Some banks in the Ninth Federal Reserve District have recently taken on more credit and interest rate risk in their investment portfolios. There is nothing inherently wrong with such actions if managed properly. However, as banks presumably seek to generate more investment revenue in the current low-rate and low-demand loan environment, management and boards of directors should review last year’s Joint Advisory on Interest Rate Risk Management (SR letter 10-01). This advisory guides institutions in supervisory expectations and sound practices for managing interest rate risk. It addresses corporate governance, policies and procedures, measurement methodologies, stress testing, risk mitigation, internal controls and model validation.
Examiners have identified deficiencies relative to this guidance and general risk management practices on recent examinations. Highlighted below are those areas where we most frequently identify deficiencies.
Due diligence. The board of directors and management should have a thorough understanding of the investment products they are purchasing and the risks inherent in them before purchase and before initiating a new investment strategy. Banks should not place undue reliance on information and analysis provided by third parties whose interests may not align with those of the bank.
Policies, procedures and limits. We expect banks to have sound policies, procedures and limits in place before embarking on a new investment strategy. The board of directors should set limits relative to the amount of risk they are willing to accept. Limits should go beyond “percentage of the portfolio” and beyond broad categories of investment. For example, for municipal bonds, where we have seen considerable recent activity, limits might include by type of municipal bond (revenue, general obligation), by type of revenue bond (hospital, utilities) and by geographic location (state or municipality). We expect banks to be aware of and manage the risks of securities issued in states or municipalities under significant financial pressure. We also encourage limits to be expressed as a percentage of capital in addition to total assets or the investment portfolio. This measure more accurately captures the risk to the institution. Compliance with the limits should be regularly monitored and reported to the board.
Limits and monitoring of aggregate interest rate risk. Overall interest rate risk limits and ongoing monitoring of interest rate risk should address both the short-term impact (net interest income) and the long-term impact (economic value of equity) of interest rate movements. The interest rate risk inherent in funding sources the bank uses should also be captured in the bank’s measurement tool.
While the discussion above focuses on a potential emerging concern regarding the investment portfolio, similar expectations apply regarding due diligence and policies, procedures and limits for the loan portfolio. Any questions from state member banks regarding the discussion above can be directed to their relationship manager.
