The Federal Reserve bank started to raise interest rates in March of 2022 to combat rising inflation. Knowing the critical importance of effective interest rate risk (IRR) management in such an economic environment, regulators made it an area of regulatory focus for 2023. Given the fact that inadequate interest rate risk management was a contributing factor to several bank failures earlier this year, effective IRR management can be a matter of survival for some banks, and the reason that regulators are now addressing weaknesses more aggressively.
Doran Jones has extensive insight into IRR management, in addition to extensive experience in risk management and compliance. Our team brings fixed income, portfolio management and trading experience analyzing yield-curves, forecasting interest rate changes and quantifying the effects of those changes on banks.
In this series of articles on interest rate risk, Doran Jones will share insight into best practices garnered from our holistic approach to IRR management that combines risk management, compliance, quantitative/analytical/technical model and forecasting, and data management expertise.
An Overview of Interest Rate Risk Management
Interest Rate Risk (IRR) is fundamental to the business of banking. Almost all activities that a bank undertakes in the normal course of business are based on receiving and making interest rate payments. Changes in interest rates on both an absolute and relative basis can have a profound impact on a bank’s earnings and capital levels by directly impacting its net interest margin and value of interest earning assets. It can also have an indirect impact on earnings- for example, when interest rates increase, mortgage demand slows and banks that are active in the mortgage markets experience lower income levels from mortgage closing and servicing revenues.
Regulators expect banks to employ an IRR management system that is appropriate for the nature and complexity of their product mix and business activities. The primary responsibility for ensuring that the bank is using effective IRR management processes is owned by the bank’s senior management and board of directors.
Regulators expect that senior management and the board understand the nature, level, sources and directional trend of the bank’s IRR and its relationship to its overall business plan and risk appetite.
The board is responsible for:
- Defining the risk appetite and strategic implementation of an IRR management system
- Approving key standards and policies, risk limits and independent monitoring and review processes.
- Assigning responsibilities to senior management for managing interest rate risk.
- Reviewing critical reports provided by senior management to verify the effectiveness of IRR management systems and processes.
Senior management is responsible for:
- Developing standards that guide the documentation and implementation of strategies, policies and procedures that align with the board’s objectives and stated risk appetite.
- Oversight of IRR risk management infrastructure and reporting
- Implementing effective internal controls and processes to mitigate interest rate risk.
- Oversight of the implementation and maintenance of management information, forecasting and other systems used in IRR management.
The IRR oversight structure will depend on the nature, level, and complexity of the bank’s activities.
Smaller banks would typically assign responsibility to a committee of senior managers (usually an asset-liability management committee, or ALCO) to provide oversight over the IRR management process. Larger, more complex banks usually spread responsibility to multiple oversight committees for major affiliates and business lines that report to a central oversight committee. Regardless of the structure, the ultimate responsibility remains with the board.
The ALCO is typically responsible for monitoring the bank’s balance sheet and IRR, oversight of IRR measurement and reporting systems, and communicating information on the level and sources of interest rate risk to senior management and the board.
Interest rate risk is a complex and technically challenging subject that is critical to the financial stability of every bank and something that senior management and the board need to understand and manage accordingly. Banks should be taking a proactive approach to ensuring that their IRR management processes are effective and consistent with regulatory expectations. We will be providing additional guidance in this regard in upcoming articles that will discuss IRR identification, measurement, monitoring, and controls.
Doran Jones can provide the regulatory compliance and risk management expertise with extensive technological knowledge and experience to design and implement a cost-effective solution that will increase efficiency and lower risk by upgrading your risk and compliance systems or identifying and remediating gaps in existing processes.
Contact us to learn how a strategic partnership with Doran Jones can provide you with cost-effective solutions by leveraging our expertise with these and other critical risk and compliance functions.