WASHINGTON –The
Office of the Comptroller of the Currency issued guidance today alerting
national banks to the risk management issues associated with assets and
liabilities with embedded options. One
example of an embedded option is the right to prepay residential mortgage loans
without penalty. When rates fall,
mortgage-related loans and securities typically pay down quickly as borrowers
refinance at lower interest rates. When
rates rise, prepayments generally slow down.
“A number of banks
have chased yields in their investment portfolios by acquiring assets with
embedded options, hoping to keep their earnings growing during the recent
period of low interest rates and weak loan demand,” said Ms. Kathryn E. Dick,
Deputy Comptroller for Risk Evaluation.
“The increasing volume of options across the balance sheet has made it
more important for banks to measure interest rate risk from an economic value
perspective. In particular, we are
concerned that some banks have locked in a disproportionate volume of their
assets at the cyclical low in yields, and may have turned an earnings event
into a capital event.”
Ms. Dick defined an
“earnings event” as a short-term decline in earnings due to changes in interest
rates. “A short-term decline in
earnings doesn’t usually pose safety and soundness concerns,” said Ms. Dick. “However, when rate changes cause
significant asset impairment, to the point where it has a material effect on
the economic value of the bank’s equity, then this does become a safety and
soundness issue which might have to be addressed with additional capital. At this point, we believe that the number of
national banks with the potential for significant asset impairment is small,
but rising.”
The OCC has had a
longstanding policy that encourages bankers and examiners to assess interest
rate risk both from a near term earnings perspective as well as a longer term
equity perspective. Banks with
significant holdings of financial instruments with embedded options need to
focus on the economic value of their equity, which represents the present value
of the expected cash inflows minus the present value of expected cash
outflows.
Ms. Dick noted that
the increasing presence of options in bank assets, both loans and securities,
and now even liabilities, has made cash flows more unpredictable. “The rise in longer-term interest rates has
had, and may continue to have, a particularly damaging effect on the values of
assets with embedded options. Values
decline first because interest rates are rising. As the anticipated maturities of these assets with embedded
options extend, values decline further because of the longer maturities.” Ms Dick described this phenomenon as the
“negative convexity” effect.
The OCC is
particularly concerned that national banks may fail to appreciate the long-term
significance of impairment in asset values, because the initial impact of
rising short-term rates may be positive for bank earnings. “Just because earnings rise over the
near-term does not mean there isn’t an interest rate risk problem,” said Ms.
Dick. “Impaired asset and economic equity
values suggest a greater potential for income problems down the road.”
The guidance
emphasizes that national banks should take a number of steps to identify,
measure and control their exposure to interest rate risk, including:
· Evaluate assets and liabilities to ensure
that management has identified all assets and liabilities with embedded
options;
· Evaluate exposure to embedded options and
apply limits consistent with the board’s risk tolerance;
· Verify that the tools used to measure interest
rate risk are appropriate;
· Identify assets with structural weaknesses
that may be particularly vulnerable to further increases in rates, and consider
risk mitigation strategies if risk exceeds approved risk tolerance;
· Understand the risk to earnings and capital
from a rising rate environment, using both parallel and non-parallel rate
changes;
· Obtain board approval for any material
investment acquisitions that layer on additional interest rate risk.
The guidance also
notes that national banks contemplating the transfer of securities from
available-for-sale to held-to-maturity should obtain prior approval from their
boards of directors, given the significant loss of flexibility associated with
that action.
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