value is defined as the present value of assets less the present value of liabilities plus the net present value of any off-balance sheet contracts. In contrast to the GAAP-based shareholders equity account, net portfolio value represents the shareholders equity account expressed in present value terms [2] The economic capital ratio for a given interest rate scenario is calculated by dividing the bank s net portfolio value that would result in that scenario by the estimated market value of its assets (including the net effect of any off-balance sheet contracts) in that same scenario. The economic capital ratio is simply a capital-to-assets ratio measured in terms of economic values (or estimated market values) in a particular rate scenario. [3] Some institutions set limits in terms of variability of income or economic equity and thus the limits represent the maximum allowable gain or loss under a specified scenario. [4] VaR approaches for determining capital adequacy are consistent with provisions of the Gramm-Leach-Bliley Financial Modernization Act of 1999 pertaining to the FHLBank System. Examiner Guidance Bulletin