How to Measure Interest Rate Risk Effectively in Banks & Credit Unions

Mary Ellen Biery
June 11, 2021
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Measuring Interest Rate Risk Can Vary by Institution

Interest rate risk measurement plays a key role in ensuring an institution's safety and soundness.

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Regulatory Emphasis

Interest rate risk measurement

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.

ALM models typically use two types of measuring sticks for interest rate risks at a financial institution. They are measurements providing a view of risk related to:

  • short-term IRR exposure
  • long-term IRR exposure

You might also like this webinar on liquidity risk. 

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EAR, Gap Analysis

Measure interest rate risk in the short-term

Earnings or income simulation models measure short-term IRR. Sometimes known as earnings-at-risk models, they typically combine data from the financial institution’s current financial position with assumptions to forecast future earnings under various scenarios, and the risk to those earnings over the next one to two years under those scenarios, according to Koch.

Gap analysis is another way to measure short-term IRR and can show potential repricing risks during a short-term period. Often focused on the next 12 months, static gap reports examine what can happen when interest rates change on assets such as loans and bonds, or liabilities such as deposits, at different times from each other.

“While the static gap report might provide some indication of the direction of IRR, it is an imprecise risk measurement tool,” said Doug Gray, then-Managing Examiner of the Federal Reserve Bank of Kansas City, and Emily Greenwald, then-Assistant Vice President at the Federal Reserve Bank of Chicago, in a “Community Bank Connections” article. “Specifically, the static gap report does not effectively capture cash flow timing from unscheduled loan and bond payments (prepayments), and slotting the repricing horizon of nonmaturity deposits becomes extremely difficult at best. Thus, it may only be suitable for banks that have very low IRR profiles to rely solely on this measure to quantify short-term IRR exposures.”

Other regulators have also said gap analysis is generally insufficient as an institution’s sole method to measure interest rate risk.

EVE Analysis

Measure long-term interest rate risk

Long-term IRR measurements focus on the possible impact to capital from changes in interest rates. This impact, of course, could result either from reduced long-term earnings or a reduced economic value.

While some financial institutions might measure long-term IRR using an extended income simulation or earnings-at-risk model, the most common model is an economic value of equity (EVE) analysis.

"Economic value models are beneficial in measuring IRR, as they incorporate the complexity of many loan, investment, and deposit products," according to the OCC. "The financial performance of many instruments is linked to pricing and cash flow options embedded within those instruments. The impact of some of these options, such as interest rate caps on adjustable-rate mortgages, withdrawal options on deposits, and prepayment options on fixed-rate mortgages, is often difficult to accurately predict, particularly if the impact of interest rate changes is evaluated only over a short-term horizon. Therefore, it is important for banks with options risk exposure to focus on both short-term (e.g., EaR) and long-term (i.e., economic value) measures."

An ALM model should provide options for measuring and monitoring both short- and long-term interest rate risk.  Furthermore, a model with the ability to combine assumptions from across the major risk categories (credit, liquidity, and interest rate) that financial institutions face will provide a more cohesive, defensible view of risk in changing environments.

Learn more about how to navigate risks facing financial institutions with this webinar series, "Managing Liquidity Risk and Profitability"
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About the Author

Mary Ellen Biery

Senior Writer and Content Specialist
Mary Ellen Biery is Senior Staff Writer & Content Specialist at Abrigo, where she works with advisors and other experts to develop whitepapers, original research, and other resources that help financial institutions drive growth and manage risk. A former equities reporter for Dow Jones Newswires whose work has been published

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About Abrigo

Abrigo enables U.S. financial institutions to support their communities through technology that fights financial crime, grows loans and deposits, and optimizes risk. Abrigo's platform centralizes the institution's data, creates a digital user experience, ensures compliance, and delivers efficiency for scale and profitable growth.

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