Bank Regulators Have a Poor Handle on Interest Rate Risk

The financial crisis elevated awareness of the critical lack of information available to regulators to assess the risks to institutions and the system in general. Although strides have been made to update and enhance the type of data provided by institutions to regulators, critical deficiencies in data gathering, reporting and measuring key risks persist across the agencies.

In many cases, regulatory agencies fall into the same trap as most of us when it comes to assessing future outcomes. Behavioral finance theorists have for many years given insight into why what has happened to us more recently, good or bad, has a major influence on the decisions we make. In the case of the mortgage crisis, bank regulators have expended enormous resources for good reason in plugging gaps in the way home loan products were originated, financed and serviced. That is a bit like revising the building code to allow for greater spacing between buildings after the Great Chicago Fire. We run the risk of not having tools and capabilities in place to anticipate and hopefully thwart other emerging risks to the system.

A case in point is the latest report on risk to the banking sector released by the Office of the Comptroller of the Currency. The report does a nice job summarizing the key risks in banking, including one that remains much discussed in the industry: interest rate risk. We first saw the ugly side of what interest rate risk can do when Treasury yields spiked last spring. Prices of fixed-income instruments of all types dropped sharply in price and firms with heavy positions in longer-dated bonds saw their portfolios take larger hits.

But only three pages out of 40 in the OCC's report are devoted to interest rate risk, and the discussion is toward the back. The detail provided in quantifying that exposure is scant.

The problem is that regulators do not have the data or reporting to systematically report on the interest rate risk profiles of commercial banks. If they did, it would be featured in their reports and research studies. Instead they rely on outside vendors' assessments of the impacts on market value of equity from changes in interest rates and on overly simplistic maturity gap measures. Instead what they have is quarterly data provided by institutions in call reports that summarizes their balance asset positions at far too high a level of aggregation, preventing regulators from building sophisticated analyses of risk sensitivities. For example, the data captures maturities of various classes of assets and liabilities rather than a more meaningful metric such as duration. If the only thing standing between our understanding of the magnitude of bank interest rate risk and disaster is an overly simplistic maturity gap profile provided from data that by the time it is processed is months old, then we should not be surprised in the future when we wake up to an interest rate risk event.

Why is this issue important? First, the long boom in fixed-income securities is nearing an end, even if it is dragged out a bit artificially by those who brought you quantitative easing; namely the Federal Reserve. In the last five years, as highlighted by the OCC, banks have piled billions of dollars into mortgage-backed securities and other longer maturity fixed-income assets, exposing them to greater interest rate risk in the process. We hope these institutions have appropriately hedged their interest rate risk, but there's really no way to know since the regulators don't track and report such risk.

From a vendor analysis of the sensitivity of bank changes in market value of equity to changes in interest rates, the OCC reports that a 2% increase in rates would lead to a 24% reduction in MVE. That is double what it was six years ago. That doesn't seem well hedged to me.

And given that result, rather than abandoning the one report the regulators had to monitor and report interest risk across the industry at a granular and sophisticated level, as the OCC did when it absorbed the Office of Thrift Supervision in 2012, the agencies should immediately develop capabilities to assess this risk using industry-standard methodologies. At a broader level, the Office of Financial Research, in its latest annual report, also cited interest rate risk as an emerging threat to the financial system, as well as significant gaps in data gathering that are critical to their assessment of systemic risk.

We know that good detailed data on bank positions under stress can be obtained from the Fed's Comprehensive Capital Analysis and Review stress test process. Relying on ad hoc, vendor-supplied estimates of industry interest rate risk exposure or woefully inadequate maturity-gap measures from call report data greatly limits regulators' abilities to spot interest rate risk at an institutional and industry level. Without having a systematic way of evaluating interest rate risk in place on a regular basis, we may once again wind up closing the barn door behind the next crisis.

Clifford Rossi is the Professor-of-the-Practice at the Robert H. Smith School of Business at the University of Maryland and a principal in Chesapeake Risk Advisors LLC.