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From Banking and Finance Law Daily, October 8, 2013

FDIC repeats warnings on interest rate increase risks

By Richard A. Roth, J.D.

The Federal Deposit Insurance Corporation is concerned over the effect that rising interest rates could have on bank earnings and capital and, as a result, has warned the state nonmember banks it supervises of the need for adequate risk management. The agency is particularly concerned over the use of hedges and derivatives to manage risks as these strategies, if misused, could make the problem worse (FIL-46-2013).

The agency notes that many institutions have significantly liability-sensitive balance sheets. In such a case, an interest rate increase could reduce net interest income and earnings. Rising interest rates also threaten a material securities depreciation in relation to capital, the FDIC says. An institution with a liability-sensitive position could be in danger of not just a decline in interest income but also the loss of deposits when rates begin to rise.

Moreover, institutions with concentrated holdings in long-duration bonds could suffer depreciation “of a magnitude that could be material relative to the capital position,” the FDIC warns. Institutions that rely too much on long-duration fixed income investments for liquidity could have trouble meeting short-term cash requirements.

Risk management processes. The FDIC’s Financial Institution Letter outlines four practices that a bank’s risk management process is expected to have, beginning with oversight by the bank’s board of directors and management. The board needs to set appropriate policies and understand both the bank’s risk from interest rate changes and the potential effects on the bank’s earnings and capital.

Second, a bank’s asset-liability management and investment policies must be revised at least once each year.

Third, each bank should have risk-management tools that consider multiple types of data, not just a single measurement of risk. The effect that interest rate changes of between 300 and 400 basis points could have on earnings and capital should be considered, and banks with longer-duration securities portfolios should give special consideration to the effect that rising rates could have.

Fourth, institutions can use a number of strategies to manage risk, including rebalancing the durations of assets and liabilities, managing non-maturity deposits, and increasing capital. Hedging is a potential strategy as well, but a bank should not use hedging strategies unless it has the appropriate knowledge and expertise. Using interest rate derivatives “can have unintended consequences, including amplified losses, if used incorrectly,” the agency warns. Both the bank’s board and management need to understand the risks fully.

Banks should continue to follow the 2010 Advisory on Interest Rate Risk Management, the FDIC adds. While the Advisory was issued at a time when interest rates were heading toward historic lows, it was intended to remind financial institutions that the low rates would not continue indefinitely. The fundamental risk management processes the Advisory described to address rising rates remain relevant, according to the agency.

RegulatoryActivity: BankingOperations FinancialStability

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