It's tough out there for banks. With so much competition from other financial institutions and new technologies, not to mention increased government regulation, it's no wonder some bankers feel overwhelmed. One of the hot topics of regulation at the moment is interest rate risk, and examiners want to know how the bank is poised to handle it. What does this come down to? It comes down to a process for handling interest rate risk, or an Interest Rate Risk Management Program.

The 4 Parts of an Effective IRR Management Program

1. IRR Measurements and Modeling

Regulators expect financial institutions to use IRR models to adequately assess risk exposures. In particular, examiners have specific expectations for four things:

• Measurements - At a minimum, models should include robust earnings simulation and capital valuation methodologies.
• Stress Scenarios - Scenarios should include immediate parallel rate shocks up to 400 basis points using a static balance sheet.
• Yield Curve Risk Assessments - IRR models should also assess the impact of meaningful non-parallel changes to the yield curve. 
• Sensitivity Testing - All key model assumptions should be sensitivity tested periodically.

2. Key IRR Model Assumptions

A critical component for an effective IRR Management Program is having well documented and supported model assumptions. With that, one needs to understand the options for setting them, and methods for sensitivity testing these assumptions. Particular emphasis should be placed on the following items:

• Deposit Repricing/Betas - Consider various methods for setting deposit repricing assumptions, including both quantitative and qualitative approaches.
• Non-Maturity Deposit Decay Rates - Conduct an institution-specific decay study by reviewing current accounts, closed accounts, and run-off rates.
• Loan and Security Prepayments - Use dynamic institution-specific prepayment assumptions for both loans and securities.
• Driver Rates - Select driver rates consistent with the terms and risks of the underlying assets and liabilities if required in your IRR model.
• Surge Deposits - Consider multiple approaches to assess the level of surge deposits and their impact on IRR.
• Discount Rates - Review options for setting appropriate discount rates for both loans and CDs.

3. IRR Oversight

Regulatory expectations regarding interest rate risk don't stop at a data level. They continue all the way up to the top of the organization. This makes it essential to know what examiners expect from the board and senior management overseeing your institution's IRR management program. These three things are what they'll really be looking at:

• Corporate Governance - While management may conduct the IRR modeling, the board has the ultimate responsibility for the IRR program. The board needs to be well informed, and ALCO reporting must be comprehensive.
• Policies and Risk Limits - Policies should outline the entire IRR management program and establish parameters for all key IRR measurements, including earnings simulations, capital valuation calculations, and non-parallel yield curve shift modeling.
• Internal Controls - A sound internal control structure includes both corporate governance and model controls.

4. Independent Review, Model Validation and Back Testing

These three items are a critical part of the IRR Management Program framework, but they are not the same. 

• Understanding the Terms - Independent Review, Model Validation, and Back Testing are terms that are often used synonymously and frequently misunderstood. It is important to understand how these individual components fit together and what regulatory guidance requires for each area.
• Third-Party Reviews - There are common shortcomings of third-party independent reviews, and it's critical to know what you should be looking for when contracting an outside firm to conduct a review.

As a financial institution, it's important to have a process in place to ensure each of these expectations is met. This means a better picture of the institution’s risk health, making for better decisions. Another positive outcome is happier examiners and a more comfortable exam process.

Does your financial institution have these four components in place in its IRR Management Program? What about all of the sub-components? If you're not sure, you might be interested in the full webinar series, Building an Effective IRR Program.

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