Measuring interest rate risk effectively is a key component of interest rate risk (IRR) management, specifically, and asset/liability management (ALM), more generally, at financial institutions.
Regulators have repeatedly stressed the importance of sound risk management practices that include the ability to identify and measure interest rate risk. “Accurate and timely IRR measurement is necessary for monitoring IRR effectively,” says the Office for the Comptroller of the Currency’s handbook on interest rate risk says. Measurement plays an important role in ensuring that interest rate risk doesn’t threaten a financial institution’s earnings and capital.
The emphasis on effective systems and tools to measure interest rate risk is especially critical in the current environment. As recently as May 2021, regulators identified interest rate risk as among the key risks in the economy, financial markets, and the banking industry that could affect insured institutions. “The large increase in deposits coupled with decreased loan demand pose interest rate risk challenges for banks,” the Federal Deposit Insurance Corp. (FDIC) noted in its 2021 Risk Review. “Because depositors can withdraw these funds at will, bank expectations related to the stability of these deposits will be crucial to effective interest rate risk management.”
Because the size and complexity of banks and credit unions can vary, the processes and systems used to measure interest rate risk in order to assess exposures relative to an institution’s established risk tolerances can also differ dramatically.
“Regardless of the measurement system used, the system should be sufficiently robust to capture all material on- and off-balance-sheet positions and incorporate a stress-testing process to identify and quantify the bank’s IRR exposure and potential problem areas,” according to the OCC. The regulator notes that management should give “special consideration” when measuring risk to the institution’s concentrations in instruments or markets. In times of stress, positions can be more difficult to liquidate or offset – a risk that concentrations can amplify.
As a starting point to evaluating IRR measurement systems, it is helpful to understand the types of IRR exposures that are addressed by ALM models.
Exposures IRR Measurement Systems Address
Measuring interest rate risk is all about estimating how much a financial institution’s earnings and market value will change as market interest rates change, says Dave Koch, Director of Advisory Services at Abrigo.