Financial Management Policies

DEPARTMENT OF THE TREASURY

Office of Thrift Supervision

[No. 98-117]

Financial Management Policies

AGENCY: Office of Thrift Supervision.

ACTION: Notice of final thrift bulletin.

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SUMMARY: The Office of Thrift Supervision (OTS) is adopting Thrift

Bulletin 13a, which provides guidance on the management of interest

rate risk, investment securities, and derivatives activities. The

Bulletin also describes the guidelines OTS examiners will use in

assigning the ``Sensitivity to Market Risk'' component rating under the

Uniform Financial Institutions Rating System.

EFFECTIVE DATE: December 1, 1998.

FOR FURTHER INFORMATION CONTACT: Ed Irmler, Senior Project Manager,

(202) 906-5730 or Anthony G. Cornyn, Director, Risk Management

Division, (202) 906-5727, Office of Thrift Supervision.

SUPPLEMENTARY INFORMATION: The Office of Thrift Supervision is today

adopting the attached document, Thrift Bulletin 13a (TB 13a),

Management of Interest Rate Risk, Investment Securities, and

Derivatives Activities. This Bulletin provides guidance on a wide range

of topics in the area of interest rate risk management, including

several on which the Federal Financial Institutions Examination Council

(FFIEC) has issued related guidance. OTS believes that adoption of this

Bulletin will simultaneously improve its supervision of interest rate

risk management and reduce regulatory burden on thrift institutions.

The Bulletin updates OTS's minimum standards for thrift

institutions' interest rate risk management practices with regard to

board-approved risk limits and interest rate risk measurement systems.

The guidance in this Bulletin, thus, replaces Thrift Bulletin 13

(Responsibilities of the Board of Directors and Management with Regard

to Interest Rate Risk), Thrift Bulletin 13-1 (Implementation of Thrift

Bulletin 13), and Thrift Bulletin 13-2 (Implementation of Thrift

Bulletin 13). The Bulletin makes several significant changes. First,

under TB 13a, institutions no longer set board-approved limits or

provide measurements for the plus and minus 400 basis point interest

rate scenarios prescribed by the original TB 13. The Bulletin also

changes the form in which those limits should be expressed. Second, the

Bulletin provides guidance on how OTS will assess the prudence of an

institution's risk limits. Third, the Bulletin raises the size

threshold above which institutions should calculate their own estimates

of the interest rate sensitivity of Net Portfolio Value (NPV) from $500

million to $1 billion in assets. Fourth, the Bulletin specifies a set

of desirable features that an institution's risk measurement

methodology should utilize. Finally, the Bulletin provides an extensive

discussion of ``sound practices'' for interest rate risk management.

TB 13a also contains guidance on thrifts' investment and

derivatives activities. As described in the FFIEC's Supervisory

Statement on Investment Securities and End-User Derivative Activities,

(FFIEC Policy Statement), 1 the FFIEC-member agencies have

discontinued use of the three-part test for suitability of investment

securities. Accordingly, the Bulletin describes the types of analysis

institutions should perform prior to purchasing securities or financial

derivatives. The Bulletin also provides guidelines on the use of

certain types of securities and financial derivatives for purposes

other than reducing portfolio risk. The final regulation on financial

derivatives, published elsewhere in this issue of the Federal Register,

as supplemented by the guidance in this final TB 13a, replaces existing

regulations governing futures (12 CFR 563.173), forward commitments (12

CFR 563.174), and options (12 CFR 563.175). TB 13a also replaces

guidance contained in Thrift Bulletin 52 (Supervisory Statement of

Policy on Securities Activities), Thrift Bulletin 52-1 (``Mismatched''

Floating Rate CMOs), and Thrift Bulletin 65 (Structured Notes).

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\1\ 63 FR 20191 (April 23, 1998).

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Finally, TB 13a provides detailed guidelines for implementing part

of the Notice announcing the revision of the Uniform Financial

Institutions Rating System (i.e., the CAMELS rating system), published

by the FFIEC. 2 That publication announced revised

interagency policies, that among other things, established the

Sensitivity to Market Risk component rating (the ``S'' rating). TB 13a

provides quantitative guidelines for an initial assessment of an

institution's level of interest rate risk. Examiners have broad

discretion in implementing those guidelines. It also provides

guidelines concerning the factors examiners consider in assessing the

quality of an institution's risk management systems and procedures.

Guidance on the topic of assigning the ``S'' rating is largely new,

though TB 13a replaces the rather limited guidelines contained in New

Directions Bulletin 95-10.

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\2\ 61 FR 67021 (December 19, 1996).

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Differences Between Proposed and Final Versions of TB 13a

On April 23, 1998, OTS published a proposed TB 13a. 3

The content of the final TB 13a is, in most respects, the same as the

proposed TB 13a. Two significant changes were made, however, in

response to comment letters.

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\3\ 63 FR 20257 (April 23, 1998).

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1. Guidelines for Assessing the Level of Risk

The guidelines examiners will use to initially assess the level of

interest rate risk at an institution, for purposes of assigning the

Sensitivity to Market Risk (``S'') component rating were contained in a

matrix shown as Table 1 in the proposed TB. Based on comments received

and on further analysis, OTS has decided to revise those guidelines.

The revised guidelines are contained in Part IV.A.3 of TB 13a. A

comparison of the ratings that are likely to result from the final

guidelines with those from the proposed guidelines is contained in Part

1.d of the discussion of comments, below.

2. Transactions in Financial Derivatives or Complex Securities that Do

Not Reduce Risk

Part III.A.3 of the proposed TB stated that the use of financial

derivatives or complex securities with high price sensitivity should

generally be limited to transactions that lower an institution's

interest rate risk. An institution using such instruments for purposes

other than reducing portfolio risk should do so in accordance with safe

and sound practices and:

(a) Obtain written authorization from its board of directors to use

such instruments for a purpose other than to reduce risk; and

(b) Ensure that, after the proposed transaction(s), the

institution's Post-shock NPV Ratio would not be less than 6 percent.

As a result of comments received, OTS has decided to reduce the 6

percent threshold in condition (b), above, to 4 percent. The reasons

for this change are discussed below in Part 3.g of the discussion of

comments.

Summary of Comments

The comment period ended on June 22, 1998. OTS received twenty-

seven comments. Commenters included: twenty savings associations, five

trade associations, one law firm, and one

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registered investment adviser. Furthermore, OTS met with

representatives of several institutions and an industry trade group to

discuss the proposed TB. The following summary identifies and discusses

the major issues raised in the comment letters and OTS's responses to

the issues.

1. General Issues

a. Coordination With Banking Agencies

Several commenters argued that OTS should coordinate the TB with

guidance issued by the other banking agencies. A number suggested that

OTS should adopt the guidance that the other federal banking agencies

have adopted with respect to the management of both interest rate risk

and investment and derivatives activities.

As a member of the FFIEC, OTS works closely with the other banking

agencies on the coordination of supervisory policies. When appropriate,

OTS and the other members of the FFIEC adopt uniform

policies.4 At the same time, the members of the FFIEC

recognize that it is not possible to achieve uniformity in all areas of

supervision and regulation. OTS's supervisory efforts have, since at

least the mid-1980s, placed more emphasis on interest rate risk than

have other regulators. This difference in emphasis reflects the nature

of the thrift industry's basic business which has historically given

thrift institutions a propensity toward maturity mismatching. OTS has

utilized the economic value concept (as described in the proposed TB)

to measure interest rate risk since the adoption of the original TB 13

in 1989. The guidelines described in the proposed TB do not represent

so much a new initiative to be coordinated with the other agencies, as

an attempt to update and improve consistency across OTS-regulated

institutions in the application of OTS's existing approach to assessing

interest rate risk.

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\4\ See Section 303 of the Riegle Community Development and

Regulatory Improvement Act of 1994. Pub.L. 103-325 (September 25,

1994).

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The proposed guidelines for investment securities and financial

derivatives are more detailed than those published in the FFIEC Policy

Statement, but are completely consistent with that policy statement.

OTS believes the added level of detail in its guidelines will be

helpful to examiners and will result in greater consistency of

application. OTS also believes the level of detail will be helpful to

institutions, not because OTS has a desire to ``micromanage'' those

institutions, but because OTS wants to reduce needless uncertainty

about how to interpret the guidance and how examiners will apply it.

b. Competitive Equity

A number of commenters argued that thrifts would be harmed

competitively because other financial institutions do not have

comparable guidelines, with respect to either the acquisition of

securities and derivatives or the ``S'' rating. This is not a valid

criticism. The purpose of TB 13a is two-fold: (1) to provide guidance

to thrift institutions on the management of interest rate risk,

including investment and derivative activities, and (2) to describe the

framework that OTS examiners will use in assigning the ``S'' rating

component. Both the proposed guidelines on the management of interest

rate risk and the framework for assigning ``S'' ratings are consistent

with guidelines issued by the other federal banking agencies. The only

significant constraint in the guidelines is on the ability of a small

fraction of the thrift industry to acquire financial derivatives and

some volatile securities for purposes other than reducing market risk.

This aspect of the guidelines is appropriate, as the limitation applies

only to those institutions least able to bear additional risk.

Comparing the fairness of ``S'' ratings at OTS-regulated

institutions with those at other institutions is not a straightforward

exercise because of the typically higher levels of interest rate risk

that one might expect at thrifts. As stated earlier, the proposed

guidelines for the ``S'' rating do not so much reflect a new approach

in the way OTS assesses interest rate risk but rather provide

quantitative guidance to examiners in applying the current assessment

process. Thrifts have competed successfully under that process for a

number of years. Moreover, it is highly unlikely that the guidelines

would result in harsher ``S'' ratings than OTS examiners have assigned

historically. Available evidence (see section 1.d below) indicates that

the opposite might occur.

c. De Facto Capital Requirement

A number of commenters asserted that the proposed guidelines for

assigning the ``S'' rating would create a de facto higher capital

requirement. This criticism is not valid for several reasons. First,

the proposed TB reflects the concept that institutions with higher

levels of capital should have greater freedom to engage in risk-taking.

Thus, for a given amount of interest rate risk--as indicated by the

Sensitivity Measure--institutions with higher Post-shock NPV Ratios

receive better ``S'' components ratings under the guidelines (see

Glossary in TB 13a for definitions of these terms). The fact that

examiners also assign a capital adequacy (i.e., ``C'') component rating

to the institution under the CAMELS rating system does not undermine

the validity of this approach for gauging the level of risk. If capital

appears to be ``double counted'' with this approach to assigning the S

rating, it is only because capital adequacy--the ability to absorb

unexpected losses--is central to evaluating an institution's safety and

soundness.

Second, the CAMELS rating system explicitly calls for consideration

of an institution's capital position in assessing the ``S'' component

rating. For example, the description of the 2 rating says in part :

``The level of earnings and capital provide adequate support for the

degree of market risk taken by the institution [emphasis added].'' \5\

Moreover, other risk assessments under the CAMELS rating system also

consider capitalization. For example, the rating level of 1 of the

asset quality (``A'') component rating is described in the interagency

document as: ``A rating of 1 indicates strong asset quality and credit

administration practices. Identified weaknesses are minor in nature and

risk exposure is modest in relation to capital protection and

management's abilities . . . [emphasis added].'' \6\

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\5\ 61 FR at 67029.

\6\ 61 FR at 67027.

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Third, unlike a regulatory minimum capital requirement, the

guidelines do not establish a minimum level of capital. There are only

two ways in which an institution can achieve compliance with a

regulatory minimum capital requirement--raise additional capital or

shrink the asset base. Under the guidelines, however, institutions have

the third option of reducing the level of interest rate risk in their

portfolio. Even institutions with very low Post-shock NPV Ratios can

receive ratings of 1 or 2 if their level of interest rate risk is also

very low.

Finally, even if one subscribes to the view that the guidelines are

a form of capital requirement, it is doubtful that the guidelines would

require generally higher capital requirements for the industry because

overall CAMELS ratings are unlikely to change, as will be discussed in

section 1.d, below.

Several commenters argued that the guidelines would create

incentives to take additional credit risk. Some institutions that

anticipate receiving a lower ``S'' rating under the proposed guidelines

might choose to reduce

[[Page 66353]]

interest rate risk, while simultaneously increasing credit risk to

maintain profitability levels. Determining the tradeoff between these

two types of risk is not new, however, it is a normal part of the

business of running a depository institution. The institution must

decide for itself what it will do, subject to safety and soundness

considerations.

Several commenters claimed that the guidelines would disadvantage

``traditional'' portfolio lenders that concentrate on making fixed-rate

mortgage loans. Some institutions that concentrate on fixed-rate

mortgages are highly interest rate sensitive and are, therefore, more

prone to receiving a poor ``S'' rating. Nonetheless, many such

institutions would fare quite well under the proposed guidelines

because they maintain relatively high levels of economic capital (NPV),

mitigating the high sensitivity. Other alternatives available to such

an institution are to reduce the extent of the maturity mismatch by

adjusting their product mix or to engage in hedging activities.

Another commenter suggested that OTS should not revise TV 13 at

this time because interest rates have been relatively stable. The

present time offers an ideal opportunity to adopt the proposed changes.

Establishing sound regulatory policies is most difficult during times

of stress or when the industry is unhealthy, because even good policies

may exacerbate problems in some segments of the industry. Today's

industry is stronger than it has been in years, interest rates have

been generally falling, earnings have been solid, the industry is well-

capitalized, and the number of problem institutions is very low. This

is an ideal environment in which to revise sound interest rate risk

guidelines.

d. Anticipated Impact of Guidelines

Table 1, in Part IV.A.3 of the proposed TB, was a matrix containing

the guidelines OTS proposed to use in initially assessing the Level of

Interest Rate Risk in determining the ``S'' component rating. Many

commenters were concerned that those proposed guidelines would

adversely affect the ``S'' component ratings of the industry. Several

commenters urged OTS to review empirical evidence on how institutions

would be affected by the guidelines before adopting the proposal. OTS

did analyze how institutions might be rated under the proposed

guidelines. A summary of this analysis is shown in the table below.

BILLING CODE 6720-01-P

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[GRAPHIC] [TIFF OMITTED] TN01DE98.004

BILLING CODE 6720-01-C

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The first row of the table shows the distribution of the actual

``S'' component ratings assigned during the most recent examination

cycle. About one-third of all institutions received an ``S'' rating of

1 at their most recent examination. More than half received a rating of

2.

The second row shows what the distribution would have been if those

same component ratings had been determined by applying the Proposed

Rating Guidelines in a totally mechanical way (i.e., with no

consideration for the quality of risk management practices, using the

NPV data available at the time of each institution's examination).

Although the proportion of institutions with ``S'' ratings of 3

increased (from 10% of all institutions to 14%), the ratings of many

more institutions improved than worsened under this simple analysis.

These results, however, omit the effect of the examiner's assessment of

the institution's risk management practices.

Table 2, in Part III.C of the proposed TB, described how various

combinations of Level of Interest Rate Risk and Quality of Risk

Management Practices would likely translate into different ratings for

the ``S'' component. The third row of the table here shows the ratings

distribution that would have occurred had the guidelines in Tables 1

and 2 of the proposed TB both been applied mechanically--and had

examiners assessed each institution's Quality of Risk Management

Practices to be of identical quality as the actual Management (``M'')

component rating assigned the institution. The ratings in this row are

significantly harsher than those in the previous row. In fact, they

overstate considerably the amount by which the ratings would worsen

from the previous row. An institution's ``M'' rating is often

downgraded for reasons other than concerns about its interest rate risk

management practices (e.g., asset quality problems, credit underwriting

deficiencies, etc.). Consequently, the ratings that result from using

the ``M'' component rating as a proxy for an examiner's qualitative

assessment of an institution's risk management practices will be overly

severe. If the guidelines in Tables 1 and 2 of the proposed TB had

actually been applied, the proportions of the industry receiving each

``S'' rating would probably have fallen between the proportions shown

in the second and third rows of the table. While broadly similar to the

``S'' ratings actually assigned, it is likely they would have resulted

in somewhat greater numbers of 3 and 4 ratings than were actually

assigned.

After considering the comments and the updated analysis, OTS has

decided to adopt a less stringent set of guidelines for assessing the

level of risk (see Table 1 in the final TB). The remaining two rows of

the table above show how these ``Final Rating Guidelines'' compare with

the actual ``S'' ratings and with the ``Proposed Rating Guidelines.''

The reasons for this change are as follows.

The current ``S'' ratings reflect the evaluation of experienced OTS

examiners. OTS believes that, in the aggregate, its examiners'

conclusions appropriately characterize the current distribution of risk

and risk management practices in the thrift industry. The purpose of

the guidelines is to provide examiners with a common starting point for

assessing an individual institution's sensitivity to interest rate

risk. This, in turn, should help produce more consistent ratings. While

individual institutions' ratings may change as examiners use their

discretion in applying these guidelines, OTS believes the overall

distribution of ratings will likely remain the same.

Consequently, the choice between the two sets of rating guidelines

was based on two factors. First, during the last examination cycle, the

Final Rating Guidelines would have produced more 1 ratings than the

Proposed Rating Guidelines, but would have produced fewer 3 ratings. A

high proportion of 1 ratings might raise ratings expectations of some

institutions that may be unfounded because of examiner concerns with

risk management practices, but this disparity is not a major flaw in

the guidelines. Whether the ``S'' component rating turns out to be a 1

or 2 rarely has a significant effect on the outcome of the overall

examination.

The second factor, the difference in the 3 ratings assigned under

the two sets of rating guidelines, has a greater potential to

substantively affect an institution because it heightens the

possibility that a composite rating of 3 or worse may be assigned.

Absent any consideration of the institution's risk management

practices, the Proposed Rating Guidelines would have resulted in about

15% of OTS thrifts receiving ratings of 3 or worse. In fact, only about

11% of thrifts received ratings of 3 or worse. This suggests that the

Proposed Rating Guidelines might be too harsh, particularly when

qualitative assessments are factored in. The Final Rating Guidelines

would, by themselves, have assigned ratings of 3 or worse to only about

7% of institutions. With the effects of the qualitative assessments

factored in, that proportion might well have increased, but it likely

would have been closer to the proportion of 3s and 4s actually assigned

(11%) than would have been the case under the Proposed Rating

Guidelines. On that basis, the Final Rating Guidelines are preferable.

2. Legal Status of TB 13a and Interest Rate Risk Capital Component

Regulation

OTS received comments regarding the legal status of Thrift Bulletin

13a and the future of the interest rate risk component of the risk

based capital requirement. OTS has addressed these issues in its final

rule on financial derivatives, published elsewhere in today's issue of

the Federal Register.

3. Comments Pertaining to Specific Parts of Proposed TB 13a

a. Limits on Change in NPV

One commenter criticized the two exhibits in Part II.A.1 of the

proposed TB. These exhibits illustrated the interest rate risk limits a

board of directors might establish. The commenter argued that the

exhibits were unrealistically conservative and should be revised to

portray a more typical institution. OTS has decided the exhibits and

much of the accompanying discussion are unnecessary. The final Bulletin

replaces the two exhibits with a simple discussion of how a board might

choose to specify its limits.

b. Prudence of IRR Limits

As described in Part II.A.3 of the proposed TB, an institution's

interest rate risk limits generally will not be considered prudent if

the limits permit NPV ratios that would ordinarily be considered to be

of ``Significant Risk'' or to warrant an ``S'' rating of 3 or worse.

Several commenters objected that this approach is too restrictive of

the board's choices.

OTS has decided to retain this approach for several reasons. First,

it is no more restrictive than the guidelines contained in Table 1 for

assessing the level of interest rate risk (discussed above). Moreover,

this approach is a reasonable basis for assessing board limits and is

consistent with the measurement approach used throughout the TB. If the

board permits a level of risk that would ordinarily be considered

``Significant'' based on OTS's rating guidelines, it would be

inconsistent for OTS to consider those limits to be sufficiently

conservative. The final TB, however, emphasizes that this evaluation is

not a simple pass-or-fail judgment, and, moreover, that it is just one

factor in the examiner's qualitative assessment.

[[Page 66356]]

c. Revision of IRR Limits

Another commenter criticized the discussion in Part II.A.4 of the

proposed TB regarding revisions to a board's interest rate risk limits.

The commenter argued that this discussion imposed unnecessary

``micromanagement'' on the industry. This section addresses the

practice of revising board limits to accommodate existing violations of

previously set limits. This practice is generally inappropriate, has

occurred too frequently at some institutions, and may be indicative of

deficiencies in board oversight. Explicit discussion of such practices

should reduce their incidence.

d. Interest Rate Sensitivity of NPV for Institutions Above $1 Billion

in Assets

Under Part II.B.2 of the proposed TB, institutions with more than

$1 billion in assets would be expected to determine their own NPV

measures. Several commenters recommended that OTS, like the FFIEC,

accept any reasonable model for measuring risk, not just NPV models.

For internal management purposes, institutions are free to use whatever

risk measurement systems they find most useful. However, from a

regulatory perspective, NPV measurements provide a valuable

characterization of an institution's interest rate risk. NPV provides a

consistent measure that considers all future cash flows expected to

result from all on- and off-balance sheet financial instruments, while

also considering embedded options. NPV, thus, provides the agency with

a yardstick against which risk at any thrift may be measured and

compared with that of other institutions. For that reason, OTS collects

financial data that permits it to calculate NPV for all institutions

over $300 million, and many under that size. These NPV estimates are,

however, necessarily based on generic assumptions regarding such

factors as prepayment rates and deposit decay rates. Because of the

importance of ensuring the safety and soundness of large institutions,

OTS believes large institutions should have the means of improving

these regulatory measures and be able to accurately measure NPV

internally, taking into account the institution's individual

characteristics.

Rather than expecting institutions to calculate NPV even if they do

not use it as a management tool, one commenter recommended that OTS

should simply provide such institutions with the OTS NPV results.

However, large institutions have already incurred the cost of

establishing an NPV measurement system based on the guidelines in

Thrift Bulletin 13, published in January 1989. As there will be some

ongoing costs of maintaining that system, OTS did consider exempting

some large institutions from internal NPV modeling. OTS agrees with the

other FFIEC agencies, however, that large, sophisticated institutions

should be capable of measuring the economic value of equity and

assessing their interest rate sensitivity. Accordingly, OTS has not

changed this guideline.

One commenter argued that institutions with internal models should

not have to file Schedule CMR, which provides the financial data used

by the OTS Model. OTS believes there is value in collecting such data

and calculating the OTS NPV estimates even for institutions that also

calculate their own. Any two models will seldom produce exactly the

same results because of differences in their calculation methodologies,

factual data inputs, or assumptions. Hence, the two sets of results may

be used to provide a check on one another. The cost of filing Schedule

CMR for an institution that maintains a sophisticated measurement

system of its own should be minimal. Further, this process permits the

production of peer group comparisons, which provide useful information

for OTS and for boards of directors. No change is being made to the CMR

filing requirements.

e. Investment Securities and Financial Derivatives

Several commenters stated that the proposed guidelines for

investment securities and derivatives in Part III of the proposed TB

are not necessary, and that OTS should adopt the FFIEC Policy Statement

without modification. In issuing that Statement, OTS and the other

agencies recognized that the guidance contained in the FFIEC Policy

Statement might not be sufficient for the purposes of each agency. In

fact, the FFIEC Policy states that, ``Each agency may issue additional

guidance to assist institutions in the implementation of the

statement.'' 7 This language provides the member agencies,

including OTS, with the ability to issue more detailed guidance on

securities and derivatives activities, including guidance on pre-

purchase analysis and stress testing.

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\7\ 63 FR 20191.

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While the FFIEC Policy Statement provides sound guidance on

investment securities and end-user derivatives activities, OTS

determined it would be desirable to explain to the industry how it will

interpret and implement the FFIEC Policy Statement, particularly in

those areas where some additional clarification or specificity is

needed. Accordingly, OTS has decided to use TB 13a to implement the

FFIEC Policy Statement.

f. Analysis and Stress Testing

Several commenters objected to the guidance in Part III.A of the

proposed TB addressing pre-purchase analysis and stress testing of

complex securities and financial derivatives. These commenters also

stated that such guidance conflicts with, or is more onerous than, the

FFIEC Policy Statement. The commenters also asserted that the OTS

guidance would place OTS-supervised institutions at a competitive

disadvantage vis-a-vis non-OTS-supervised institutions.

The FFIEC Policy Statement states that institutions should conduct

a pre-purchase analysis for ``complex instruments, less familiar

instruments, and potentially volatile instruments.'' 8 (The

FFIEC Policy Statement does not define the terms ``complex

instruments,'' ``less familiar instruments,'' or ``potentially volatile

instruments.'') The FFIEC Policy Statement states that:

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\8\ 63 FR at 20195.

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For relatively more complex instruments, less familiar instruments,

and potentially volatile instruments, institutions should fully address

pre-purchase analyses in their policies. Price sensitivity analysis is

an effective way to perform the pre-purchase analysis of individual

instruments. For example, a pre-purchase analysis should show the

impact of an immediate parallel shift in the yield curve of plus and

minus 100, 200, and 300 basis points. Where appropriate, such analysis

should encompass a wider range of scenarios, including non-parallel

changes in the yield curve. A comprehensive analysis may also take into

account other relevant factors, such as changes in interest rate

volatility and changes in credit spreads.9

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\9\ 63 FR at 20195.

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Some commenters may have interpreted this statement to mean that a

pre-purchase analysis showing the price impact of parallel shifts in

the yield curve of plus and minus 100, 200, and 300 basis points is not

expected for complex securities and derivatives. OTS, however,

disagrees with that interpretation. Management should understand the

price sensitivities of investments and derivatives prior to their

acquisition. Moreover, the pre-purchase analysis guidance in the

proposed TB is consistent with the FFIEC Policy Statement. This

guidance

[[Page 66357]]

is designed to foster sound investment practice and should not

disadvantage savings associations vis-a-vis other depository

institutions.

Several commenters indicated that the proposed guidelines for

analyzing/testing securities and derivatives are too detailed and go

beyond the guidance in the FFIEC Policy Statement. OTS has concluded

that the detail in the proposed guidelines is appropriate and is

consistent with the FFIEC Policy Statement.

One commenter stated that the guidelines for analyzing/testing

securities and derivatives should focus only on the plus and minus 200

basis point scenarios. There is considerable benefit to be derived from

evaluating potential investment and derivative transactions in the

context of several alternative scenarios. The advantage of conducting

multiple scenario analysis is that decision-makers will consider

environments that they might otherwise ignore. Moreover, as shown in

the portion of the FFIEC Policy Statement quoted above, OTS and the

other members of the FFIEC agree that the stress testing of securities

and derivatives should not be limited to the plus and minus 200 basis

point rate scenario.

g. Limitation on Transactions Involving Derivatives and Complex

Securities With High Price Sensitivity

A number of commenters criticized Part III.A.3 of the proposed TB

on transactions involving derivatives and complex securities with high

price sensitivity. Under the proposal, an institution should not engage

in a ``risk increasing transaction'' involving derivatives or complex

securities with high price sensitivity if the transaction would cause

the institution's Post-shock NPV Ratio to fall below 6 percent.

One commenter stated that the 6 percent threshold is not needed

because guidelines calling for self-imposed risk limits will serve the

purpose of constraining excessive risk taking. Another commenter noted

that the 6 percent threshold is problematic because some hedging

transactions may reduce risk in some--but not all--interest rate

scenarios. One commenter noted that the threshold may discourage

transactions where the incremental increase in risk may be

insignificant. Another commenter noted that the proposed 6 percent

limitation is more onerous that the former FFIEC ``high-risk test,''

which was recently eliminated.

Upon reconsideration, OTS has concluded that the proposed 6 percent

threshold may be too restrictive, particularly in light of the other

safeguards in the TB. For example, board-approved interest rate risk

limits should discourage institutions from engaging in risk-increasing

transactions that would cause their institution's Post-shock NPV Ratio

to fall to a low level. Moreover, if an institution intends to use

derivatives or complex securities with high price sensitivity for

purposes other than reducing market risk, it should obtain the prior

approval of its board of directors. In addition, the examiner guidance

for assigning ``S'' ratings should discourage institutions with

relatively low Post-shock NPV Ratios from using such instruments for

non-risk-reducing purposes. Accordingly, OTS is lowering the 6 percent

threshold to 4 percent in the final Thrift Bulletin 13a. Under the

guidelines for the ``S'' rating, institutions with less than a 4

percent Post-shock NPV Ratio will typically receive adverse ratings

unless they have very low interest rate sensitivity. In general, the

use of financial derivatives or complex securities with high price

sensitivity should be limited to transactions that lower an

institution's interest rate risk.

h. Significant Transactions

Several commenters objected to guidance, in Part III.A.1 of the

proposed TB, that institutions should conduct a pre-purchase portfolio

sensitivity analysis for any ``significant transaction'' involving

securities or financial derivatives. Under the proposed guidelines, a

significant transaction is defined as any transaction that might

reasonably be expected to increase an institution's Sensitivity Measure

by more than 25 basis points. The definition of a ``significant

transaction,'' was intended to provide a wide ``safe harbor'' for

savings associations by limiting the number of transactions subject to

the incremental portfolio analysis. Very few transactions are likely to

be large enough to meet the 25 basis point test.

Several commenters noted that by defining a ``significant

transaction'' in quantitative terms, OTS might encourage institutions

to circumvent the guidance for pre-purchase analysis by entering into a

series of smaller transactions. One commenter noted that the FFIEC

Policy Statement is silent on what is a significant transaction and

indicated that the definition should be left to management. The FFIEC

Policy states, ``When the incremental effect of an investment position

is likely to have a significant effect on the risk profile of the

institution, it is a sound practice to analyze the effect of such a

position on the overall financial condition of the institution.''

10 Another commenter suggested that the definition of

``significant'' transaction should vary depending on an institution's

financial condition and management sophistication.

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\10\ 63 FR at 20195.

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Although some institutions might enter into smaller transactions to

avoid the proposed guidance on incremental portfolio analysis,

institutions would have little to gain by doing so. It is clearly in an

institution's self-interest to understand how significant transactions

might alter its overall interest rate sensitivity. Moreover, while few

transactions meet the proposed 25 basis point threshold, the analysis

called for by the guidelines should not be a burden to well-run

institutions that have adequate risk monitoring systems in place.

The suggestion that the definition of ``significant'' should vary

with the financial condition and management sophistication of the

institution is reasonable and is consistent with OTS's risk-based

approach to supervision. In this instance, however, OTS believes that

it is more beneficial to provide certainty by adopting a simple rule of

thumb under which incremental portfolio analyses would be expected only

relatively infrequently. Accordingly, OTS has decided to retain the 25

basis point threshold for defining a significant transaction.

i. Definition of Complex Securities

Several commenters criticized the proposed definition of a

``complex security'' in Part III.A of the proposed TB. Several

commenters also noted that identifying selected types of complex

securities for special analysis is inconsistent with the FFIEC Policy

Statement, which did not define the term. A few respondents argued that

the term should be left undefined, fearing that an explicit definition

would discourage thrifts from buying complex securities because such

securities might be viewed negatively by examiners.

OTS and the other members of the FFIEC agree that ``complex

securities'' require more analysis than non-complex securities. The

FFIEC Policy states: ``For relatively more complex instruments, less

familiar instruments, and potentially volatile instruments,

institutions should fully address pre-purchase analysis in their

policies.'' 11 OTS recognizes that the proposed definition

of a ``complex security'' is imprecise. Nevertheless, we believe the

definition will provide guidance and

[[Page 66358]]

will avoid--or at least reduce--disagreements between examiners and

thrift management.

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\11\ 63 FR at 20195.

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Some commenters thought that the proposed definition of a ``complex

security'' was overly broad. Others noted that the proposed definition

included securities that few would consider to be truly complex and

excluded others--such as mortgage-pass-through-securities--that are

actually highly complex. As defined in proposed TB 13a, the term

``complex security'' includes any collateralized mortgage obligation,

real estate mortgage conduit, callable mortgage-pass through security,

stripped-mortgage-backed-security, structured note, and any security

not meeting the definition of an ``exempt security.'' An ``exempt

security'' includes: (1) standard mortgage-pass-through securities, (2)

non-callable, fixed rate securities, and (3) non-callable floating rate

securities whose interest rate is (a) not leveraged (i.e., not based on

a multiple of the index), and (b) at least 400 basis points from the

lifetime rate cap at the time of purchase.

While OTS recognizes that the proposed definition is imperfect and

that certain securities that would be classified as ``complex'' under

the proposed definition, such as ``plain vanilla'' CMO tranches, are

viewed as non-complex securities by some market participants, OTS

doubts that attempts to develop a highly refined definition of a

complex security would be well received. Accordingly, OTS has decided

to leave the proposed definition of a complex security substantially

intact. However, OTS is simplifying the definition of an ``exempt

security.'' Under the modified definition, an ``exempt security''

includes non-callable, ``plain vanilla'' instruments of the following

types: (1) mortgage-pass-through securities, (2) fixed-rate securities,

and (3) floating rate securities.

j. Overemphasis on Price Sensitivity

One respondent suggested that the guidelines for pre-purchase

analysis in the proposed TB should focus on earnings sensitivity and

total return analysis, not just on price sensitivity. OTS agrees that

institutions should not focus on price sensitivity to the exclusion of

other relevant considerations. Accordingly, the final Bulletin has been

modified to stress the importance of taking other factors, such as

total return, into account in conducting pre-purchase analysis.

k. Use of Dealer/Issuer Information

One commenter suggested that Part III.A.1 of the proposed TB be

modified to permit the use of dealer/issuer information in conducting

pre-purchase analysis. The FFIEC Policy states that institutions should

conduct their own in-house pre-acquisition analysis, or to the extent

possible, make use of specific third party analyses that are

independent of the seller or counterparty. Similarly, the proposed TB

states that an institution may rely on an analysis conducted by an

independent third party (i.e., someone other than the seller or

counterparty), provided management understands the analysis and its key

assumptions. Nothing in the FFIEC Policy or TB 13a prohibits an

institution from using information provided by a dealer or issuer;

however, both caution against relying solely on dealer/issuer generated

analysis for pre-purchase analysis.

l. Assessing the Level of Interest Rate Risk

Several commenters objected to the guidelines for determining the

level of interest rate risk, in Part IV.A of the proposed TB.

Commenters argued that NPV is a liquidation model that is not relevant

for a going concern. As defined in the proposed TB, NPV does not

attempt to account for the effects of all future actions by an

institution (e.g., reinvestment decisions, business growth, strategy

changes, etc.). As such, it may technically be considered a liquidation

analysis, but that does not diminish its relevance for ``going

concerns.'' Mutual funds are going concerns, yet their net asset value

is clearly of interest to shareholders. Borrowers may be viewed as

going concerns, yet their net worth is of interest to lenders. A

depository institution's NPV represents the major part of its total

economic value and is, therefore, of concern to both shareholders and

regulators. Furthermore, the value of existing holdings is subject to

less uncertainty than other components of an institution's economic

value, such as the net value of possible future business, the

measurement of which relies on a host of assumptions beyond those

necessary to calculate NPV.

Many commenters argued that the proposed guidelines relied too

heavily on the OTS Model. Most institutions do not have a means of

calculating NPV internally. For those that do, the TB permits examiners

to use internal results in lieu of the results of the OTS Model. The

degree of reliance the examiner will place on the institution's model

is a matter of judgment. It will depend on many factors, including the

perceived quality of the institution's model, the quality of the data

and assumptions used to drive it, and how well the examiner believes

the OTS Model fits the circumstances at the institution. If an

institution has no internal model, or uses an unacceptable method of

calculation, OTS will place primary reliance on the OTS Model to

measure interest rate risk. This is appropriate because it provides

examiners with a means of assessing the level of IRR of all

institutions using a single, objective, standard of measure.

A number of commenters argued that the proposed guidelines are too

focused on NPV, rather than on earnings. Though the proposed TB

encourages institutions to have a means of calculating the interest

rate sensitivity of their projected earnings, NPV provides a superior

measure for regulatory purposes. NPV sensitivity considers all

projected cash flows from all financial instruments and contracts to

which an institution is currently a party. Earnings measures do not

take adequate account of the significant customer options that are

often embedded in financial instruments. Earnings measures also

typically are relatively short-term in nature--most often just 1 to 3

years of future earnings are projected. Earnings measures may, thus,

ignore net cash flows farther in the future, where serious earnings

shortfalls might occur.

Many commenters argued that the proposed guidelines place too much

emphasis on capital, which is already separately evaluated by

examiners. As discussed above, the TB relies strongly on the concept

that institutions with higher levels of economic capital should have

greater freedom to engage in risk-taking. Thus, for a given amount of

interest rate risk--as indicated by the Sensitivity Measure--

institutions with higher Post-shock NPV Ratios receive better ``S''

component ratings under the guidelines in Table 1. The fact that

examiners also assign a capital adequacy (i.e., ``C'') component rating

to the institution does not change the validity of this approach to

gauging the level of risk. If capital appears to be ``double counted''

by this approach, it is only because capital adequacy--the ability to

absorb potential losses--is central to evaluating an institution's

safety and soundness. Moreover, this approach is consistent with the

language of the interagency Uniform Financial Institutions Rating

System for the ``S'' rating. For example, the description of the 2

rating says in part: ``The level of earnings and capital

[[Page 66359]]

provide adequate support for the degree of market risk taken by the

institution [emphasis added].'' 12

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\12\ 61 FR at 67029.

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Several commenters argued that the proposed guidelines for the

level of IRR should not focus on the level of the NPV Ratio, but rather

only on its sensitivity. As explained above, the Uniform Financial

Institutions Rating System explicitly incorporates consideration of

capitalization into the assessment of the ``S'' component rating. It

would be unfair and largely counterproductive to good management to

assign the ``S'' rating on the basis of the Sensitivity Measure alone,

as suggested in this comment.

Consider, for example, two institutions. The first has a Post-shock

NPV Ratio of 1% and the second has a Post-shock NPV Ratio of 15%. Both

have Sensitivity Measures of 300 basis points, indicating that their

Post-shock NPV Ratios are 3 percentage points below their respective

Pre-shock Ratios. While both institutions would suffer the same decline

in economic value in an adverse interest rate environment, the first

institution has much less of a buffer against that risk than the

second. In fact, the level of interest rate risk at the first is

``high'' relative to its ability to bear that risk, while the level of

interest rate risk at the second is ``minimal.'' The proposed rating

guidelines appropriately reflect that difference.

Several commenters argued that OTS provided no rationale for the

NPV levels in Table 1. The matrix in Table 1 establishes guidelines

that, for a given level of the ``S'' rating, permits institutions with

a greater ability to absorb potential losses to take more interest rate

risk. The guidelines also broadly reflect the component ratings

actually assigned by examiners in the past.

Under OTS's New Directions Bulletin 95-10, institutions with Post-

shock NPV Ratios below 4 percent and more than 200 b.p. of interest

rate sensitivity were generally presumed to warrant a component rating

of 4 or 5. Those two thresholds provided the initial features of the

matrix: Post-shock Ratios below 4 percent would be in the lowest row.

The line between ``significant risk'' and ``high risk'' in that row

would be a Sensitivity Measure of 200 b.p. From that starting point,

successively higher rows in the matrix were defined as corresponding to

better levels of the ``S'' rating. Thresholds were chosen to

approximate the proportionate distributions of actual ratings. (As

discussed earlier, in the final TB some thresholds have been modified.)

In recognition of the practical limits on an institution's ability

to reduce risk, the leftmost column of Table 1 (Sensitivity Measure

between 0-100 b.p.) was established so that institutions with very low

Post-shock Ratios but lower than average Sensitivity Measures would not

be adversely rated. Such institutions may have capital adequacy

problems, but are not considered interest rate risk problems.

Several commenters argued that the ratings guidelines should not be

based on today's extremely healthy industry statistics. The economic

environment for the past several years has been highly conducive to

producing healthy, very well-capitalized thrift institutions. It is

possible that OTS may revise the guidelines in the future should

circumstances change. As discussed earlier, the guidelines in the final

TB are somewhat less stringent than the proposed guidelines and may,

thus, mitigate this criticism.

Several commenters suggested alternative matrices for the

guidelines for the level of risk in Table 1.

One commenter proposed determining the level of risk by comparing

an institution's Sensitivity Measure with qualitative factors, such as

planned corrective actions to be taken if rates move adversely. This

proposal, however, would be highly speculative and not take into

account the Post-shock NPV Ratio, which is critical in assessing an

institution's ability to bear risk.

Another commenter objected to the guidelines in Table 1 because the

guidelines suggest that an institution with a Post-shock NPV Ratio of

11.99% and an interest rate Sensitivity Measure of 401 b.p. poses

``significant risk'' while an institution with 2% and 99 b.p. poses

only ``moderate risk.'' The commenter is correct in arguing that the

former institution is better suited to absorb the risk than the latter.

Institutions in the lower left cell of the matrix are, however, special

cases. Institutions in that cell have low NPV ratios and, thus, little

capacity to absorb risk of any kind. There are, however, practical

limits to how far they can reduce their level of interest rate risk.

Thus, if an institution with a Post-shock NPV Ratio below 4% has a

Sensitivity Measure of less than 100 b.p. (which is typically well

below average) the guidelines treat it as having only moderate risk (a

2 rating), rather than significant risk (a 3 rating).

Another commenter proposed revising Table 1 to compare the Interest

Rate Sensitivity Measure with the Pre-shock NPV Ratio (instead of the

Post-shock NPV Ratio actually used in the Table). The commenter argued

that this would avoid ``double counting'' the adverse impact of the

rate shock. The commenter's proposal is based on the premise that the

percentage change in NPV is the relevant measurement standard. OTS

believes that the amount of capital remaining after the adverse shock

is more pertinent. An institution with a large percentage change in NPV

that retains a large amount of NPV is able to bear that risk safely.

A fourth commenter proposed that institutions with a Post-shock NPV

Ratio exceeding 6% warrant a rating of 1, whatever the Sensitivity

Measure. Higher levels of interest rate sensitivity require higher

Post-shock NPV. OTS does not believe the commenter's approach is

sufficiently conservative given (1) the possibility of rapid changes in

interest rates (not necessarily immediate shocks) of more than 200

b.p., (2) the possibility of changes in the shape or the slope of the

yield curve, and (3) inaccuracies in measuring risk.

m. Examiner Use of Guidelines on Level of Risk

One commenter recommended that the guidelines in Table 1, of Part

IV.A.3 of the proposed TB, should focus on more than one time period.

Explicit procedures for analysis of multiple time periods would

complicate the guidelines and would add to the unfounded perception

that OTS is attempting to micromanage the examination process. The

proposed TB stated that examiners should take into consideration any

relevant trends in an institution's interest rate risk. Additional

guidance is not necessary.

One commenter recommended that OTS should warn its examiners that

the NPV levels in the guidelines are ``for discussion purposes and not

standards for assessing risk.'' The proposed guidelines are exactly

that: guidelines. The proposed guidelines establish a common set of

criteria for translating quantitative risk estimates into the

categories described in the ratings descriptions (i.e., ``minimal

risk'', ``moderate risk'', etc.). Rather than relying on hundreds of

examiners to invent their own standards independently and hoping that

those standards will be consistent with one another, the guidelines

provide a common starting point for examiners. They are only starting

points because examiners must consider many complex facts, both

quantitative and qualitative, in their evaluation of the institution's

risk level and in assigning the rating.

Several commenters opined that examiners will not deviate from the

guidelines. The final version of the TB emphasizes that the guidelines

are only

[[Page 66360]]

a starting point in an examiner's assessment of the ``S'' rating. For

example, New Directions Bulletin 95-10, a precursor to the proposed TB,

stated that, ``Institutions with a [Post-shock NPV] Ratio below 4% and

a Sensitivity Measure over 200 basis points will ordinarily receive a 4

or 5 rating for the ``L'' component [rating].'' Yet, examiners did not

assign ratings of 4 or 5 to all institutions that fit this description.

n. Calculation of NPV Ratios

Several commenters discussed the calculation of NPV and the NPV

Ratio. Two argued that the NPV Ratio should be redefined so that

``deposit intangibles'' (i.e., the difference between the face value of

deposits and their economic value) are not treated as assets. OTS

initially presented deposit intangibles as assets on the Interest Rate

Risk Exposure Report to resemble the presentation of core deposit

intangibles on the balance sheet under GAAP. Commenters, however,

pointed out that treating deposit intangibles as assets depresses NPV

ratios. For example, the NPV ratio of the average institution in

December 1997 would have been 10 basis points higher in the base case

(10.34 vs. 10.24 percent) and 19 basis points higher (8.96 vs. 8.77

percent) in the +200 b.p. rate shock scenario, if the deposit

intangibles had been presented as contra-liabilities or if deposits had

simply been shown at their present values. Removing the deposit

intangibles from the asset side would also be more logically consistent

with the purpose of the NPV ratio, which is to relate an institution's

NPV to the size of the institution. An institution does not actually

grow if it replaces a $100 borrowing with $100 of retail accounts, yet

because the latter type of liability contributes to the deposit

intangible, the denominator of the NPV ratio increases.

Accordingly, OTS will study whether it should to move deposit

intangibles to the liability side of the Interest Rate Risk Exposure

Report by reporting deposits at their present value. Though NPV ratios

would generally rise as a result of this format change, the amount of

the change is so small that OTS would not modify the guidelines in

Table 1 to compensate for it. There are many data processing

considerations involved in making such a change, however. The small

amount of improvement in the NPV ratios may not warrant the cost and

potential confusion the change would entail.

One commenter urged OTS to solve the analytical problems involved

in estimating core deposit value sensitivity before finalizing the

proposed TB. Refining the OTS Model is an ongoing activity. Among other

issues, OTS is working on updating its modeling of core deposits.

Examiners are currently using the results of the OTS Model during their

safety and soundness examinations. There is no reason to wait for all

revisions to be completed before finalizing the TB. While the OTS Model

does not yet fully customize its treatment of core deposit behavior to

individual institutions, a degree of customization is performed for

institutions that report several items of additional optional

information (on Schedule CMR, lines 659 through 661). Yet, relatively

few institutions avail themselves of that opportunity.

Another commenter argued that by valuing purchased goodwill as zero

in the calculation of NPV, OTS disadvantages institutions that have

been involved in mergers using purchase accounting. OTS disagrees with

that criticism.

NPV is defined as the economic value of an institution's existing

assets, less the economic value of its existing liabilities, plus the

net economic value of any existing off-balance sheet contracts. In

other words, NPV is the net economic value of an institution's

portfolio of identifiable assets and liabilities. If two institutions

merge, the NPV of the resulting entity will consist of the combined net

economic value of the two portfolios, or more simply, the combined NPV

will be the sum of the individual NPVs. The value of the two portfolios

will not change merely because the institutions have merged. Yet, that

is exactly what would occur if goodwill were included as a component of

the combined institution's NPV; the resulting NPV would be larger than

the sum of the two constituent NPVs. The source of the confusion is

that the commenter is attempting to measure more than just the value of

the portfolio.

Goodwill is defined as the amount by which the purchase price of an

acquired entity exceeds the net fair value of its identifiable assets,

liabilities, and off-balance sheet financial instruments. Thus, by

definition, goodwill represents value over and above the net economic

value of the acquired institution's portfolio of identifiable assets

and liabilities. As a practical matter, goodwill reflects the buyer's

(and seller's) assessment of the economic value of unidentifiable

intangibles (such as a well-trained staff, a good franchise from which

to conduct future business, etc.) at the acquired institution. All

institutions, not just those involved in acquisitions, possess

unidentifiable intangibles that may be expected to have economic value.

Unfortunately, the economic value of such intangibles is extremely

difficult to quantify, and determining how their economic value will

change under different interest rate scenarios makes the task even more

difficult. For those reasons, OTS limits itself to estimating the

interest rate risk inherent in institutions' portfolios of identifiable

financial and non-financial assets and liabilities. It is not that a

broader measure is undesirable, but simply that such a measure is

impractical as a regulatory measure of risk.

Several institutions commented that the OTS Model does not

accurately reflect every institution's circumstances, and that ratings

based on those results are unfair. The OTS Model does rely on many

generic, industry-wide assumptions and circumstances at individual

institutions may differ from these assumptions. There will often be

offsetting errors so that the ``bottom line'' result will still be

reasonable for such an institution, but it is certainly possible that

the OTS Model might materially over-or understate the level of risk at

an institution. There are, however, two defenses against an unfair

rating. The first is the judgment of the examiner. The second defense

is the institution itself. The guidelines explicitly permit the use of

institutions' internal results in assessing the level of risk in

situations where the OTS Model is demonstrably incorrect.

o. Assessing the Quality of Risk Management

One commenter recommended that in assessing the quality of risk

management practices at an institution, discussed in Part IV.B of the

proposed TB, examiners should consider the institution's historical

earnings results. Examiners may well consider an institution's

historical earnings stability in judging the quality of its risk

management practices. All factors that an examiner considers relevant

may bear on his or her assessment.

p. Combining Assessments of the Level of Risk and Risk Management

Practices

A number of commenters stated that the guidelines in Table 2, of

Part IV.C of the proposed TB, place too much weight on quantitative

factors and insufficient weight on qualitative ones (i.e., good risk

management should be able to offset a higher level of risk). The

proposed guidelines shown in Table 2 represent an accurate

implementation of the interagency CAMELS rating system. Moreover, the

proposition that good risk management can fully offset higher levels of

risk is questionable. The interest rate sensitivity of NPV is a

[[Page 66361]]

measure of the amount of risk embedded in the current portfolio. There

is little evidence that managers can successfully anticipate the

magnitude or direction of movements in interest rates. While skillful

management may be able to alter an institution's risk level quickly in

response to changes in market conditions, it is not certain that

management will actually take any action in such an eventuality. For

example, during the interest rate shock that occurred in 1994, few

institutions responded with swift portfolio restructuring.

Practically speaking, however, both the assessment of risk

management practices and the assignment of the S component rating are

currently--and will remain--inexact processes that are heavily

dependent on examiner judgment. Strong risk management practices cannot

help but influence examiners to be inclined favorably toward the

institution in assigning the ``S'' component rating. Accordingly, no

change is being made to the guidelines in Table 2 of the proposal.

The final Thrift Bulletin is set forth below.

Thrift Bulletin 13a: Management of Interest Rate Risk, Investment

Securities, and Derivatives Activities

Summary: This Thrift Bulletin provides guidance to management and

boards of directors of thrift institutions on the management of

interest rate risk, including the management of investment and

derivatives activities. In addition, it describes the framework

examiners will use in assigning the ``Sensitivity to Market Risk'' (or

``S'') component rating.

Thrift Bulletin 13a replaces Thrift Bulletins 13, 13-1, 13-2, 52,

52-1, and 65, and New Directions Bulletin 95-10.

Contents

Part I: Background

A. Definition and Sources of Interest Rate Risk

Part II: OTS Minimum Guidelines Regarding Interest Rate Risk

A. Interest Rate Risk Limits

B. Systems for Measuring Interest Rate Risk

Part III: Investment Securities and Financial Derivatives

A. Analysis and Stress Testing

B. Record-Keeping

C. Supervisory Assessment of Investment and Derivatives

Activities

Part IV: Guidelines for the ``Sensitivity to Market Risk'' Component

Rating

A. Assessing the Level of Interest Rate Risk

B. Assessing the Quality of Risk Management

C. Combining Assessments of the Level of Risk and Risk

Management Practices

D. Examiner Judgment

Part V: Supervisory Action

Appendix A: Evaluating Prudence of Interest Rate Risk Limits

Appendix B: Sound Practices for Market Risk Management

Appendix C: Excerpt from Interagency Uniform Financial Institutions

Rating System

Appendix D: Glossary

Part I: Background

An effective interest rate risk (IRR) management process that

maintains interest rate risk within prudent levels is important for the

safety and soundness of any financial institution. This is especially

true for thrift institutions, which by the nature of their business,

are particularly prone to IRR. In recognition of that fact, 12 CFR

563.176 requires institutions to implement proper IRR management

procedures. In January 1989, OTS issued Thrift Bulletin 13 (TB 13),

Responsibilities of the Board of Directors and Management with Regard

to Interest Rate Risk, to provide guidance in the area of IRR

management. Since TB 13 was first issued, a great deal of progress has

been made in the areas of IRR measurement technology and IRR

management. The present Thrift Bulletin, TB 13a, updates the guidelines

contained in the original TB 13. It also provides guidance implementing

the Federal Financial Institutions Examination Council's Supervisory

Policy Statement on Investment Securities and End-User Derivative

Activities (63 Fed. Reg. 20191 [1998]) and OTS's final rule on

financial derivatives at Section 563.172. The following Thrift

Bulletins are hereby rescinded:

TB 13: Responsibilities of the Board of Directors and Management

with Regard to Interest Rate Risk;

TB 13-1: Implementation of Thrift Bulletin 13;

TB 13-2: Implementation of Thrift Bulletin 13;

TB 52: Supervisory Statement of Policy on Securities Activities;

TB 52-1: ``Mismatched'' Floating Rate CMOs; and

TB 65: Structured Notes.

Also rescinded is New Directions Bulletin 95-10, Interim Policy On

Supervisory Action to Address Interest Rate Risk.

A. Definition and Sources of Interest Rate Risk

The term ``interest rate risk'' refers to the vulnerability of an

institution's financial condition to movements in interest rates.

Although interest rate risk is a normal part of financial

intermediation, excessive interest rate risk poses a significant threat

to an institution's earnings and capital. Changes in interest rates

affect an institution's earnings by altering interest-sensitive income

and expenses. Changes in interest rates also affect the underlying

value of an institution's assets, liabilities, and off-balance sheet

instruments because the present value of future cash flows (and in some

cases, the cash flows themselves) change when interest rates change.

Savings associations confront interest rate risk from several

sources. These include repricing risk, yield curve risk, basis risk,

and options risk.

1. Repricing Risk. The primary form of interest rate risk arises

from timing differences in the maturity and repricing of assets,

liabilities, and off-balance sheet positions. While such repricing

mismatches are fundamental to the business, they can expose a savings

association's income and economic value fluctuations as interest rates

vary. For example, a thrift that funded a long-term, fixed-rate loan

with a short-term deposit could face a decline in both the future

income arising from the position and its economic value if interest

rates increase. These declines occur because the cash flows on the loan

are fixed, while the interest paid on the funding is variable, and

therefore increases after the short-term deposit matures.

2. Yield Curve Risk. Repricing mismatches can also expose a thrift

to changes in both the slope and shape of the yield curve. Yield curve

risk arises when unexpected shifts of the yield curve have adverse

effects on an institution's income or economic value. For example,

suppose an institution has variable-rate assets whose interest rate is

indexed to the 1-year Treasury rate and which are funded by variable-

rate liabilities having the same repricing date but indexed to the 3-

month Treasury rate. A flattening of the yield curve will have an

adverse impact on the institution's income and economic value, even

though a parallel movement in the yield curve might have no effect.

3. Basis Risk. Another source of interest rate risk arises from

imperfect correlation in the adjustment of the rates earned and paid on

different financial instruments with otherwise similar repricing

characteristics. When interest rates change, these differences can

cause changes in the cash flows and earnings spread between assets,

liabilities and off-balance sheet instruments of similar maturities or

repricing frequencies. For example, a strategy of funding a three-year

loan that reprices quarterly based on the three-month U.S. Treasury

bill rate, with a three-year deposit that reprices quarterly based on

three-month LIBOR, exposes the institution to the

[[Page 66362]]

risk that the spread between the two index rates may change

unexpectedly.

4. Options Risk. Interest rate risk also arises from options

embedded in many financial instruments. An option provides the holder

the right, but not the obligation, to buy, sell, or in some manner

alter the cash flows of an instrument or financial contract. Options

may be stand alone instruments such as exchange-traded options and

over-the-counter (OTC) contracts, or they may be embedded within

standard instruments. Instruments with embedded options include bonds

and notes with call or put provisions, loans which give borrowers the

right to prepay balances, adjustable rate loans with interest rate caps

or floors that limit the amount by which the rate may adjust, and

various types of non-maturity deposits which give depositors the right

to withdraw funds at any time, often without any penalties. If not

adequately managed, the asymmetrical payoff characteristics of

instruments with option features can pose significant risk,

particularly to those who sell them, since the options held, both

explicit and embedded, are generally exercised to the advantage of the

holder.

Part II: OTS Minimum Guidelines Regarding Interest Rate Risk

OTS has established specific minimum guidelines for thrift

institutions to observe in two areas of interest rate risk management.

The first guideline concerns establishment and maintenance of board-

approved limits on interest rate risk. The second, concerns

institutions' ability to measure their risk level.

A. Interest Rate Risk Limits

Effective control of interest rate risk begins with the board of

directors, which defines the institution's tolerance for risk. OTS

regulation Sec. 563.176 requires all institutions to establish board-

approved interest rate risk limits.

1. Limits on Change in Net Portfolio Value. All institutions should

establish and demonstrate quarterly compliance with board-approved

limits on interest rate risk that are defined in terms of net portfolio

value (NPV).1 These limits should specify the minimum NPV

Ratio 2 the board is willing to allow under current interest

rates and for a range of six hypothetical interest rate scenarios. The

hypothetical scenarios are represented by immediate, permanent,

parallel movements in the term structure of interest rates of plus and

minus 100, 200, and 300 basis points from the actual term structure

observed at quarter end.3 The level of detail with which the

limits are specified depends on the board's preferences. In their

simplest form, the limits could specify a single minimum NPV Ratio

which would apply to all seven rate scenarios, while more detailed

limits might specify a different minimum NPV Ratio for each of the

scenarios.

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\1\ Net portfolio value (NPV) is defined as the net present

value of an institution's existing assets, liabilities, and off-

balance sheet contracts. In the original TB 13, this measure was

referred to as the ``market value of portfolio equity'' (MVPE). A

detailed description of how OTS defines and calculates NPV is

provided in the manual entitled, The OTS Net Portfolio Value Model.

\2\ An institution's NPV Ratio for a given interest rate

scenario is calculated by dividing the net portfolio value that

would result in that scenario by the present value of the

institution's assets in that same scenario and is expressed in

percentage terms. The NPV ratio is analogous to the capital-to-

assets ratio used to measure regulatory capital, but NPV is measured

in terms of economic values (or present values) in a particular rate

scenario. These limits represent a change in format from those

called for by the original TB 13. They will provide a greater degree

of comparability across institutions and will mesh better with the

OTS guidelines for the Sensitivity to Market Risk component rating,

described later in this Bulletin.

\3\ Institutions that do not file Schedule CMR of the Thrift

Financial Report and do not have a means of calculating NPV should

have suitable alternative limits.

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2. Limits on Earnings Sensitivity. Many institutions also set risk

limits expressed in terms of the interest rate sensitivity of projected

earnings. Such limits can provide a useful supplement to the NPV-based

limits. Although institutions are not required by OTS to establish

limits and conduct analysis in terms of earnings sensitivity, OTS

considers it a good management practice for institutions to estimate

the interest rate sensitivity of their earnings and to incorporate this

analysis into their business plan and budgeting process. The

institution has total discretion over the type of earnings sensitivity

analysis and all details of how that analysis is performed. However,

OTS encourages institutions to develop earnings simulations utilizing

base case and adverse interest rate scenarios and to compare results to

actual earnings on a quarterly basis.

3. Prudence of IRR Limits. In assessing the prudence of their

institution's NPV limits, as well as in evaluating their institution's

current level of risk relative to the rest of the industry, the board

of directors will find it useful to refer to the quarterly OTS

publication, Thrift Industry Interest Rate Risk Measures.4

This publication contains statistical data about key interest rate risk

measures for the industry. The board should also be aware that

examiners will evaluate the institution's IRR limits as part of their

assessment of the quality of the institution's risk management

practices. See Part IV.B.2, Prudence of Limits, and Appendix A,

Evaluating Prudence of Interest Rate Risk Limits, for discussion of

this topic.

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\4\ Thrift Industry Interest Rate Risk Measures is published for

a particular quarter approximately seven weeks after the end of that

quarter. It may be retrieved using the OTS PubliFax system, at (202)

906-5660, or from the OTS World Wide Web site, http://

www.ots.treas.gov/quarter.html

_____________________________________-

4. Revision of IRR Limits. Interest rate risk limits reflect the

board of directors' risk tolerance. Although the board should

periodically re-evaluate the appropriateness of the institution's

interest rate risk limits, particularly after a significant change in

market interest rates, any changes should receive careful consideration

and be documented in the minutes of the board meeting.

If the institution's level of risk at some point does violate the

board's limits, that fact should be recorded in the minutes of the

board meeting, along with management's explanation for that occurrence.

Depending on the circumstances and the board's tolerance for risk, the

board may elect to revise the risk limits. Alternatively, the board may

wish to retain the existing limits and direct management to adopt an

acceptable plan for an orderly return to compliance with the limits.

Recurrent changes to interest rate risk limits for the purpose of

accommodating instances in which the limits have been, or are about to

be, breached may be indicative of inadequate risk management practices

and procedures.

B. Systems for Measuring Interest Rate Risk

Key elements in managing market risk are identifying, measuring,

and monitoring interest rate risk. To ensure compliance with its

board's IRR limits and to comply with OTS regulation Sec. 563.176, each

institution must have a way to measure its interest rate risk. OTS

guidelines for interest rate risk measurement systems are as follows,

though examiners have broad discretion to require more rigorous

systems.

1. Interest Rate Sensitivity of NPV for Institutions below $1

Billion in Assets. Unless otherwise directed by their OTS Regional

Director, institutions below $1 billion in assets may usually rely on

the quarterly NPV estimates produced by OTS and distributed in the

Interest Rate Risk Exposure Report. If such an institution owns complex

securities (see Glossary for definition) whose recorded investment

exceeds 5 percent of total assets, the institution should be able to

measure or have access to measures of the economic value of those

securities under the range of interest rate scenarios

[[Page 66363]]

described in Part II.A.1, Limits on Change in Net Portfolio Value. The

institution may rely on the OTS estimates for the other financial

instruments in its portfolio, unless examiners direct otherwise.

2. Interest Rate Sensitivity of NPV for Institutions above $1

Billion in Assets. Those institutions with more than $1 billion in

assets should measure their own NPV and its interest rate sensitivity.

OTS examiners will look for the following desirable methodological

features in evaluating the quality of such institutions' NPV

measurement systems:

(a) The institution's NPV estimates utilize information on its

financial holdings that is generally more detailed than the information

reported on Schedule CMR.

(b) Value is ascribed only to financial instruments currently in

existence or for which commitments or other contracts currently exist

(i.e., future business is not included in NPV).

(c) Values are, where feasible, based directly or indirectly on

observed market prices.

(d) Zero-coupon (spot) rates of the appropriate maturities are used

to discount cash flows.

(e) Implied forward interest rates are used to model adjustable

rate cash flows.

(f) Cash flows are adjusted for reasonable non-interest costs the

institution will incur in servicing both its assets and liabilities.

(g) Valuations take account of embedded options using, at a

minimum, the static discounted cash flow technique, but preferably

using more rigorous options pricing techniques (which normally produce

a value greater than zero even for out-of-the-money options).

(h) Valuation of deposits is based, at least in part, on

institution-specific data regarding retention rates of existing deposit

accounts and the rates offered by the institution on deposits.

Preferably, the institution would base these valuations on sound

econometric research into such data.

Examiners may determine an institution should use more

sophisticated measurement techniques for individual financial

instruments or categories of instruments where they believe it is

warranted (e.g., because of the volume and price sensitivity of a group

of financial instruments; because of concern that the institution's

results may materially misstate the level of risk; because of the

combination of a low Post-shock NPV Ratio and high Sensitivity Measure;

etc.). In any case, the institution should be familiar with the details

of the assumptions, term structure, and logic used in performing the

measurements. Measures obtained from financial screens or vendors may,

therefore, not always be adequate.

In addition to the prescribed parallel-shock interest rate

scenarios described above, OTS recommends that institutions evaluate

the effects of other stressful market conditions (e.g., non-parallel

movements in the term structure, basis changes, changes in volatility),

as well as the effects of breakdowns in key assumptions (e.g.,

prepayment and core deposit attrition rates).

3. Integration of Risk Measurement and Operations. As part of their

assessment of the quality of an institution's risk management

practices, examiners will consider the extent to which the

institution's risk measurement process is integrated with management

decision-making. Examiners will evaluate whether, in making significant

operational decisions (e.g., changes in portfolio structure,

investments, business planning, derivatives activities, funding

decisions, pricing decisions, etc.), the institution considers their

effect on the level of interest rate risk. Institutions may do this by

using an earnings sensitivity approach, an NPV sensitivity approach, or

any other reasonable approach. The institution has discretion over all

aspects of such analysis. The analysis, however, should not be merely

pro forma in nature, but rather should be an active factor in the

institution's decision-making process. If evidence of such integration

is not apparent, examiner criticism or an adverse rating may result.

Part III: Investment Securities and Financial Derivatives

A. Analysis and Stress Testing

Management should exercise diligence in assessing the risks and

returns (including expected total return) associated with investment

securities and financial derivatives. As a matter of sound practice,

prior to taking an investment position or initiating a derivatives

transaction, an institution should:

(a) Ensure that the proposed transaction is legally permissible for

a savings institution;

(b) Review the terms and conditions of the security or financial

derivative;

(c) Ensure that the proposed transaction is allowable under the

institution's investment or derivatives policies;

(d) Ensure that the proposed transaction is consistent with the

institution's portfolio objectives and liquidity needs;

(e) Exercise diligence in assessing the market value, liquidity,

and credit risk of the security or financial derivative;

(f) Conduct a pre-purchase portfolio sensitivity analysis for any

significant transaction involving securities or financial derivatives

(as described below in Significant Transactions);

(g) Conduct a pre-purchase price sensitivity analysis of any

complex security 5 or financial derivative 6

prior to taking a position (as described below in Complex Securities

and Financial Derivatives).

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\5\ For purposes of this Thrift Bulletin, the term ``complex

security'' includes any collateralized mortgage obligation

(``CMO''), real estate mortgage investment conduit (``REMIC''),

callable mortgage pass-through security, stripped-mortgage-backed-

security, structured note, and any security not meeting the

definition of an ``exempt security.'' An ``exempt security''

includes non-callable, ``plain vanilla'' instruments of the

following types: (1) mortgage-pass-through securities, (2) fixed-

rate securities, and (3) floating-rate securities.

\6\ The following financial derivatives are exempt from the pre-

purchase analysis called for above: commitments to originate,

purchase, or sell mortgages. To perform the pre-purchase analysis

for derivatives whose initial value is zero (e.g., futures, swaps),

the institution should calculate the change in value as a percentage

of the notional principal amount.

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1. Significant Transactions. A ``significant transaction'' is any

transaction (including one involving instruments other than complex

securities) that might reasonably be expected to increase an

institution's Sensitivity Measure by more than 25 basis points. Prior

to undertaking any significant transaction, management should conduct

an analysis of the incremental effect of the proposed transaction on

the interest rate risk profile of the institution. The analysis should

show the expected change in the institution's net portfolio value (with

and without the proposed transaction) that would result from an

immediate parallel shift in the yield curve of plus and minus 100, 200,

and 300 basis points. In general, an institution should conduct its own

analysis. It may, however, rely on analysis conducted by an independent

third-party (i.e., someone other than the seller or counterparty)

provided management understands the analysis and its key assumptions.

Institutions with less than $1 billion in assets that do not have

the internal modeling capability to conduct such an incremental

analysis may use the most recent quarterly NPV estimates for their

institution provided by OTS to estimate the incremental effect of a

proposed

[[Page 66364]]

transaction on the sensitivity of its net portfolio value.7

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\7\ Institutions that are exempt from filing Schedule CMR and

that choose not to file voluntarily, should ensure that no

transaction--whether involving complex securities, financial

derivatives, or any other financial instruments--causes the

institution to fall out of compliance with its board of directors''

interest rate risk limits.

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2. Complex Securities and Financial Derivatives. Prior to taking a

position in any complex security or financial derivative, an

institution should conduct a price sensitivity analysis (i.e., pre-

purchase analysis) of the instrument. At a minimum, the analysis should

show the expected change in the value of the instrument that would

result from an immediate parallel shift in the yield curve of plus and

minus 100, 200, and 300 basis points. Where appropriate, the analysis

should encompass a wider range of scenarios (e.g., non-parallel changes

in the yield curve, changes in interest rate volatility, changes in

credit spreads, and in the case of mortgage-related securities, changes

in prepayment speeds). In general, an institution should conduct its

own in-house pre-acquisition analysis. An institution may, however,

rely on an analysis conducted by an independent third-party (i.e.,

someone other than the seller or counterparty) provided management

understands the analysis and its key assumptions.

Investments in complex securities and the use of financial

derivatives by institutions that do not have adequate risk measurement,

monitoring, and control systems may be viewed as an unsafe and unsound

practice.

3. Risk Reduction. In general, the use of financial derivatives or

complex securities with high price sensitivity 8 should be

limited to transactions and strategies that lower an institution's

interest rate risk as measured by the sensitivity of net portfolio

value to changes in interest rates. An institution that uses financial

derivatives or invests in such securities for a purpose other than that

of reducing portfolio risk should do so in accordance with safe and

sound practices and should:

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\8\ For purposes of this Bulletin, ``complex securities with

high price sensitivity'' include those whose price would be expected

to decline by more than 10 percent under an adverse parallel change

in interest rates of 200 basis points.

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(a) Obtain written authorization from its board of directors to use

such instruments for a purpose other than to reduce risk; and

(b) Ensure that, after the proposed transaction(s), the

institution's Post-shock NPV Ratio would not be less than 4 percent.

The use of financial derivatives or complex securities with high

price sensitivity for purposes other than to reduce risk by

institutions that do not meet the conditions set forth above may be

viewed as an unsafe and unsound practice.

B. Record-Keeping

Institutions must maintain accurate and complete records of all

securities and derivatives transactions in accordance with 12 CFR

562.1. Institutions should retain any analyses (including pre-and post-

purchase analyses) relating to investments and derivatives transactions

and make such analyses available to examiners upon request.

In addition, for each type of financial derivative instrument

authorized by the board of directors, the institution should maintain

records containing:

(a) The names, duties, responsibilities, and limits of authority

(including position limits) of employees authorized to engage in

transactions involving the instrument;

(b) A list of approved counterparties with which transactions may

be conducted;

(c) A list showing the credit risk limit for each approved

counterparty; and

(d) A contract register containing key information on all

outstanding contracts and positions.

The contract registers should specify the type of contract, the

price of each open contract, the dollar amount, the trade and maturity

dates, the date and manner in which contracts were offset, and the

total outstanding positions.

Where deferred gains or losses on derivatives from hedging

activities have been recorded consistent with generally accepted

accounting principles (GAAP), the institution should maintain

appropriate supporting documentation.9

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\9\ In June 1998, the FASB issued SFAS No. 133, ``Accounting for

Derivative Instruments and Hedging Activities.'' Under SFAS No. 133,

all ``derivative instruments,'' as defined therein, including those

used for hedging purposes, would be accounted for at fair value.

Accordingly, under that Standard, deferred gains and losses on

``derivative instruments'' from hedging activities will no longer be

reported.

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C. Supervisory Assessment of Investment and Derivatives Activities

Examiners will assess the overall quality and effectiveness of the

institution's risk management process governing investment and

derivatives activities. In making such assessments, examiners will take

into account compliance with the guidelines set forth above and the

quality of the institution's risk management process. The quality of

the institution's risk management process will be evaluated in the

context of Appendix B, Sound Practices for Market Risk Management.

Part IV: Guidelines for the ``Sensitivity to Market Risk''

Component Rating

Consistent with the interagency Uniform Financial Institutions

Rating System, or CAMELS rating system, of which an excerpt is attached

as Appendix C, the ``Sensitivity to Market Risk'' component rating

(i.e., the ``S'' rating) is based on examiners'' conclusions about two

dimensions: (1) an institution's level of market risk and (2) the

quality of its practices for managing market risk. This section

discusses the guidelines that examiners will use in assessing the two

dimensions and combining those assessments into a component rating.

Because few thrift institutions have significant exposure to foreign

exchange risk or commodity or equity price risks, interest rate risk

will generally be the only form of market risk to be assessed under

this component rating.

A. Assessing the Level of Interest Rate Risk

Examiners will base their conclusions about an institution's level

of interest rate risk--the first dimension for determining the ``S''

component rating--primarily on the interest rate sensitivity of the

institution's net portfolio value. The two specific measures of risk

that will receive examiners' primary attention are the Interest Rate

Sensitivity Measure and the Post-shock NPV Ratio (see Glossary for

definitions).

OTS uses risk measures based on NPV for several reasons. First, the

NPV measures are more readily comparable across institutions than

internally generated measures of earnings sensitivity. Second, NPV

focuses on a longer-term analytical horizon than institutions'

internally generated earnings sensitivity measures. (The interest rate

sensitivity of earnings is typically measured over a short-term horizon

such as a year, while NPV is based on all future cash flows anticipated

from an institution's existing assets, liabilities, and off-balance

sheet contracts.) Third, the NPV-based measures take better account of

the embedded options present in the typical thrift institution's

portfolio.

1. Interest Rate Sensitivity Measure. In assessing the level of

interest rate risk, a high (i.e., risky) Interest Rate Sensitivity

Measure, by itself, may not give cause for supervisory concern when the

institution has a strong capital position. Because an institution's

risk of failure is inextricably linked to capital and, hence, to its

ability to absorb

[[Page 66365]]

adverse economic shocks, an institution with a high level of economic

capital (i.e., NPV) may be able safely to support a high Sensitivity

Measure.

2. Post-Shock NPV Ratio. The Post-shock NPV Ratio is a more

comprehensive gauge of risk than the Sensitivity Measure because it

incorporates estimates of the current economic value of an

institution's portfolio, in addition to the reported capital level and

interest rate risk sensitivity. There are three potential causes of a

low (i.e., risky) Post-shock NPV Ratio: (i) low reported capital; (ii)

significant unrecognized depreciation in the value of the portfolio; or

(iii) high interest rate sensitivity. Although the first two of these,

low reported capital and significant unrecognized depreciation in

portfolio value, may cause supervisory concern (and receive attention

under the portions of the examination devoted to evaluating Capital

Adequacy, Asset Quality, or Earnings), they do not necessarily

represent an ``interest rate risk problem.'' Only when an institution's

low Post-shock Ratio is, in whole or in part, caused by high interest

rate sensitivity is an interest rate risk problem suggested. That

condition is reflected in the guidelines discussed below.

3. Guidelines for Determining the Level of Interest Rate Risk. In

describing the five levels of the ``S'' component rating, the

interagency uniform ratings system established several broad,

descriptive levels of risk: ``minimal,'' ``moderate,'' ``significant,''

``high,'' and ``imminent threat.'' The following interest rate risk

levels are ordinarily indicated for OTS-regulated institutions, based

on the combination of each institution's Post-shock NPV Ratio and

Interest Rate Sensitivity Measure. (These guidelines are summarized in

Table 1 below.) These risk levels are for guidance, they are not

mandatory; examiners utilize them as starting points in their ratings

assessments but have broad discretion to exercise judgment (see Part

IV.D, Examiner Judgment).

An institution with a Post-shock NPV Ratio below 4% and an Interest

Rate Sensitivity Measure of:

(a) More than 200 basis points will ordinarily be characterized as

having ``high'' risk. Such an institution will typically receive a 4 or

5 rating for the ``S'' component.10

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\10\ According to the interagency uniform ratings system (61

Fed. Reg. 67029 [1996]), the level of market risk at a 4-rated

institution is ``high,'' while that at a 5-rated institution is so

high as to pose ``an imminent threat to its viability.'' Under the

Prompt Corrective Action regulation, 12 CFR Part 565, supervisory

action is tied to regulatory capital. An institution's viability is,

therefore, directly dependent on regulatory capital, not on economic

capital. Because regulatory capital can remain positive for an

extended period of time after economic capital has become zero or

negative, the NPV measures are not by themselves indicators of near-

term viability. For an institution's level of interest rate risk to

constitute an imminent threat to viability, the institution will

typically have a high level of interest rate risk and will have

other serious financial problems that place it in imminent danger of

closure.

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(b) 100 to 200 basis points will ordinarily be characterized as

having ``significant'' risk. Such an institution will typically receive

a 3 rating for the ``S'' component.

(c) 0 to 100 basis points will ordinarily be characterized as

having ``moderate'' risk. Such an institution will typically receive a

rating of 2 for the ``S'' component. If the institution's sensitivity

is extremely low, a rating of 1 may be supportable unless the

institution is likely to incur larger losses under rate shocks other

than the parallel shocks depicted in the OTS NPV Model.

An institution with a Post-shock NPV Ratio between 4% and 6% and an

Interest Rate Sensitivity Measure of:

(a) More than 400 basis points will ordinarily be characterized as

having ``high'' risk. Such an institution will typically receive a 4 or

5 rating for the ``S'' component.

(b) 200 to 400 basis points will ordinarily be characterized as

having ``significant'' risk. Such an institution will typically receive

a 3 rating for the ``S'' component.

(c) 100 to 200 basis points will ordinarily be characterized as

having ``moderate'' risk. Such an institution will typically receive a

2 rating for the ``S'' component.

(d) 0 to 100 basis points will ordinarily be characterized as

having ``minimal'' risk. Such an institution will typically receive a

rating of 1 for the ``S'' component.

An institution with a Post-shock NPV Ratio between 6% and 10% and

an Interest Rate Sensitivity Measure of:

(a) More than 400 basis points will ordinarily be characterized as

having ``significant'' risk. Such an institution will typically receive

a 3 rating for the ``S'' component.

(b) 200 to 400 basis points will ordinarily be characterized as

having ``moderate'' risk. Such an institution will typically receive a

2 rating for the ``S'' component.

(c) Less than 200 basis points will ordinarily be characterized as

having ``minimal'' risk. Such an institution will typically receive a

rating of 1 for the ``S'' component.

An institution with a Post-shock NPV Ratio of more than 10% and an

Interest Rate Sensitivity Measure of:

(a) More than 400 basis points will ordinarily be characterized as

having ``moderate'' risk. Such an institution will typically receive a

2 rating for the ``S'' component.

(b) Less than 400 basis points will ordinarily be characterized as

having ``minimal'' risk. Such an institution will typically receive a

rating of 1 for the ``S'' component.

[[Page 66366]]

[GRAPHIC] [TIFF OMITTED] TN01DE98.005

In Table 1 the numbers in parentheses represent the ``S'' component

ratings that examiners would typically use as starting points in their

analysis, assuming there are no deficiencies in the institution's risk

management practices. Examiners may assign a different rating based on

their interpretation of the facts and circumstances at each

institution.

4. Internal vs. OTS Risk Measures. In applying the guidelines

described above, examiners will encounter three general types of

situations regarding the availability of risk measures.

First, if the institution does not have internal NPV measures, but

does file Schedule CMR, examiners will use the NPV measures produced by

OTS. In such instances, examiners must be aware of the importance of

accurate reporting by the institution on Schedule CMR, particularly of

items for which the institution provides its own market value estimates

in the various interest rate scenarios, such as for mortgage derivative

securities. They must also be aware of circumstances in which the OTS

measures may overstate or understate the sensitivity of an

institution's financial instruments.

Second, if the institution does produce its own NPV measures,

examiners will have to decide whether to use the institution's or OTS's

risk measures.

(a) If the institution's own measures and those produced by OTS are

broadly consistent and result in the same risk category (e.g.,

``minimal risk,'' ``moderate risk,'' etc.), the choice between using

the institution's measures or the OTS estimates probably does not

matter, though examiners should attempt to ascertain the reasons for

any major discrepancies between the two sets of results.

(b) If the institution's NPV measures place it in a different risk

category than the OTS measures do, examiners (in consultation with

their Regional Capital Markets group or the Washington Risk Management

Division) should determine which financial instruments are the source

of that discrepancy. If the institution's valuations for those

instruments are judged more reliable than OTS's, the institution's

results will be used to replace the OTS results for those financial

instruments in calculating NPV in the various interest rate scenarios.

(c) If examiners have reason to doubt both the institution's own

measures and those produced by OTS, they may modify (in consultation

with their Regional Capital Markets group or the Washington Risk

Management Division) either or both measures to arrive at NPV measures

that the examiners consider reasonable.

In deciding whether to rely on an institution's internal NPV

measures, examiners will ensure that the institution's measures are

produced in a manner that is broadly consistent with the OTS measures.

(The major methodological points to consider are described in Part

II.B, Systems for Measuring Interest Rate Risk.)

The third situation examiners will encounter is one in which the

institution calculates no internal NPV measures and does not report on

Schedule CMR. Because no NPV results will be available in such cases,

the guidelines are not directly applicable. In addition to reviewing

the institution's balance sheet structure in such cases, examiners will

review whatever interest rate risk measurement and management tools the

institution uses to comply with Sec. 563.176. Depending on their

findings regarding the institution's general level of risk and its risk

management practices, examiners might reconsider the appropriateness of

the institution's continued exemption from filing Schedule CMR.

B. Assessing the Quality of Risk Management

In drawing conclusions about the quality of an institution's risk

management practices--the second dimension of the ``S'' component

rating--examiners will assess all significant facets of the

institution's risk management process. To aid in that assessment,

examiners will refer to Appendix B of this Bulletin which provides a

set of Sound Practices for Market Risk Management. These sound

practices suggest the sorts of management practices institutions of

varying levels of sophistication may utilize. As (i) the size of the

institution increases, (ii) the complexity of its assets, liabilities,

or off-balance sheet contracts increases, or (iii) the overall level of

interest rate risk at the institution increases, its risk management

process should exhibit more of the elements included in the Sound

Practices and should display a greater degree of formality and rigor.

Because there is no formula for determining the adequacy of such

systems, examiners will make that determination on a case-by-case

basis. Examiners will take the following eight factors, among others,

into consideration in assessing the quality of an institution's risk

management practices.

1. Oversight by Board and Senior Management. Examiners will assess

the quality of oversight provided by the institution's board and senior

management. That assessment may have many facets, as described in

Appendix B, Sound Practices for Market Risk Management.

2. Prudence of Limits. Examiners will assess the prudence of the

institution's board-approved interest rate risk limits.

[[Page 66367]]

Ordinarily, a set of IRR limits will raise examiner concerns if the

limits permit the institution to have a Post-shock NPV Ratio and

Interest Rate Sensitivity Measure that would ordinarily warrant an

``S'' component rating of 3 or worse. (For examples of how examiners

will make that determination, see Appendix A, Evaluating Prudence of

Interest Rate Risk Limits.) Depending on the level of concern, such

limits may result in examiner criticism or an adverse ``S'' component

rating.

3. Adherence to Limits. Examiners will assess the degree to which

the institution adheres to its interest rate risk limits. Frequent

exceptions to the board's limits may indicate weak interest rate risk

management practices. Similarly, recurrent changes to the institution's

limits to accommodate exceptions to the limits may reflect ineffective

board oversight.

4. Quality of System for Measuring NPV Sensitivity. Examiners will

consider whether the quality of the institution's risk measurement and

monitoring system is commensurate with the institution's size, the

complexity of its financial instruments, and its level of interest rate

risk. Examiners will generally expect the quality of an institution's

system for measuring the interest rate sensitivity of NPV to be

consistent with the descriptions in Part II.B, Systems for Measuring

Interest Rate Risk.

5. Quality of System for Measuring Earnings Sensitivity. OTS places

considerable reliance on NPV analysis to assess an institution's

interest rate risk. Other types of measures may, however, be considered

in evaluating an institution's risk management practices. In

particular, utilization of a well-supported earnings sensitivity

analysis may be viewed as a favorable factor in determining an

institution's component rating. In fact, all institutions are

encouraged to measure the interest rate sensitivity of projected

earnings. Despite inherent limitations,11 such analyses can

provide useful information to an institution's management.

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\11\ The effectiveness of an earnings sensitivity model to

identify interest rate risk depends on the composition of an

institution's portfolio. In particular, management should recognize

that such models generally do not fully take account of longer-term

risk factors.

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Methodologies used in measuring earnings sensitivity vary

considerably among different institutions. To assist examiners in

reviewing the earnings modeling process, institutions should have clear

descriptions of the methodologies and assumptions used in their models.

Of particular importance are the type of rate scenarios used (e.g.,

instantaneous or gradual, consistent with forward yield curve) and

assumptions regarding new business (i.e., type of assets, dollar

amounts, and interest rates). In addition, formulas for projecting

interest rate changes on existing business (e.g., ARMs, transaction

deposits) should be clearly described and any major differences from

analogous formulas used in the OTS NPV Model should be explained and

supported.

6. Integration of Risk Management with Decision-Making. Examiners

will consider the extent to which the results of an institution's risk

measurement system are used by management in making operational

decisions (e.g., changes in portfolio structure, investments,

derivatives activities, business planning, funding decisions, pricing

decisions). This is of particular significance if the institution's

Post-shock NPV Ratio is relatively low, and thus provides less of an

economic buffer against loss.

Examiners will evaluate whether management considers the effect of

significant operational decisions on the institution's level of

interest rate risk. The form of analysis used for measuring that effect

(earnings sensitivity, NPV sensitivity, or any other reasonable

approach) and all details of the measurement are up to the institution.

That analysis should be an active factor in management's decision-

making and not be generated solely to avoid examiner criticism. In the

absence of such a decision-making process, examiner criticism or an

adverse rating may be appropriate.

7. Investments and Derivatives. Examiners will consider the

adequacy of the institution's risk management policies and procedures

regarding investment and derivatives activities. See Part III of this

Bulletin, Investment Securities and Financial Derivatives, for a

detailed discussion.

8. Size Complexity, and Risk Profile. Under the interagency uniform

ratings descriptions, an institution's risk management practices are

evaluated relative to the institution's ``size, complexity, and risk

profile.'' Thus, a small institution with a simple portfolio and a

consistently low level of risk may receive an ``S'' rating of 1 even if

its risk management practices are fairly rudimentary. A large

institution with these same characteristics would be expected to have

more rigorous risk management practices, but would not be held to the

same risk management standards as a similarly sized institution with

either a higher level of risk or a portfolio containing complex

securities or financial derivatives. An institution making a conscious

business decision to maintain a low risk profile by investing in low

risk products or maintaining a high level of capital may not require

elaborate and costly risk management systems.

C. Combining Assessments of the Level of Risk and Risk Management

Practices

Guidelines examiners will use in assessing an institution's level

of risk and the quality of its risk management practices have been

described in the two previous sections. This section provides

guidelines for combining those two assessments into an ``S'' component

rating for the institution.

The interagency uniform ratings descriptions specify the criteria

for the ``S'' component ratings in terms of the level of risk and the

quality of risk management practices (see Appendix C). For example:

A rating of 1 indicates that market risk sensitivity is well

controlled and that there is minimal potential that the earnings

performance or capital position will be adversely affected. * * *

[emphasis added] \12\

---------------------------------------------------------------------------

\12\ 61 Fed. Reg. 67029 (1996).

Thus, if market risk is less than ``well controlled'' (i.e.,

``adequately controlled,'' ``in need of improvement,'' or

``unacceptable''), the institution does not qualify for a component

rating of 1. Likewise, if the level of market risk is more than

``minimal'' (i.e., ``moderate,'' ``significant,'' or ``high''), the

institution similarly does not qualify for a rating of 1.

Applying the same logic to the descriptions of the 2, 3, 4, and 5

levels of the ``S'' component rating results in the ratings guidelines

shown in Table 2. That table summarizes how various combinations of

examiner assessments about an institution's ``level of interest rate

risk'' and ``quality of risk management practices'' translate into a

suggested rating.\13\

---------------------------------------------------------------------------

\13\ Some of the combinations of risk management quality and

level of risk shown in the table will rarely, if ever, be

encountered (e.g., an institution with ``unacceptable'' risk

management practices, but a ``minimal'' level of risk). For the sake

of completeness, however, all cells of the matrix are shown.

---------------------------------------------------------------------------

Two important caveats must be noted about this table. First, the

two dimensions are not totally independent of one another, because the

quality of risk management practices is evaluated relative to an

institution's level of risk (among other things). Thus, for example, an

institution's risk management practices are more likely to be assessed

as ``well controlled'' if the institution has minimal risk than if it

has a higher level of risk. Second, as described

[[Page 66368]]

further in the next section, the ratings shown in Table 2 provide a

starting point, but examiners have broad discretion to exercise

---------------------------------------------------------------------------

judgment and deviate from them.

[GRAPHIC] [TIFF OMITTED] TN01DE98.006

D. Examiner Judgment

Blind adherence to the guidelines is undesirable. Examiners have a

responsibility to exercise judgment in assigning ratings based on the

facts they encounter at each institution. This section provides a non-

exhaustive list of factors examiners might consider in applying the

``S'' rating guidelines to a particular institution.

1. Judgment in Assessing the Level of Risk. In assessing the level

of interest rate risk, the likelihood that examiners will deviate from

the guidelines in Table 1 is heightened in cases where the Post-shock

NPV Ratio and the Interest Rate Sensitivity Measure are both near cell

boundaries. For example, there is no material difference between an

institution whose Post-shock Ratio and Sensitivity Measure, are,

respectively, 4.01% and 199 b.p. and one where they are 3.99% and 201

b.p., yet the guidelines in Table 1 suggest a 2 rating for the former

and a 4 for the latter. Clearly, the row and column boundaries of the

cells in the table must be interpreted as transition zones or ``gray

areas,'' rather than as precise cut-off points, between suggested

ratings. As such, examiners will more commonly deviate from the stated

guidelines in the vicinity of cell borders than in their interior.

Open-ended cells are another instance where examiners will more

commonly deviate from the guidelines. For example, in assessing an

institution whose Sensitivity Measure is well beyond 400 b.p., an

examiner might very well determine that its level of risk is higher

than the guidelines in the rightmost column of Table 1. In applying the

guidelines in Table 1, many considerations may cause an examiner to

reach a different conclusion than suggested by the guidelines. Such

considerations include the following:

(a) The trend in the institution's risk measures during recent

quarters.

(b) The trend in the institution's risk measures compared with

those of the rest of the industry in recent quarters. (Comparison with

the results for the industry as a whole often provides a useful

backdrop for evaluating an institution's results, particularly during a

period of volatile interest rates.)

(c) The examiner's level of comfort with the overall accuracy of

the available risk measures as applied to the particular products of

the institution.

(d) The existence of items with particularly volatile or uncertain

interest rate sensitivity for which the examiner wants to allow an

added margin for possible error.

(e) The effect of any restructuring that may have occurred since

the most recently available risk measures.

(f) Other available evidence that causes the examiner to favor a

higher or lower risk assessment than that suggested by the guidelines.

2. Judgment in Assessing the Quality of Risk Management Practices.

Conclusions about the quality of risk management practices should be

based, in part, on the institution's level of risk, with less risky

institutions requiring less rigorous risk management practices.

Considerations listed in the Judgment in Assessing the Level of Risk,

above, may therefore cause the examiner to modify his or her assessment

of the institution's risk management practices. In addition, if changes

have occurred in the institution's level of risk since the last

evaluation, the examiner may wish to reassess the quality of the

institution's risk management practices in light of these changes.

Part V: Supervisory Action

If supervisory action to address interest rate risk is needed,

examiners will discuss the problem with management and obtain their

commitment to correct the problem as quickly as practicable.

If deemed necessary, examiners will request a written plan from the

board and management to reduce interest rate sensitivity, increase

capital, or both. The plan should include specific risk measure

targets. If the initial plan is inadequate, examiners will require

amendment and re-submission. Examiners will document the corrective

strategy and results and review progress at case reviewing meetings.

For institutions with composite ratings of 4 or 5, the presumption

of formal enforcement action generally requires a supervisory

agreement, cease

[[Page 66369]]

and desist order, prompt corrective action directive, or other formal

supervisory action. If an institution's interest rate risk increases

between examinations, examiners will consider whether a downgrade of

the ``S'' component rating or the composite rating is warranted.

Examiners will obtain quarterly progress reports (more frequently if

the situation is severe). Where appropriate, examiners may require the

institution to develop the capacity to conduct its own modeling.

Appendix A: Evaluating Prudence of Interest Rate Risk Limits

The basic principle examiners will use in evaluating the prudence

of an institution's risk limits is whether they permit NPV to drop to a

level where the Post-shock NPV Ratio and Sensitivity Measure would

suggest an ``S'' component rating of 3 or worse under the guidelines

for the Level of Risk (reproduced here as Table 1).

[GRAPHIC] [TIFF OMITTED] TN01DE98.007

Examples of Evaluating the Prudence of Interest Rate Risk Limits

The following examples illustrate how OTS examiners will evaluate

an institution's interest rate risk limits. In each example, the

interest rate risk limits approved by the institution's board of

directors are shown in column [b]. These specify a minimum NPV Ratio

for each of the interest rate scenarios shown in column [a]. The NPV

Ratios currently estimated for the institution for each rate scenario

are shown in column [c].

Example Institution A

Institution A has a detailed set of interest rate risk limits by

which the board of directors specifies a minimum NPV Ratio for each of

the seven rate shock scenarios described in Part II.A.1 of this

bulletin.

Institution A--Limits and Current NPV Ratios

Board limits (minimum NPV Institution's current NPV

Rate shock (in basis points) ratios) ratios)

[a] [b] [c]

----------------------------------------------------------------------------------------------------------------

+300................................................ 6.00% 10.00%

+200................................................ 7.00 11.50

+100................................................ 8.00 12.50

0................................................... 9.00 13.00

-100................................................ 10.00 13.25

-200................................................ 11.00 13.50

-300................................................ 12.00 13.75

----------------------------------------------------------------------------------------------------------------

To assess the prudence of Institution A's interest rate risk

limits, examiners will evaluate the risk measures permitted under those

limits relative to the guidelines for the Level of Risk in Table 1. The

Post-shock NPV Ratio permitted by the institution's board limits is

7.00% (from the +200 b.p. scenario in column [b], above). The

Sensitivity Measure permitted by the limits is not known; it depends on

the actual level of the base case NPV Ratio, which will probably be

higher than the limit for the base case scenario. Examiners will,

therefore, use the institution's current Sensitivity Measure (based on

OTS's results or those of the institution) in performing their

evaluation. Institution A's current Sensitivity Measure is 150 basis

points (i.e., [13.00%-11.50%], the NPV Ratios in the 0 b.p. and +200

b.p. scenarios in column [c], above).

Referring to Table 1, the Post-shock NPV Ratio allowed by the

institution's limits falls into the ``6% to 10%'' row and its current

Sensitivity Measure falls into the ``100 to 200 b.p.'' column. The

rating suggested by Table 1 is, therefore, a 1, and Institution A's

risk limits would, thus, probably be considered prudent.14

---------------------------------------------------------------------------

\14\ This example assumes there are no significant deficiencies

in the institution's risk management practices.

---------------------------------------------------------------------------

Example Institution B

[[Page 66370]]

Institution B--Limits and Current NPV Ratios

Board limits Institution's

Rate shock (in basis points) (minimum NPV current NPV

ratios ratios)

[a] [b] [c]

------------------------------------------------------------------------

+300............................ 6.00% 6.00%

+200............................ 7.00 8.50

+100............................ 8.00 11.00

0............................... 9.00 13.00

-100............................ 10.00 14.00

-200............................ 11.00 14.50

-300............................ 12.00 15.00

------------------------------------------------------------------------

Institution B has identical interest rate risk limits as

Institution A, but is considerably more interest rate sensitive than

Institution A at the present time. Institution B's Sensitivity Measure

is 450 b.p. (i.e., [13.00%-8.50%]). For purposes of applying the

guidelines in Table 1 to the limits, the Post-shock NPV Ratio of 7.00%

permitted by the institution's board limits falls into the ``6% to

10%'' row. Its current Sensitivity Measure, however, falls into the

``Over 400 b.p.'' column of Table 1. The rating suggested by the

guidelines is therefore a 3, and Institution B's risk limits would

probably not be considered sufficiently prudent. Even though its limits

are identical to those of Institution A, its much higher current

Sensitivity Measure requires the support of a higher Post-shock NPV

Ratio than the minimum permitted by the board limits.

Example Institution C

Institution C--Limits and Current NPV Ratios

Board limits

Rate shock (in basis points) (minimum NPV Institution's

ratios) current NPV ratios

[a] [b] [c]

------------------------------------------------------------------------

+300............................ 6.00% 6.00%

+200............................ 6.00 8.50

+100............................ 6.00 11.00

0............................... 6.00 13.00

-100............................ 6.00 14.00

-200............................ 6.00 14.50

-300............................ 6.00 15.00

------------------------------------------------------------------------

Institution C has the same current NPV Ratios as Institution B. Its

board of directors has established the institution's interest rate risk

limits as a single minimum NPV Ratio of 6% that applies to all seven

rate shock scenarios. In assessing the prudence of those limits,

therefore, the Post-shock NPV Ratio permitted by the limits is 6.00%.

The current Sensitivity Measure, like that of Institution B, is 450

b.p.

In applying the Table 1 guidelines to the limits, Institution C's

Post-shock NPV Ratio is in either the ``4% to 6%'' or the ``6% to 10%''

row and its Sensitivity Measure in the ``Over 400 b.p.'' column of

Table 1. The rating suggested by the table is, therefore, a 3 or a 4,

and so Institution C's risk limits would also probably not be

considered sufficiently prudent.

Example Institution D

Institution D--Limits and Current NPV Ratios

Board limits

Rate shock (in basis points) (minimum NPV Institution's

ratios) current NPV ratios

[a] [b] [c]

------------------------------------------------------------------------

+300............................ 3.50% 2.50%

+200............................ 3.50 3.25

+100............................ 3.50 3.75

0........................... 3.50 4.00

-100............................ 3.50 4.25

-200............................ 3.50 4.50

-300............................ 3.50 4.75

------------------------------------------------------------------------

Institution D has quite a low base case level of economic capital,

and its board limits recognize that fact by permitting low NPV Ratios.

Furthermore, the institution's level of interest rate risk currently

exceeds the board limits (i.e., the current NPV Ratios in the +200 and

+300 scenarios are below the board's 3.50% minimum). While examiners

[[Page 66371]]

would be very likely to express concern about that aspect of the

institution's risk management process, the limits themselves might

still be viewed as prudent.

To determine whether the institution's limits are prudent,

examiners will use the Post-shock NPV Ratio of 3.50% permitted by the

limits and the institution's current Sensitivity Measure of 75 basis

points (i.e., [4.00%-3.25%]). In applying Table 1, the Post-shock NPV

Ratio permitted by the limits falls into the ``Below 4%'' row and the

current Sensitivity Measure falls into the ``0 to 100 b.p.'' column.

The rating suggested by Table 1 is therefore a 2, and assuming that

Institution A's Sensitivity Measure has been consistently low, its risk

limits would probably be considered prudent. Because of the critical

importance of the Sensitivity Measure in this determination, examiners

might well arrive at a different conclusion if they lack assurance that

the institution has the ability to maintain that measure at its

current, low level. Thus, if the Sensitivity Measure has been volatile

in the past or if examiners have concerns about the quality of the

institution's risk management practices, they might well conclude that

the risk limits are not sufficiently prudent.

Appendix B: Sound Practices for Market Risk Management

This section describes the key elements for effective management of

market risk exposures. These key elements encompass sound practices for

both interest rate risk management and the management of investment and

derivatives activities. The degree of formality and rigor with which an

institution implements these elements in its own risk management system

should be consistent with the institution's size, the complexity of its

financial instruments, its tolerance for risk, and the level of market

risk at which it actually operates.

A. Board and Senior Management Oversight

Effective oversight is an integral part of an effective risk

management program. The board and senior management should understand

their oversight responsibilities regarding interest rate risk

management and the management of investment and derivatives activities

conducted by their institution.

Board of Directors. The board of directors should approve broad

strategies and major policies relating to market risk management and

ensure that management takes the steps necessary to monitor and control

market risk. The board of directors should be informed regularly of the

institution's risk exposures.

The board of directors has ultimate responsibility for

understanding the nature and level of risk taken by the institution.

Board oversight need not involve the entire board, but may be carried

out by an appropriate subcommittee of the board. The board, or an

appropriate subcommittee of board members, should:

Approve broad objectives and strategies and major policies

governing interest rate risk management and investment and derivatives

activities.

Provide clear guidance to management regarding the board's

tolerance for risk.

Ensure that senior management takes steps to measure,

monitor, and control risk.

Review periodically information that is sufficient in

timeliness and detail to allow it to understand and assess the

institution's interest rate risk and risks related to investment and

derivatives activities.

Assess periodically compliance with board-approved

policies, procedures, and risk limits.

Review policies, procedures and risk limits at least

annually.

Although board members are not required to have detailed technical

knowledge, they should ensure that management has the expertise needed

to understand the risks incurred by the institution and that the

institution has personnel with the expertise needed to manage interest

rate risk and conduct investment and derivative activities in a safe

and sound manner.

Senior Management. Senior management should ensure that the

institution's operations are effectively managed, that appropriate risk

management policies and procedures are established and maintained, and

that resources are available to conduct the institution's activities in

a safe and sound manner.

Senior management is responsible for the daily oversight and

management of the institution's activities, including the

implementation of adequate risk management polices and procedures. To

carry out its responsibilities, senior management should:

Ensure that effective risk management systems are in place

and properly maintained. An institution's risk management systems

should include (1) systems for measuring risk, valuing positions, and

measuring performance, (2) appropriate risk limits, (3) a comprehensive

reporting and review process, and (4) effective internal controls.

Establish and maintain clear lines of authority and

responsibility for managing interest rate risk and for conducting

investment and derivatives activities.

Ensure that the institution's operations and activities

are conducted by competent staff with technical knowledge and

experience consistent with the nature and scope of their activities.

Provide the board of directors with periodic reports and

briefings on the institution's market-risk related activities and risk

exposures.

Review periodically the institution's risk management

systems, including related policies, procedures, and risk limits.

Lines of Responsibility and Authority for Managing Market Risk.

Institutions should identify the individuals and/or committees

responsible for risk management and should ensure there is adequate

separation of duties in key elements of the risk management process to

avoid potential conflicts of interest. Institutions should have a risk

management function (or unit) with clearly defined duties that is

sufficiently independent from position-taking functions.

Institutions should identify the individuals and/or committees

responsible for conducting risk management. Senior management should

define lines of authority and responsibility for developing strategies,

implementing tactics, and conducting the risk measurement and reporting

functions.

The risk management unit should report directly to both senior

management and the board of directors, and should be separate from, and

independent of, business lines. The function may be part of, or may

draw its staff from, more general operations (e.g., the audit,

compliance, or Treasury units). Large institutions should, however,

have a separate risk management unit, particularly if the Treasury unit

is also a profit center. Smaller institutions with limited resources

and personnel should provide additional oversight by outside directors

in order to compensate for the lack of separation of duties.

Management should ensure that sufficient safeguards exist to

minimize the potential that individuals initiating risk-taking

positions may inappropriately influence key control functions of the

risk management process such as the development and enforcement of

policies and procedures, the reporting of risks to senior

[[Page 66372]]

management, and the conduct of back-office functions.

B. Adequate Policies and Procedures

Institutions should have clearly defined risk management policies

and procedures. The board of directors has ultimate responsibility for

the adequacy of those policies and procedures; senior management and

the institution's risk management function have immediate

responsibility for their design and implementation. Policies and

procedures should be reviewed periodically and revised as needed.

Interest Rate Risk. Institutions should have written policies and

procedures for limiting and controlling interest rate risk. Such

policies and procedures should be consistent with the institution's

strategies, financial condition, risk-management systems, and tolerance

for risk. An institution's policies and procedures (or documentation

issued pursuant to such policies) should:

Address interest rate risk at the appropriate level(s) of

consolidation. (Although the board will generally be most concerned

with the consolidated entity, it should be aware that accounting and

legal restrictions may not permit gains and losses occurring in

different subsidiaries to be netted.)

Delineate lines of responsibility and identify individuals

or committees responsible for (1) developing interest rate risk

management strategies and tactics, (2) making interest rate risk

management decisions, and (3) conducting oversight.

Identify authorized types of financial instruments and

hedging strategies.

Describe a clear set of procedures for controlling the

institution's aggregate interest rate risk exposure.

Define quantitative limits on the acceptable level of

interest rate risk for the institution.

Define procedures and conditions necessary for exceptions

to policies, limits, and authorizations.

Investment and Derivatives Activities. Institutions should have

written policies and procedures governing investment and derivatives

activities. Such policies and procedures should be consistent with the

institution's strategies, financial condition, risk-management systems,

and tolerance for risk. An institution's policies and procedures (or

documentation issued pursuant to such policies) should:

Identify the staff authorized to conduct investment and

derivatives activities, their lines of authority, and their

responsibilities.

Identify the types of authorized investment securities and

derivative instruments.

Specify the type and scope of pre-purchase analysis that

should be conducted for various types or classes of investment

securities and derivative instruments.

Define, where appropriate, position limits and other

constraints on each type of authorized investment and derivative

instrument, including constraints on the purpose(s) for which such

instruments may be used.

Identify dealers, brokers, and counterparties that the

board or a committee designated by the board (e.g., a credit policy

committee) has authorized the institution to conduct business with and

identify credit exposure limits for each authorized entity.

Ensure that contracts are legally enforceable and

documented correctly.

Establish a code of ethics and standards of professional

conduct applicable to personnel involved in investment and derivatives

activities.

Define procedures and approvals necessary for exceptions

to policies, limits, and authorizations.

Policies and procedures governing investment and derivatives

activities may be embedded in other policies, such as the institution's

interest rate risk policies, and need not be stand-alone documents.

C. Risk Measurement, Monitoring, and Control Functions

Interest Rate Risk Measurement. Institutions should have interest

rate risk measurement systems that capture all material sources of

interest rate risk. Measurement systems should utilize accepted

financial concepts and risk measurement techniques and should

incorporate sound assumptions and parameters. Management should

understand the assumptions underlying their systems. Ideally,

institutions should have interest rate risk measurement systems that

assess the effects of interest rate changes on both earnings and

economic value.

An institution's interest rate risk measurement system should

address all material sources of interest rate risk including repricing,

yield curve, basis and option risk exposures. In many cases, the

interest rate sensitivity of an institution's mortgage portfolio will

dominate its aggregate risk profile. While all of an institution's

holdings should receive appropriate treatment, instruments whose

interest rate sensitivity may significantly affect the institution's

overall results should receive special attention, as should instruments

whose embedded options may have a significant effect on the results.

The usefulness of any interest rate risk measurement system depends

on the validity of the underlying assumptions and accuracy of the

methodologies. In designing interest rate risk measurement systems,

institutions should ensure that the degree of detail about the nature

of their interest-sensitive positions is commensurate with the

complexity and risk inherent in those positions.

Management should assess the significance of the potential loss of

precision in determining the extent of aggregation and simplification

used in its measurement approach.

Institutions should ensure that all material positions and cash

flows, including off-balance-sheet positions, are incorporated into the

measurement system. Where applicable, these data should include

information on the coupon rates or cash flows of associated instruments

and contracts. Any adjustments to underlying data should be documented,

and the nature and reasons for the adjustments should be understood. In

particular, any adjustments to expected cash flows for expected

prepayments or early redemptions should be documented.

Key assumptions used to measure interest rate risk exposure should

be re-evaluated at least annually. Assumptions used in assessing the

interest rate sensitivity of complex instruments should be documented

and reviewed periodically.

Management should pay special attention to those positions with

uncertain maturities, such as savings and time deposits, which provide

depositors with the option to make withdrawals at any time. In

addition, institutions often choose not to change the rates paid on

these deposits when market rates change. These factors complicate the

measurement of interest rate risk, since the value of the positions and

the timing of their cash flows can change when interest rates vary.

Mortgages and mortgage-related instruments also warrant special

attention due to the uncertainty about the timing of cash flows

introduced by the borrowers' ability to prepay.

IRR Limits. Institutions should establish and enforce risk limits

that maintain exposures within prudent levels. Management should ensure

that the institution's interest rate risk exposure is maintained within

self-imposed limits. A system of interest rate risk limits should set

prudent boundaries for the level of interest rate risk for the

institution and, where

[[Page 66373]]

appropriate, should also provide the capability to set limits for

individual portfolios, activities, or business units.

Limit systems should also ensure that positions exceeding limits or

predetermined levels receive prompt management attention.

Senior management should be notified immediately of any breaches of

limits. There should be a clear policy as to how senior management will

be informed and what action should be taken. Management should specify

whether the limits are absolute in the sense that they should never be

exceeded or whether, under specific circumstances, breaches of limits

can be tolerated for a short period of time.

Limits should be consistent with the institution's approach to

measuring interest rate risk.

Interest rate risk limits should be tied to specific scenarios for

movements in market interest rates and should include ``high stress''

interest rate scenarios.

Limits may also be based on measures derived from the underlying

statistical distribution of interest rates, using ``earnings-at-risk''

or ``value-at-risk'' techniques.

Stress Testing. Institutions should measure their risk exposure

under a number of different scenarios and consider the results when

establishing and reviewing their policies and limits for interest rate

risk.

Institutions should use interest rate scenarios that are

sufficiently varied to encompass different stressful conditions.

Stress tests should include ``worst case'' scenarios in addition to

more probable scenarios. Possible stress scenarios might include abrupt

changes in the general level of interest rates, changes in the

relationships among key market rates (i.e., basis risk), changes in the

slope and the shape of the yield curve (i.e., yield curve risk),

changes in the liquidity of key financial markets or changes in the

volatility of market rates. In conducting stress tests, special

consideration should be given to instruments or positions that may be

difficult to liquidate or offset in stressful situations. Management

and the board of directors should periodically review both the design

and the results of such stress tests and ensure that appropriate

contingency plans are in place.

Market Risk Monitoring and Reporting. Institutions should have

accurate, informative, and timely management information systems, both

to inform management and to support compliance with board policy.

Reports for monitoring and controlling market risk exposures should be

provided on a timely basis to the board of directors and senior

management.

The board of directors and senior management should review market

risk reports (i.e., interest rate risk reports and reports on

investment and derivatives activities) on a regular basis (at least

quarterly). While the types of reports prepared for the board and

various levels of management will vary, they should include:

Summaries of the institution's aggregate interest rate

risk and other market risk exposures including results of stress tests;

Reports on the institution's compliance with risk

management policies, procedures, and limits;

Reports comparing the institution's level of interest rate

risk with other savings associations using industry data provided by

OTS;

A summary of any major differences between the results of

the OTS Net Portfolio Value Model and the institution's own results;

and

Summaries of internal and external reviews of the

institution's risk management framework, including reviews of policies,

procedures, risk measurement and control systems, and risk exposures.

D. Internal Controls

Institutions should have an adequate system of internal controls

over their interest rate risk management process. A fundamental

component of the internal control system involves regular independent

reviews and evaluations of the effectiveness of the system.

Internal controls should be an integral part of an institution's

risk management system. The controls should promote effective and

efficient operations, reliable financial and regulatory reporting, and

compliance with relevant laws, regulations, and institutional policies.

An effective system of internal control for interest rate risk should

include:

effective policies, procedures, and risk limits;

an adequate process for measuring and evaluating risk;

adequate risk monitoring and reporting systems;

a strong control environment; and

continual review of adherence to established policies and

procedures.

Institutions are encouraged to have their risk measurement systems

reviewed by knowledgeable outside parties. Reviews of risk measurement

systems should include assessments of the assumptions, parameter

values, and methodologies used. Such a review should evaluate the

system's accuracy and recommend solutions to any identified weaknesses.

The results of the review, along with any recommendations for

improvement, should be reported to senior management and the board, and

acted upon in a timely manner.

Institutions should review their system of internal controls at

least annually. Reviews should be performed by individuals independent

of the function being reviewed. Results should be reported to the

board. The following factors should be considered in reviewing an

institution's internal controls:

Are risk exposures maintained at prudent levels?

Are the risk measures employed appropriate to the nature

of the portfolio?

Are board and senior management actively involved in the

risk management process?

Are policies, controls, and procedures well documented?

Are policies and procedures followed?

Are the assumptions of the risk measurement system well

documented?

Are data accurately processed?

Is the risk management staff adequate?

Have risk limits been changed since the last review?

Have there been any significant changes to the

institution's system of internal controls since the last review?

Are internal controls adequate?

E. Analysis and Stress Testing of Investments and Financial Derivatives

Management should undertake a thorough analysis of the various

risks associated with investment securities and derivative instruments

prior to making an investment or taking a significant position in

financial derivatives and periodically thereafter. Major initiatives

involving investments and derivatives transactions should be approved

in advance by the board of directors or a committee of the board.

As a matter of sound practice, prior to taking an investment

position or initiating a derivatives transaction, an institution

should:

Ensure that the proposed investment or derivative

transaction is legally permissible for a savings institution.

Review the terms and conditions of the investment

instrument or derivative contract.

Ensure that the proposed transaction is allowable under

the institution's investment or derivatives policies.

Ensure that the proposed transaction is consistent with

the

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institution's portfolio objectives and liquidity needs.

Exercise diligence in assessing the market value,

liquidity, and credit risk of any investment security or derivative

instrument.

Conduct a price sensitivity analysis of the security or

financial derivative prior to taking a position.

Conduct an analysis of the incremental effect of any

proposed transaction on the overall interest rate sensitivity of the

institution.

Prior to taking a position in any complex securities or financial

derivatives, it is important to have an understanding of how the future

direction of interest rates and other changes in market conditions

could affect the instrument's cash flows and market value. In

particular, management should understand:

the structure of the instrument;

the best-case and worst-case interest rates scenarios for

the instrument;

how the existence of any embedded options or adjustment

formulas might affect the instrument's performance under different

interest rate scenarios;

the conditions, if any, under which the instrument's cash

flows might be zero or negative;

the extent to which price quotes for the instrument are

available;

the instrument's universe of potential buyers; and

the potential loss on the instrument (i.e., the potential

discount from its fair value) if sold prior to maturity.

F. Evaluation of New Products, Activities, and Financial Instruments

Involvement in new products, activities, and financial instruments

(assets, liabilities, or off-balance sheet contracts) can entail

significant risk, sometimes from unexpected sources. Senior management

should evaluate the risks inherent in new products, activities, and

instruments and ensure that they are subject to adequate review

procedures and controls.

Products, activities, and financial instruments that are new to the

organization should be carefully reviewed before use or implementation.

The board, or an appropriate committee, should approve major new

initiatives involving new products, activities, and financial

instruments.

Prior to authorizing a new initiative, the review committee should

be provided with:

a description of the relevant product, activity, or

instrument;

an analysis of the appropriateness of the proposed

initiative in relation to the institution's overall financial condition

and capital levels; and

a description of the procedures to be used to measure,

monitor, and control the risks of the proposed product, activity, or

instrument.

Management should ensure that adequate risk management procedures

are in place in advance of undertaking any significant new initiatives.

Appendix C: Excerpt From Interagency Uniform Financial Institutions

Rating System 15

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\15\ 61 Fed. Reg. 67029 (1996).

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Sensitivity to Market Risk

The sensitivity to market risk component reflects the degree to

which changes in interest rates, foreign exchange rates, commodity

prices, or equity prices can adversely affect a financial institution's

earnings or economic capital. When evaluating this component,

consideration should be given to: management's ability to identify,

measure, monitor, and control market risk; the institution's size; the

nature and complexity of its activities; and the adequacy of its

capital and earnings in relation to its level of market risk exposure.

For many institutions, the primary source of market risk arises

from non-trading positions and their sensitivity to changes in interest

rates. In some larger institutions, foreign operations can be a

significant source of market risk. For some institutions, trading

activities are a major source of market risk.

Market risk is rated based upon, but not limited to, an assessment

of the following evaluation factors:

The sensitivity of the financial institution's earnings or

the economic value of its capital to adverse changes in interest rates,

foreign exchange rates, commodity prices, or equity prices.

The ability of management to identify, measure, monitor,

and control exposure to market risk given the institution's size,

complexity, and risk profile.

The nature and complexity of interest rate risk exposure

arising from non-trading positions.

Where appropriate, the nature and complexity of market

risk exposure arising from trading and foreign operations.

Ratings

1. A rating of 1 indicates that market risk sensitivity is well

controlled and that there is minimal potential that the earnings

performance or capital position will be adversely affected. Risk

management practices are strong for the size, sophistication, and

market risk accepted by the institution. The level of earnings and

capital provide substantial support for the degree of market risk taken

by the institution.

2. A rating of 2 indicates that market risk sensitivity is

adequately controlled and that there is only moderate potential that

the earnings performance or capital position will be adversely

affected. Risk management practices are satisfactory for the size,

sophistication, and market risk accepted by the institution. The level

of earnings and capital provide adequate support for the degree of

market risk taken by the institution.

3. A rating of 3 indicates that control of market risk sensitivity

needs improvement or that there is significant potential that the

earnings performance or capital position will be adversely affected.

Risk management practices need to be improved given the size,

sophistication, and level of market risk accepted by the institution.

The level of earnings and capital may not adequately support the degree

of market risk taken by the institution.

4. A rating of 4 indicates that control of market risk sensitivity

is unacceptable or that there is high potential that the earnings

performance or capital position will be adversely affected. Risk

management practices are deficient for the size, sophistication, and

level of market risk accepted by the institution. The level of earnings

and capital provide inadequate support for the degree of market risk

taken by the institution.

5. A rating of 5 indicates that control of market risk sensitivity

is unacceptable or that the level of market risk taken by the

institution is an imminent threat to its viability. Risk management

practices are wholly inadequate for the size, sophistication, and level

of market risk accepted by the institution. [Emphasis added.]

Appendix D: Glossary

Alternate Interest Rate Scenarios: Scenarios that depict

hypothetical shocks to, or movements in, the current term structure of

interest rates. As currently utilized in the OTS NPV Model, there are

eight alternate interest rate scenarios, depicting shocks in which the

term structure has been changed by the same amount at all maturities.

The changes currently depicted in the alternate scenarios range from--

400 basis points to +400 basis points. (Institutions need only provide

board limits for scenarios ranging from-300 to +300 basis points.)

Base Case: A term sometimes used for the prevailing term structure

of interest rates (i.e., the current interest rate scenario). Also

known as the ``pre-

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shock'' or ``no shock'' scenario, one not subjected to a change in

interest rates. This is in contrast to, say, the plus or minus 100

basis point rate shock scenarios.

CAMELS Rating System: A uniform ratings system, applied to all

banks, thrifts, and credit unions, which provides an indication of an

institution's overall condition.. The six factors of the CAMELS rating

system represent Capital Adequacy, Asset Quality, Management, Earnings,

Liquidity, and Sensitivity to Market Risk. Quantitative and qualitative

factors are used to establish a rating, ranging from 1 to 5 for each

CAMELS component rating. A rating of 1 represents the best rating and

least degree of concern, while a 5 rating represents the worst rating

and greatest degree of concern. The six CAMELS component ratings are

used in developing the overall Composite Rating for an institution.

Complex Securities: The term ``complex security'' includes any

collateralized mortgage obligation (``CMO''), real estate mortgage

investment conduit (``REMIC''), callable mortgage pass-through

security, stripped-mortgage-backed-security, structured note, and any

security not meeting the definition of an ``exempt security.'' An

``exempt security'' includes non-callable, ``plain vanilla''

instruments of the following types: (1) mortgage-pass-through

securities, (2) fixed-rate securities, and (3) floating-rate

securities.

Composite Rating: A rating that summarizes an institution's overall

condition under the CAMELS rating system. This overall rating is

expressed through a numerical scale of 1 through 5, with 1 representing

the best rating and least degree of concern, and 5 representing the

worst rating and highest degree of concern.

Financial Derivative: Any financial contract whose value depends on

the value of one or more underlying assets, indices, or reference

rates. The most common types of financial derivatives are futures,

forward commitments, options, and swaps. A mortgage derivative

security, such as a collateralized mortgage obligation or a real estate

mortgage investment conduit, is not a financial derivative under this

definition.

Interest Rate Risk: The vulnerability of an institution's financial

condition to movements in interest rates. Changes in interest rates

affect an institution's earnings and economic value.

Interest Rate Risk Exposure Report: A quarterly report, sent by OTS

to all institutions that file Schedule CMR, presenting the results of

the OTS NPV Model for each institution.

Interest Rate Sensitivity Measure: The magnitude of the decline in

an institution's NPV Ratio that occurs as a result of an adverse rate

shock of 200 basis points. The measure equals the difference between an

institution's Pre-shock NPV Ratio and its Post-shock NPV Ratio and is

expressed in basis points. In general, institutions that have

significant imbalances between the interest rate sensitivity (i.e.,

duration) of their assets and liabilities tend to have high Interest

Rate Sensitivity Measures.

MVPE: The abbreviation for Market Value of Portfolio Equity, a term

previously used for Net Portfolio Value. This term is no longer used by

OTS because some of the fact

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