Embedded Options and Long-Term Interest Rate Risk: Interest Rate Risk

As of January 12, 2012, this guidance applies to federal savings associations in addition to national banks.*

Purpose

This bulletin alerts banks to the importance of measuring the cash flow and valuation risks for assets and liabilities with embedded options.¹ It emphasizes the steps banks should take in order to effectively manage interest rate risk, and repeats the caution provided in OCC Bulletin 2002-19 regarding the assumption of unwarranted levels of risk in the investment portfolio. The guidance in this bulletin is supplemental to the detailed supervisory expectations included in the "Interest Rate Risk" booklet of the Comptroller's Handbook.

The Office of the Comptroller of the Currency (OCC) is concerned that some national banks have not adequately identified, measured, and controlled the potential exposure to earnings and capital that may arise from a scenario of rising interest rates. Continued signs of strength in the U. S. economy raise the possibility of higher interest rates. Banks that have invested a significant portion of their earning assets in products with embedded options at the generational low for yields on fixed income assets may now be highly vulnerable to rising rates.

The OCC is concerned about the impact on earnings and economic equity for both rising and falling interest rates. However, given ongoing pressure on net interest margins and continued concerns about yield chasing in the investment portfolio, the OCC is particularly concerned about a repeat of the structural problems that faced a number of institutions during the last period of materially rising interest rates. Bank management and boards of directors should remember the lessons learned in 1994. Although many interest rate risk models incorporate scenarios with interest rate changes of 300 basis points or more, bank management too often focuses exclusively on scenarios deemed to be "most likely." Low probability events do occur and can have significant impact on asset values and projected net interest margins. Assets with long maturities, and assets expected to have short maturities but whose maturities are designed to extend significantly as rates rise, can deteriorate rapidly in value. Finally, the investor community looks at depreciation in fixed income portfolios when evaluating the financial health of a banking company. It is critical that bank managers fully understand their institution's interest rate risk exposures and ensure that their risk management framework incorporates the controls and tools necessary to conduct asset/liability management activities in a safe and sound manner.

Background

Identifying and measuring interest rate risk exposures can be challenging due to the complexities of bank balance sheets and the processes used to measure risk. Banks incur interest rate risk as a natural consequence of managing the assets and liabilities that result not only from customer preferences but also management's own asset/liability management decisions. The OCC has a long-standing expectation that national banks with significant amounts of assets or liabilities with embedded options should have a robust interest rate risk measurement process that includes, among other things, an economic value of equity² (EVE) model and appropriate systems for stress testing. It is not inherently unsafe or unsound for banks to have balance sheets with exposures to the risks of embedded options. It is unsafe and unsound, however, to materially increase positions in instruments with embedded options and/or higher sensitivity to interest rate changes without an adequate understanding of the existing vulnerability to rate changes and a meaningful process that identifies, measures, and controls such risks.

Faced with weak loan demand and the prospect of declining net interest margins, many banks have increased the size of their investment portfolio to absorb excess liquidity and to improve yields. In particular, many banks have increased their holdings of mortgage-backed and callable securities. The volume of mortgage-related assets in the banking system has increased from 10 percent of total assets in 1987 to 27 percent of total assets as of year-end 2003. Earnings pressures have also enticed bank management at some institutions to pursue aggressive investment strategies by using borrowed funds to finance its portfolio holdings (leverage programs). These leverage programs often result in an asset and liability management position in which the bank has sold options on both sides of the balance sheet. For example, these strategies typically involve the bank purchasing callable/prepayable securities, funded by liabilities that allow the funds provider to increase the rate as interest rates increase. The asymmetrical behavior of the options can leave the bank's net interest margin exposed to both rising and falling interest rates.

The sustained low interest rate environment has caused assets with embedded options to prepay rapidly. With prepayments at very high levels, and (until recently) expectations for a sustained period of low interest rates, many bankers have not adequately considered the long contractual lives of assets acquired with cash flows from prepayments, since they believed that the assets were simply serving as a temporary bridge until loan demand improved or the interest rate environment changed.

Since the increase in longer-term interest rates that began in the second half of 2003, some bank portfolios are now experiencing declining portfolio cash flows and an extension in the portfolio's average life. A security that an investment manager may have thought had a two-year maturity when purchased might now have a much longer maturity because rates have risen; the longer maturity results in heightened price sensitivity. This is the "negative convexity" effect of securities with embedded options. This extension risk can be especially problematic for structured securities such as CMOs and callable bonds. The OCC is particularly concerned that national banks may overlook the impact of interest rate increases on the economic value of their equity, given that for many banks the initial impact on earnings from a rise in short-term interest rates could be positive. Deterioration in the value of a bank's economic equity over time can have sharply negative consequences for earnings and capital adequacy. It is important that national banks with significant volumes of assets and liabilities with embedded options measure their interest rate risk from both short-term earnings, as well as a long-term economic value perspective.

Risk Management Considerations

Bank management should carefully consider the trade-off between actions taken to retain or improve net interest margin, and the long-term risks of building a significant position of assets or liabilities with embedded options. Banks should review their potential exposure to rising interest rates and implement risk control measures, as appropriate. Banks that wait to take action until rates rise further may find evaluating and implementing risk control measures, such as selling assets and/or implementing derivatives hedges, difficult and expensive, since many similarly positioned investors may be attempting to do the same. It is unsafe and unsound to expose the earnings and capital of a national bank to heightened levels of interest rate risk without demonstrating a thorough understanding of the risk and an ability to prudently manage the risk with an effective risk control process.

National banks should take a number of steps to ensure that they have properly identified, measured, and controlled interest rate risks. The following steps are important risk management actions that bank management should consider to ensure a disciplined approach to assuming interest rate risk.

• Risk Identification
  • Evaluate bank assets and liabilities to ensure that management has identified all assets and liabilities with embedded options. The balance sheet accounts most likely to hold significant amounts of embedded options include, but are not limited to, mortgage loans, mortgage-related securities, callable securities, structured notes, deposit liabilities, and Federal Home Loan Bank convertible advances. The source of much of the current compression in net interest margin is the increasing presence of options sold on both sides of the balance sheet. Options embedded in assets cause prepayments as rates decline, leading to reinvestment at lower yields (reinvestment risk). In a rising rate environment, these same options extend cash flows, depriving institutions of an opportunity to secure more attractive returns. Options embedded in liabilities (a phenomenon the OCC has noted with increasing frequency) result in high-cost funding when rates are falling but also result in higher funding costs when rates rise because the option to reprice is held by the funds provider. National banks should evaluate their exposure to embedded options and apply limits consistent with the board's risk tolerance.
  • Identify assets with structural weaknesses. Because assets with structurally complex cash flow profiles pose special risks, management should conduct a detailed analysis of their potential performance under various rate scenarios. The cash flows of certain classes of CMOs, for example, may remain relatively stable within a specified range of prepayment speeds, but extend significantly when rates rise. As interest rates rise, these products will likely experience increased price sensitivity and diminished liquidity. Banks should identify any material positions in these products and carefully assess the long-term implications of such holdings, and consider risk mitigation strategies if risk exceeds approved risk tolerances.
• Risk Measurement
  • Verify that the tools used to measure interest rate risk are appropriate. Banks with material amounts of embedded options should supplement their net income simulation modeling efforts with a long-term measure such as economic value of equity (EVE). An EVE model is particularly valuable for assessing the longer-term implications of decisions involving embedded options, as income simulation models alone may not adequately capture interest rate risk over the full term of existing exposures.
  • Obtain and review current investment portfolio valuations and conduct portfolio sensitivity analyses³ to estimate the potential exposure to interest rate changes, especially scenarios of nonparallel changes in the yield curve. Banks should ensure that portfolio sensitivity is consistent with the policy limits outlined in bank policy.
  • Review key modeling assumptions, e.g., pricing, deposit sensitivity, prepayment assumptions, and reinvestment assumptions to ensure that these assumptions are relevant for a scenario of rising rates.
• Risk Control
  • Understand the risk to earnings and capital from a rising rate environment, and consider risk mitigation strategies, as appropriate. Bank managers should ensure that they understand their institution's exposure to rising interest rates under both parallel⁴ and selected nonparallel⁵ yield curve changes. Most bankers assess the impact of parallel interest rate changes. However, it is important to model nonparallel changes as well, because rates rarely change in a parallel fashion. Potential exposure to rising interest rates should be consistent with approved risk limits. Well-understood risk limits are an important control tool that should accurately reflect the board's risk tolerance.
  • Compare the original expected investment horizon for assets with embedded options to the likely investment horizon if interest rates rise. If a bank originally acquired material positions in securities with embedded options as a temporary holding, any changes to the investment horizon should be discussed formally with the asset liability management committee (ALCO) or the board of directors. Given the range of interest rates over the past 25 years, interest rates could rise significantly from current levels and yet remain low by historical standards. Bank management's decision to adopt a longer-term investment horizon should occur only after a complete evaluation of the risks involved, e.g., the potential for significant asset depreciation, much smaller portfolio cash flows, and deterioration in the net interest margin due to carrying a large volume of earning assets acquired at very low yields.
  • Obtain board approval for any material investment acquisitions that layer on additional interest rate risk as higher available yields might tempt incremental investments in this environment of compressed net interest margins. A higher risk strategy is only appropriate for national banks with well-controlled asset/liability management programs, and capital to support the bank's total risk profile. The OCC is concerned that some national banks may accelerate their investments in long-term securities without a full understanding of their existing risk profile. Incremental trades to increase net interest margin in the steep yield curve environment, particularly if done with long-term securities, may inappropriately exacerbate long-term risk exposure. Without appropriate consideration of the bank's overall asset/liability management position, and an assessment of a bank's capacity to assume incremental risk, such investment practices may represent inappropriate yield chasing and an unsafe and unsound banking practice.

The larger the institution, the more likely it is that day-to-day interest-rate risk management is separated from executive management. However, executive management remains responsible for setting the bank's business strategy and monitoring the implementation of that strategy. To accomplish this, a risk reporting system that effectively conveys the magnitude and sources of the institution's risk must be in place. Executive management should review key risk reports, e.g., earnings and economic value of equity at risk, at least quarterly.

Accounting Considerations

National banks should consider the accounting requirements for evaluating and recognizing "other-than-temporary" impairment in securities, including recently issued guidance provided by the Financial Accounting Standards Board (FASB) in Emerging Issues Task Force Issue No. 03-01. This guidance is effective for reporting periods beginning after June 15, 2004. (Disclosure requirements for investment securities in an unrealized loss position were effective for annual financial statements issued after December 15, 2003.) Specifically, management is reminded that "other-than-temporary" impairment can result from changes in interest rates as well as downgrades in credit ratings.

National banks contemplating the transfer of securities from available-for-sale to held-to-maturity should obtain prior approval from the board of directors. Some institutions have considered such transfers in an effort to lower the visibility of deteriorating portfolio values from equity accounts in published financial statements. Given the significant loss of management flexibility associated with such a transfer, banks should not make such transfers without board approval. National banks are reminded that the OCC will consider depreciation in the securities portfolio when evaluating capital adequacy.

Supervisory Review of Interest Rate Risk

In light of the highly uncertain interest rate environment, OCC examiners will evaluate how national banks have identified, measured, and controlled interest rate risk. Examiners will assess the appropriateness of the tools used to manage risk, the assumptions (and any changes) used in the interest rate risk measurement process, and banks' strategic responses to changes in the interest rate environment. Examinations of asset/liability management activities will assess how well and how accurately national banks have reported exposures to their boards of directors, changes to investment horizons for assets with embedded options, management's ability to operate within the board's risk tolerance, and whether policies adequately control risks. Examiners will also consider depreciation in investment portfolios in their assessment of capital adequacy.

Responsible Office

Questions or concerns regarding this guidance should be directed to Credit and Market Risk Division at (202) 649-6360.

Michael C. Drennan
Director, Treasury and Market Risk Division

*References in this guidance to national banks or banks generally should be read to include federal savings associations (FSA).  If statutes, regulations, or other OCC guidance is referenced herein, please consult those sources to determine applicability to FSAs.  If you have questions about how to apply this guidance, please contact your OCC supervisory office.