|6. Asset & Liability Committee|
|What you need to know||Join the meeting||Review the Reports||The board´s response|
|Monitoring Liquidity and
|Monitoring Bank Liquidity||Financial Modeling||Gap Analysis||Earnings at Risk (EAR) Models||Practice|
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:
Once you have reviewed the Gap and EAR lessons, complete the Try This at Your Bank exercise: Market Risk.
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.
After you complete this lesson, you should be able to:
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.
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.
Ask yourself whether a few key assumptions are driving the model results. For instance:
Because of their importance, have assumptions written out for you.
Problems can come from the models themselves, but they can also arise when models are used incorrectly.
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