In their 1996 policy statement, the federal banking agencies stated that the board of directors is responsible for interest rate risk management. To carry out this responsibility, the board of directors is to:

Establish and guide the bank’s tolerance for interest rate risk, including approving risk limits and other key policies, identifying lines of authority and responsibility for managing interest rate risk, and ensuring adequate resources are devoted to interest rate risk management….Monitor the bank’s overall risk profile and ensure that the level of interest rate risk is maintained at prudent levels.” May 23, 1996 , Joint Policy Statement on Interest Rate Risk

However, assessing a bank’s market risk can be complicated and requires having a basic understanding of the tools banks often use to judge their exposure. This section of the course provides an introduction to some of the more common tools used by banks to monitor their sensitivity to market risk.

Use the following text links to navigate through the lesson material:

Overview
Economic Value of Equity (EVE) Models
Some Best Practices Regarding Models

Once you have reviewed the Gap and EAR lessons, complete the Try This at Your Bank exercise: Market Risk.

Overview
This section of the course is devoted to the board’s monitoring responsibility and the tools banks use to judge their interest rate risk to ensure that this risk stays within established limits.

Banks generally use financial models to monitor their interest rate risk exposure, that is, to monitor a bank’s net interest income or earnings that are vulnerable to interest rate changes. These models are, in essence, a series of financial calculations that can be used to assess income and capital at risk. Because banks can face losses on both capital and earnings, the federal banking agencies recommend that banks measure their exposure to each.

There are numerous modeling approaches to judging a bank’s earnings and capital exposure to changing interest rates. The focus here is on three of the most popular of these approaches: Gap analysis, Earnings At Risk (EAR) models and Economic Value of Equity (EVE) models. Gap and EAR are used to assess earnings exposure to interest rate movements. EVE is used to assess capital risk and is covered briefly in this lesson. Gap and EAR each have their own dedicated lessons.

The bank may develop and run its own models or it may provide input to a vendor who, in turn, runs the models and provides the bank with summary reports of the results. Because different models tend to use much of the same information, summary reports often include results from several different models, leaving it to the bank to decide which model and results to use for its purposes.

The material in this course provides a general overview of these models. It is intended only as an introduction to the models, including what they attempt to measure, how they attempt to measure it and some matters to consider when looking at model results.

Lesson Objectives

After you complete this lesson, you should be able to:

• State a director’s responsibilities in overseeing a bank’s market risk exposure.
• State the short- and long-run impact of interest rates on a bank’s financial position.
• List three basic models banks used to assess market risk exposure and apply these models to judge a bank’s exposure to interest rate changes.

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Economic Value of Equity (EVE) Models

Economic Value of Equity (EVE) models compute the bank’s exposure to interest rate risk under a variety of alternate scenarios. However, EVE looks at the changes in capital, rather than in earnings, that can result from such exposures. Remember that the market prices of a bank's assets and liabilities can change immediately in response to changes in interest rates. The amounts by which a certain asset's or liability's value changes depends on its specific terms: its maturity, payment schedule, and so on. The total change in the value of a bank's assets, net of the change in the value of its liabilities, determines the impact on the economic value of capital.

In these models, an attempt is made to find the market value of the bank’s individual assets and liabilities under assumed interest rate changes. Because there is little market data on many bank assets and liabilities, market value is estimated by computing the present value of the expected cash flows for the various balance sheet components. You don’t have to be an expert on calculating present values. However, you need to know that key components in determining the value of an asset or liability are the payment amount, payment frequency, loan term, principal amount and interest rate. From this information, the present value of a bank’s assets and liabilities—and, hence, its capital—is determined, and a summary report is generated. EVE methodologies are able to capture all four sources of interest rate risk.

Like the summary report done for other types of interest rate models, the bank’s capital exposure under a base-case, a most likely case and various up and down interest rate scenarios might be presented. Because there are many types of analyses you may encounter, it behooves you to ask for details on what specifically is being reported to you.

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Some Best Practices Regarding Models

Here are a few best practices pertaining specifically to models and monitoring your bank’s interest rate risk exposure:

Model results depend heavily on assumptions.
You can get almost any result you want by changing the assumptions on which a model is built. One study showed that nine different firms using the same simulation model on a hypothetical portfolio got nine different answers. Therefore, it is important to be aware of the assumptions that were used to generate the results and that you make some judgment about their plausibility.

Ask yourself whether a few key assumptions are driving the model results. For instance:

• What interest rate assumptions have been made and what maturity assumptions have been used for deposit accounts without specified maturities?
• What assumptions were made with respect to the optionality in the bank’s assets and liabilities? What business strategies were incorporated into the analysis?
• What assumptions were made regarding customer behavior as interest rates change?
• Have assumptions changed since the last time you saw model results? If so, why?

Because of their importance, have assumptions written out for you.

Be familiar with how your bank’s models work and don’t be intimidated to ask questions about forecasts and assumptions.
The banking agencies emphasize that the systems and processes used by a bank should be “appropriate to the nature and complexity of its operations.” A general understanding of what your models do and don’t do will help you assess their adequacy in meeting the bank’s needs.

Have checks in place to ensure there are no data-entry errors .
One person should enter the data and another person should review what was entered. Another check, if the model provides sufficient reports (and it should), is to reconcile the model information with the bank’s financial statements. This helps ensure that the model result reflects the bank’s risk position and not data-entry errors.

If your bank does not use a vendor, get training for employees who enter data and run the models.
Make sure these employees understand the inputting process. There may be instances in which the data generated by your bank’s management information systems are not in the right format for your model. In this case, some judgments must be made in order to correctly input the data. Also, consider designating someone to answer questions about data entry. Have them document what they’ve done to ensure consistent treatment of input issues over time.

Compare predicted with actual results, a practice called “back testing.”
Where model results don’t closely match your bank’s actual experience, adjustments may have to be made. Problems with models can come from different sources.

• Were the assumptions used in the model wrong?
• Was the model simply inadequate to capture the bank’s market risk exposure?
• Or, more fundamentally, did management take planned actions to reduce market risk exposure? Were these actions taken in a timely manner?

Problems can come from the models themselves, but they can also arise when models are used incorrectly.

Periodically subject the bank’s entire market risk monitoring process to an internal or external audit to determine its adequacy and whether improvements are needed.