Reports are another important tool that banks use to manage their market risk. These reports are generated by models that banks run to assess their market risk. The information taken from these reports is a key input into decisions regarding how best to manage the bank’s potential risk exposure.

Most reports pertaining to a bank’s market risk tend to be summaries. Don’t be fooled by this—a tremendous amount of complexity may lie beneath the surface. A lot of assumptions about interest rates, bank strategies, customer behavior, competitor response and a host of other factors are made to generate the simple line graphs and charts that portray the bank’s earnings and capital exposure to interest rate changes. As a result, the validity of what you see in the summaries you review depends upon the soundness of the assumptions made and their correspondence to what actually occurs.

In light of the critical importance of assumptions, it is important that you know what they are. To help you with this, it is helpful to have the key assumptions used in the model accompany the reports you receive. As you look over these assumptions, pay close attention to the treatment of nonmaturity deposits (deposits with no set maturity date), such as demand accounts, savings accounts, NOW accounts and money market accounts. Because these accounts make up a majority of most banks’ liabilities, the assumed behavior of account holders to changes in interest rates can have a significant effect on the results you see.

Also, pay particular attention to the interest rate changes that are modeled. The federal banking agencies suggest modeling a once-and-for-all 200 basis point (2 percentage point) rise and fall in interest rates. This rate bump will help reveal options risk in the portfolio. The agencies also recommend modeling a gradual rise and fall in rates.

Besides considerations related to key assumptions, here are some additional matters to think about:

Report Frequency – depends upon the bank’s potential earnings and capital exposure. At least quarterly if exposure is low to moderate, more frequently if exposure is high (for instance, if the bank would become undercapitalized if forecasted results were to occur).

Limits – metrics chosen to track market risk exposure and the policy limits set for these metrics should appear on the report so that directors can compare where the bank stands with respect to limits.

Capital – exposures that would cause the bank to become undercapitalized should be flagged on reports.

Managed response – results of any actions taken to manage the bank’s market risk exposure should be highlighted to help directors judge their effectiveness in minimizing the exposure.

How are these report considerations reflected in your bank? Consider the Try This at Your Bank: Market Risk Reports exercise.

Management Response

Once the extent of the bank’s exposure to market risk is known, the board must ask whether it wants to do anything about the exposure, and, if so, what action it should take. The bank’s current position may place it well within limits set by the board, so that no action needs to be taken. On the other hand, the bank may be within prescribed limits, but adverse trends in the bank’s market risk sensitivity might lead the board to take steps to reverse these trends. If the bank’s current position exceeds established limits or models forecast that limits will be breached, action may be required.

If something is to be done, what actions should be taken? Should the bank change the mix of assets and liabilities to achieve an acceptable level of risk exposure? Should the bank use derivatives such as options, futures or swaps to reduce its risk? A derivative is a financial instrument whose characteristics and value depend upon the characteristics of an underlier, typically a commodity, bond, equity or currency. Advanced investors sometimes purchase or sell derivatives to manage the risk associated with the underlying security, to protect against fluctuations in value or to profit from periods of inactivity or decline. These techniques can be quite complicated and risky. Read more about Basic Investment Concepts for Banks.

In some instances, there may be factors that limit the actions a bank can take to manage its risk exposure. For example, a bank might:

• Be unable to take certain actions because it doesn’t have ready access to financial markets.
• Not have sufficient time to implement an action.
• Not have the expertise to utilize an action.
• Find an action too costly to use.
• Find that an action would have an adverse impact on its other risk exposures.

How does management respond to market risk at your bank? Review the Try This at Your Bank exercise: Market Risk Reports.