# Financial Management Policies

> Briefs, arguments, decisions, and more.

URL: https://www.frixlaw.com/law-library/documents/fr%3A98-9882

## Record

- **Collection:** Federal Register
- **Document type:** Notice
- **Published:** April 23, 1998
- **Citation:** 63 FR 20257

## Text

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

\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.

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

[[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.
BILLING CODE 6720-01-P
[GRAPHIC] [TIFF OMITTED] TN23AP98.001

BILLING CODE 6720-01-C
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
---------------------------------------------------------------------------

\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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BILLING CODE 6720-01-C

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]]

BILLING CODE 6720-01-C

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

[[Page 20268]]

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

[[Page 20269]]

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

[[Page 20270]]

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.

[[Page 20271]]

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

[[Page 20272]]

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

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Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3A98-9882. Public record. Not legal advice.