Interest Rate Risk Management

FARM CREDIT ADMINISTRATION

[BM-14-May-98-02]

Interest Rate Risk Management

AGENCY: Farm Credit Administration.

ACTION: Proposed policy statement with request for comment.

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SUMMARY: The Farm Credit Administration (FCA or Agency), through the

FCA Board (Board), is issuing for comment a proposed policy statement

that provides guidance on interest rate risk management practices to

Farm Credit System (System) institutions and describes the Agency's

approach to evaluating interest rate risk when making a determination

of capital adequacy.

The proposed policy statement identifies key elements of sound

business principles and practices for interest rate risk management by

a System institution. The policy statement also provides criteria by

which the Agency will evaluate the adequacy and effectiveness of a

System institution's interest rate risk management.

DATES: Written comments should be received on or before June 22, 1998.

ADDRESSES: Comments may be mailed or delivered to Patricia W. DiMuzio,

Director, Regulation and Policy Division, Office of Policy and

Analysis, Farm Credit Administration, 1501 Farm Credit Drive, McLean,

Virginia 22102-5090 or sent by facsimile transmission to (703) 734-

5784. Comments may also be submitted via electronic mail to ``reg-

[email protected].'' Copies of all communications received will be available

for review by interested parties in the Office of Policy and Analysis,

Farm Credit Administration.

FOR FURTHER INFORMATION CONTACT:

Andrew D. Jacob, Senior Policy Analyst, Office of Policy and Analysis,

Farm Credit Administration, McLean, Virginia 22102-5090, (703) 883-

4498, TDD (703) 883-4444,

or

Wendy R. Laguarda, Senior Attorney, Office of General Counsel, Farm

Credit Administration, McLean, Virginia 22102-5090, (703) 883-4020, TDD

(703) 883-4444.

SUPPLEMENTARY INFORMATION:

I. Background

The FCA's proposed Capital Phase III rule, in Secs. 615.5180 and

615.5182, proposes that System banks and other System institutions

(excluding the Federal Agricultural Mortgage Corporation) with interest

rate risk implement appropriate risk management practices (see 62 FR

49623, Sept. 23, 1997). Proposed Sec. 615.5181 provides that a System

institution's board of directors (board) is responsible for maintaining

effective oversight of interest rate risk management whereas senior

management is responsible for ensuring that interest rate risk is

properly managed. In the supplementary information to the proposed

Capital Phase III rule, the Board stated its intention to provide

additional guidance regarding sound interest rate risk management

practices for A System institution.

In addition, proposed Secs. 615.5350(b)(7) and 615.5355(a)(4)

provide that the FCA may take action against an institution for failure

to maintain sufficient capital for interest rate risk exposures. A

System institution found to have high levels of exposure or weak

interest rate risk management practices may be directed by the Agency

to take corrective action, which may include raising additional

capital, strengthening interest rate risk management expertise,

improving interest rate risk management practices, reducing levels of

exposure, or a combination thereof. The supplementary information to

the proposed Capital Phase III rule states that a risk assessment

approach will be used to evaluate a System institution's capital

adequacy for interest rate risk and to determine what corrective

action, if any, may be necessary. Additional guidance is now being

provided by the FCA in this proposed policy statement.

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Over the past several years, FCA examiners have considered the

level of interest rate risk exposure, as well as the effectiveness of

interest rate risk management practices, when concluding on an

institution's capital adequacy and compliance with the requirements of

Sec. 615.5200(b)(7).\1\ Considering previous examination results, the

Agency does not anticipate that a System institution will be required

to hold additional capital or enhance existing risk management

practices for interest rate risk based solely on the Agency's

implementation of the criteria contained in the proposed policy

statement.

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\1\ Section 615.5200(b)(7) requires the board of directors of a

System institution to consider other risk-oriented activities, such

as interest rates risks, in developing its formal written capital

adequacy plan.

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II. Discussion

The proposed policy statement addresses prudent interest rate risk

management principles that the FCA expects a System institution to

consider in its interest rate risk management processes. The FCA has

emphasized these principles over the past several years in its

examination, supervisory, and regulatory efforts. Moreover, many System

institutions have already implemented interest rate risk management

practices consistent with the principles contained in this policy

statement. The policy statement also provides criteria by which the

Agency will evaluate the adequacy and effectiveness of a System

institution's interest rate risk management. In addition, the

principles discussed here are consistent with the joint policy

statement issued by other Federal financial institution regulatory

agencies on interest rate risk management principles as applied to

federally insured and supervised commercial banks and savings banks

(see 61 FR 33166, June 26, 1996).\2\

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\2\ The Federal agencies that issued a joint policy statement on

interest rate risk management are the Office of the Comptroller of

the Currency, the Board of Governors of the Federal Reserve System,

and the Federal Deposit Insurance Corporation.

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Interest rate changes can affect an institution's earnings by

changing net interest income and the level of other interest-sensitive

income and operating expenses. Changes in interest rates also affect

the underlying market value of an institution's assets, liabilities and

off-balance sheet instruments. This occurs because the present value of

a financial instrument's future cashflows, and in many cases the

cashflows themselves, change when interest rates change. The combined

effects of the changes in the present values of an institution's assets

and liabilities reflect the change in an institution's underlying

market value of equity.

Interest rate risk results from:

Maturity or coupon adjustment timing differences of

assets, liabilities, and off-balance sheet instruments (repricing or

mismatch risk);

Changes in the slope of the yield curve (yield curve

risk);

Imperfect correlation in the adjustment of the rates

earned and paid on different instruments with otherwise similar

repricing characteristics (basis risk); and

Interest rate-related options embedded in assets,

liabilities, and off-balance sheet instruments (options risk).

While interest rate risk is an inherent part of banking, it can

become excessive and pose a significant threat to an institution's

earnings and capital base. Accordingly, a well-managed risk management

process that maintains interest rate risk within prudent levels is

essential to the safety and soundness of a System institution.

III. Request for Comment

The Board requests comment on the Agency's proposed policy

statement on interest rate risk management as set forth below in its

entirety.

Policy Statement on Interest Rate Risk Management

BM-14-May-98-02

FCA-PS-##

Effective Date: None; Proposed Policy Statement with request for

comment. Comment period is 30 days from publication in the Federal

Register.

Effect on Previous Actions: None.

Source of Authority: Sections 5.9 and 5.17 of the Farm Credit

Act of 1971, as amended.

I. Purpose

Interest rate risk is the exposure of a Farm Credit System

(System) institution's financial condition to adverse movements in

interest rates. This policy statement provides guidance to System

institutions on prudent interest rate risk management principles.

The policy statement also provides criteria by which the Farm Credit

Administration (FCA or Agency) will evaluate the adequacy and

effectiveness of a System institution's interest rate risk

management.

II. Board of Directors' Responsibilities

Effective board of directors (board) oversight of an

institution's interest rate risk activities is the cornerstone of a

sound risk management process. The board should understand the

nature and level of interest rate risks and how such risks relate to

the overall business strategies of the institution. The board should

also define its risk tolerance levels and expectations for interest

rate risk management. To accomplish effective oversight, a board

should, at a minimum, carry out the following responsibilities:

Approve major business strategies and policies

addressing interest rate risk, including establishing relevant risk

limits, and integrating such strategies and policies into the

institution's overall strategic and financial planning processes;

Ensure that senior management implements a sound risk

management process that facilitates the identification, measurement,

monitoring, reporting, and control of interest rate risk;

Monitor the institution's performance and overall

interest rate risk profile to ensure that risk is maintained at

prudent levels; and

Ensure that adequate resources and proper control

systems are devoted to interest rate risk management, including

measurement activities.

III. Senior Management Responsibilities

Senior management is responsible for ensuring that interest rate

risk is properly managed on both a long-range and day-to-day basis.

In managing the institution's activities, senior management should,

at a minimum:

Develop and implement procedures that translate the

board's major business strategies and policies addressing interest

rate risk, including risk limits, into operating standards;

Ensure adherence to the lines of authority and

responsibility that the board has approved for managing, measuring,

and reporting interest rate risk exposures;

Oversee the implementation and maintenance of

management information and other systems that appropriately manage

and control interest rate risk; and

Establish proper internal controls and audits over the

interest rate risk management process.

An institution's board or senior management may delegate

authority for implementing many aspects of board policy on risk

management to an internal committee composed of qualified officers

and staff members. Any such risk management committee should be a

decision-making body involved in the acquisition, allocation, and

pricing of the institution's resources in a manner consistent with

both the goals established in a business plan and the risk

tolerances established by the board.

IV. Interest Rate Risk Management Process

Effective control of interest rate risk requires a comprehensive

management process that includes the following elements:

Policies and procedures designed to control the nature

and amount of interest rate risk that the institution assumes;

A system for identifying and measuring interest rate

risk;

A system for monitoring and reporting interest rate

risk; and

A system of internal controls, review, and audit to

ensure the integrity of the overall risk management process.

Each of the foregoing elements is discussed below.

A. Risk Limits

Each System institution should establish appropriate controls to

effectively limit interest rate risk exposures within the risk

tolerances established by the board. Established risk limits should

be consistent

[[Page 27964]]

with the overall measurement approach and should consider capital

levels and earnings performance. Risk limits also should be clearly

defined, ensure that exposures will not lead to an unsafe or unsound

condition, be consistent with the nature and complexity of the

institution's activities, and be evaluated within the institution's

total risk-bearing capacity. The risk limits should address the

potential impact of changes in market interest rates on both

reported earnings and the market value of equity. Exceptions to

established risk limits should be appropriately reported, approved,

and controlled. In addition, risk limits should be reviewed at least

annually to ensure that they remain appropriate. A System

institution's board and senior management should further ensure that

adequate operational procedures, controls, and risk limits are in

place prior to introducing a new product, hedging, or position-

taking strategy that has the potential to increase materially the

institution's interest rate risk exposure.

B. Interest Rate Risk Identification and Measurement

Senior management should ensure the adequacy and completeness of

the interest rate risk identification and measurement system. The

quality and reliability of the identification and measurement system

depends on the type of system used, the quality of the data, and

various assumptions used in the model; therefore, close attention to

these areas is needed. Senior management should ensure that the

identification and measurement system:

Enables management to recognize and identify in a

timely and accurate manner risks arising from the institution's

existing activities and from new business activities;

Captures and measures all material sources of interest

rate risk in ways that are consistent with the scope of the

institution's activities \3\ and considers all relevant repricing

and maturity data such as current balances, contractual rates,

principal payments, interest reset dates, maturities, index rates,

and rate caps and floors;

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For a System institution with a high level of interest rate

risk or a complex risk exposure, interest rate risk should be

measured over a range of potential interest rate changes, economic

scenarios, and yield curve shifts so as to effectively capture all

material interest rate risk exposures (options, mismatch/repricing,

basis, and yield curve). For a System association where the majority

of interest rate risk is managed by the funding bank, any locally

managed interest rate risk should be measured at least annually as

part of its annual financial planning process.

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Contains assumptions that are clearly communicated to

and understood by risk managers and the board of directors; and

Measures an institution's vulnerability to loss under

stressful market conditions, including a breakdown of key

assumptions.

When assessing the scope of an institution's exposure, risk

managers should consider the effect on earnings and, when

appropriate, market value of equity. The effect on earnings is

important because reduced earnings or losses can adversely affect

liquidity and capital adequacy. The effect on market value of equity

is important because adverse changes in the market value of assets,

liabilities, and off-balance sheet instruments can affect the future

performance and liquidity of a System institution.

C. Monitoring and Reporting

Each System institution must have adequate information systems

for monitoring and reporting interest rate risk exposures. These

systems should provide the board, senior management, and any risk

management committee with clear, concise, and timely summaries of

the institution's aggregate exposures, compare current exposure to

policy limits, and allow for a determination of whether the

institution holds sufficient capital in relation to the level of

risk exposure. Risk reports should provide sufficient information

for the board and senior management to assess exposure. The

frequency of internal reporting should be determined by the board

and senior management and should depend on the amount and complexity

of an institution's level of risk.

D. Internal Controls and Audits \4\

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\4\ ``Audits'' is used here to refer to audits performed by

either internal or external auditors. An institution can rely on

qualified internal auditors to perform the audit functions by may

wish to consider using external auditors if the interest rate risk

exposures are complex and appropriate interest rate risk management

practices and critical to controlling risk exposures at prudent

levels.

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Each System institution should maintain an effective system of

internal controls as part of its interest rate risk management

process. Controls should include a process for identifying and

evaluating risk, establishing appropriate approval processes and

exposure limits, and requiring reconciliations, audits, and other

mechanisms designed to provide reasonable assurance that interest

rate risk is managed in a safe and sound manner. The controls should

ensure official lines of authority and the appropriate separation of

duties to avoid conflicts of interest, and should ensure that

personnel follow established policies and procedures.

An institution with more complex interest rate risk exposures

should ensure that its interest rate risk process is audited on a

regular basis. The audits should be conducted by qualified

individuals who are independent of the function they are assigned to

audit. The audits should test the effectiveness of controls and

ensure appropriate follow-up with management where risk limits have

been exceeded or deficiencies in interest rate risk management are

identified. Audits of risk measurement systems and models should

include assessments of the assumptions, parameters, and

methodologies used. The audit results should be reported to the

board and senior management.

E. Additional Guidance on the Interest Rate Risk Management Process

The interest rate risk management process will vary among each

System institution in accordance with the level of its interest rate

risk exposure. For instance, a System bank, direct lender

association, or a service corporation that is exposed to and

managing major sources of interest rate risk should employ

comprehensive interest rate risk management and measurement

practices that address all applicable elements of an effective

interest rate risk management process discussed in this policy

statement. These practices should ensure the establishment and

maintenance of adequate controls over the identification,

measurement, monitoring, and reporting of all sources of interest

rate risk.

The formality and comprehensiveness of the risk management

process will vary among each System association depending on the

extent to which interest rate risk is centrally managed by its

funding bank. For instance, a direct lender association that is

managing some sources of interest rate risk locally and that has the

potential for a moderate level of interest rate risk exposure should

implement an interest rate risk program that includes:

(a) A policy that defines the board's interest rate risk

tolerance arising from the sources of interest rate risk being

managed locally and that sets risk limits from an earnings

perspective and, if appropriate considering the sources of interest

rate risk being managed, a market value of equity perspective;

(b) Procedures and practices established by senior management

that adequately identify, measure, control, monitor, and report

interest rate risks within the association's direct control;

(c) Procedures and practices established by senior management

that ensure that the board understands the sources and exposure

levels of interest rate risk;

(d) Reliable information systems and modeling capabilities that

are commensurate with the nature of the interest rate risk being

managed and that measure interest rate risk under various economic

scenarios; and

(e) Consideration of interest rate risk exposures in the capital

adequacy plan as required by Sec. 615.5200(b)(7).

Finally, a direct lender association that relies on its funding

bank to manage essentially all sources of interest rate risk and

that has a minimal level of interest rate risk exposure should

establish an interest rate risk management program that includes:

(a) A policy that establishes the board's tolerance for interest

rate risk;

(b) Procedures to ensure that the board and senior management

understand the sources and exposure levels of interest rate risk;

(c) Consideration of interest rate risk exposures in the capital

adequacy plan as required by Sec. 615.5200(b)(7); and

(d) An analysis, prepared at least annually, of potential

earnings exposure to changing interest rates.

V. FCA's Capital Assessment for Interest Rate Risk

FCA examiners will assess an institution's capital adequacy for

interest rate risk based on the evaluation of an institution's level

of interest rate risk exposure and its risk management practices

performed in accordance with the FCA's Financial Institution Rating

System. The results of an institution's interest rate risk

management measures will be considered when evaluating interest rate

risk exposure levels.

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Dated: May 15, 1998.

Floyd Fithian,

Secretary, Farm Credit Administration Board.

[FR Doc. 98-13626 Filed 5-20-98; 8:45 am]

BILLING CODE 6705-01-P