Sensitivity to Market Risk

Bank Analysis and Examination School

Sensitivity to Market Risk Objectives

Background Review Four kinds of interest rate risk Short-term and long-term views Risk measurement models Regulatory guidance

Assign the “S” rating

Market Risk Background

SR 93-69: “Risk Management and Internal Controls of Trading Activities”

SR 95-17: “Risk Management and Internal

Controls of Non Trading Activities” SR 95-51: “Rating Risk Management

Processes and Internal Controls”

Market Risk Background

SR 96-38 “Uniform Financial Institutions Rating System”

“Sensitivity to Market Risk” rating Rating Based On: Level of exposure to market risk Quality of risk management Nature and complexity of activities

SR 97-4 “...Common Questions...”

Sensitivity to Market Risk

Principal form of market risk affecting banks is Interest Rate Risk

The possibility that changes in interest rates will adversely affect the banking organization.

Four Kinds of Interest Rate Risk

Interest rate risk is the principal form of market risk for banks. Four sources include:

Mismatch risk Basis risk Options risk Yield curve risk

Interest Rate Risk: Two Views

Short-term: Effect on net interest income. Earnings-at-Risk Gap analysis Net interest income simulation

Long-term: Effect on the net present value of future earnings.

Economic Value of Equity-at-Risk Duration of equity analysis Present value scenario analysis

GAP ANALYSIS

Gap Analysis

Rate-sensitive assets (RSA) and liabilities (RSL) are slotted according to repricing date. RSL are subtracted from RSA to yield

the “gap”. The gap number can be either positive

or negative.

Estimate Earnings-at-Risk Using Gap Analysis

EAR = (Rate change) x (Cumulative gap) = (1%) x ($4,250 MM) = $42.5 MM

Gap Analysis

Assumptions: Time bucket selection Slotting assets and liabilities Slotting non-maturity items Static balance sheet Parallel changes in the yield curve

Gap Analysis

Weaknesses: Short-term focus Does not capture basis, option, or yield

curve risk Inappropriate for complex balance

sheets

NET INTEREST INCOME SIMULATION

Net Interest Income Simulation

Models calculate expected income using: Various rate scenarios Projected balances for assets and liabilities Other assumptions

Rate changes should be large enough to reveal sources of risk Complexity of the model can vary

Net Interest Income Simulation

Advantages: Projects net interest income Addresses assumptions Can capture mismatch, basis, and

option risk Can be used for strategic planning and

“what if?” scenarios

Net Interest Income Simulation

Weaknesses: Short-term focus (12 - 24 months) Only captures option risk when options

are “in the money” Difficult to project far into the future Results can be shaded by management Apparent precision can be misleading

ECONOMIC VALUE-AT-RISK

MODELS

Economic Value-at-Risk Models

Duration of Equity Analysis and Present Value Scenario Analysis measure the economic-value-of-equity at risk to changes in rates.

Duration of Equity Analysis

The weighted average duration of assets, less the weighted average duration of liabilities, plus the net weighted average duration of off-balance sheet items, divided by equity. DE = DA(A) - DL(L) + DOBS (E)

Duration of Equity Analysis

Duration of equity calculation can be used as a forecast of the sensitivity of the economic value of equity to a change in rates in the same way as the duration of a bond can be used to predict its price.

Change in EVE = (-DE) x (% Change in Rates)

Duration of Equity Analysis

Weaknesses: Only accurate for small rate changes. Duration of different instruments will

change at different rates over time. Does not capture basis or option risk.

Present Value Scenario

Analysis

Like the duration of equity model except: Calculates current net present value of each asset,

liability, and off-balance sheet item Then recalculates the net present value of each

instrument for a given rate scenario Finally, the net present value of equity is calculated:

PVE = PVA - PVL + PVOBS

Present Value Scenario

Analysis

Advantages: Long-term measure of interest rate risk Captures mismatch, basis, yield curve,

and option risk Accurate even for larger rate change

scenarios (200 b.p.)

Risk Measurement Models Review

QUESTIONS? Models?

Assumptions?

Assigning the “S” Rating

Component reflects: Level of exposure to market risk Quality of market risk management Nature and complexity of activities

Evaluated in relation to the adequacy of

the institution’s capital and earnings

Level of Exposure Assigning the “S” Rating

Cumulative Gap As % of total assets or capital

Earnings at Risk % change for given shift in interest rates

Economic Value of Equity at Risk Change (as % of assets) for given shift in

interest rates

Quality of Risk Management Assigning the “S” Rating

Management’s ability to identify, measure, monitor, and control market risk Board oversight Policies and procedures MIS: assumptions, adequacy Internal controls and audit Credit, liquidity, operational,

legal, and reputational risk

Nature & Complexity of Activities Assigning the “S” Rating

Nontrading activities Hedging Trading activities

Nontrading Activities Assigning the “S” Rating

Factors to Consider: Long-term fixed rate assets Complex investments Options Funding sources Nonmaturity deposits Mortgage banking and servicing assets

Hedging Activities Assigning the “S” Rating

Instruments to Consider: Forward based contracts Option contracts Option-based agreements Short sales

Trading Activities Assigning the “S” Rating

Factors to Consider: Types of trading Market risk exposure Market risk limits

“S” Rating Write-up Guidelines

Conclusion with support and a rating Quantity of risk Quality of oversight, MIS, and controls Recommendations

QUESTIONS?