CAMELS Ratings: Sensitivity to Market Risk

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This post is part of a series titled “Supervising Our Nation’s Financial Institutions.” The series, written by Julie Stackhouse, executive vice president and officer-in-charge of supervision at the St. Louis Federal Reserve, appears at least once each month.

Last month, we addressed the examiner's process for reviewing and rating bank liquidity. This month, we examine the sixth and final component of the safety and soundness rating system for banks (called CAMELS): sensitivity to market risk. The first component that we addressed was capital adequacy, followed by asset quality, management, earnings and liquidity. See Stackhouse, Julie. “The ABCs of CAMELS.” St. Louis Fed On the Economy, July 24, 2018.

Sensitivity to market risk is defined by regulators as the degree to which changes in interest rates, foreign exchange rates, commodity prices or equity prices can adversely affect a bank’s earnings and, in turn, its financial health. For many  banks—and especially community banks—interest rate risk is the predominant market risk they face.

Common Interest Rate Risk Challenges

In general, banks must manage four types of interest rate risk: Gray, Doug. “Interest Rate Risk Management at Community Banks.” Community Banking Connections, Third Quarter 2012.

• Repricing risk: The risk that assets and liabilities will reprice or mature at different times.
• Basis risk: The risk that changes in the rates used to price assets and liabilities do not change in a corresponding manner. For example, the interest rate on a loan tied to the national prime rate might not change in the same manner as the rate on a certificate of deposit tied to a U.S. Treasury rate.
• Prepayment or extension risk: Prepayment risk is the risk that asset repayments pick up at a time when interest rates are low, resulting in both reduced interest income and the reinvestment of repaid funds in lower-yielding assets. The inverse of prepayment risk is extension risk. In this situation, asset repayments slow, reducing the funds available to invest at higher yields.
• Yield curve risk: The risk that uneven changes in short- and long-term interest rates will disproportionately affect asset values or cash flows. A yield curve is a line on a graph that plots interest rates of similar financial instruments at differing maturity dates.

If a bank fails to manage these risks adequately, its earnings, capital and liquidity can be damaged.

What Are Regulatory Expectations?

During their review, examiners determine the level of sensitivity to market risk posed by the bank’s assets and liabilities and assess its potential impact on capital and earnings. This assessment includes both quantitative and qualitative components, including:

• The composition of assets and liabilities on the bank’s balance sheet
• Policies and limitations set by the board of directors that establish risk tolerance
• Risk measurement systems and reporting
• The level of protection provided by earnings and capital
• Audit and/or independent review of the bank’s market risk management procedures
• Recent or planned changes in the bank’s strategic direction

As with other components in the CAMELS rating system, sensitivity to market risk is assigned a rating of 1 to 5. Organizations with ratings of 3, 4 or 5 will be expected to take action to strengthen their management of market risk.

Notes and References

¹The first component that we addressed was capital adequacy, followed by asset quality, management, earnings and liquidity. See Stackhouse, Julie. “The ABCs of CAMELS.” St. Louis Fed On the Economy, July 24, 2018.

² Gray, Doug. “Interest Rate Risk Management at Community Banks.” Community Banking Connections, Third Quarter 2012.

³ A yield curve is a line on a graph that plots interest rates of similar financial instruments at differing maturity dates.

Additional Resources

• On the Economy: Why Are Banks Regulated?
• On the Economy: Why Does the Fed Supervise Small Banks?
• On the Economy: The ABCs of CAMELS