FDIC Keeps Up Drumbeat on Interest Rate Risk

WASHINGTON — The Federal Deposit Insurance Corp. sounded additional warnings Tuesday about the risks banks face from rising interest rates.

Regulators have maintained a consistent drumbeat about the need for institutions to be prepared for when the historically low rates rebound, and rate jumps have already led to sharp reductions in the value of many banks' available-for-sale securities.

The FDIC urged its banks in a letter to take asset-liability management seriously — including the need to revise investment policies at least annually — and the regulator said examiners pay attention to how interest rate risk affects securities portfolios.

"Although net unrealized losses on securities may not flow through to regulatory capital under certain circumstances, examiners consider the amount of unrealized losses in the investment portfolio and an institution's exposure to the possibility of further unrealized losses when qualitatively assessing capital adequacy and liquidity and assigning examination ratings," the letter said.

All of the federal bank regulators issued joint guidance in early 2010 — when rates were still headed toward historic lows — warning institutions to avoid becoming too concentrated in higher-yielding instruments that become volatile when rates shift.

The FDIC said it was "re-emphasizing" the need for robust interest rate risk management, noting concern "that certain institutions may not be sufficiently prepared or positioned for sustained increases in, or volatility of, interest rates."

"The FDIC believes that asset-liability management should be viewed as an ongoing process that requires effective measurement and monitoring systems, clear communication of modeling results, evaluation of exposures relative to established policy limitations, and consideration of risk mitigation options as appropriate," the agency said.

"As economic and interest rate cycles evolve, asset-liability management processes should be revisited to confirm that the institution has avoided a speculative position and reduced the likelihood of adverse outcomes."

Lately, concerns about rising interest rates have been more than academic. After the yield on the 10-year Treasury bond rose from 1.60% in May to 2.48% at the end of the second quarter, the FDIC reported in August that the industry suffered a $51 billion drop in unrealized gains on available-for-sale securities during the quarter.

The decline, which was the largest in the nearly 20 years that the FDIC keeps such data, was attributed in part to investors demanding bonds with higher yields than those banks currently hold. Such value declines do not affect income, but are factored into capital calculations under "generally accepted accounting principles" and starting next year must be included in the regulatory capital for large banks subject to the Basel III advanced approaches.

The agency said Tuesday that some banks under its watch could be more susceptible to a volatile rate environment than others.

"For a number of FDIC-supervised institutions, the potential exists for material securities depreciation relative to capital in a rising interest rate environment," the FDIC said.

The FDIC's letter urged boards to constantly be reviewing a bank's asset-liability management process. "Asset-liability management and investment policies should be revised at least annually to ensure authorities, risk tolerance levels, and exposure limits are prudent," the agency said. "Policy limitations should formalize the board's risk philosophy, guide management's day-to-day decision making, and protect capital from undue risk. Given the potential for prospective interest rate volatility, directorates should review policies and exposure limits to promote safe-and-sound banking."

The agency highlighted certain tools at banks' disposal to mitigate risks — such as those that rebalance asset and liability durations — but also said institutions should understand the tools they are using.

"Financial institutions' use of hedging instruments to mitigate interest rate risk exposure is only appropriate when institutions have the requisite knowledge and expertise to engage in such transactions, including the ability to accurately determine the exposure being hedged and to understand possible effects on the bank's financial performance and capital position," the letter said.