Abstract: Consider the following scenario: Your bank thinks it its interest rate risk pretty well nailed down. But a new regulation allows examiners wide discretion in assessing this risk. The examiner determines that the same interest rate risk exposure you are comfortable with is instead so that it requires significant additional capital to cover it. If you cannot find the capital, you may be compelled to absorb punishing expense in laying the risk off through swap markets (which would have its own capital requirement). Meanwhile the examiner can look over your shoulder while the capital deficiency remains, and specify all the rates that you could offer on deposits. Far fetched? Far from it. A FDICIA legacy. Under the FDIC Improvement Act, the federal bank regulatory agencies have been directed to revise risk-based capital standards to reflect interest rate risk and to publish the final regulations by June 19, 1993. Capital increases mandated by rate-risk standards will be supplemental to those required by credit risk standards. As a first step, the Federal Reserve Board, Office of the Comptroller of the Currency, and FDIC issued a joint advance notice of proposed rulemaking in the Aug. 10 Federal Register. Initial regulatory comments on the proposal, quoted in news reports, minimized its significance. Yet in the same breath that one regulator played down the proposal, he noted that 20% of the industry will be found to have excessive rate risk. Don't be fooled. The proposal's guidelines are at best imprecise. A bank might be accustomed to optimistically interpreting its risk exposure for internal reporting purposes and might conclude that its risk lay within normal parameters. Yet an examiner conservatively making the same assessment may well find the bank to be a high-risk outlier that owes capital. Up to a point, the techniques found in the agencies' proposal are imaginative and well-intentioned. However, as published, the notice contains serious shortcomings, in our opinion. THe PROPOSAL The agencies' intent is straightforward. Using duration, the proposal states rate risk in present-value terms that reflect the price elasticity of instruments on bank balance sheets in response to rate changes. Arbitrarily, the regulators stipulate that institutions with present-valued net price-sensitive assets or liabilities exceeding 1% of total assets fall in the high risk category, and so require additional capital. The notice proposes a straightforward process for calculating rate risk. Banks construct gap positions in their usual fashion, but with restrictions. For example, prepayments are only counted on instruments with maturities over seven years. For present valuation purposes, assets are differentiated among three categories: amortizing, non-amortizing, and deep discount. On the liabilities side, maximum maturities are specified for core deposits. Then the proposed framework applies rate-risk weights to each of the time flames and categories based on the modified duration of instruments with maturities, cash flows, coupons and yields that are assumed to be representative of the position being weighed. A weak basis. The modified duration method limitations. The agencies readily acknowledge them, noting at one point that the approach assumes small, instantaneous, parallel shifts in the yield curve. Indeed, the yield shifts would have to be small. Duration is a static measure of price elasticity, reflecting a price/yield trade-off that is linear compared to the curves of actual price elasticity. As a result, the greater an instrument's convexity, due to low coupons or long maturities, the less accurate duration will be. The fact that modified duration has the attractive attribute of summarizing the [interest-rate risk] exposure of an institution in a single number, as the Fed put it, is of little comfort when it is likely to be wrong. …
Publication Year: 1992
Publication Date: 1992-11-01
Language: en
Type: article
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