On December 1, 1998, the Office of Thrift Supervision issued updated guidelines to enable thrifts to protect their financial condition from movements in interest rates. Thrift Bulletin 13a supersedes previous interest rate risk regulations and requires thrifts to limit and monitor interest rate risk in accordance with OTS-supplied formulas. This article highlights some of the changes in thrift interest rate risk monitoring and management practices in light of TB13a.
Previously, Thrift Bulletin 13 governed thrift interest rate risk monitoring and management practices. Under TB13, a thrift had four main interest rate risk related responsibilities. Its board was required to (1) adopt a formal interest rate risk policy statement defining the maximum potential reduction in earnings and net worth acceptable as a result of possible changes in market interest rates, (2) integrate that policy in business planning by providing specific authorizations and restrictions regarding the thrift's trading activities, (3) conduct an interest rate risk sensitivity analysis before investing in mortgage-backed securities that demonstrates the effect of the MBS on the thrift's net interest earnings and portfolio equity and (4) review the results of management's implementation of the policy on a quarterly basis. Management noncompliance with board policy or unacceptably high interest rate risk limits could result in OTS supervision or other enforcement measures.
TB13a expands on TB13's guidelines and adds important new features to interest rate risk management and monitoring practices. Under TB13a, thrifts must:
- establish limits on changes in net portfolio value and earnings sensitivity as a result of interest rate movements (net portfolio value, or NPV, is the net present value of an institution's existing assets, liabilities and off-balance sheet contracts);
- undertake an interest rate risk sensitivity analysis before investing in MBS or other securities; and
- adopt and institute interest rate risk limits and management practices in accordance with the CAMELS rating system approach (the CAMELS ratings system provides an indication of a thrift's overall condition based on six factors: (1) Capital adequacy, (2) Asset quality, (3) Management, (4) Earnings, (5) Liquidity and (6) Sensitivity to market risk).
Limits on Change in NPV and Earnings Sensitivity
Thrift boards of directors must now define interest rate risk exposure limits in terms of NPV and specify the minimum NPV ratio the board is willing to allow under current interest rates and for an adverse change of plus/minus 100, 200 and 300 basis points. The NPV ratio for a given interest rate scenario is calculated by dividing the NPV that would result in that scenario by the present value of the institution's assets in that same scenario. Use of NPV ratios may significantly ease the board's administrative compliance burden. Under TB13's requirement that boards set limits in terms of permissible percentage declines in earnings, the board had to revise its limits after each movement in interest rates in order to adjust and re-calculate earnings and net worth in light of the new interest rates. Without this adjustment, the cumulative effect of each adverse interest rate movement would cause the thrift to exceed its limits.
Under TB13a, the board can avoid revising limits after each movement in rates by establishing a single minimum NPV ratio that applies to all interest rate scenarios. In such a case, the cumulative effect of interest rate movements becomes irrelevant so long as the established NPV ratio is not exceeded. Thrifts are also urged to estimate the interest rate sensitivity of their earnings via earnings simulations that use current interest rates and adverse interest rate scenarios, compare the results to actual earnings on a quarterly basis and incorporate this analysis into their business plans and budgeting processes. Noncompliance with board-approved limits or failure to estimate earnings sensitivity can result in supervisory action, including a downgrading of the CAMELS rating.
Sensitivity Analysis for MBS and Other Securities Transactions
TB13a urges thrifts to conduct a pre-transaction price sensitivity analysis of any MBS investment or other transaction that might be expected to increase a thrift's interest rate sensitivity measure by more than 25 basis points. This analysis is expected to show the change in the value of the investment that would result under various interest rate and prepayment scenarios, including changes in interest rates from current levels to plus/minus 100, 200 and 300 basis points and adverse changes in prepayment rates (e.g., 50% faster than those anticipated). MBS with high price sensitivity (a 10% or greater decline in price in the face of a parallel change in interest rates of 200 basis points) should be limited to transactions that lower a thrift's interest rate risk as measured by the sensitivity of NPV to changes in interest rates. In order to invest in such securities for purposes other than reducing portfolio risk, the board must authorize any such transaction in writing and ensure that the institution's post-shock NPV ratio would not be less than 4%. This 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 rates, whichever produces a smaller ratio.
CAMELS Rating Systems Approach
Finally, TB13a gives guidance to thrifts on how to adopt and institute interest rate risk limits and management practices consistent with the CAMELS rating system approach. Thrifts are now aware that two specific measures will receive examiners' attention -- the interest rate sensitivity measure and the post-shock NPV ratio. Moreover, TB13a includes tables with the formulas examiners will use to assess any given post-shock NPV ratio and interest rate sensitivity measure. Thrifts are advised that, while there is no single formula to determine the adequacy of management practices, examiners will take into consideration factors relating to (1) board and senior management oversight, (2) prudence of and adherence to interest rate risk limits, (3) quality of systems for measuring NPV and earnings sensitivity, (4) integration of risk management with decision-making, (5) investment and derivative policies and due diligence and (6) size, complexity and risk profile. The interest rate risk limits and quality of risk management ratings are combined and each thrift is assigned a composite rating. Achieving a favorable composite CAMELS rating is critical because an unsatisfactory rating may trigger supervisory or other disciplinary action.
Thanks to TB13a, the interest rate risk regulatory climate has become much more transparent and manageable. Thrifts are now subjected to more rigorous and detailed scrutiny than before. This step in thrift regulation makes sense -- especially in light of the recent market volatility and globalization of the world economy. Thrifts covered by these guidelines should consult counsel and accounting professionals to determine the effect of these guidelines on their business activities.