[Federal Register Volume 63, Number 78 (Thursday, April 23, 1998)]
[Notices]
[Pages 20257-20272]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-9882]



  Federal Register / Vol. 63, No. 78 / Thursday, April 23, 1998 / 
Notices  

[[Page 20257]]



DEPARTMENT OF THE TREASURY

Office of Thrift Supervision
[No. 98-38]


Financial Management Policies

AGENCY: Office of Thrift Supervision.

ACTION: Notice and request for comment.

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SUMMARY: The Office of Thrift Supervision (OTS) is proposing to adopt a 
Thrift Bulletin that provides guidance on the management of interest 
rate risk, investment securities, and derivatives activities. The 
proposed Bulletin also describes the guidelines OTS examiners will use 
in assigning the ``Sensitivity to Market Risk'' component rating.

DATES: Comments must be received on or before June 22, 1998.

ADDRESSES: Send comments on the proposed Thrift Bulletin to: Manager, 
Dissemination Branch, Records Management and Information Policy, Office 
of Thrift Supervision, 1700 G Street, N.W., Washington, D.C. 20552, 
Attention Docket No. 98-38. These submissions may be hand-delivered to 
1700 G Street, N.W., from 9:00 a.m. to 5:00 p.m. on business days; they 
may be sent by facsimile transmission to FAX number (202) 906-7755; or 
by e-mail: [email protected]. Those commenting by e-mail should 
include their name and telephone number. Comments will be available for 
inspection at 1700 G Street, N.W., from 9:00 a.m. until 4:00 p.m. on 
business days.

FOR FURTHER INFORMATION CONTACT: Ed Irmler, Senior Project Manager, 
(202) 906-5730 or Anthony Cornyn, Director, Risk Management Division, 
(202) 906-5727.

SUPPLEMENTARY INFORMATION: The Office of Thrift Supervision is 
publishing for public comment the attached document, which it proposes 
to issue as Thrift Bulletin 13a (TB 13a), Management of Interest Rate 
Risk, Investment Securities, and Derivatives Activities. This proposed 
bulletin would provide guidance on a wide range of topics in the area 
of interest rate risk management, including several on which the 
Federal Financial Institutions Examination Council (FFIEC) has issued 
related guidance. OTS believes that adoption of the proposed bulletin 
would simultaneously improve its supervision of interest rate risk 
management and reduce regulatory burden on thrift institutions.
    The proposed bulletin would update OTS's minimum standards for 
thrift institutions' interest rate risk management practices with 
regard to board-approved risk limits and interest rate risk measurement 
systems. The guidance in this bulletin would, thus, replace Thrift 
Bulletin 13 (Responsibilities of the Board of Directors and Management 
with Regard to Interest Rate Risk), Thrift Bulletin 13-1 
(Implementation of Thrift Bulletin 13), and Thrift Bulletin 13-2 
(Implementation of Thrift Bulletin 13). The proposed bulletin would 
make several significant changes. First, under TB 13a, institutions 
would no longer set board-approved limits or provide measurements for 
the plus and minus 400 basis point interest rate scenarios prescribed 
by the original TB 13. The proposed bulletin would also change the form 
in which those limits are expressed. Second, the bulletin would provide 
guidance on how OTS will assess the prudence of an institution's risk 
limits. Third, the proposed bulletin would raise the size threshold 
above which institutions would be responsible for calculating their own 
estimates of the interest rate sensitivity of Net Portfolio Value (NPV) 
from $500 million to $1 billion in assets. Fourth, the proposed 
bulletin would specify a set of desirable features that an 
institution's risk measurement methodology should utilize. Finally, the 
proposed bulletin provides an extensive discussion of ``sound 
practices'' for interest rate risk management.
    The proposed TB 13a also contains guidance on thrifts' investment 
and derivatives activities. As described in the FFIEC's Supervisory 
Statement on Investment Securities and End-User Derivative Activities, 
published elsewhere in this issue of the Federal Register, the FFIEC-
member agencies will be discontinuing use of the three-part test for 
suitability of investment securities. Accordingly, the proposed 
bulletin describes the types of analysis OTS would expect institutions 
to perform prior to purchasing securities or financial derivatives. The 
proposed bulletin also provides guidelines on the use of certain types 
of securities and financial derivatives for purposes other than 
reducing portfolio risk. The proposed regulation on financial 
derivatives, published elsewhere in this issue of the Federal Register, 
as supplemented by the guidance in proposed TB 13a, would replace 
existing regulations governing futures (12 CFR 563.173), forward 
commitments (12 CFR 563.174), and options (12 CFR 563.175). TB 13a 
would also replace guidance presently contained in Thrift Bulletin 52 
(Supervisory Statement of Policy on Securities Activities), Thrift 
Bulletin 52-1 (``Mismatched'' Floating Rate CMOs), and Thrift Bulletin 
65 (Structured Notes).
    Finally, TB 13a would provide detailed guidelines for implementing 
part of the Announcement of the Revision for the Uniform Financial 
Institutions Rating System, published by the FFIEC on December 19, 
1996. That publication announced revised interagency policies, that 
among other things, established the Sensitivity to Market Risk 
component rating (the ``S'' rating). TB 13a would provide quantitative 
guidelines for assessing an institution's level of interest rate risk, 
although examiners would have considerable discretion in implementing 
those guidelines. It would also provide guidelines detailing the 
factors examiners would consider in assessing the quality of an 
institution's risk management systems and procedures. Guidance on the 
topic of assigning the ``S'' rating is largely new, though TB 13a would 
replace the rather limited guidelines currently contained in New 
Directions Bulletin 95-10.

Request for Comment

    OTS requests comments on all aspects of proposed TB 13a, including 
the following questions:
    (1) The proposed Thrift Bulletin and the proposed regulation on 
financial derivatives are integral parts of OTS's approach to 
supervision of derivatives transactions. OTS does not intend to 
finalize one without the other. Do you support this approach?
    (2) Does the revised format for the board of directors' limits on 
the interest rate sensitivity of net portfolio value (described in Part 
II.A.1) impose an unnecessary regulatory burden? Do you believe that 
specifying the limits in this form would cause more, or less, work for 
your institution?
    (3) Should the discussion of prudent limits in Part II.A.3 and 
Appendix A be modified? Do you agree with the approach described in 
those sections?
    (4) For institutions that will be responsible for producing their 
own NPV estimates, does your institution have the sophistication to 
meet the methodological guidelines described in Part II.B.2?
    (5) Do you support the guidelines in Part II.B.3 regarding the 
integration of risk measurement and operations?
    (6) Given the announced elimination of the FFIEC three-part test 
for investment security suitability, do the guidelines in Part III.A.1 
regarding pre-purchase portfolio sensitivity analyses for any 
significant transactions in securities or financial derivatives provide 
a good balance between burden and regulatory prudence. Similarly, are

[[Page 20258]]

the guidelines, in Part III.A.2, calling for pre-purchase price 
analyses for complex securities and financial derivatives reasonable?
    (7) Are the definitions of complex securities and financial 
derivatives understandable and adequate? Are the guidelines, in Part 
III.A.3(b), regarding the use of complex securities and financial 
derivatives reasonable?
    (8) Is the use of explicit guidelines for assigning the Sensitivity 
to Market Risk component rating (described in Part IV) a sound approach 
for providing greater ratings consistency and transparency?
    (9) Do the quantitative guidelines shown in Part IV.A.3 provide 
examiners an adequate starting point for assessing the level of 
interest rate risk? Do the guidelines described in Part IV.A.4, provide 
adequate opportunity for the use of institutions' internal results in 
the risk assessment?
    (10) Do the criteria for assessing the quality of an institution's 
risk management practices (described in Part IV.B) provide an adequate 
framework for such an evaluation?
    (11) Are the guidelines for the Sensitivity to Market Risk 
component rating (shown in Table 2 of Part IV.C) a reasonable 
implementation of the criteria described in the interagency Uniform 
Financial Institutions Rating System (see Appendix C)?
    (12) Do the ``Sound Practices for Market Risk Management,'' listed 
in Appendix B, provide a sufficiently good frame of reference that 
examiners may evaluate an institution's risk management practices 
against them? Are any elements missing from that Appendix? Should any 
be deleted?
    The proposed Thrift Bulletin is set forth below.

Proposed Thrift Bulletin 13a: Management of Interest Rate Risk, 
Investment Securities, and Derivatives Activities

    Summary: This Thrift Bulletin provides guidance to management and 
boards of directors of thrift institutions on the management of 
interest rate risk, including the management of investment and 
derivatives activities. In addition, it describes the framework 
examiners will use in assigning the ``Sensitivity to Market Risk'' (or 
``S'') component rating. Thrift Bulletin 13a replaces Thrift Bulletins 
13, 13-1, 13-2, 52, 52-1, and 65, and New Directions Bulletin 95-10.

Contents

Part I: Background
    A. Definition and Sources of Interest Rate Risk
Part II: OTS Minimum Guidelines Regarding Interest Rate Risk
    A. Interest Rate Risk Limits
    B. Systems for Measuring Interest Rate Risk
Part III: Investment Securities and Financial Derivatives
    A. Analysis and Stress Testing
    B. Record-Keeping
    C. Supervisory Assessment of Investment and Derivatives 
Activities
Part IV: Guidelines for the ``Sensitivity to Market Risk'' Component 
Rating
    A. Assessing the Level of Interest Rate Risk
    B. Assessing the Quality of Risk Management
    C. Combining Assessments of the Level of Risk and Risk 
Management Practices
    D. Examiner Judgment
Part V: Supervisory Action
Appendix A: Identifying Prudent Interest Rate Risk Limits
Appendix B: Sound Practices for Market Risk Management
Appendix C: Excerpt from Interagency Uniform Financial Institutions 
Rating System
Appendix D: Glossary

Part I: Background

    An effective interest rate risk (IRR) management process that 
maintains interest rate risk within prudent levels is important for the 
safety and soundness of any financial institution. This is especially 
true for thrift institutions, which by the nature of their business, 
are particularly prone to IRR. In recognition of that fact, 12 CFR 
563.176 requires institutions to implement proper IRR management 
procedures. In January 1989, OTS issued Thrift Bulletin 13 (TB 13), 
Responsibilities of the Board of Directors and Management with Regard 
to Interest Rate Risk, to provide guidance in the area of IRR 
management. Since TB 13 was first issued, a great deal of progress has 
been made in the areas of IRR measurement technology and IRR 
management. The present Thrift Bulletin, TB 13a, updates the guidelines 
contained in the original TB 13. It also provides guidance implementing 
the Federal Financial Institutions Examination Council's Supervisory 
Policy Statement on Investment Securities and End-User Derivative 
Activities and OTS's proposed rule at Section 563.172, both of which 
are published elsewhere in this issue of the Federal Register. The 
following Thrift Bulletins are hereby rescinded:

TB 13: Responsibilities of the Board of Directors and Management with 
Regard to Interest Rate Risk;
TB 13-1: Implementation of Thrift Bulletin 13;
TB 13-2: Implementation of Thrift Bulletin 13;
TB 52: Supervisory Statement of Policy on Securities Activities;
TB 52-1: ``Mismatched'' Floating Rate CMOs; and
TB 65: Structured Notes.

Also rescinded is New Directions Bulletin 95-10, Interim Policy On 
Supervisory Action to Address Interest Rate Risk.

A. Definition and Sources of Interest Rate Risk

    The term ``interest rate risk'' refers to the vulnerability of an 
institution's financial condition to movements in interest rates. 
Although interest rate risk is a normal part of financial 
intermediation, excessive interest rate risk poses a significant threat 
to an institution's earnings and capital. Changes in interest rates 
affect an institution's earnings by altering interest-sensitive income 
and expenses. Changes in interest rates also affect the underlying 
value of an institution's assets, liabilities, and off-balance sheet 
instruments because the present value of future cash flows (and in some 
cases, the cash flows themselves) change when interest rates change.
    Savings associations confront interest rate risk from several 
sources. These include repricing risk, yield curve risk, basis risk, 
and options risk.
    1. Repricing Risk. The primary form of interest rate risk arises 
from timing differences in the maturity and repricing of assets, 
liabilities, and off-balance sheet positions. While such repricing 
mismatches are fundamental to the business, they can expose a savings 
association's income and economic value fluctuations as interest rates 
vary. For example, a thrift that funded a long-term fixed rate loan 
with a short-term deposit could face a decline in both the future 
income arising from the position and its economic value if interest 
rates increase. These declines occur because the cash flows on the loan 
are fixed, while the interest paid on the funding is variable, and 
therefore increases after the short-term deposit matures.
    2. Yield Curve Risk. Repricing mismatches can also expose a thrift 
to changes in both the slope and shape of the yield curve. Yield curve 
risk arises when unexpected shifts of the yield curve have adverse 
effects on an institution's income or economic value. For example, 
suppose an institution has variable-rate assets whose interest rate is 
indexed to the 1-year Treasury rate and which are funded by variable-
rate liabilities having the same repricing date but indexed to the 3-
month Treasury rate. A flattening of the yield curve will have an 
adverse impact on the institution's income and economic value, even 
though a parallel movement in the yield curve might have no effect.

[[Page 20259]]

    3. Basis Risk. Another source of interest rate risk arises from 
imperfect correlation in the adjustment of the rates earned and paid on 
different financial instruments with otherwise similar repricing 
characteristics. When interest rates change, these differences can 
cause changes in the cash flows and earnings spread between assets, 
liabilities and off-balance sheet instruments of similar maturities or 
repricing frequencies. For example, a strategy of funding a three-year 
loan that reprices quarterly based on the three-month U.S. Treasury 
bill rate, with a three-year deposit that reprices quarterly based on 
three-month LIBOR, exposes the institution to the risk that the spread 
between the two index rates may change unexpectedly.
    4. Options Risk. Interest rate risk also arises from options 
embedded in many financial instruments. An option provides the holder 
the right, but not the obligation, to buy, sell, or in some manner 
alter the cash flows of an instrument or financial contract. Options 
may be stand alone instruments such as exchange-traded options and 
over-the-counter (OTC) contracts, or they may be embedded within 
standard instruments. Instruments with embedded options include bonds 
and notes with call or put provisions, loans which give borrowers the 
right to prepay balances, adjustable rate loans with interest rate caps 
or floors that limit the amount by which the rate may adjust, and 
various types of non-maturity deposits which give depositors the right 
to withdraw funds at any time, often without any penalties. If not 
adequately managed, the asymmetrical payoff characteristics of 
instruments with option features can pose significant risk, 
particularly to those who sell them, since the options held, both 
explicit and embedded, are generally exercised to the advantage of the 
holder.

Part II: OTS Minimum Guidelines Regarding Interest Rate Risk

    OTS has established specific minimum guidelines for thrift 
institutions to observe in two areas of interest rate risk management. 
The first guideline concerns establishment and maintenance of board-
approved limits on interest rate risk. The second, concerns 
institutions' ability to measure their risk level.

A. Interest Rate Risk Limits

    Effective control of interest rate risk begins with the board of 
directors, which defines the institution's tolerance for risk. OTS 
regulation Sec. 563.176 requires all institutions to establish board-
approved interest rate risk limits.
1. Limits on Change in Net Portfolio Value
    All institutions should establish and demonstrate quarterly 
compliance with board-approved limits on interest rate risk that are 
defined in terms of net portfolio value (NPV).1 These limits 
should specify the minimum NPV Ratio 2 the board is willing 
to allow under current interest rates and for a range of six 
hypothetical interest rate scenarios. These six scenarios are 
represented by immediate, permanent, parallel movements in the term 
structure of interest rates of plus and minus 100, 200, and 300 basis 
points from the actual term structure observed at quarter 
end.3
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    \1\ Net portfolio value (NPV) is defined as the net present 
value of an institution's existing assets, liabilities, and off-
balance sheet contracts. In the original TB 13, this measure was 
referred to as the ``market value of portfolio equity'' (MVPE). A 
detailed description of how OTS defines and calculates NPV is 
provided in the manual entitled, The OTS Net Portfolio Value Model.
    \2\ An institution's NPV Ratio for a given interest rate 
scenario is calculated by dividing the net portfolio value that 
would result in that scenario by the present value of the 
institution's assets in that same scenario and is expressed in 
percentage terms. The NPV ratio is analogous to the capital-to-
assets ratio used to measure regulatory capital, but NPV is measured 
in terms of economic values (or present values) in a particular rate 
scenario. These limits represent a change in format from those 
called for by the original TB 13. They will provide a greater degree 
of comparability across institutions and will mesh better with the 
OTS guidelines for the Sensitivity to Market Risk component rating, 
described later in this Bulletin.
    \3\ Institutions that do not file Schedule CMR of the Thrift 
Financial Report and do not have a means of calculating NPV should 
have suitable alternative limits.
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    Two illustrations of such limits are provided in Exhibits 1 and 2. 
(The numerical limits shown in these exhibits are examples only and 
should not be interpreted as appropriate limits or regulatory 
requirements.)

BILLING CODE 6720-01-P
[GRAPHIC] [TIFF OMITTED] TN23AP98.000

BILLING CODE 6720-01-C
    In Exhibit 1, the board of directors of ABC Savings Association has 
specified that the institution's risk be limited so that for each 
interest rate change listed in column [a] the institution's NPV Ratio 
would fall to no less than the level shown in column [b]. The limits 
set by the board in this example are more demanding in falling interest 
rate scenarios than in rising ones to reflect the board's expectation 
that the institution should perform better in the former than in the 
latter. Because each rate scenario has a different minimum allowable 
NPV Ratio, this set of limits will likely require frequent review and 
adjustment by the board. For example, if market interest rates have 
risen since ABC's limits were established, and ABC's NPV Ratio has 
fallen significantly, the NPV limits may well require adjustment.
    In Exhibit 2, the board of XYZ Savings Association has indicated an 
unwillingness to allow the institution's NPV Ratio to fall below 10 
percent in any of the interest rate scenarios. While

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such a set of limits will not require attention as frequently as those 
in Exhibit 1, they should still be reviewed periodically, particularly 
if market interest rates change substantially. In both exhibits, 
management would be responsible for structuring the institution's 
portfolio so that an immediate increase in interest rates of 300 basis 
points would reduce the institution's NPV Ratio to no less than 10 
percent.
2. Limits on Earnings Sensitivity
    Many institutions also set risk limits expressed in terms of the 
interest rate sensitivity of projected earnings. Such limits can 
provide a useful supplement to the NPV-based limits. Although 
institutions are not required by OTS to establish limits and conduct 
analysis in terms of earnings sensitivity, OTS considers it a good 
management practice for institutions to estimate the interest rate 
sensitivity of their earnings and to incorporate this analysis into 
their business plan and budgeting process. The institution has total 
discretion over the type of earnings sensitivity analysis and all 
details of how that analysis is performed. However, OTS encourages 
institutions to develop earnings simulations utilizing base case and 
adverse interest rate scenarios and to compare results to actual 
earnings on a quarterly basis.
3. Prudence of IRR Limits
    In assessing the prudence of their institution's NPV limits, as 
well as in evaluating their institution's current level of risk 
relative to the rest of the industry, the board of directors will find 
it useful to refer to the quarterly OTS publication, Thrift Industry 
Interest Rate Risk Measures.4 This publication contains 
statistical data about key interest rate risk measures for the 
industry.
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    \4\ Thrift Industry Interest Rate Risk Measures is published for 
a particular quarter approximately seven weeks after the end of that 
quarter. It may be retrieved using the OTS PubliFax system, at (202) 
906-5660, or from the OTS World Wide Web site, http://
www.ots.treas.gov.
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    Examiners will consider all pertinent facts in their analysis, but 
will usually consider an institution's interest rate risk limits to be 
imprudent if they permit the institution to exhibit a Post-shock NPV 
Ratio and Interest Rate Sensitivity Measure that would warrant an ``S'' 
component rating of 3 or worse. (See Part IV.B.2, Prudent Limits, and 
Appendix A, Identifying Prudent Interest Rate Risk Limits, for 
discussion of this topic.) Imprudent NPV limits may result in examiner 
criticism or an adverse ``S'' component rating.
4. Revision of IRR Limits
    Interest rate risk limits reflect the board of directors' risk 
tolerance. Although the board should periodically re-evaluate the 
appropriateness of the institution's interest rate risk limits, 
particularly after a significant change in market interest rates, any 
changes should receive careful consideration and be documented in the 
minutes of the board meeting.
    If the institution's level of risk at some point does violate the 
board's limits, that fact should be recorded in the minutes of the 
board meeting, along with management's explanation for that occurrence. 
Depending on the circumstances and the board's tolerance for risk, the 
board may elect to revise the risk limits. Alternatively, the board may 
wish to retain the existing limits and direct management to adopt an 
acceptable plan for an orderly return to compliance with the limits.
    Recurrent changes to interest rate risk limits for the purpose of 
accommodating instances in which the limits have been, or are about to 
be, breached may be indicative of inadequate risk management practices 
and procedures.

B. Systems for Measuring Interest Rate Risk

    The ability to identify, measure, and monitor interest rate risk 
are key elements in risk management. To ensure compliance with its 
board's IRR limits and to comply with OTS regulation Sec. 563.176, each 
institution must have a way of measuring its interest rate risk. OTS 
guidelines for interest rate risk measurement systems are as follows, 
though examiners have broad discretion to require more less rigorous 
systems.
1. Interest Rate Sensitivity of NPV for Institutions Below $1 Billion 
in Assets
    Unless otherwise directed by their OTS Regional Director, 
institutions below $1 billion in assets may usually rely on the 
quarterly NPV estimates produced by OTS and distributed in the Interest 
Rate Risk Exposure Report. If such an institution owns complex 
securities whose recorded investment exceeds 5 percent of total assets, 
the institution should be able to measure or have access to measures of 
the economic value of those securities under the range of interest rate 
scenarios described in Part II.A.1, Limits on Change in Net Portfolio 
Value. The institution may rely on the OTS estimates for the other 
financial instruments in its portfolio, unless examiners direct 
otherwise.
2. Interest Rate Sensitivity of NPV for Institutions Above $1 Billion 
in Assets
    Those institutions with more than $1 billion in assets should 
measure their own NPV and its interest rate sensitivity. OTS examiners 
will look for the following desirable methodological features in 
evaluating the quality of such institutions' NPV measurement systems:
    (a) The institution's NPV estimates utilize information on its 
financial holdings that are generally more detailed than the 
information reported on Schedule CMR.
    (b) Value is ascribed only to financial instruments currently in 
existence or for which commitments or other contracts currently exist 
(i.e., future business is not included in NPV).
    (c) Values are, where feasible, based directly or indirectly on 
observed market prices.
    (d) Zero-coupon (spot) rates of the appropriate maturities are used 
to discount cash flows.
    (e) Implied forward interest rates are used to model adjustable 
rate cash flows.
    (f) Cash flows are adjusted for reasonable non-interest costs the 
institution will incur in servicing both its assets and liabilities.
    (g) Valuations take account of embedded options using, at least, 
the static discounted cash flow technique, but preferably using more 
rigorous options pricing techniques (which normally produce a value 
greater than zero even for out-of-the-money options).
    (h) Valuation of deposits is based, at least in part, on 
institution-specific data regarding retention rates of existing deposit 
accounts and the rates offered by the institution on deposits. 
Preferably, the institution would base these valuations on sound 
econometric research into such data.
    Examiners may determine an institution should use more 
sophisticated measurement techniques for individual financial 
instruments or categories of instruments where they believe it to be 
warranted (e.g., because of the volume and price sensitivity of a group 
of financial instruments; because of concern that the institution's 
results may materially misstate the level of risk; because of the 
combination of a low Post-shock NPV Ratio and high Sensitivity Measure; 
etc.). In any case, the institution should be familiar with the details 
of the assumptions, term structure, and logic used in performing the 
measurements. Measures obtained from financial screens or vendors may, 
therefore, not always be adequate.
    In addition to the prescribed parallel shock interest rate 
scenarios described

[[Page 20261]]

above, OTS recommends that institutions evaluate the effects of other 
stressful market conditions (e.g., non-parallel movements in the term 
structure, basis changes, changes in volatility), as well as the 
effects of breakdowns in key assumptions (e.g., prepayment and core 
deposit attrition rates).
3. Integration of Risk Measurement and Operations
    As part of their assessment of the quality of an institution's risk 
management practices, examiners will consider the extent to which the 
institution's risk measurement process is integrated with management 
decision-making. Examiners will evaluate whether, in making significant 
operational decisions (e.g., changes in portfolio structure, 
investments, business planning, derivatives activities, funding 
decisions, pricing decisions, etc.), the institution considers their 
effect on the level of interest rate risk. Institutions may do this 
using an earnings sensitivity approach, one based on NPV sensitivity, 
or any other reasonable approach. The institution has discretion over 
all aspects of such analysis. The analysis, however, should not be 
merely pro forma in nature, but rather should be an active factor in 
the institution's decision-making process. If evidence of such 
integration is not apparent, examiner criticism or an adverse rating 
may result.

Part III: Investment Securities and Financial Derivatives

A. Analysis and Stress Testing

    Management should understand the various risks associated with 
investment securities and financial derivatives. As a matter of sound 
practice, prior to taking an investment position or initiating a 
derivatives transaction, an institution should:
    (a) Ensure that the proposed transaction is legally permissible for 
a savings institution;
    (b) Review the terms and conditions of the security or financial 
derivative;
    (c) Ensure that the proposed transaction is allowable under the 
institution's investment or derivatives policies;
    (d) Ensure that the proposed transaction is consistent with the 
institution's portfolio objectives and liquidity needs;
    (e) Exercise diligence in assessing the market value, liquidity, 
and credit risk of the security or financial derivative;
    (f) Conduct a pre-purchase portfolio sensitivity analysis for any 
significant transaction involving securities or financial derivatives 
(as described below in Significant Transactions);
    (g) Conduct a pre-purchase price sensitivity analysis of any 
complex security 5 or financial derivative 6 
prior to taking a position (as described below in Complex Securities 
and Financial Derivatives).
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    \5\ For purposes of the pre-purchase analysis, the term 
``complex security'' includes any collateralized mortgage obligation 
(``CMO''), real estate residential mortgage conduit (``REMIC''), 
callable mortgage pass-through security, stripped-mortgage-backed-
security, structured note, and any security not meeting the 
definition of an ``exempt security.'' An ``exempt security'' 
includes: (1) standard mortgage-pass-through securities, (2) non-
callable, fixed-rate securities, and (3) non-callable, floating-rate 
securities whose interest rate is (a) not leveraged (i.e., the rate 
is not based on a multiple of the index), and (b) at least 400 basis 
points from the lifetime rate cap at the time of purchase.
    \6\ The following financial derivatives are exempt from the pre-
purchase analysis called for above: commitments to originate, 
purchase, or sell mortgages. To perform the pre-purchase analysis 
for derivatives whose initial value is zero (e.g., futures, swaps), 
the institution should calculate the change in value as a percentage 
of the notional principal amount.
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1. Significant Transactions
    A ``significant transaction'' is any transaction (including one 
involving instruments other than complex securities) that might 
reasonably be expected to increase an institution's Sensitivity Measure 
by more than 25 basis points. Prior to undertaking any significant 
transaction, management should conduct an analysis of the incremental 
effect of the proposed transaction on the interest rate risk profile of 
the institution. The analysis should show the expected change in the 
institution's net portfolio value (with and without the proposed 
transaction) that would result from an immediate parallel shift in the 
yield curve of plus and minus 100, 200, and 300 basis points. In 
general, an institution should conduct its own analysis. It may, 
however, rely on analysis conducted by an independent third-party 
(i.e., someone other than the seller or counterparty) provided 
management understands the analysis and its key assumptions.
    Institutions with less than $1 billion in assets that do not have 
the internal modeling capability to conduct such an incremental 
analysis may use the most recent quarterly NPV estimates for their 
institution provided by OTS to estimate the incremental effect of a 
proposed transaction on the sensitivity of its net portfolio 
value.7
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    \7\ Institutions that are exempt from filing Schedule CMR and 
that choose not to file voluntarily, should ensure that no 
transaction--whether involving complex securities, financial 
derivatives, or any other financial instruments--causes the 
institution to fall out of compliance with its board of directors' 
interest rate risk limits.
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2. Complex Securities and Financial Derivatives
    Prior to taking a position in any complex security or financial 
derivative, an institution should conduct a price sensitivity analysis 
(i.e., pre-purchase analysis) of the instrument. At a minimum, the 
analysis should show the expected change in the value of the instrument 
that would result from an immediate parallel shift in the yield curve 
of plus and minus 100, 200, and 300 basis points. Where appropriate, 
the analysis should encompass a wider range of scenarios (e.g., non-
parallel changes in the yield curve, changes in interest rate 
volatility, changes in credit spreads, and in the case of mortgage-
related securities, changes in prepayment speeds). In general, an 
institution should conduct its own in-house pre-acquisition analysis. 
An institution may, however, rely on an analysis conducted by an 
independent third-party (i.e., someone other than the seller or 
counterparty) provided management understands the analysis and its key 
assumptions.
    Investments in complex securities and the use of financial 
derivatives by institutions that do not have adequate risk measurement, 
monitoring, and control systems may be viewed as an unsafe and unsound 
practice.
3. Risk Reduction
    In general, the use of financial derivatives or complex securities 
with high price sensitivity 8 should be limited to 
transactions and strategies that lower an institution's interest rate 
risk as measured by the sensitivity of net portfolio value to changes 
in interest rates. An institution that uses financial derivatives or 
invests in such securities for a purpose other than that of reducing 
portfolio risk should do so in accordance with safe and sound practices 
and should:
---------------------------------------------------------------------------

    \8\ For purposes of this Bulletin, ``complex securities with 
high price sensitivity'' include those whose price would be expected 
to decline by more than 10 percent under an adverse parallel change 
in interest rates of 200 basis points.
---------------------------------------------------------------------------

    (a) Obtain written authorization from its board of directors to use 
such instruments for a purpose other than to reduce risk; and
    (b) Ensure that, after the proposed transaction(s), the 
institution's Post-Shock NPV Ratio would not be less than 6 percent.
    The use of financial derivatives or complex securities with high 
price sensitivity for purposes other than to reduce risk by 
institutions that do not meet the conditions set forth above may

[[Page 20262]]

be viewed as an unsafe and unsound practice.

B. Record-Keeping

    Institutions must maintain accurate and complete records of all 
securities and derivatives transactions in accordance with 12 CFR 
562.1. Institutions should retain any analyses (including pre-and post-
purchase analyses) relating to investments and derivatives transactions 
and make such analyses available to examiners upon request.
    In addition, for each type of financial derivative instrument 
authorized by the board of directors, the institution should maintain 
records containing:
    (a) The names, duties, responsibilities, and limits of authority 
(including position limits) of employees authorized to engage in 
transactions involving the instrument;
    (b) A list of approved counterparties with which transactions may 
be conducted;
    (c) A list showing the credit risk limit for each approved 
counterparty; and
    (d) A contract register containing key information on all 
outstanding contracts and positions.
    The contract registers should specify the type of contract, the 
price of each open contract, the dollar amount, the trade and maturity 
dates, the date and manner in which contracts were offset, and the 
total outstanding positions.
    Where deferred gains or losses on derivatives from hedging 
activities have been recorded consistent with generally accepted 
accounting principles (GAAP), the institution should maintain 
appropriate supporting documentation.9
---------------------------------------------------------------------------

    \9\ At the time of this writing, it was anticipated that the 
FASB's proposed standard, ``Accounting for Derivative and Similar 
Financial Instruments and for Hedging Activities,'' would be issued 
in 1998, to be effective in 1999. Under that proposal, all 
``derivative financial instruments,'' as defined, including those 
used for hedging purposes, would be accounted for at fair value. 
Accordingly, under the FASB's proposal, deferred gains and losses on 
``derivative financial instruments'' from hedging activities would 
no longer be recorded.
---------------------------------------------------------------------------

C. Supervisory Assessment of Investment and Derivatives Activities

    Examiners will assess the overall quality and effectiveness of the 
institution's risk management process governing investment and 
derivatives activities. In making such assessments, examiners will take 
into account compliance with the guidelines set forth above and the 
quality of the institution's risk management process. The quality of 
the institution's risk management process will be evaluated in the 
context of Appendix B, Sound Practices for Market Risk Management.

Part IV: Guidelines for the ``Sensitivity to Market Risk'' 
Component Rating

    Consistent with the interagency Uniform Financial Institutions 
Rating System, or CAMELS rating system, of which an excerpt is attached 
as Appendix C, the ``Sensitivity to Market Risk'' component rating 
(i.e., the ``S'' rating) is based on examiners' conclusions about two 
dimensions: (1) An institution's level of market risk and (2) the 
quality of its practices for managing market risk. This section 
discusses the guidelines that examiners will use in assessing the two 
dimensions and combining those assessments into a component rating. 
Because few thrift institutions have significant exposure to foreign 
exchange risk or commodity or equity price risks, interest rate risk 
will generally be the only form of market risk to be assessed under 
this component rating.

A. Assessing the Level of Interest Rate Risk

    Examiners will base their conclusions about an institution's level 
of interest rate risk--the first dimension for determining the ``S'' 
component rating--primarily on the interest rate sensitivity of the 
institution's net portfolio value. The two specific measures of risk 
that will receive examiners' primary attention are the Interest Rate 
Sensitivity Measure and the Post-shock NPV Ratio (see Glossary for 
definitions).
    OTS uses risk measures based on NPV for several reasons. First, the 
NPV measures are more readily comparable across institutions than 
internally generated measures of earnings sensitivity. Second, NPV 
focuses on a longer-term analytical horizon than institutions' 
internally generated earnings sensitivity measures. (The interest rate 
sensitivity of earnings is typically measured over a short-term horizon 
such as a year, while NPV is based on all future cash flows anticipated 
from an institution's existing assets, liabilities, and off-balance 
sheet contracts.) Third, the NPV-based measures take better account of 
the embedded options present in the typical thrift institution's 
portfolio.
1. Interest Rate Sensitivity Measure
    In assessing the level of interest rate risk, a high (i.e., risky) 
Interest Rate Sensitivity Measure, by itself, may not give cause for 
supervisory concern when the institution has a strong capital position. 
Because an institution's risk of failure is inextricably linked to 
capital and, hence, to its ability to absorb adverse economic shocks, 
an institution with a high level of economic capital (i.e., NPV) may be 
able safely to support a high Sensitivity Measure.
2. Post-Shock NPV Ratio
    The Post-shock NPV Ratio is a more comprehensive gauge of risk than 
the Sensitivity Measure because it incorporates estimates of the 
current economic value of an institution's portfolio, in addition to 
the reported capital level and interest rate risk sensitivity. There 
are three potential causes of a low (i.e., risky) Post-shock NPV Ratio: 
(i) Low reported capital; (ii) significant unrecognized depreciation in 
the value of the portfolio; or (iii) high interest rate sensitivity. 
Although the first two of these, low reported capital and significant 
unrecognized depreciation in portfolio value, may cause supervisory 
concern (and receive attention under the portions of the examination 
devoted to evaluating Capital Adequacy, Asset Quality, or Earnings), 
they do not necessarily represent an ``interest rate risk problem.'' 
Only when an institution's low Post-shock Ratio is, in whole or in 
part, caused by high interest rate sensitivity is an interest rate risk 
problem suggested. That condition is reflected in the guidelines 
discussed below.
3. Guidelines for Determining the Level of Interest Rate Risk
    In describing the five levels of the ``S'' component rating, the 
interagency uniform ratings system established several qualitative 
levels of risk: ``minimal,'' ``moderate,'' ``significant,'' ``high,'' 
and ``imminent threat.'' The following interest rate risk levels are 
ordinarily indicated for OTS-regulated institutions, based on the 
combination of each institution's Post-shock NPV Ratio and Interest 
Rate Sensitivity Measure. (These guidelines are summarized in Table 1 
below.) These risk levels are for guidance, they are not mandatory; 
examiners have discretion to exercise judgment in a number of respects 
(see Part IV.D, Examiner Judgment).
    An institution with a Post-shock NPV Ratio below 4% and an Interest 
Rate Sensitivity Measure of:
    (a) More than 200 basis points will ordinarily be characterized as 
having ``high'' risk. Such an institution will typically receive a 4 or 
5 rating for the ``S'' component.10
---------------------------------------------------------------------------

    \10\ According to the interagency uniform ratings system, the 
level of market risk at a 4-rated institution is ``high,'' while 
that at a 5-rated institution is so high as to pose ``an imminent 
threat to its viability.'' Under the Prompt Corrective Action 
regulation, 12 CFR Part 565, supervisory action is tied to 
regulatory capital. An institution's viability is, therefore, 
directly dependent on regulatory capital, not on economic capital. 
Because regulatory capital can remain positive for an extended 
period of time after economic capital has become zero or negative, 
the NPV measures are not by themselves indicators of near-term 
viability. For an institution's level of interest rate risk to 
constitute an imminent threat to viability, the institution will 
typically have a high level of risk and will be critically 
undercapitalized.

---------------------------------------------------------------------------

[[Page 20263]]

    (b) 100 to 200 basis points will ordinarily be characterized as 
having ``significant'' risk. Such an institution will typically receive 
a 3 rating for the ``S'' component.
    (c) 0 to 100 basis points will ordinarily be characterized as 
having ``moderate'' risk. Such an institution will typically receive a 
rating of 2 for the ``S'' component. If the institution's sensitivity 
is extremely low, a rating of 1 may be supportable if the institution 
is not likely to incur larger losses under rate shocks other than the 
parallel shocks depicted in the OTS NPV Model.
    An institution with a Post-shock NPV Ratio between 4% and 8% and an 
Interest Rate Sensitivity Measure of:
    (a) More than 400 basis points will ordinarily be characterized as 
having ``high'' risk. Such an institution will typically receive a 4 or 
5 rating for the ``S'' component.
    (b) 200 to 400 basis points will ordinarily be characterized as 
having ``significant'' risk. Such an institution will typically receive 
a 3 rating for the ``S'' component.
    (c) 100 to 200 basis points will ordinarily be characterized as 
having ``moderate'' risk. Such an institution will typically receive a 
2 rating for the ``S'' component.
    (d) 0 to 100 basis points will ordinarily be characterized as 
having ``minimal'' risk. Such an institution will typically receive a 
rating of 1 for the ``S'' component.
    An institution with a Post-shock NPV Ratio between 8% and 12% and 
an Interest Rate Sensitivity Measure of:
    (a) More than 400 basis points will ordinarily be characterized as 
having ``significant'' risk. Such an institution will typically receive 
a 3 rating for the ``S'' component.
    (b) 200 to 400 basis points will ordinarily be characterized as 
having ``moderate'' risk. Such an institution will typically receive a 
2 rating for the ``S'' component.
    (c) Less than 200 basis points will ordinarily be characterized as 
having ``minimal'' risk. Such an institution will typically receive a 
rating of 1 for the ``S'' component.
    An institution with a Post-shock NPV Ratio of more than 12% and an 
Interest Rate Sensitivity Measure of:
    (a) More than 400 basis points will ordinarily be characterized as 
having ``moderate'' risk. Such an institution will typically receive a 
2 rating for the ``S'' component.
    (b) Less than 400 basis points will ordinarily be characterized as 
having ``minimal'' risk. Such an institution will typically receive a 
rating of 1 for the ``S'' component.
BILLING CODE 6720-01-P
[GRAPHIC] [TIFF OMITTED] TN23AP98.001

BILLING CODE 6720-01-C
    In Table 1 the numbers in parentheses represent the preliminary 
``S'' component ratings that an institution would ordinarily receive 
barring deficiencies in its risk management practices. Examiners may 
assign a different rating based on their interpretation of the facts 
and circumstances at each institution.
4. Internal vs. OTS Risk Measures
    In applying the guidelines described above, examiners will 
encounter three general types of situations regarding the availability 
of risk measures.
    First, if the institution does not have internal NPV measures, but 
does file Schedule CMR, examiners will use the NPV measures produced by 
OTS. In such instances, examiners must be
  
aware of the importance of accurate reporting by the institution on 
Schedule CMR, particularly of items for which the institution provides 
its own market value estimates in the various interest rate scenarios, 
such as for mortgage derivative securities. They must also be aware of 
circumstances in which the OTS measures may overstate or understate the 
sensitivity of an institution's financial instruments.
    Second, if the institution does produce its own NPV measures, 
examiners will have to decide whether to use the institution's or OTS' 
risk measures.
    (a) If the institution's own measures and those produced by OTS are 
broadly consistent and result in the same risk category (e.g., 
``minimal risk,''
  
``moderate risk,'' etc.), the choice between using the institution's 
measures or the OTS estimates probably does not matter, though 
examiners should attempt to ascertain the reasons for any major 
discrepancies between the two sets of results.
    (b) If the institution's NPV measures place it in a different risk 
category than the OTS measures do, examiners (in consultation with 
their Regional Capital Markets group or the Washington Risk Management 
Division) should determine which financial instruments are the source 
of that discrepancy. If the institution's valuations for those 
instruments are judged more reliable than OTS', the institution's 
results will be used to replace the OTS results for

[[Page 20264]]

those financial instruments in calculating NPV in the various interest 
rate scenarios.
    (c) If examiners have reason to doubt both the institution's own 
measures and those produced by OTS, they may modify (in consultation 
with their Regional Capital Markets group or the Washington Risk 
Management Division) either or both measures to arrive at NPV measures 
they consider reasonable.
    In deciding whether to rely on an institution's internal NPV 
measures, examiners will ensure that the institution's measures are 
produced in a manner that is broadly consistent with the OTS measures. 
(The major methodological points to consider are described in Part 
II.B, Systems for Measuring Interest Rate Risk.)
    The third situation examiners will encounter is one in which the 
institution calculates no internal NPV measures and does not report on 
Schedule CMR. Because no NPV results will be available in such cases, 
the guidelines are not directly applicable. In addition to reviewing 
the institution's balance sheet structure in such cases, examiners will 
review whatever interest rate risk measurement and management tools the 
institution uses to comply with Sec. 563.176. Depending on their 
findings regarding the institution's general level of risk and its risk 
management practices, examiners might reconsider the appropriateness of 
the institution's continued exemption from filing Schedule CMR.

B. Assessing the Quality of Risk Management

    In drawing conclusions about the quality of an institution's risk 
management practices--the second dimension of the ``S'' component 
rating--examiners will assess all significant facets of the 
institution's risk management process. To aid in that assessment, 
examiners will refer to Appendix B of this Bulletin which provides a 
set of Sound Practices for Market Risk Management. These sound 
practices suggest the sorts of management practices institutions of 
varying levels of sophistication may utilize. As (i) the size of the 
institution increases, (ii) the complexity of its assets, liabilities, 
or off-balance sheet contracts increases, or (iii) the overall level of 
interest rate risk at the institution increases, its risk management 
process should exhibit more of the elements included in the Sound 
Practices and should display a greater degree of formality and rigor. 
Because there is no formula for determining the adequacy of such 
systems, examiners will make that determination on a case-by-case 
basis. Examiners will, however, take the following eight factors, among 
others, into consideration in assessing the quality of an institution's 
risk management process.
1. Oversight by Board and Senior Management
    Examiners will assess the quality of oversight provided by the 
institution's board and senior management. That assessment may include 
many facets, as described in Appendix B, Sound Practices for Market 
Risk Management.
2. Prudent Limits
    Examiners will assess whether the institution's board-approved 
interest rate risk limits are prudent. Ordinarily, examiners will 
consider a set of IRR limits imprudent if they permit the institution's 
NPV potentially to exhibit a Post-shock NPV Ratio and Interest Rate 
Sensitivity Measure that would ordinarily warrant an ``S'' component 
rating of 3 or worse (see Table 1, in Part IV.A.3). Imprudent limits 
may result in examiner criticism or an adverse ``S'' rating. See 
Appendix A, Identifying Prudent Interest Rate Risk Limits, for examples 
of how examiners will make that determination.
3. Adherence to Limits
    Assuming the institution's interest rate risk limits are considered 
prudent, examiners will assess the degree to which the institution 
adheres to those limits. Frequent exceptions to the board's limits may 
indicate weak interest rate risk management practices. Similarly, 
recurrent changes to the institution's limits to accommodate exceptions 
to the limits may reflect ineffective board oversight.
4. Quality of System for Measuring NPV Sensitivity
    Examiners will consider whether the quality of the institution's 
risk measurement and monitoring system is commensurate with the 
institution's size, the complexity of its financial instruments, and 
its level of interest rate risk. Examiners will generally expect the 
quality of an institution's system for measuring the interest rate 
sensitivity of NPV to be consistent with the descriptions in Part II.B, 
Systems for Measuring Interest Rate Risk.
5. Quality of System for Measuring Earnings Sensitivity
    OTS places considerable reliance on NPV analysis to assess an 
institution's interest rate risk. Other sorts of measures may, however, 
be considered in evaluating an institution's risk management practices. 
In particular, utilization of a well-supported earnings sensitivity 
analysis may be viewed as a favorable factor in determining an 
institution's component rating. In fact, all institutions are 
encouraged to measure the interest rate sensitivity of projected 
earnings. Despite inherent limitations,11 such analyses can 
provide useful information to an institution's management.
---------------------------------------------------------------------------

    \11\ The effectiveness of an earnings sensitivity model to 
identify interest rate risk depends on the composition of an 
institution's portfolio. In particular, management should recognize 
that such models generally do not fully take account of longer-term 
risk factors.
---------------------------------------------------------------------------

    Methodologies used in measuring earnings sensitivity vary 
considerably among different institutions. To assist the examiner in 
reviewing the earnings modeling process, institutions should have clear 
descriptions of the methodologies and assumptions used in their models. 
Of particular importance are the type of rate scenarios used (e.g., 
instantaneous or gradual, consistent with forward yield curve) and 
assumptions regarding new business (i.e., type of assets, dollar 
amounts, and interest rates). In addition, formulas for projecting 
interest rate changes on existing business (e.g., ARMs, transaction 
deposits) should be clearly described and any major differences from 
analogous formulas used in the OTS NPV Model should be explained and 
supported.
6. Integration of Risk Management With Decision-Making
    Examiners will consider the extent to which the results of an 
institution's risk measurement system are used by management in making 
operational decisions (e.g., changes in portfolio structure, 
investments, derivatives activities, business planning, funding 
decisions, pricing decisions). This is of particular significance if 
the institution's Post-shock NPV Ratio is relatively low, and thus 
provides less of an economic buffer against loss.
    Examiners will evaluate whether management considers the effect of 
significant operational decisions on the institution's level of 
interest rate risk. The form of analysis used for measuring that effect 
(earnings sensitivity, NPV sensitivity, or any other reasonable 
approach) and all details of the measurement are up to the institution. 
That analysis should be an active factor in management's decision-
making and not be generated solely to avoid examiner criticism. In the 
absence of such a decision-making process, examiner criticism or an 
adverse rating may be appropriate.

[[Page 20265]]

7. Investments and Derivatives
    Examiners will consider the adequacy of the institution's risk 
management policies and procedures regarding investment and derivatives 
activities. See Part III of this Bulletin, Investment Securities and 
Financial Derivatives, for a detailed discussion.
8. Size, Complexity, and Risk Profile
    Under the interagency uniform ratings descriptions, an 
institution's risk management practices are evaluated relative to its 
``size, complexity, and risk profile.'' Thus, a small institution with 
a simple portfolio and a consistently low level of risk may receive an 
``S'' rating of 1 even if its risk management practices are fairly 
rudimentary. A large institution with these same characteristics would 
be expected to have more rigorous risk management practices, but would 
not be held to the same risk management standards as a similarly sized 
institution with either a higher level of risk or a portfolio 
containing complex securities or financial derivatives. An institution 
making a conscious business decision to maintain a low risk profile by 
investing in low risk products or maintaining a high level of capital 
may not require elaborate and costly risk management systems.

C. Combining Assessments of the Level of Risk and Risk Management 
Practices

    Guidelines examiners will use in assessing an institution's level 
of risk and the quality of its risk management practices have been 
described in the two previous sections. This section provides 
guidelines for combining those two assessments into an ``S'' component 
rating for the institution.
    The interagency uniform ratings descriptions specify the criteria 
for the ``S'' component ratings in terms of the level of risk and the 
quality of risk management practices (see Appendix C). For example:

    A rating of 1 indicates that market risk sensitivity is well 
controlled and that there is minimal potential that the earnings 
performance or capital position will be adversely affected. * * * 
[emphasis added]

    Thus, if market risk is less than ``well controlled'' (i.e., 
``adequately controlled,'' ``in need of improvement,'' or 
``unacceptable'') the institution does not qualify for a component 
rating of 1. Likewise, if the level of market risk is more than 
``minimal'' (i.e., ``moderate,'' ``significant,'' or ``high'') the 
institution similarly does not qualify for a rating of 1.
    Applying the same logic to the descriptions of the 2, 3, 4, and 5 
levels of the ``S'' component rating results in the ratings guidelines 
shown in Table 2. That table summarizes how various combinations of 
examiner assessments about an institution's ``level of interest rate 
risk'' and ``quality of risk management practices'' translate into a 
suggested rating.12
---------------------------------------------------------------------------

    \12\ Some of the combinations of risk management quality and 
level of risk shown in the table will rarely, if ever, be 
encountered (e.g., an institution with ``unacceptable'' risk 
management practices, but a ``minimal'' level of risk). For the sake 
of completeness, however, all cells of the matrix are shown.
---------------------------------------------------------------------------

    Two important caveats must be noted about this table. First, the 
two dimensions are not totally independent of one another, because the 
quality of risk management practices is evaluated relative to an 
institution's level of risk (among other things). Thus, for example, an 
institution's risk management practices are more likely to be assessed 
as ``well controlled'' if the institution has minimal risk than if it 
has a higher level of risk. Second, as described further in the next 
section, the ratings shown in Table 2 are provisional and subject to 
examiner discretion.

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[GRAPHIC] [TIFF OMITTED] TN23AP98.002

BILLING CODE 6720-01-C

D. Examiner Judgment

    Examiners have a responsibility to exercise judgment in assigning 
ratings based on the facts they encounter at each institution. This 
section provides a non-exhaustive list of factors examiners may 
consider in applying the ``S'' rating guidelines to a particular 
institution.
1. Judgment in Assessing the Level of Risk
    In assessing the level of interest rate risk, the likelihood that 
examiners will deviate from the guidelines in Table 1 is heightened in 
cases where the Post-shock NPV Ratio and the Interest Rate Sensitivity 
Measure are both near cell boundaries. For example, there is no 
material difference between an institution whose Post-shock Ratio and 
Sensitivity Measure are, respectively, 4.01% and 199 b.p. and one where 
they

[[Page 20266]]

are 3.99% and 201 b.p., yet the guidelines in Table 1 suggest a 2 
rating for the former and a 4 for the latter. Clearly, the boundaries 
of the cells in the table must be interpreted as transition zones, 
rather than precise cut-off points, between suggested ratings. As such, 
examiners will more commonly deviate from the stated guidelines in the 
vicinity of cell borders than in their interior.
    In applying the guidelines in Table 1 generally, but especially in 
such borderline cases, many considerations may cause an examiner to 
reach a different conclusion than suggested by the guidelines. Such 
considerations include the following:
    (a) The trend in the institution's risk measures during recent 
quarters.
    (b) The trend in the institution's risk measures compared with 
those of the rest of the industry in recent quarters. (Comparison with 
the results for the industry as a whole often provides a useful 
backdrop for evaluating an institution's results, particularly during a 
period of volatile interest rates.)
    (c) The examiner's level of comfort with the overall accuracy of 
the available risk measures as applied to the particular products of 
the institution.
    (d) The existence of items with particularly volatile or uncertain 
interest rate sensitivity for which the examiner wants to allow an 
added margin for possible error.
    (e) The effect of any restructuring that may have occurred since 
the most recently available risk measures.
    (f) Other available evidence that causes the examiner to favor a 
higher or lower risk assessment than that suggested by the guidelines.
2. Judgment in Assessing the Quality of Risk Management Practices
    Conclusions about the quality of risk management practices should 
be based, in part, on the institution's level of risk, with less risky 
institutions requiring less rigorous risk management practices. 
Considerations listed in the Judgment in Assessing the Level of Risk, 
above, may therefore cause the examiner to modify his or her assessment 
of the institution's risk management practices. In addition, if changes 
have occurred in the institution's level of risk since the last 
evaluation, the examiner may wish to reassess the quality of the 
institution's risk management practices in light of these changes.

Part V: Supervisory Action

    If supervisory action to address interest rate risk is needed, 
examiners will discuss the problem with management and obtain their 
commitment to correct the problem as quickly as practicable.
    If deemed necessary, examiners will request a written plan from the 
board and management to reduce interest rate sensitivity, increase 
capital, or both. The plan should include specific risk measure 
targets. If the initial plan is inadequate, examiners will require 
amendment and resubmission. Examiners will document the corrective 
strategy and results in the Regulatory Plan, and review progress at 
case review meetings.
    For institutions with composite ratings of 4 or 5, the presumption 
of formal enforcement action generally requires a supervisory 
agreement, cease and desist order, prompt corrective action directive, 
or other formal supervisory action.
    If an institution's interest rate risk increases between 
examinations, examiners will consider whether a downgrade of the ``S'' 
component rating or the composite rating is warranted. Examiners will 
obtain quarterly progress reports (more frequently if the situation is 
severe). Where appropriate, examiners may require the institution to 
develop the capacity to conduct its own modeling.

Appendix A: Identifying Prudent Interest Rate Risk Limits

    The basic principle examiners will use in determining whether an 
institution's risk limits are prudent is that the limits should not 
permit NPV to reach such a level that the Post-shock NPV Ratio and 
Sensitivity Measure would suggest an ``S'' component rating of 3 or 
worse under the guidelines for the Level of Risk (reproduced here as 
Table 1).

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[[Page 20267]]


BILLING CODE 6720-01-C

Examples of Evaluating the Prudence of Interest Rate Risk Limits

    The following examples illustrate how OTS examiners will evaluate 
whether an institution's interest rate risk limits are prudent. In each 
example, the interest rate risk limits approved by the institution's 
board of directors are shown in column [b]. These specify a minimum NPV 
Ratio for each of the interest rate scenarios shown in column [a]. The 
NPV Ratios currently estimated for the institution for each rate 
scenario are shown in column [c].

Example Institution A

              Institution A.--Limits and Current NPV Ratios             
------------------------------------------------------------------------
                                                [b] Board               
                                                  limits        [c]     
                                                 (minimum  Institution's
       [a] Rate shock (in basis points)            NPV      current NPV 
                                                 ratios)       ratios   
                                                (percent)    (percent)  
------------------------------------------------------------------------
+300..........................................       6.00        10.00  
+200..........................................       7.00        11.50  
+100..........................................       8.00        12.50  
0.............................................       9.00        13.00  
-100..........................................      10.00        13.25  
-200..........................................      11.00        13.50  
-300..........................................      12.00        13.75  
------------------------------------------------------------------------

    To determine whether Institution A's interest rate risk limits are 
prudent, examiners will evaluate the risk measures permitted under 
those limits relative to the guidelines for the Level of Risk in Table 
1. The Post-shock NPV Ratio permitted by the institution's board limits 
is 7.00% (from the +200 b.p. scenario in column [b], above). The 
Sensitivity Measure permitted by the limits is not known; it depends on 
the actual level of the base case NPV Ratio which will probably be 
higher than the limit for the base case scenario. Examiners will, 
therefore, use the institution's current Sensitivity Measure (based on 
OTS' results or those of the institution) in performing their 
evaluation. Institution A's current Sensitivity Measure is 150 basis 
points (i.e., [13.00%--11.50%], the NPV Ratios in the 0 b.p. and +200 
b.p. scenarios in column [c], above).
    Referring to Table 1, the Post-shock NPV Ratio allowed by the 
institution's limits falls into the ``4% to 8%'' row and its current 
Sensitivity Measure falls into the ``100 to 200 b.p.'' column. The 
rating suggested by Table 1 is, therefore, a 2, and Institution A's 
risk limits would, thus, probably be considered prudent.13
---------------------------------------------------------------------------

    \13\ This example assumes there are no significant deficiencies 
in the institution's risk management practices.
---------------------------------------------------------------------------

Example Institution B

              Institution B.--Limits and Current NPV Ratios             
------------------------------------------------------------------------
                                                [b] Board               
                                                  limits        [c]     
                                                 (minimum  Institution's
       [a] Rate shock (in basis points)            NPV      current NPV 
                                                 ratios)       ratios   
                                                (percent)    (percent)  
------------------------------------------------------------------------
+300..........................................       6.00         6.00  
+200..........................................       7.00         8.50  
+100..........................................       8.00        11.00  
0.............................................       9.00        13.00  
-100..........................................      10.00        14.00  
-200..........................................      11.00        14.50  
-300..........................................      12.00        15.00  
------------------------------------------------------------------------

    Institution B has identical interest rate risk limits as 
Institution A, but is considerably more interest rate sensitive than 
Institution A. Institution B's Sensitivity Measure is 450 b.p. (i.e., 
[13.00%--8.50%]).
    For purposes of applying the guidelines in Table 1 to the limits, 
the Post-shock NPV Ratio of 7.00% permitted by the institution's board 
limits falls into the ``4% to 8%'' row. Its current Sensitivity 
Measure, however, falls into the ``Over 400 b.p.'' column of Table 1. 
The rating suggested by the guidelines is therefore a 4, and 
Institution B's risk limits would probably not be considered prudent. 
Even though its limits are identical to those of Institution A, its 
much higher current Sensitivity Measure requires the support of a 
higher Post-shock NPV Ratio than the minimum permitted by the board 
limits.

Example Institution C

              Institution C.--Limits and Current NPV Ratios             
------------------------------------------------------------------------
                                                [b] Board               
                                                  limits        [c]     
                                                 (minimum  Institution's
       [a] Rate shock (in basis points)            NPV      current NPV 
                                                 ratios)       ratios   
                                                (percent)    (percent)  
------------------------------------------------------------------------
+300..........................................       6.00         6.00  
+200..........................................       6.00         8.50  
+100..........................................       6.00        11.00  
0.............................................       6.00        13.00  
-100..........................................       6.00        14.00  
-200..........................................       6.00        14.50  
-300..........................................       6.00        15.00  
------------------------------------------------------------------------

    Institution C has the same current NPV Ratios as Institution B, but 
its board limits are a uniform 6.00% in all rate scenarios. In judging 
the prudence of its limits, the Post-shock NPV Ratio permitted by the 
limits is, therefore, 6.00%. Its current Sensitivity Measure, like that 
of Institution B, is 450 b.p.
    In applying the Table 1 guidelines to the limits, Institution C's 
Post-shock NPV Ratio is in the ``4% to 8%'' row and its Sensitivity 
Measure in the ``Over 400 b.p.'' column of Table 1, so the rating 
suggested by the table is a 4, just like Institution B. Thus, 
Institution C's risk limits would also probably not be considered 
prudent.

Example Institution D

              Institution D.--Limits and Current NPV Ratios             
------------------------------------------------------------------------
                                                [b] board               
                                                  limits        [c]     
                                                 (minimum  Institution's
       [a] Rate shock (in basis points)            NPV      current NPV 
                                                 ratios)       ratios   
                                                (percent)    (percent)  
------------------------------------------------------------------------
+300..........................................       3.50         2.50  
+200..........................................       3.50         3.25  
+100..........................................       3.50         3.75  
0.............................................       3.50         4.00  
-100..........................................       3.50         4.25  
-200..........................................       3.50         4.50  
-300..........................................       3.50         4.75  
------------------------------------------------------------------------

    Institution D has a relatively low base case level of economic 
capital, and its board limits recognize that fact by permitting 
relatively low NPV Ratios. Furthermore, the institution's level of 
interest rate risk currently exceeds the board limits (i.e., the 
current NPV Ratios in the +200 and +300 scenarios are below the 3.50% 
minimums). While examiners would be very likely to express concern 
about that aspect of the institution's risk management process, the 
limits themselves might still be prudent.
    To determine whether the institution's limits are prudent, 
examiners will use the Post-shock NPV Ratio of 3.50% permitted by the 
limits and the institution's current Sensitivity Measure of 75 basis 
points (i.e., [4.00%-3.25%]). In applying Table 1, the Post-shock NPV 
Ratio permitted by the limits falls into the ``Below 4%'' row and the 
current Sensitivity Measure falls into the ``0 to 100 b.p.'' column. 
The rating suggested by Table 1 is therefore a 2, and assuming that 
Institution A's Sensitivity Measure has been consistently low, its risk 
limits would probably be considered prudent. Because of the critical 
importance of the Sensitivity Measure in this determination, examiners 
might well arrive at a different conclusion if they

[[Page 20268]]

lack assurance that the institution has the ability to maintain that 
measure at its current, low level. Thus, if the Sensitivity Measure has 
been volatile in the past or if examiners have concerns about the 
quality of the institution's risk management practices, they may 
probably conclude that the risk limits are not prudent.

Appendix B: Sound Practices for Market Risk Management

    This section describes the key elements for effective management of 
market risk exposures. These key elements encompass sound practices for 
both interest rate risk management and the management of investment and 
derivatives activities.
    The degree of formality and rigor with which an institution 
implements these elements in its own risk management system should be 
consistent with the institution's size, the complexity of its financial 
instruments, its tolerance for risk, and the level of market risk at 
which it actually operates.

A. Board and Senior Management Oversight

    Effective oversight is an integral part of an effective risk 
management program. The board and senior management should understand 
their oversight responsibilities regarding interest rate risk 
management and the management of investment and derivatives activities 
conducted by their institution.
Board of Directors
    The board of directors should approve broad strategies and major 
policies relating to market risk management and ensure that management 
takes the steps necessary to monitor and control market risk. The board 
of directors should be informed regularly of the institution's risk 
exposures.
    The board of directors has ultimate responsibility for 
understanding the nature and level of risk taken by the institution. 
Board oversight need not involve the entire board, but may be carried 
out by an appropriate subcommittee of the board. The board, or an 
appropriate subcommittee of board members, should:
     Approve broad objectives and strategies and major policies 
governing interest rate risk management and investment and derivatives 
activities.
     Provide clear guidance to management regarding the board's 
tolerance for risk.
     Ensure that senior management takes steps to measure, 
monitor, and control risk.
     Review periodically information that is sufficient in 
timeliness and detail to allow it to understand and assess the 
institution's interest rate risk and risks related to investment and 
derivatives activities.
     Assess periodically compliance with board-approved 
policies, procedures, and risk limits.
     Review policies, procedures and risk limits at least 
annually.
    Although board members are not required to have detailed technical 
knowledge, they should ensure that management has the expertise needed 
to understand the risks incurred by the institution and that the 
institution has personnel with the expertise needed to manage interest 
rate risk and conduct investment and derivative activities in a safe 
and sound manner.
Senior Management
    Senior management should ensure that the institution's operations 
are effectively managed, that appropriate risk management policies and 
procedures are established and maintained, and that resources are 
available to conduct the institution's activities in a safe and sound 
manner.
    Senior management is responsible for the daily oversight and 
management of the institution's activities, including the 
implementation of adequate risk management policies and procedures. To 
carry out its responsibilities, senior management should:
     Ensure that effective risk management systems are in place 
and properly maintained. An institution's risk management systems 
should include (1) systems for measuring risk, valuing positions, and 
measuring performance, (2) appropriate risk limits, (3) a comprehensive 
reporting and review process, and (4) effective internal controls.
     Establish and maintain clear lines of authority and 
responsibility for managing interest rate risk and for conducting 
investment and derivatives activities.
     Ensure that the institution's operations and activities 
are conducted by competent staff with technical knowledge and 
experience consistent with the nature and scope of their activities.
     Provide the board of directors with periodic reports and 
briefings on the institution's market-risk related activities and risk 
exposures.
     Review periodically the institution's risk management 
systems, including related policies, procedures, and risk limits.
Lines of Responsibility and Authority for Managing Market Risk
    Institutions should identify the individuals and/or committees 
responsible for risk management and should ensure there is adequate 
separation of duties in key elements of the risk management process to 
avoid potential conflicts of interest. Institutions should have a risk 
management function (or unit) with clearly defined duties that is 
sufficiently independent from position-taking functions.
    Institutions should identify the individuals and/or committees 
responsible for conducting risk management. Senior management should 
define lines of authority and responsibility for developing strategies, 
implementing tactics, and conducting the risk measurement and reporting 
functions.
    The risk management unit should report directly to both senior 
management and the board of directors, and should be separate from, and 
independent of, business lines. The function may be part of, or may 
draw its staff from, more general operations (e.g., the audit, 
compliance, or Treasury units). Large institutions should, however, 
have a separate risk management unit, particularly if the Treasury unit 
is also a profit center. Smaller institutions with limited resources 
and personnel should provide additional oversight by outside directors 
in order to compensate for the lack of separation of duties.
    Management should ensure that sufficient safeguards exist to 
minimize the potential that individuals initiating risk-taking 
positions may inappropriately influence key control functions of the 
risk management process such as the development and enforcement of 
policies and procedures, the reporting of risks to senior management, 
and the conduct of back-office functions.

B. Adequate Policies and Procedures

    Institutions should have clearly defined risk management policies 
and procedures. The board of directors has ultimate responsibility for 
the adequacy of those policies and procedures; senior management and 
the institution's risk management function have immediate 
responsibility for their design and implementation. Policies and 
procedures should be reviewed periodically and revised as needed.
Interest Rate Risk
    Institutions should have written policies and procedures for 
limiting and

[[Page 20269]]

controlling interest rate risk. Such policies and procedures should be 
consistent with the institution's strategies, financial condition, 
risk-management systems, and tolerance for risk. An institution's 
policies and procedures (or documentation issued pursuant to such 
policies) should:
     Address interest rate risk at the appropriate level(s) of 
consolidation. (Although the board will generally be most concerned 
with the consolidated entity, it should be aware that accounting and 
legal restrictions may not permit gains and losses occurring in 
different subsidiaries to be netted.)
     Delineate lines of responsibility and identify individuals 
or committees responsible for (1) developing interest rate risk 
management strategies and tactics, (2) making interest rate risk 
management decisions, and (3) conducting oversight.
     Identify authorized types of financial instruments and 
hedging strategies.
     Describe a clear set of procedures for controlling the 
institution's aggregate interest rate risk exposure.
     Define quantitative limits on the acceptable level of 
interest rate risk for the institution.
     Define procedures and conditions necessary for exceptions 
to policies, limits, and authorizations.
Investment and Derivatives Activities
    Institutions should have written policies and procedures governing 
investment and derivatives activities. Such policies and procedures 
should be consistent with the institution's strategies, financial 
condition, risk-management systems, and tolerance for risk. An 
institution's policies and procedures (or documentation issued pursuant 
to such policies) should:
     Identify the staff authorized to conduct investment and 
derivatives activities, their lines of authority, and their 
responsibilities.
     Identify the types of authorized investment securities and 
derivative instruments.
     Specify the type and scope of pre-purchase analysis that 
should be conducted for various types or classes of investment 
securities and derivative instruments.
     Define, where appropriate, position limits and other 
constraints on each type of authorized investment and derivative 
instrument, including constraints on the purpose(s) for which such 
instruments may be used.
     Identify dealers, brokers, and counterparties that the 
board or a committee designated by the board (e.g., a credit policy 
committee) has authorized the institution to conduct business with and 
identify credit exposure limits for each authorized entity.
     Ensure that contracts are legally enforceable and 
documented correctly.
     Establish a code of ethics and standards of professional 
conduct applicable to personnel involved in investment and derivatives 
activities.
     Define procedures and approvals necessary for exceptions 
to policies, limits, and authorizations.
    Policies and procedures governing investment and derivatives 
activities may be embedded in other policies, such as the institution's 
interest rate risk policies, and need not be stand-alone documents.

C. Risk Measurement, Monitoring, and Control Functions

Interest Rate Risk Measurement
    Institutions should have interest rate risk measurement systems 
that capture all material sources of interest rate risk. Measurement 
systems should utilize accepted financial concepts and risk measurement 
techniques and should incorporate sound assumptions and parameters. 
Management should understand the assumptions underlying their systems. 
Ideally, institutions should have interest rate risk measurement 
systems that assess the effects of interest rate changes on both 
earnings and economic value.
    An institution's interest rate risk measurement system should 
address all material sources of interest rate risk including repricing, 
yield curve, basis and option risk exposures. In many cases, the 
interest rate sensitivity of an institution's mortgage portfolio will 
dominate its aggregate risk profile. While all of an institution's 
holdings should receive appropriate treatment, instruments whose 
interest rate sensitivity may significantly affect the institutions 
overall results should receive special attention, as should instruments 
whose embedded options may have a significant effect on the results.
    The usefulness of any interest rate risk measurement system depends 
on the validity of the underlying assumptions and accuracy of the 
methodologies. In designing interest rate risk measurement systems, 
institutions should ensure that the degree of detail about the nature 
of their interest-sensitive positions is commensurate with the 
complexity and risk inherent in those positions.
    Management should assess the significance of the potential loss of 
precision in determining the extent of aggregation and simplification 
used in its measurement approach.
    Institutions should ensure that all material positions and cash 
flows, including off-balance-sheet positions, are incorporated into the 
measurement system. Where applicable, these data should include 
information on the coupon rates or cash flows of associated instruments 
and contracts. Any adjustments to underlying data should be documented, 
and the nature and reasons for the adjustments should be understood. In 
particular, any adjustments to expected cash flows for expected 
prepayments or early redemptions should be documented.
    Key assumptions used to measure interest rate risk exposure should 
be re-evaluated at least annually. Assumptions used in assessing the 
interest rate sensitivity of complex instruments should be documented 
and reviewed periodically.
    Management should pay special attention to those positions with 
uncertain maturities, such as savings and time deposits, which provide 
depositors with the option to make withdrawals at any time. In 
addition, institutions often choose not to change the rates paid on 
these deposits when market rates change. These factors complicate the 
measurement of interest rate risk, since the value of the positions and 
the timing of their cash flows can change when interest rates vary. 
Mortgages and mortgage-related instruments also warrant special 
attention due to the uncertainty about the timing of cash flows 
introduced by the borrowers' ability to prepay.
IRR Limits
    Institutions should establish and enforce risk limits that maintain 
exposures within prudent levels.
    Management should ensure that the institution's interest rate risk 
exposure is maintained within self-imposed limits. A system of interest 
rate risk limits should set prudent boundaries for the level of 
interest rate risk for the institution and, where appropriate, should 
also provide the capability to set limits for individual portfolios, 
activities, or business units.
    Limit systems should also ensure that positions exceeding limits or 
predetermined levels receive prompt management attention.
    Senior management should be notified immediately of any breaches of 
limits. There should be a clear policy as to how senior management will 
be informed and what action should be taken. Management should specify 
whether the limits are absolute in the sense that they should never be

[[Page 20270]]

exceeded or whether, under specific circumstances, breaches of limits 
can be tolerated for a short period of time.
    Limits should be consistent with the institution's approach to 
measuring interest rate risk.
    Interest rate risk limits should be tied to specific scenarios for 
movements in market interest rates and should include ``high stress'' 
interest rate scenarios.
    Limits may also be based on measures derived from the underlying 
statistical distribution of interest rates, using ``earnings-at-risk'' 
or ``value-at-risk'' techniques.
Stress Testing
    Institutions should measure their risk exposure under a number of 
different scenarios and consider the results when establishing and 
reviewing their policies and limits for interest rate risk.
    Institutions should use interest rate scenarios that are 
sufficiently varied to encompass different stressful conditions.
    Stress tests should include ``worst case'' scenarios in addition to 
more probable scenarios. Possible stress scenarios might include abrupt 
changes in the general level of interest rates, changes in the 
relationships among key market rates (i.e., basis risk), changes in the 
slope and the shape of the yield curve (i.e., yield curve risk), 
changes in the liquidity of key financial markets or changes in the 
volatility of market rates. In conducting stress tests, special 
consideration should be given to instruments or positions that may be 
difficult to liquidate or offset in stressful situations. Management 
and the board of directors should periodically review both the design 
and the results of such stress tests and ensure that appropriate 
contingency plans are in place.
Market Risk Monitoring and Reporting
    Institutions should have accurate, informative, and timely 
management information systems, both to inform management and to 
support compliance with board policy. Reports for monitoring and 
controlling market risk exposures should be provided on a timely basis 
to the board of directors and senior management.
    The board of directors and senior management should review market 
risk reports (i.e., interest rate risk reports and reports on 
investment and derivatives activities) on a regular basis (at least 
quarterly). While the types of reports prepared for the board and 
various levels of management will vary, they should include:
     Summaries of the institution's aggregate interest rate 
risk and other market risk exposures including results of stress tests.
     Reports on the institution's compliance with risk 
management policies, procedures, and limits.
     Reports comparing the institution's level of interest rate 
risk with other savings associations using industry data provided by 
OTS.
     A summary of any major differences between the results of 
the OTS Net Portfolio Value Model and the institution's own results.
     Summaries of internal and external reviews of the 
institution's risk management framework, including reviews of policies, 
procedures, risk measurement and control systems, and risk exposures.

D. Internal Controls

    Institutions should have an adequate system of internal controls 
over their interest rate risk management process. A fundamental 
component of the internal control system involves regular independent 
reviews and evaluations of the effectiveness of the system.
    Internal controls should be an integral part of an institution's 
risk management system. The controls should promote effective and 
efficient operations, reliable financial and regulatory reporting, and 
compliance with relevant laws, regulations, and institutional policies. 
An effective system of internal control for interest rate risk should 
include:
     Effective policies, procedures, and risk limits.
     An adequate process for measuring and evaluating risk.
     Adequate risk monitoring and reporting systems.
     A strong control environment.
     Continual review of adherence to established policies and 
procedures.
    Institutions are encouraged to have their risk measurement systems 
reviewed by knowledgeable outside parties. Reviews of risk measurement 
systems should include assessments of the assumptions, parameter 
values, and methodologies used. Such a review should evaluate the 
system's accuracy and recommend solutions to any identified weaknesses. 
The results of the review, along with any recommendations for 
improvement, should be reported to senior management and the board, and 
acted upon in a timely manner.
    Institutions should review their system of internal controls at 
least annually. Reviews should be performed by individuals independent 
of the function being reviewed. Results should be reported to the 
board. The following factors should be considered in reviewing an 
institution's internal controls:
     Are risk exposures maintained at prudent levels?
     Are the risk measures employed appropriate to the nature 
of the portfolio?
     Are board and senior management actively involved in the 
risk management process?
     Are policies, controls, and procedures well documented?
     Are policies and procedures followed?
     Are the assumptions of the risk measurement system well 
documented?
     Are data accurately processed?
     Is the risk management staff adequate?
     Have risk limits been changed since the last review?
     Have there been any significant changes to the 
institution's system of internal controls since the last review?
     Are internal controls adequate?

E. Analysis and Stress Testing of Investments and Financial Derivatives

    Management should undertake a thorough analysis of the various 
risks associated with investment securities and derivative instruments 
prior to making an investment or taking a significant position in 
financial derivatives and periodically thereafter. Major initiatives 
involving investments and derivatives transactions should be approved 
in advance by the board of directors or a committee of the board.
    As a matter of sound practice, prior to taking an investment 
position or initiating a derivatives transaction, an institution 
should:
     Ensure that the proposed investment or derivative 
transaction is legally permissible for a savings institution;
     Review the terms and conditions of the investment 
instrument or derivative contract;
     Ensure that the proposed transaction is allowable under 
the institution's investment or derivatives policies;
     Ensure that the proposed transaction is consistent with 
the institution's portfolio objectives and liquidity needs;
     Exercise diligence in assessing the market value, 
liquidity, and credit risk of any investment security or derivative 
instrument;
     Conduct a price sensitivity analysis of the security or 
financial derivative prior to taking a position, and
     Conduct an analysis of the incremental effect of any 
proposed transaction on the overall interest rate sensitivity of the 
institution.

[[Page 20271]]

    Prior to taking a position in any complex securities or financial 
derivatives, it is important to have an understanding of how the future 
direction of interest rates and other changes in market conditions 
could affect the instrument's cash flows and market value. In 
particular, management should understand:
     The structure of the instrument;
     The best-case and worst-case interest rates scenarios for 
the instrument;
     How the existence of any embedded options or adjustment 
formulas might affect the instrument's performance under different 
interest rate scenarios;
     The conditions, if any, under which the instrument's cash 
flows might be zero or negative;
     The extent to which price quotes for the instrument are 
available;
     The instrument's universe of potential buyers; and
     The potential loss on the instrument (i.e., the potential 
discount from its fair value) if sold prior to maturity.

F. Evaluation of New Products, Activities, and Financial Instruments

    Involvement in new products, activities, and financial instruments 
(assets, liabilities, or off-balance sheet contracts) can entail 
significant risk, sometimes from unexpected sources. Senior management 
should evaluate the risks inherent in new products, activities, and 
instruments and ensure that they are subject to adequate review 
procedures and controls.
    Products, activities, and financial instruments that are new to the 
organization should be carefully reviewed before use or implementation. 
The board, or an appropriate committee, should approve major new 
initiatives involving new products, activities, and financial 
instruments.
    Prior to authorizing a new initiative, the review committee should 
be provided with:
     A description of the relevant product, activity, or 
instrument
     An analysis of the appropriateness of the proposed 
initiative in relation to the institution's overall financial condition 
and capital levels
     A description of the procedures to be used to measure, 
monitor, and control the risks of the proposed product, activity, or 
instrument
    Management should ensure that adequate risk management procedures 
are in place in advance of undertaking any significant new initiatives.

Appendix C: Excerpt From Interagency Uniform Financial Institutions 
Rating System

Sensitivity to Market Risk

    The sensitivity to market risk component reflects the degree to 
which changes in interest rates, foreign exchange rates, commodity 
prices, or equity prices can adversely affect a financial institution's 
earnings or economic capital. When evaluating this component, 
consideration should be given to: management's ability to identify, 
measure, monitor, and control market risk; the institution's size; the 
nature and complexity of its activities; and the adequacy of its 
capital and earnings in relation to its level of market risk exposure.
    For many institutions, the primary source of market risk arises 
from non-trading positions and their sensitivity to changes in interest 
rates. In some larger institutions, foreign operations can be a 
significant source of market risk. For some institutions, trading 
activities are a major source of market risk.
    Market risk is rated based upon, but not limited to, an assessment 
of the following evaluation factors:
     The sensitivity of the financial institution's earnings or 
the economic value of its capital to adverse changes in interest rates, 
foreign exchange rates, commodity prices, or equity prices.
     The ability of management to identify, measure, monitor, 
and control exposure to market risk given the institution's size, 
complexity, and risk profile.
     The nature and complexity of interest rate risk exposure 
arising from non-trading positions.
     Where appropriate, the nature and complexity of market 
risk exposure arising from trading and foreign operations.

Ratings

    1. A rating of 1 indicates that market risk sensitivity is well 
controlled and that there is minimal potential that the earnings 
performance or capital position will be adversely affected. Risk 
management practices are strong for the size, sophistication, and 
market risk accepted by the institution. The level of earnings and 
capital provide substantial support for the degree of market risk taken 
by the institution.
    2. A rating of 2 indicates that market risk sensitivity is 
adequately controlled and that there is only  moderate  potential that 
the earnings performance or capital position will be adversely 
affected. Risk management practices are satisfactory for the size, 
sophistication, and market risk accepted by the institution. The level 
of earnings and capital provide adequate support for the degree of 
market risk taken by the institution.
    3. A rating of 3 indicates that control of market risk sensitivity 
needs improvement or that there is significant potential that the 
earnings performance or capital position will be adversely affected. 
Risk management practices need to be improved given the size, 
sophistication, and level of market risk accepted by the institution. 
The level of earnings and capital may not adequately support the degree 
of market risk taken by the institution.
    4. A rating of 4 indicates that control of market risk sensitivity 
is unacceptable or that there is high potential that the earnings 
performance or capital position will be adversely affected. Risk 
management practices are deficient for the size, sophistication, and 
level of market risk accepted by the institution. The level of earnings 
and capital provide inadequate support for the degree of market risk 
taken by the institution.
    5. A rating of 5 indicates that control of market risk sensitivity 
is unacceptable or that the level of market risk taken by the 
institution is an imminent threat to its viability. Risk management 
practices are wholly inadequate for the size, sophistication, and level 
of market risk accepted by the institution. [Emphasis added].

    Source: Uniform Financial Institutions Rating System, December 
1996, pp. 12-13.

Appendix D: Glossary

    Alternate Interest Rate Scenarios: Scenarios that depict 
hypothetical shocks to, or movements in, the current term structure of 
interest rates. As currently utilized in the OTS NPV Model, there are 
eight alternate interest rate scenarios, depicting shocks in which the 
term structure has been changed by the same amount at all maturities. 
The changes currently depicted in the alternate scenarios range from 
-400 basis points to +400 basis points. (Institutions need only provide 
board limits for scenarios ranging from -300 to +300 basis points.)
    Base Case: A term sometimes used for the prevailing term structure 
of interest rates (i.e., the current interest rate scenario). Also 
known as the ``pre-shock'' or ``no shock'' scenario, one not subjected 
to a change in interest rates. This is in contrast to, say, the plus or 
minus 100 basis point rate shock scenarios.
    CAMELS Rating System: A uniform ratings system, applied to all 
banks, thrifts, and credit unions, which provides an indication of an

[[Page 20272]]

institution's overall condition. The six factors of the CAMELS rating 
system represent Capital Adequacy, Asset Quality, Management, Earnings, 
Liquidity, and Sensitivity to Market Risk. Quantitative and qualitative 
factors are used to establish a rating, ranging from 1 to 5 for each 
CAMELS component rating. A rating of 1 represents the best rating and 
least degree of concern, while a 5 rating represents the worst rating 
and greatest degree of concern. The six CAMELS component ratings are 
used in developing the overall Composite Rating for an institution.
    Complex Securities: The term ``complex security'' includes any 
collateralized mortgage obligation (``CMO''), real estate mortgage 
investment conduit (``REMIC''), callable mortgage pass-through 
security, stripped-mortgage-backed-security, structured note, and any 
security not meeting the definition of an ``exempt security.'' An 
``exempt security'' includes: (1) standard mortgage-pass-through 
securities, (2) non-callable, fixed-rate securities, and (3) non-
callable, floating-rate securities whose interest rate is (a) not 
leveraged (i.e., the rate is not based on a multiple of the index), and 
(b) at least 400 basis points from the lifetime rate cap at the time of 
purchase.
    Composite Rating: A rating that summarizes an institution's overall 
condition under the CAMELS rating system. This overall rating is 
expressed through a numerical scale of 1 through 5, with 1 representing 
the best rating and least degree of concern, and 5 representing the 
worst rating and highest degree of concern.
    Financial Derivative: Any financial contract whose value depends on 
the value of one or more underlying assets, indices, or reference 
rates. The most common types of financial derivatives are futures, 
forward commitments, options, and swaps. A mortgage derivative 
security, such as a collateralized mortgage obligation or a real estate 
mortgage investment conduit, is not a financial derivative under this 
definition.
    Interest Rate Risk: The vulnerability of an institution's financial 
condition to movements in interest rates. Changes in interest rates 
affect an institution's earnings and economic value.
    Interest Rate Risk Exposure Report: A quarterly report, sent by OTS 
to all institutions that file Schedule CMR, presenting the results of 
the OTS NPV Model for each institution.
    Interest Rate Sensitivity Measure: The magnitude of the decline in 
an institution's NPV Ratio that occurs as a result of an adverse rate 
shock of 200 basis points. The measure equals the difference between an 
institution's Pre-shock NPV Ratio and its Post-shock NPV Ratio and is 
expressed in basis points. In general, institutions that have 
significant imbalances between the interest rate sensitivity (i.e., 
duration) of their assets and liabilities tend to have high Interest 
Rate Sensitivity Measures.
    MVPE: The abbreviation for Market Value of Portfolio Equity, a term 
previously used for Net Portfolio Value. This term is no longer used by 
OTS because some of the factors used to determine NPV may not be market 
based.
    NPV: The abbreviation for Net Portfolio Value which equals the 
present value of expected net cash flows from existing assets minus the 
present value of expected net cash flows from existing liabilities plus 
the present value of net expected cash flows from existing off-balance 
sheet contracts.
    Post-shock NPV Ratio: Along with the Sensitivity Measure, one of 
the two primary measures of interest rate risk used by OTS. The ratio 
is determined by dividing an institution's NPV by the present value of 
its assets, where both the numerator and denominator are measured after 
a 200 basis point increase or decrease in market interest rates, 
whichever produces the smaller ratio. A higher Post-shock Ratio 
indicates a lower level of interest rate risk. Also sometimes referred 
to as the ``Exposure Measure.''
    Pre-shock NPV Ratio: Ratio determined by dividing an institution's 
NPV by the present value of its assets, where both the numerator and 
denominator are measured in the base case. The ratio is a measure of an 
institution's economic capitalization. It is also referred to as the 
``Base Case NPV Ratio.
    Prompt Corrective Action: A system of enforcement actions, 
established under the Federal Deposit Insurance Corporation Improvement 
Act of 1991, that regulators are required to take against insured 
institutions whose capital falls below certain critical thresholds.
    ``S'' Component Rating: see ``Sensitivity to Market Risk Component 
Rating.''
    Schedule CMR: A section of the Thrift Financial Report that is used 
by OTS to collect financial data for the OTS NPV Model.
    Sensitivity Measure: see ``Interest Rate Sensitivity Measure.''
    ``Sensitivity to Market Risk'' Component Rating: The component 
rating in the CAMELS rating system designed to express the degree to 
which changes in interest rates, foreign exchange rates, commodity 
prices, or equity prices can adversely affect a financial institution's 
earnings or economic capital. The rating is based on two components: an 
institution's level of market risk and the quality of its practices for 
managing market risk. The ``S'' component rating.
    Shocked Rate Scenarios: see ``Alternate Interest Rate Scenarios.''
    Uniform Financial Institutions Rating System: see ``CAMELS Rating 
System'' and ``Composite Rating.''
    Value-at-risk: A measure of market risk. An estimate of the maximum 
potential loss in economic value over a given period of time for a 
given probability level.

    Dated: April 9, 1998.

    By the Office of Thrift Supervision.

Ellen Seidman,
Director.
[FR Doc. 98-9882 Filed 4-22-98; 8:45 am]
BILLING CODE 6720-01-P