Financial Management Policies

SUMMARY: The Office of Thrift Supervision (OTS) is proposing to adopt a

Thrift Bulletin that provides guidance on the management of interest

rate risk, investment securities, and derivatives activities. The

proposed Bulletin also describes the guidelines OTS examiners will use

in assigning the ``Sensitivity to Market Risk'' component rating.

DATES: Comments must be received on or before June 22, 1998.

ADDRESSES: Send comments on the proposed Thrift Bulletin to: Manager,

Dissemination Branch, Records Management and Information Policy, Office

of Thrift Supervision, 1700 G Street, N.W., Washington, D.C. 20552,

Attention Docket No. 98-38. These submissions may be hand-delivered to

1700 G Street, N.W., from 9:00 a.m. to 5:00 p.m. on business days; they

may be sent by facsimile transmission to FAX number (202) 906-7755; or

by e-mail: [email protected]. Those commenting by e-mail should

include their name and telephone number. Comments will be available for

inspection at 1700 G Street, N.W., from 9:00 a.m. until 4:00 p.m. on

business days.

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

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

(202) 906-5727.

SUPPLEMENTARY INFORMATION: The Office of Thrift Supervision is

publishing for public comment the attached document, which it proposes

to issue as Thrift Bulletin 13a (TB 13a), Management of Interest Rate

Risk, Investment Securities, and Derivatives Activities. This proposed

bulletin would provide 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 the proposed bulletin

would simultaneously improve its supervision of interest rate risk

management and reduce regulatory burden on thrift institutions.

The proposed bulletin would update 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 would, thus, replace 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 proposed bulletin would

make several significant changes. First, under TB 13a, institutions

would 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 proposed bulletin would also change the form

in which those limits are expressed. Second, the bulletin would provide

guidance on how OTS will assess the prudence of an institution's risk

limits. Third, the proposed bulletin would raise the size threshold

above which institutions would be responsible for calculating their own

estimates of the interest rate sensitivity of Net Portfolio Value (NPV)

from $500 million to $1 billion in assets. Fourth, the proposed

bulletin would specify a set of desirable features that an

institution's risk measurement methodology should utilize. Finally, the

proposed bulletin provides an extensive discussion of ``sound

practices'' for interest rate risk management.

The proposed 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,

published elsewhere in this issue of the Federal Register, the FFIEC-

member agencies will be discontinuing use of the three-part test for

suitability of investment securities. Accordingly, the proposed

bulletin describes the types of analysis OTS would expect institutions

to perform prior to purchasing securities or financial derivatives. The

proposed bulletin also provides guidelines on the use of certain types

of securities and financial derivatives for purposes other than

reducing portfolio risk. The proposed regulation on financial

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

as supplemented by the guidance in proposed TB 13a, would replace

existing regulations governing futures (12 CFR 563.173), forward

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

would also replace guidance presently 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).

Finally, TB 13a would provide detailed guidelines for implementing

part of the Announcement of the Revision for the Uniform Financial

Institutions Rating System, published by the FFIEC on December 19,

1996. That publication announced revised interagency policies, that

among other things, established the Sensitivity to Market Risk

component rating (the ``S'' rating). TB 13a would provide quantitative

guidelines for assessing an institution's level of interest rate risk,

although examiners would have considerable discretion in implementing

those guidelines. It would also provide guidelines detailing the

factors examiners would 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 would

replace the rather limited guidelines currently contained in New

Directions Bulletin 95-10.

Request for Comment

OTS requests comments on all aspects of proposed TB 13a, including

the following questions:

(1) The proposed Thrift Bulletin and the proposed regulation on

financial derivatives are integral parts of OTS's approach to

supervision of derivatives transactions. OTS does not intend to

finalize one without the other. Do you support this approach?

(2) Does the revised format for the board of directors' limits on

the interest rate sensitivity of net portfolio value (described in Part

II.A.1) impose an unnecessary regulatory burden? Do you believe that

specifying the limits in this form would cause more, or less, work for

your institution?

(3) Should the discussion of prudent limits in Part II.A.3 and

Appendix A be modified? Do you agree with the approach described in

those sections?

(4) For institutions that will be responsible for producing their

own NPV estimates, does your institution have the sophistication to

meet the methodological guidelines described in Part II.B.2?

(5) Do you support the guidelines in Part II.B.3 regarding the

integration of risk measurement and operations?

(6) Given the announced elimination of the FFIEC three-part test

for investment security suitability, do the guidelines in Part III.A.1

regarding pre-purchase portfolio sensitivity analyses for any

significant transactions in securities or financial derivatives provide

a good balance between burden and regulatory prudence. Similarly, are

[[Page 20258]]

the guidelines, in Part III.A.2, calling for pre-purchase price

analyses for complex securities and financial derivatives reasonable?

(7) Are the definitions of complex securities and financial

derivatives understandable and adequate? Are the guidelines, in Part

III.A.3(b), regarding the use of complex securities and financial

derivatives reasonable?

(8) Is the use of explicit guidelines for assigning the Sensitivity

to Market Risk component rating (described in Part IV) a sound approach

for providing greater ratings consistency and transparency?

(9) Do the quantitative guidelines shown in Part IV.A.3 provide

examiners an adequate starting point for assessing the level of

interest rate risk? Do the guidelines described in Part IV.A.4, provide

adequate opportunity for the use of institutions' internal results in

the risk assessment?

(10) Do the criteria for assessing the quality of an institution's

risk management practices (described in Part IV.B) provide an adequate

framework for such an evaluation?

(11) Are the guidelines for the Sensitivity to Market Risk

component rating (shown in Table 2 of Part IV.C) a reasonable

implementation of the criteria described in the interagency Uniform

Financial Institutions Rating System (see Appendix C)?

(12) Do the ``Sound Practices for Market Risk Management,'' listed

in Appendix B, provide a sufficiently good frame of reference that

examiners may evaluate an institution's risk management practices

against them? Are any elements missing from that Appendix? Should any

be deleted?

The proposed Thrift Bulletin is set forth below.

Proposed 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: Identifying Prudent 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 and OTS's proposed rule at Section 563.172, both of which

are published elsewhere in this issue of the Federal Register. 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.

[[Page 20259]]

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 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. These six 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

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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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Two illustrations of such limits are provided in Exhibits 1 and 2.

(The numerical limits shown in these exhibits are examples only and

should not be interpreted as appropriate limits or regulatory

requirements.)

BILLING CODE 6720-01-P

[GRAPHIC] [TIFF OMITTED] TN23AP98.000

BILLING CODE 6720-01-C

In Exhibit 1, the board of directors of ABC Savings Association has

specified that the institution's risk be limited so that for each

interest rate change listed in column [a] the institution's NPV Ratio

would fall to no less than the level shown in column [b]. The limits

set by the board in this example are more demanding in falling interest

rate scenarios than in rising ones to reflect the board's expectation

that the institution should perform better in the former than in the

latter. Because each rate scenario has a different minimum allowable

NPV Ratio, this set of limits will likely require frequent review and

adjustment by the board. For example, if market interest rates have

risen since ABC's limits were established, and ABC's NPV Ratio has

fallen significantly, the NPV limits may well require adjustment.

In Exhibit 2, the board of XYZ Savings Association has indicated an

unwillingness to allow the institution's NPV Ratio to fall below 10

percent in any of the interest rate scenarios. While

[[Page 20260]]

such a set of limits will not require attention as frequently as those

in Exhibit 1, they should still be reviewed periodically, particularly

if market interest rates change substantially. In both exhibits,

management would be responsible for structuring the institution's

portfolio so that an immediate increase in interest rates of 300 basis

points would reduce the institution's NPV Ratio to no less than 10

percent.

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.

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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.

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Examiners will consider all pertinent facts in their analysis, but

will usually consider an institution's interest rate risk limits to be

imprudent if they permit the institution to exhibit a Post-shock NPV

Ratio and Interest Rate Sensitivity Measure that would warrant an ``S''

component rating of 3 or worse. (See Part IV.B.2, Prudent Limits, and

Appendix A, Identifying Prudent Interest Rate Risk Limits, for

discussion of this topic.) Imprudent NPV limits may result in examiner

criticism or an adverse ``S'' component rating.

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

The ability to identify, measure, and monitor interest rate risk

are key elements in risk management. To ensure compliance with its

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

institution must have a way of measuring its interest rate risk. OTS

guidelines for interest rate risk measurement systems are as follows,

though examiners have broad discretion to require more less 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 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 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 are 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 least,

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 to be

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

[[Page 20261]]

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

using an earnings sensitivity approach, one based on NPV sensitivity,

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 understand the various risks 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 the pre-purchase analysis, the term

``complex security'' includes any collateralized mortgage obligation

(``CMO''), real estate residential mortgage 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: (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., the rate

is 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.

\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 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 6 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

[[Page 20262]]

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\ At the time of this writing, it was anticipated that the

FASB's proposed standard, ``Accounting for Derivative and Similar

Financial Instruments and for Hedging Activities,'' would be issued

in 1998, to be effective in 1999. Under that proposal, all

``derivative financial instruments,'' as defined, including those

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

Accordingly, under the FASB's proposal, deferred gains and losses on

``derivative financial instruments'' from hedging activities would

no longer be recorded.

---------------------------------------------------------------------------

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 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 qualitative

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 have discretion to exercise judgment in a number of respects

(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

---------------------------------------------------------------------------

\10\ According to the interagency uniform ratings system, 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 risk and will be critically

undercapitalized.

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[[Page 20263]]

(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 if the institution

is not 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 8% 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 8% and 12% 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 12% 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.

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In Table 1 the numbers in parentheses represent the preliminary

``S'' component ratings that an institution would ordinarily receive

barring deficiencies in its 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'

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', the institution's

results will be used to replace the OTS results for

[[Page 20264]]

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

they 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, however, take the following eight factors, among

others, into consideration in assessing the quality of an institution's

risk management process.

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 include

many facets, as described in Appendix B, Sound Practices for Market

Risk Management.

2. Prudent Limits

Examiners will assess whether the institution's board-approved

interest rate risk limits are prudent. Ordinarily, examiners will

consider a set of IRR limits imprudent if they permit the institution's

NPV potentially to exhibit a Post-shock NPV Ratio and Interest Rate

Sensitivity Measure that would ordinarily warrant an ``S'' component

rating of 3 or worse (see Table 1, in Part IV.A.3). Imprudent limits

may result in examiner criticism or an adverse ``S'' rating. See

Appendix A, Identifying Prudent Interest Rate Risk Limits, for examples

of how examiners will make that determination.

3. Adherence to Limits

Assuming the institution's interest rate risk limits are considered

prudent, examiners will assess the degree to which the institution

adheres to those 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 sorts 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.

---------------------------------------------------------------------------

\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.

---------------------------------------------------------------------------

Methodologies used in measuring earnings sensitivity vary

considerably among different institutions. To assist the examiner 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.

[[Page 20265]]

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 its

``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]

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.12

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\12\ 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 further in the next

section, the ratings shown in Table 2 are provisional and subject to

examiner discretion.

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D. Examiner Judgment

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 may

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

[[Page 20266]]

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 boundaries

of the cells in the table must be interpreted as transition zones,

rather than 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.

In applying the guidelines in Table 1 generally, but especially in

such borderline cases, 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 resubmission. Examiners will document the corrective

strategy and results in the Regulatory Plan, and review progress at

case review meetings.

For institutions with composite ratings of 4 or 5, the presumption

of formal enforcement action generally requires a supervisory

agreement, cease 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: Identifying Prudent Interest Rate Risk Limits

The basic principle examiners will use in determining whether an

institution's risk limits are prudent is that the limits should not

permit NPV to reach such a level that 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).

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[[Page 20267]]

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Examples of Evaluating the Prudence of Interest Rate Risk Limits

The following examples illustrate how OTS examiners will evaluate

whether an institution's interest rate risk limits are prudent. 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.--Limits and Current NPV Ratios

------------------------------------------------------------------------

[b] Board

limits [c]

(minimum Institution's

[a] Rate shock (in basis points) NPV current NPV

ratios) ratios

(percent) (percent)

------------------------------------------------------------------------

+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 determine whether Institution A's interest rate risk limits are

prudent, 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' 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 ``4% to 8%'' row and its current

Sensitivity Measure falls into the ``100 to 200 b.p.'' column. The

rating suggested by Table 1 is, therefore, a 2, and Institution A's

risk limits would, thus, probably be considered prudent.13

---------------------------------------------------------------------------

\13\ This example assumes there are no significant deficiencies

in the institution's risk management practices.

---------------------------------------------------------------------------

Example Institution B

Institution B.--Limits and Current NPV Ratios

------------------------------------------------------------------------

[b] Board

limits [c]

(minimum Institution's

[a] Rate shock (in basis points) NPV current NPV

ratios) ratios

(percent) (percent)

------------------------------------------------------------------------

+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. 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 ``4% to 8%'' 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 4, and

Institution B's risk limits would probably not be considered 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

------------------------------------------------------------------------

[b] Board

limits [c]

(minimum Institution's

[a] Rate shock (in basis points) NPV current NPV

ratios) ratios

(percent) (percent)

------------------------------------------------------------------------

+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, but

its board limits are a uniform 6.00% in all rate scenarios. In judging

the prudence of its limits, the Post-shock NPV Ratio permitted by the

limits is, therefore, 6.00%. Its 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 the ``4% to 8%'' row and its Sensitivity

Measure in the ``Over 400 b.p.'' column of Table 1, so the rating

suggested by the table is a 4, just like Institution B. Thus,

Institution C's risk limits would also probably not be considered

prudent.

Example Institution D

Institution D.--Limits and Current NPV Ratios

------------------------------------------------------------------------

[b] board

limits [c]

(minimum Institution's

[a] Rate shock (in basis points) NPV current NPV

ratios) ratios

(percent) (percent)

------------------------------------------------------------------------

+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 a relatively low base case level of economic

capital, and its board limits recognize that fact by permitting

relatively 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 3.50%

minimums). While examiners would be very likely to express concern

about that aspect of the institution's risk management process, the

limits themselves might still be 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

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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 may

probably conclude that the risk limits are not 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 policies 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 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

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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 institutions

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 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

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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.

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.

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 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, and

Conduct an analysis of the incremental effect of any

proposed transaction on the overall interest rate sensitivity of the

institution.

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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

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

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].

Source: Uniform Financial Institutions Rating System, December

1996, pp. 12-13.

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-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

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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: (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., the rate is 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.

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 factors used to determine NPV may not be market

based.

NPV: The abbreviation for Net Portfolio Value which equals the

present value of expected net cash flows from existing assets minus the

present value of expected net cash flows from existing liabilities plus

the present value of net expected cash flows from existing off-balance

sheet contracts.

Post-shock NPV Ratio: Along with the Sensitivity Measure, one of

the two primary measures of interest rate risk used by OTS. The ratio

is determined by dividing an institution's NPV by the present value of

its assets, where both the numerator and denominator are measured after

a 200 basis point increase or decrease in market interest rates,

whichever produces the smaller ratio. A higher Post-shock Ratio

indicates a lower level of interest rate risk. Also sometimes referred

to as the ``Exposure Measure.''

Pre-shock NPV Ratio: Ratio determined by dividing an institution's

NPV by the present value of its assets, where both the numerator and

denominator are measured in the base case. The ratio is a measure of an

institution's economic capitalization. It is also referred to as the

``Base Case NPV Ratio.

Prompt Corrective Action: A system of enforcement actions,

established under the Federal Deposit Insurance Corporation Improvement

Act of 1991, that regulators are required to take against insured

institutions whose capital falls below certain critical thresholds.

``S'' Component Rating: see ``Sensitivity to Market Risk Component

Rating.''

Schedule CMR: A section of the Thrift Financial Report that is used

by OTS to collect financial data for the OTS NPV Model.

Sensitivity Measure: see ``Interest Rate Sensitivity Measure.''

``Sensitivity to Market Risk'' Component Rating: The component

rating in the CAMELS rating system designed to express 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. The rating is based on two components: an

institution's level of market risk and the quality of its practices for

managing market risk. The ``S'' component rating.

Shocked Rate Scenarios: see ``Alternate Interest Rate Scenarios.''

Uniform Financial Institutions Rating System: see ``CAMELS Rating

System'' and ``Composite Rating.''

Value-at-risk: A measure of market risk. An estimate of the maximum

potential loss in economic value over a given period of time for a

given probability level.

Dated: April 9, 1998.

By the Office of Thrift Supervision.

Ellen Seidman,

Director.

[FR Doc. 98-9882 Filed 4-22-98; 8:45 am]

BILLING CODE 6720-01-P