A new request list and questionnaire from the OCC is making its way around the banking community and the NCUA has issued one of its own. Regardless of who you answer to, expect more scrutiny on your asset liability management (ALM) model. For some of you this might be "old hat", but we’ve fielded calls by clients asking for interpretation of the IRR Data Collection. So, Plansmitties, and even non-Smitties, take note: there is a letter with your name on it and we’re here to help.

Before taking a closer look at the 14 items requested, the letter itself offers insight to the seriousness of getting it right. The letter opens with "Interest rate risk (IRR) remains a key regulatory focus and continues with "historical deposit studies are no longer valid." Clearly, regulators are concerned with behavior changes within your client base: are long time deposit clients now more price sensitive and therefore less sticky? What percent of your deposits are simply funds being parked until the next best yield opportunity? In the last year, we’ve had a pickup in our advisory clients asking for deposit studies – bank specific analysis to use in interest rate risk models. To sum it up, there is no national or regional study of averages that is suitable for you to use in your interest rate risk model.

The letter goes on: "The pressure to accurately forecast Interest Rate Risk exposures and then develop strategies to address either risk exposures or weaknesses in Interest Rate Risk planning is high…" If you’ve spoken with me then you may have heard me give my life cycle explanation of interest rate risk analysis. In the ‘90s – buy a system; later, take it off the shelf. Then learn to use it, learn to explain the reports and, most recently, justify and document your assumptions. I bolded portions above to make a point – it all comes down to planning – something Plansmith finds more important above all. Answer the questions that your interest rate risk report asks. Run multiple scenarios, test your model, create forecasts. In short, make it a tool to better manage risk and set the direction of the bank.

With that as a backdrop, the OCC is asking banks for information about their asset liability management model and how it’s being used. If I fully understand it, they will use the data to input into their own model in an effort to evaluate banks remotely based on quarterly call data. This means that bank provided assumptions entered into the regulatory model could result in an unscheduled visit from your friendly field examiner. They end with "The OCC intends to provide customized benchmark reports…in relation to actual interest rate risk exposures…" and other risk factors.

The data collected spans from the simple (name of interest rate risk vendor) to the complex. We’ll presuppose you know where you get your model and what reports are provided. But can you discuss the "assumptions that are significant factors in the model’s forecasted results" (there it is again – forecasting)?

Question 1: TYPES OF IRR AND VARIABLES/ASSUMPTIONS

Some creative language is being tossed around as if we all learned it in grammar school – Bull Flat, Bear Flat – how is one flat flatter and how is this dangerous? I’ve always felt hills were scarier, but I’m from another kind of flat: Chicago.

• Repricing or Maturity Mismatch Risk – when rates change, in what order does the balance sheet reprice, liabilities or assets first? Traditionally, this is called a GAP report. But we all know that a GAP report provides little in the way of interest rate risk analysis. While it might give an indication of the direction of change in income, it cannot reasonably estimate the magnitude of the change. For this reason GAP reports are largely ignored, although many banks still provide them to their board.

Regulatory guidance calls for parallel rate shock analysis to capture the magnitude of the impact repricing and maturity mismatches have on margin and value. This sets up an interesting debate on the usefulness of such analysis – I’ll take the affirmative and side with the examiners for a moment: While it does nothing to advance the management of a successful bank, it does offer a low probability, high impact event. As this regulatory requirement is not going away, you need a reliable source of data for the repricing and maturity mismatch as this represents a significant variable.

• Basis Risk – Often overlooked since many clients price everything based on the local competition and not the broad market. But if you are making prime rate loans and taking deposits based the 6 month treasury, how quickly do these two rates change relative to one another and by what magnitude? This type of risk is often confused with yield curve risk. Banks that are pricing off multiple curves – LIBOR, UST and, perhaps, the FHLB rate curve – are more concerned with basis risk. It’s not easy to understand what to expect the 6 month LIBOR rate to do when the U.S. prime rate changes.

• Yield Curve Risk – A bit easier to comprehend: you price products along the different maturities of the same yield curve, often the treasury curve. For instance, variable rate loans are priced off the 10 year CMT and are funded by non-maturity (core) deposits priced off the 6 month treasury. If the short end of the treasury curve goes up and the long end stays put, your margin is squeezed. Likewise, if the long end goes down and the short end goes nowhere, the result is the same. You hear us discussing non-parallel rate shocks as part of our standard analysis: stressing the shape of the yield curve to assess the risk to margin and value. Bull flat is when the long end drops, bear flat is when the short end rises (and beer flat is never a good thing). Compared to parallel rate shocks, non-parallel rate shocks are more realistic since the yield curve does not shift in unison across all tenors.

• Option Risk – when your customer has the ability to change the cash flows (remember, a significant variable), then the outcome of your analysis is altered as well. A very real concern is that banks have CDs with penalties for early redemption, but the customer is willing to pay the penalty in order to put the principal in a higher yielding instrument. If the short end of the yield curve surges and the stock market continues its own record path, there are a lot of customers who will be impatient about waiting 12 months before they can jump on the gravy train. Being able to model the earnings and value at risk due to options like this is a requirement.

And that’s just one question. To give you some time to digest this, and write or call in with questions, I will pick up the remaining 10 in next week’s post.