[Federal Register Volume 63, Number 230 (Tuesday, December 1, 1998)]
[Notices]
[Pages 66351-66375]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-31672]



  Federal Register / Vol. 63, No. 230 / Tuesday, December 1, 1998 / 
Notices  

[[Page 66351]]


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DEPARTMENT OF THE TREASURY

Office of Thrift Supervision
[No. 98-117]


Financial Management Policies

AGENCY: Office of Thrift Supervision.

ACTION: Notice of final thrift bulletin.

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SUMMARY: The Office of Thrift Supervision (OTS) is adopting Thrift 
Bulletin 13a, which provides guidance on the management of interest 
rate risk, investment securities, and derivatives activities. The 
Bulletin also describes the guidelines OTS examiners will use in 
assigning the ``Sensitivity to Market Risk'' component rating under the 
Uniform Financial Institutions Rating System.

EFFECTIVE DATE: December 1, 1998.

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

SUPPLEMENTARY INFORMATION: The Office of Thrift Supervision is today 
adopting the attached document, Thrift Bulletin 13a (TB 13a), 
Management of Interest Rate Risk, Investment Securities, and 
Derivatives Activities. This Bulletin provides 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 this 
Bulletin will simultaneously improve its supervision of interest rate 
risk management and reduce regulatory burden on thrift institutions.
    The Bulletin updates 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, thus, replaces 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 Bulletin makes several significant changes. First, 
under TB 13a, institutions 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 Bulletin also 
changes the form in which those limits should be expressed. Second, the 
Bulletin provides guidance on how OTS will assess the prudence of an 
institution's risk limits. Third, the Bulletin raises the size 
threshold above which institutions should calculate their own estimates 
of the interest rate sensitivity of Net Portfolio Value (NPV) from $500 
million to $1 billion in assets. Fourth, the Bulletin specifies a set 
of desirable features that an institution's risk measurement 
methodology should utilize. Finally, the Bulletin provides an extensive 
discussion of ``sound practices'' for interest rate risk management.
    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, 
(FFIEC Policy Statement), 1 the FFIEC-member agencies have 
discontinued use of the three-part test for suitability of investment 
securities. Accordingly, the Bulletin describes the types of analysis 
institutions should perform prior to purchasing securities or financial 
derivatives. The Bulletin also provides guidelines on the use of 
certain types of securities and financial derivatives for purposes 
other than reducing portfolio risk. The final regulation on financial 
derivatives, published elsewhere in this issue of the Federal Register, 
as supplemented by the guidance in this final TB 13a, replaces existing 
regulations governing futures (12 CFR 563.173), forward commitments (12 
CFR 563.174), and options (12 CFR 563.175). TB 13a also replaces 
guidance 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).
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    \1\ 63 FR 20191 (April 23, 1998).
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    Finally, TB 13a provides detailed guidelines for implementing part 
of the Notice announcing the revision of the Uniform Financial 
Institutions Rating System (i.e., the CAMELS rating system), published 
by the FFIEC. 2 That publication announced revised 
interagency policies, that among other things, established the 
Sensitivity to Market Risk component rating (the ``S'' rating). TB 13a 
provides quantitative guidelines for an initial assessment of an 
institution's level of interest rate risk. Examiners have broad 
discretion in implementing those guidelines. It also provides 
guidelines concerning the factors examiners 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 replaces the rather limited guidelines contained in New 
Directions Bulletin 95-10.
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    \2\ 61 FR 67021 (December 19, 1996).
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Differences Between Proposed and Final Versions of TB 13a

    On April 23, 1998, OTS published a proposed TB 13a. 3 
The content of the final TB 13a is, in most respects, the same as the 
proposed TB 13a. Two significant changes were made, however, in 
response to comment letters.
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    \3\  63 FR 20257 (April 23, 1998).
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1. Guidelines for Assessing the Level of Risk

    The guidelines examiners will use to initially assess the level of 
interest rate risk at an institution, for purposes of assigning the 
Sensitivity to Market Risk (``S'') component rating were contained in a 
matrix shown as Table 1 in the proposed TB. Based on comments received 
and on further analysis, OTS has decided to revise those guidelines. 
The revised guidelines are contained in Part IV.A.3 of TB 13a. A 
comparison of the ratings that are likely to result from the final 
guidelines with those from the proposed guidelines is contained in Part 
1.d of the discussion of comments, below.

2. Transactions in Financial Derivatives or Complex Securities that Do 
Not Reduce Risk

    Part III.A.3 of the proposed TB stated that the use of financial 
derivatives or complex securities with high price sensitivity should 
generally be limited to transactions that lower an institution's 
interest rate risk. An institution using such instruments for purposes 
other than reducing portfolio risk should do so in accordance with safe 
and sound practices and:
    (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.

As a result of comments received, OTS has decided to reduce the 6 
percent threshold in condition (b), above, to 4 percent. The reasons 
for this change are discussed below in Part 3.g of the discussion of 
comments.

Summary of Comments

    The comment period ended on June 22, 1998. OTS received twenty-
seven comments. Commenters included: twenty savings associations, five 
trade associations, one law firm, and one

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registered investment adviser. Furthermore, OTS met with 
representatives of several institutions and an industry trade group to 
discuss the proposed TB. The following summary identifies and discusses 
the major issues raised in the comment letters and OTS's responses to 
the issues.

1. General Issues

a. Coordination With Banking Agencies
    Several commenters argued that OTS should coordinate the TB with 
guidance issued by the other banking agencies. A number suggested that 
OTS should adopt the guidance that the other federal banking agencies 
have adopted with respect to the management of both interest rate risk 
and investment and derivatives activities.
    As a member of the FFIEC, OTS works closely with the other banking 
agencies on the coordination of supervisory policies. When appropriate, 
OTS and the other members of the FFIEC adopt uniform 
policies.4 At the same time, the members of the FFIEC 
recognize that it is not possible to achieve uniformity in all areas of 
supervision and regulation. OTS's supervisory efforts have, since at 
least the mid-1980s, placed more emphasis on interest rate risk than 
have other regulators. This difference in emphasis reflects the nature 
of the thrift industry's basic business which has historically given 
thrift institutions a propensity toward maturity mismatching. OTS has 
utilized the economic value concept (as described in the proposed TB) 
to measure interest rate risk since the adoption of the original TB 13 
in 1989. The guidelines described in the proposed TB do not represent 
so much a new initiative to be coordinated with the other agencies, as 
an attempt to update and improve consistency across OTS-regulated 
institutions in the application of OTS's existing approach to assessing 
interest rate risk.
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    \4\ See Section 303 of the Riegle Community Development and 
Regulatory Improvement Act of 1994. Pub.L. 103-325 (September 25, 
1994).
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    The proposed guidelines for investment securities and financial 
derivatives are more detailed than those published in the FFIEC Policy 
Statement, but are completely consistent with that policy statement. 
OTS believes the added level of detail in its guidelines will be 
helpful to examiners and will result in greater consistency of 
application. OTS also believes the level of detail will be helpful to 
institutions, not because OTS has a desire to ``micromanage'' those 
institutions, but because OTS wants to reduce needless uncertainty 
about how to interpret the guidance and how examiners will apply it.
b. Competitive Equity
    A number of commenters argued that thrifts would be harmed 
competitively because other financial institutions do not have 
comparable guidelines, with respect to either the acquisition of 
securities and derivatives or the ``S'' rating. This is not a valid 
criticism. The purpose of TB 13a is two-fold: (1) to provide guidance 
to thrift institutions on the management of interest rate risk, 
including investment and derivative activities, and (2) to describe the 
framework that OTS examiners will use in assigning the ``S'' rating 
component. Both the proposed guidelines on the management of interest 
rate risk and the framework for assigning ``S'' ratings are consistent 
with guidelines issued by the other federal banking agencies. The only 
significant constraint in the guidelines is on the ability of a small 
fraction of the thrift industry to acquire financial derivatives and 
some volatile securities for purposes other than reducing market risk. 
This aspect of the guidelines is appropriate, as the limitation applies 
only to those institutions least able to bear additional risk.
    Comparing the fairness of ``S'' ratings at OTS-regulated 
institutions with those at other institutions is not a straightforward 
exercise because of the typically higher levels of interest rate risk 
that one might expect at thrifts. As stated earlier, the proposed 
guidelines for the ``S'' rating do not so much reflect a new approach 
in the way OTS assesses interest rate risk but rather provide 
quantitative guidance to examiners in applying the current assessment 
process. Thrifts have competed successfully under that process for a 
number of years. Moreover, it is highly unlikely that the guidelines 
would result in harsher ``S'' ratings than OTS examiners have assigned 
historically. Available evidence (see section 1.d below) indicates that 
the opposite might occur.
c. De Facto Capital Requirement
    A number of commenters asserted that the proposed guidelines for 
assigning the ``S'' rating would create a de facto higher capital 
requirement. This criticism is not valid for several reasons. First, 
the proposed TB reflects the concept that institutions with higher 
levels of capital should have greater freedom to engage in risk-taking. 
Thus, for a given amount of interest rate risk--as indicated by the 
Sensitivity Measure--institutions with higher Post-shock NPV Ratios 
receive better ``S'' components ratings under the guidelines (see 
Glossary in TB 13a for definitions of these terms). The fact that 
examiners also assign a capital adequacy (i.e., ``C'') component rating 
to the institution under the CAMELS rating system does not undermine 
the validity of this approach for gauging the level of risk. If capital 
appears to be ``double counted'' with this approach to assigning the S 
rating, it is only because capital adequacy--the ability to absorb 
unexpected losses--is central to evaluating an institution's safety and 
soundness.
    Second, the CAMELS rating system explicitly calls for consideration 
of an institution's capital position in assessing the ``S'' component 
rating. For example, the description of the 2 rating says in part : 
``The level of earnings and capital provide adequate support for the 
degree of market risk taken by the institution [emphasis added].'' \5\ 
Moreover, other risk assessments under the CAMELS rating system also 
consider capitalization. For example, the rating level of 1 of the 
asset quality (``A'') component rating is described in the interagency 
document as: ``A rating of 1 indicates strong asset quality and credit 
administration practices. Identified weaknesses are minor in nature and 
risk exposure is modest in relation to capital protection and 
management's abilities . . . [emphasis added].'' \6\
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    \5\ 61 FR at 67029.
    \6\ 61 FR at 67027.
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    Third, unlike a regulatory minimum capital requirement, the 
guidelines do not establish a minimum level of capital. There are only 
two ways in which an institution can achieve compliance with a 
regulatory minimum capital requirement--raise additional capital or 
shrink the asset base. Under the guidelines, however, institutions have 
the third option of reducing the level of interest rate risk in their 
portfolio. Even institutions with very low Post-shock NPV Ratios can 
receive ratings of 1 or 2 if their level of interest rate risk is also 
very low.
    Finally, even if one subscribes to the view that the guidelines are 
a form of capital requirement, it is doubtful that the guidelines would 
require generally higher capital requirements for the industry because 
overall CAMELS ratings are unlikely to change, as will be discussed in 
section 1.d, below.
    Several commenters argued that the guidelines would create 
incentives to take additional credit risk. Some institutions that 
anticipate receiving a lower ``S'' rating under the proposed guidelines 
might choose to reduce

[[Page 66353]]

interest rate risk, while simultaneously increasing credit risk to 
maintain profitability levels. Determining the tradeoff between these 
two types of risk is not new, however, it is a normal part of the 
business of running a depository institution. The institution must 
decide for itself what it will do, subject to safety and soundness 
considerations.
    Several commenters claimed that the guidelines would disadvantage 
``traditional'' portfolio lenders that concentrate on making fixed-rate 
mortgage loans. Some institutions that concentrate on fixed-rate 
mortgages are highly interest rate sensitive and are, therefore, more 
prone to receiving a poor ``S'' rating. Nonetheless, many such 
institutions would fare quite well under the proposed guidelines 
because they maintain relatively high levels of economic capital (NPV), 
mitigating the high sensitivity. Other alternatives available to such 
an institution are to reduce the extent of the maturity mismatch by 
adjusting their product mix or to engage in hedging activities.
    Another commenter suggested that OTS should not revise TV 13 at 
this time because interest rates have been relatively stable. The 
present time offers an ideal opportunity to adopt the proposed changes. 
Establishing sound regulatory policies is most difficult during times 
of stress or when the industry is unhealthy, because even good policies 
may exacerbate problems in some segments of the industry. Today's 
industry is stronger than it has been in years, interest rates have 
been generally falling, earnings have been solid, the industry is well-
capitalized, and the number of problem institutions is very low. This 
is an ideal environment in which to revise sound interest rate risk 
guidelines.
d. Anticipated Impact of Guidelines
    Table 1, in Part IV.A.3 of the proposed TB, was a matrix containing 
the guidelines OTS proposed to use in initially assessing the Level of 
Interest Rate Risk in determining the ``S'' component rating. Many 
commenters were concerned that those proposed guidelines would 
adversely affect the ``S'' component ratings of the industry. Several 
commenters urged OTS to review empirical evidence on how institutions 
would be affected by the guidelines before adopting the proposal. OTS 
did analyze how institutions might be rated under the proposed 
guidelines. A summary of this analysis is shown in the table below.

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BILLING CODE 6720-01-C

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    The first row of the table shows the distribution of the actual 
``S'' component ratings assigned during the most recent examination 
cycle. About one-third of all institutions received an ``S'' rating of 
1 at their most recent examination. More than half received a rating of 
2.
    The second row shows what the distribution would have been if those 
same component ratings had been determined by applying the Proposed 
Rating Guidelines in a totally mechanical way (i.e., with no 
consideration for the quality of risk management practices, using the 
NPV data available at the time of each institution's examination). 
Although the proportion of institutions with ``S'' ratings of 3 
increased (from 10% of all institutions to 14%), the ratings of many 
more institutions improved than worsened under this simple analysis. 
These results, however, omit the effect of the examiner's assessment of 
the institution's risk management practices.
    Table 2, in Part III.C of the proposed TB, described how various 
combinations of Level of Interest Rate Risk and Quality of Risk 
Management Practices would likely translate into different ratings for 
the ``S'' component. The third row of the table here shows the ratings 
distribution that would have occurred had the guidelines in Tables 1 
and 2 of the proposed TB both been applied mechanically--and had 
examiners assessed each institution's Quality of Risk Management 
Practices to be of identical quality as the actual Management (``M'') 
component rating assigned the institution. The ratings in this row are 
significantly harsher than those in the previous row. In fact, they 
overstate considerably the amount by which the ratings would worsen 
from the previous row. An institution's ``M'' rating is often 
downgraded for reasons other than concerns about its interest rate risk 
management practices (e.g., asset quality problems, credit underwriting 
deficiencies, etc.). Consequently, the ratings that result from using 
the ``M'' component rating as a proxy for an examiner's qualitative 
assessment of an institution's risk management practices will be overly 
severe. If the guidelines in Tables 1 and 2 of the proposed TB had 
actually been applied, the proportions of the industry receiving each 
``S'' rating would probably have fallen between the proportions shown 
in the second and third rows of the table. While broadly similar to the 
``S'' ratings actually assigned, it is likely they would have resulted 
in somewhat greater numbers of 3 and 4 ratings than were actually 
assigned.
    After considering the comments and the updated analysis, OTS has 
decided to adopt a less stringent set of guidelines for assessing the 
level of risk (see Table 1 in the final TB). The remaining two rows of 
the table above show how these ``Final Rating Guidelines'' compare with 
the actual ``S'' ratings and with the ``Proposed Rating Guidelines.'' 
The reasons for this change are as follows.
    The current ``S'' ratings reflect the evaluation of experienced OTS 
examiners. OTS believes that, in the aggregate, its examiners' 
conclusions appropriately characterize the current distribution of risk 
and risk management practices in the thrift industry. The purpose of 
the guidelines is to provide examiners with a common starting point for 
assessing an individual institution's sensitivity to interest rate 
risk. This, in turn, should help produce more consistent ratings. While 
individual institutions' ratings may change as examiners use their 
discretion in applying these guidelines, OTS believes the overall 
distribution of ratings will likely remain the same.
    Consequently, the choice between the two sets of rating guidelines 
was based on two factors. First, during the last examination cycle, the 
Final Rating Guidelines would have produced more 1 ratings than the 
Proposed Rating Guidelines, but would have produced fewer 3 ratings. A 
high proportion of 1 ratings might raise ratings expectations of some 
institutions that may be unfounded because of examiner concerns with 
risk management practices, but this disparity is not a major flaw in 
the guidelines. Whether the ``S'' component rating turns out to be a 1 
or 2 rarely has a significant effect on the outcome of the overall 
examination.
    The second factor, the difference in the 3 ratings assigned under 
the two sets of rating guidelines, has a greater potential to 
substantively affect an institution because it heightens the 
possibility that a composite rating of 3 or worse may be assigned. 
Absent any consideration of the institution's risk management 
practices, the Proposed Rating Guidelines would have resulted in about 
15% of OTS thrifts receiving ratings of 3 or worse. In fact, only about 
11% of thrifts received ratings of 3 or worse. This suggests that the 
Proposed Rating Guidelines might be too harsh, particularly when 
qualitative assessments are factored in. The Final Rating Guidelines 
would, by themselves, have assigned ratings of 3 or worse to only about 
7% of institutions. With the effects of the qualitative assessments 
factored in, that proportion might well have increased, but it likely 
would have been closer to the proportion of 3s and 4s actually assigned 
(11%) than would have been the case under the Proposed Rating 
Guidelines. On that basis, the Final Rating Guidelines are preferable.

2. Legal Status of TB 13a and Interest Rate Risk Capital Component 
Regulation

    OTS received comments regarding the legal status of Thrift Bulletin 
13a and the future of the interest rate risk component of the risk 
based capital requirement. OTS has addressed these issues in its final 
rule on financial derivatives, published elsewhere in today's issue of 
the Federal Register.

3. Comments Pertaining to Specific Parts of Proposed TB 13a

a. Limits on Change in NPV
    One commenter criticized the two exhibits in Part II.A.1 of the 
proposed TB. These exhibits illustrated the interest rate risk limits a 
board of directors might establish. The commenter argued that the 
exhibits were unrealistically conservative and should be revised to 
portray a more typical institution. OTS has decided the exhibits and 
much of the accompanying discussion are unnecessary. The final Bulletin 
replaces the two exhibits with a simple discussion of how a board might 
choose to specify its limits.
b. Prudence of IRR Limits
    As described in Part II.A.3 of the proposed TB, an institution's 
interest rate risk limits generally will not be considered prudent if 
the limits permit NPV ratios that would ordinarily be considered to be 
of ``Significant Risk'' or to warrant an ``S'' rating of 3 or worse. 
Several commenters objected that this approach is too restrictive of 
the board's choices.
    OTS has decided to retain this approach for several reasons. First, 
it is no more restrictive than the guidelines contained in Table 1 for 
assessing the level of interest rate risk (discussed above). Moreover, 
this approach is a reasonable basis for assessing board limits and is 
consistent with the measurement approach used throughout the TB. If the 
board permits a level of risk that would ordinarily be considered 
``Significant'' based on OTS's rating guidelines, it would be 
inconsistent for OTS to consider those limits to be sufficiently 
conservative. The final TB, however, emphasizes that this evaluation is 
not a simple pass-or-fail judgment, and, moreover, that it is just one 
factor in the examiner's qualitative assessment.

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c. Revision of IRR Limits
    Another commenter criticized the discussion in Part II.A.4 of the 
proposed TB regarding revisions to a board's interest rate risk limits. 
The commenter argued that this discussion imposed unnecessary 
``micromanagement'' on the industry. This section addresses the 
practice of revising board limits to accommodate existing violations of 
previously set limits. This practice is generally inappropriate, has 
occurred too frequently at some institutions, and may be indicative of 
deficiencies in board oversight. Explicit discussion of such practices 
should reduce their incidence.
d. Interest Rate Sensitivity of NPV for Institutions Above $1 Billion 
in Assets
    Under Part II.B.2 of the proposed TB, institutions with more than 
$1 billion in assets would be expected to determine their own NPV 
measures. Several commenters recommended that OTS, like the FFIEC, 
accept any reasonable model for measuring risk, not just NPV models. 
For internal management purposes, institutions are free to use whatever 
risk measurement systems they find most useful. However, from a 
regulatory perspective, NPV measurements provide a valuable 
characterization of an institution's interest rate risk. NPV provides a 
consistent measure that considers all future cash flows expected to 
result from all on- and off-balance sheet financial instruments, while 
also considering embedded options. NPV, thus, provides the agency with 
a yardstick against which risk at any thrift may be measured and 
compared with that of other institutions. For that reason, OTS collects 
financial data that permits it to calculate NPV for all institutions 
over $300 million, and many under that size. These NPV estimates are, 
however, necessarily based on generic assumptions regarding such 
factors as prepayment rates and deposit decay rates. Because of the 
importance of ensuring the safety and soundness of large institutions, 
OTS believes large institutions should have the means of improving 
these regulatory measures and be able to accurately measure NPV 
internally, taking into account the institution's individual 
characteristics.
    Rather than expecting institutions to calculate NPV even if they do 
not use it as a management tool, one commenter recommended that OTS 
should simply provide such institutions with the OTS NPV results. 
However, large institutions have already incurred the cost of 
establishing an NPV measurement system based on the guidelines in 
Thrift Bulletin 13, published in January 1989. As there will be some 
ongoing costs of maintaining that system, OTS did consider exempting 
some large institutions from internal NPV modeling. OTS agrees with the 
other FFIEC agencies, however, that large, sophisticated institutions 
should be capable of measuring the economic value of equity and 
assessing their interest rate sensitivity. Accordingly, OTS has not 
changed this guideline.
    One commenter argued that institutions with internal models should 
not have to file Schedule CMR, which provides the financial data used 
by the OTS Model. OTS believes there is value in collecting such data 
and calculating the OTS NPV estimates even for institutions that also 
calculate their own. Any two models will seldom produce exactly the 
same results because of differences in their calculation methodologies, 
factual data inputs, or assumptions. Hence, the two sets of results may 
be used to provide a check on one another. The cost of filing Schedule 
CMR for an institution that maintains a sophisticated measurement 
system of its own should be minimal. Further, this process permits the 
production of peer group comparisons, which provide useful information 
for OTS and for boards of directors. No change is being made to the CMR 
filing requirements.
e. Investment Securities and Financial Derivatives
    Several commenters stated that the proposed guidelines for 
investment securities and derivatives in Part III of the proposed TB 
are not necessary, and that OTS should adopt the FFIEC Policy Statement 
without modification. In issuing that Statement, OTS and the other 
agencies recognized that the guidance contained in the FFIEC Policy 
Statement might not be sufficient for the purposes of each agency. In 
fact, the FFIEC Policy states that, ``Each agency may issue additional 
guidance to assist institutions in the implementation of the 
statement.'' 7 This language provides the member agencies, 
including OTS, with the ability to issue more detailed guidance on 
securities and derivatives activities, including guidance on pre-
purchase analysis and stress testing.
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    \7\ 63 FR 20191.
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    While the FFIEC Policy Statement provides sound guidance on 
investment securities and end-user derivatives activities, OTS 
determined it would be desirable to explain to the industry how it will 
interpret and implement the FFIEC Policy Statement, particularly in 
those areas where some additional clarification or specificity is 
needed. Accordingly, OTS has decided to use TB 13a to implement the 
FFIEC Policy Statement.
f. Analysis and Stress Testing
    Several commenters objected to the guidance in Part III.A of the 
proposed TB addressing pre-purchase analysis and stress testing of 
complex securities and financial derivatives. These commenters also 
stated that such guidance conflicts with, or is more onerous than, the 
FFIEC Policy Statement. The commenters also asserted that the OTS 
guidance would place OTS-supervised institutions at a competitive 
disadvantage vis-a-vis non-OTS-supervised institutions.
    The FFIEC Policy Statement states that institutions should conduct 
a pre-purchase analysis for ``complex instruments, less familiar 
instruments, and potentially volatile instruments.'' 8 (The 
FFIEC Policy Statement does not define the terms ``complex 
instruments,'' ``less familiar instruments,'' or ``potentially volatile 
instruments.'') The FFIEC Policy Statement states that:
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    \8\ 63 FR at 20195.
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    For relatively more complex instruments, less familiar instruments, 
and potentially volatile instruments, institutions should fully address 
pre-purchase analyses in their policies. Price sensitivity analysis is 
an effective way to perform the pre-purchase analysis of individual 
instruments. For example, a pre-purchase analysis should show the 
impact of an immediate parallel shift in the yield curve of plus and 
minus 100, 200, and 300 basis points. Where appropriate, such analysis 
should encompass a wider range of scenarios, including non-parallel 
changes in the yield curve. A comprehensive analysis may also take into 
account other relevant factors, such as changes in interest rate 
volatility and changes in credit spreads.9
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    \9\ 63 FR at 20195.
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    Some commenters may have interpreted this statement to mean that a 
pre-purchase analysis showing the price impact of parallel shifts in 
the yield curve of plus and minus 100, 200, and 300 basis points is not 
expected for complex securities and derivatives. OTS, however, 
disagrees with that interpretation. Management should understand the 
price sensitivities of investments and derivatives prior to their 
acquisition. Moreover, the pre-purchase analysis guidance in the 
proposed TB is consistent with the FFIEC Policy Statement. This 
guidance

[[Page 66357]]

is designed to foster sound investment practice and should not 
disadvantage savings associations vis-a-vis other depository 
institutions.
    Several commenters indicated that the proposed guidelines for 
analyzing/testing securities and derivatives are too detailed and go 
beyond the guidance in the FFIEC Policy Statement. OTS has concluded 
that the detail in the proposed guidelines is appropriate and is 
consistent with the FFIEC Policy Statement.
    One commenter stated that the guidelines for analyzing/testing 
securities and derivatives should focus only on the plus and minus 200 
basis point scenarios. There is considerable benefit to be derived from 
evaluating potential investment and derivative transactions in the 
context of several alternative scenarios. The advantage of conducting 
multiple scenario analysis is that decision-makers will consider 
environments that they might otherwise ignore. Moreover, as shown in 
the portion of the FFIEC Policy Statement quoted above, OTS and the 
other members of the FFIEC agree that the stress testing of securities 
and derivatives should not be limited to the plus and minus 200 basis 
point rate scenario.
g. Limitation on Transactions Involving Derivatives and Complex 
Securities With High Price Sensitivity
    A number of commenters criticized Part III.A.3 of the proposed TB 
on transactions involving derivatives and complex securities with high 
price sensitivity. Under the proposal, an institution should not engage 
in a ``risk increasing transaction'' involving derivatives or complex 
securities with high price sensitivity if the transaction would cause 
the institution's Post-shock NPV Ratio to fall below 6 percent.
    One commenter stated that the 6 percent threshold is not needed 
because guidelines calling for self-imposed risk limits will serve the 
purpose of constraining excessive risk taking. Another commenter noted 
that the 6 percent threshold is problematic because some hedging 
transactions may reduce risk in some--but not all--interest rate 
scenarios. One commenter noted that the threshold may discourage 
transactions where the incremental increase in risk may be 
insignificant. Another commenter noted that the proposed 6 percent 
limitation is more onerous that the former FFIEC ``high-risk test,'' 
which was recently eliminated.
    Upon reconsideration, OTS has concluded that the proposed 6 percent 
threshold may be too restrictive, particularly in light of the other 
safeguards in the TB. For example, board-approved interest rate risk 
limits should discourage institutions from engaging in risk-increasing 
transactions that would cause their institution's Post-shock NPV Ratio 
to fall to a low level. Moreover, if an institution intends to use 
derivatives or complex securities with high price sensitivity for 
purposes other than reducing market risk, it should obtain the prior 
approval of its board of directors. In addition, the examiner guidance 
for assigning ``S'' ratings should discourage institutions with 
relatively low Post-shock NPV Ratios from using such instruments for 
non-risk-reducing purposes. Accordingly, OTS is lowering the 6 percent 
threshold to 4 percent in the final Thrift Bulletin 13a. Under the 
guidelines for the ``S'' rating, institutions with less than a 4 
percent Post-shock NPV Ratio will typically receive adverse ratings 
unless they have very low interest rate sensitivity. In general, the 
use of financial derivatives or complex securities with high price 
sensitivity should be limited to transactions that lower an 
institution's interest rate risk.
h. Significant Transactions
    Several commenters objected to guidance, in Part III.A.1 of the 
proposed TB, that institutions should conduct a pre-purchase portfolio 
sensitivity analysis for any ``significant transaction'' involving 
securities or financial derivatives. Under the proposed guidelines, a 
significant transaction is defined as any transaction that might 
reasonably be expected to increase an institution's Sensitivity Measure 
by more than 25 basis points. The definition of a ``significant 
transaction,'' was intended to provide a wide ``safe harbor'' for 
savings associations by limiting the number of transactions subject to 
the incremental portfolio analysis. Very few transactions are likely to 
be large enough to meet the 25 basis point test.
    Several commenters noted that by defining a ``significant 
transaction'' in quantitative terms, OTS might encourage institutions 
to circumvent the guidance for pre-purchase analysis by entering into a 
series of smaller transactions. One commenter noted that the FFIEC 
Policy Statement is silent on what is a significant transaction and 
indicated that the definition should be left to management. The FFIEC 
Policy states, ``When the incremental effect of an investment position 
is likely to have a significant effect on the risk profile of the 
institution, it is a sound practice to analyze the effect of such a 
position on the overall financial condition of the institution.'' 
10 Another commenter suggested that the definition of 
``significant'' transaction should vary depending on an institution's 
financial condition and management sophistication.
---------------------------------------------------------------------------

    \10\ 63 FR at 20195.
---------------------------------------------------------------------------

    Although some institutions might enter into smaller transactions to 
avoid the proposed guidance on incremental portfolio analysis, 
institutions would have little to gain by doing so. It is clearly in an 
institution's self-interest to understand how significant transactions 
might alter its overall interest rate sensitivity. Moreover, while few 
transactions meet the proposed 25 basis point threshold, the analysis 
called for by the guidelines should not be a burden to well-run 
institutions that have adequate risk monitoring systems in place.
    The suggestion that the definition of ``significant'' should vary 
with the financial condition and management sophistication of the 
institution is reasonable and is consistent with OTS's risk-based 
approach to supervision. In this instance, however, OTS believes that 
it is more beneficial to provide certainty by adopting a simple rule of 
thumb under which incremental portfolio analyses would be expected only 
relatively infrequently. Accordingly, OTS has decided to retain the 25 
basis point threshold for defining a significant transaction.
i. Definition of Complex Securities
    Several commenters criticized the proposed definition of a 
``complex security'' in Part III.A of the proposed TB. Several 
commenters also noted that identifying selected types of complex 
securities for special analysis is inconsistent with the FFIEC Policy 
Statement, which did not define the term. A few respondents argued that 
the term should be left undefined, fearing that an explicit definition 
would discourage thrifts from buying complex securities because such 
securities might be viewed negatively by examiners.
    OTS and the other members of the FFIEC agree that ``complex 
securities'' require more analysis than non-complex securities. The 
FFIEC Policy states: ``For relatively more complex instruments, less 
familiar instruments, and potentially volatile instruments, 
institutions should fully address pre-purchase analysis in their 
policies.'' 11 OTS recognizes that the proposed definition 
of a ``complex security'' is imprecise. Nevertheless, we believe the 
definition will provide guidance and

[[Page 66358]]

will avoid--or at least reduce--disagreements between examiners and 
thrift management.
---------------------------------------------------------------------------

    \11\ 63 FR at 20195.
---------------------------------------------------------------------------

    Some commenters thought that the proposed definition of a ``complex 
security'' was overly broad. Others noted that the proposed definition 
included securities that few would consider to be truly complex and 
excluded others--such as mortgage-pass-through-securities--that are 
actually highly complex. As defined in proposed TB 13a, the term 
``complex security'' includes any collateralized mortgage obligation, 
real estate mortgage conduit, 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., 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.
    While OTS recognizes that the proposed definition is imperfect and 
that certain securities that would be classified as ``complex'' under 
the proposed definition, such as ``plain vanilla'' CMO tranches, are 
viewed as non-complex securities by some market participants, OTS 
doubts that attempts to develop a highly refined definition of a 
complex security would be well received. Accordingly, OTS has decided 
to leave the proposed definition of a complex security substantially 
intact. However, OTS is simplifying the definition of an ``exempt 
security.'' Under the modified definition, an ``exempt security'' 
includes non-callable, ``plain vanilla'' instruments of the following 
types: (1) mortgage-pass-through securities, (2) fixed-rate securities, 
and (3) floating rate securities.
j. Overemphasis on Price Sensitivity
    One respondent suggested that the guidelines for pre-purchase 
analysis in the proposed TB should focus on earnings sensitivity and 
total return analysis, not just on price sensitivity. OTS agrees that 
institutions should not focus on price sensitivity to the exclusion of 
other relevant considerations. Accordingly, the final Bulletin has been 
modified to stress the importance of taking other factors, such as 
total return, into account in conducting pre-purchase analysis.
k. Use of Dealer/Issuer Information
    One commenter suggested that Part III.A.1 of the proposed TB be 
modified to permit the use of dealer/issuer information in conducting 
pre-purchase analysis. The FFIEC Policy states that institutions should 
conduct their own in-house pre-acquisition analysis, or to the extent 
possible, make use of specific third party analyses that are 
independent of the seller or counterparty. Similarly, the proposed TB 
states that an institution may 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. Nothing in the FFIEC Policy or TB 13a prohibits an 
institution from using information provided by a dealer or issuer; 
however, both caution against relying solely on dealer/issuer generated 
analysis for pre-purchase analysis.
l. Assessing the Level of Interest Rate Risk
    Several commenters objected to the guidelines for determining the 
level of interest rate risk, in Part IV.A of the proposed TB. 
Commenters argued that NPV is a liquidation model that is not relevant 
for a going concern. As defined in the proposed TB, NPV does not 
attempt to account for the effects of all future actions by an 
institution (e.g., reinvestment decisions, business growth, strategy 
changes, etc.). As such, it may technically be considered a liquidation 
analysis, but that does not diminish its relevance for ``going 
concerns.'' Mutual funds are going concerns, yet their net asset value 
is clearly of interest to shareholders. Borrowers may be viewed as 
going concerns, yet their net worth is of interest to lenders. A 
depository institution's NPV represents the major part of its total 
economic value and is, therefore, of concern to both shareholders and 
regulators. Furthermore, the value of existing holdings is subject to 
less uncertainty than other components of an institution's economic 
value, such as the net value of possible future business, the 
measurement of which relies on a host of assumptions beyond those 
necessary to calculate NPV.
    Many commenters argued that the proposed guidelines relied too 
heavily on the OTS Model. Most institutions do not have a means of 
calculating NPV internally. For those that do, the TB permits examiners 
to use internal results in lieu of the results of the OTS Model. The 
degree of reliance the examiner will place on the institution's model 
is a matter of judgment. It will depend on many factors, including the 
perceived quality of the institution's model, the quality of the data 
and assumptions used to drive it, and how well the examiner believes 
the OTS Model fits the circumstances at the institution. If an 
institution has no internal model, or uses an unacceptable method of 
calculation, OTS will place primary reliance on the OTS Model to 
measure interest rate risk. This is appropriate because it provides 
examiners with a means of assessing the level of IRR of all 
institutions using a single, objective, standard of measure.
    A number of commenters argued that the proposed guidelines are too 
focused on NPV, rather than on earnings. Though the proposed TB 
encourages institutions to have a means of calculating the interest 
rate sensitivity of their projected earnings, NPV provides a superior 
measure for regulatory purposes. NPV sensitivity considers all 
projected cash flows from all financial instruments and contracts to 
which an institution is currently a party. Earnings measures do not 
take adequate account of the significant customer options that are 
often embedded in financial instruments. Earnings measures also 
typically are relatively short-term in nature--most often just 1 to 3 
years of future earnings are projected. Earnings measures may, thus, 
ignore net cash flows farther in the future, where serious earnings 
shortfalls might occur.
    Many commenters argued that the proposed guidelines place too much 
emphasis on capital, which is already separately evaluated by 
examiners. As discussed above, the TB relies strongly on the concept 
that institutions with higher levels of economic capital should have 
greater freedom to engage in risk-taking. Thus, for a given amount of 
interest rate risk--as indicated by the Sensitivity Measure--
institutions with higher Post-shock NPV Ratios receive better ``S'' 
component ratings under the guidelines in Table 1. The fact that 
examiners also assign a capital adequacy (i.e., ``C'') component rating 
to the institution does not change the validity of this approach to 
gauging the level of risk. If capital appears to be ``double counted'' 
by this approach, it is only because capital adequacy--the ability to 
absorb potential losses--is central to evaluating an institution's 
safety and soundness. Moreover, this approach is consistent with the 
language of the interagency Uniform Financial Institutions Rating 
System for the ``S'' rating. For example, the description of the 2 
rating says in part: ``The level of earnings and capital

[[Page 66359]]

provide adequate support for the degree of market risk taken by the 
institution [emphasis added].'' 12
---------------------------------------------------------------------------

    \12\ 61 FR at 67029.
---------------------------------------------------------------------------

    Several commenters argued that the proposed guidelines for the 
level of IRR should not focus on the level of the NPV Ratio, but rather 
only on its sensitivity. As explained above, the Uniform Financial 
Institutions Rating System explicitly incorporates consideration of 
capitalization into the assessment of the ``S'' component rating. It 
would be unfair and largely counterproductive to good management to 
assign the ``S'' rating on the basis of the Sensitivity Measure alone, 
as suggested in this comment.
    Consider, for example, two institutions. The first has a Post-shock 
NPV Ratio of 1% and the second has a Post-shock NPV Ratio of 15%. Both 
have Sensitivity Measures of 300 basis points, indicating that their 
Post-shock NPV Ratios are 3 percentage points below their respective 
Pre-shock Ratios. While both institutions would suffer the same decline 
in economic value in an adverse interest rate environment, the first 
institution has much less of a buffer against that risk than the 
second. In fact, the level of interest rate risk at the first is 
``high'' relative to its ability to bear that risk, while the level of 
interest rate risk at the second is ``minimal.'' The proposed rating 
guidelines appropriately reflect that difference.
    Several commenters argued that OTS provided no rationale for the 
NPV levels in Table 1. The matrix in Table 1 establishes guidelines 
that, for a given level of the ``S'' rating, permits institutions with 
a greater ability to absorb potential losses to take more interest rate 
risk. The guidelines also broadly reflect the component ratings 
actually assigned by examiners in the past.
    Under OTS's New Directions Bulletin 95-10, institutions with Post-
shock NPV Ratios below 4 percent and more than 200 b.p. of interest 
rate sensitivity were generally presumed to warrant a component rating 
of 4 or 5. Those two thresholds provided the initial features of the 
matrix: Post-shock Ratios below 4 percent would be in the lowest row. 
The line between ``significant risk'' and ``high risk'' in that row 
would be a Sensitivity Measure of 200 b.p. From that starting point, 
successively higher rows in the matrix were defined as corresponding to 
better levels of the ``S'' rating. Thresholds were chosen to 
approximate the proportionate distributions of actual ratings. (As 
discussed earlier, in the final TB some thresholds have been modified.)
    In recognition of the practical limits on an institution's ability 
to reduce risk, the leftmost column of Table 1 (Sensitivity Measure 
between 0-100 b.p.) was established so that institutions with very low 
Post-shock Ratios but lower than average Sensitivity Measures would not 
be adversely rated. Such institutions may have capital adequacy 
problems, but are not considered interest rate risk problems.
    Several commenters argued that the ratings guidelines should not be 
based on today's extremely healthy industry statistics. The economic 
environment for the past several years has been highly conducive to 
producing healthy, very well-capitalized thrift institutions. It is 
possible that OTS may revise the guidelines in the future should 
circumstances change. As discussed earlier, the guidelines in the final 
TB are somewhat less stringent than the proposed guidelines and may, 
thus, mitigate this criticism.
    Several commenters suggested alternative matrices for the 
guidelines for the level of risk in Table 1.
    One commenter proposed determining the level of risk by comparing 
an institution's Sensitivity Measure with qualitative factors, such as 
planned corrective actions to be taken if rates move adversely. This 
proposal, however, would be highly speculative and not take into 
account the Post-shock NPV Ratio, which is critical in assessing an 
institution's ability to bear risk.
    Another commenter objected to the guidelines in Table 1 because the 
guidelines suggest that an institution with a Post-shock NPV Ratio of 
11.99% and an interest rate Sensitivity Measure of 401 b.p. poses 
``significant risk'' while an institution with 2% and 99 b.p. poses 
only ``moderate risk.'' The commenter is correct in arguing that the 
former institution is better suited to absorb the risk than the latter. 
Institutions in the lower left cell of the matrix are, however, special 
cases. Institutions in that cell have low NPV ratios and, thus, little 
capacity to absorb risk of any kind. There are, however, practical 
limits to how far they can reduce their level of interest rate risk. 
Thus, if an institution with a Post-shock NPV Ratio below 4% has a 
Sensitivity Measure of less than 100 b.p. (which is typically well 
below average) the guidelines treat it as having only moderate risk (a 
2 rating), rather than significant risk (a 3 rating).
    Another commenter proposed revising Table 1 to compare the Interest 
Rate Sensitivity Measure with the Pre-shock NPV Ratio (instead of the 
Post-shock NPV Ratio actually used in the Table). The commenter argued 
that this would avoid ``double counting'' the adverse impact of the 
rate shock. The commenter's proposal is based on the premise that the 
percentage change in NPV is the relevant measurement standard. OTS 
believes that the amount of capital remaining after the adverse shock 
is more pertinent. An institution with a large percentage change in NPV 
that retains a large amount of NPV is able to bear that risk safely.
    A fourth commenter proposed that institutions with a Post-shock NPV 
Ratio exceeding 6% warrant a rating of 1, whatever the Sensitivity 
Measure. Higher levels of interest rate sensitivity require higher 
Post-shock NPV. OTS does not believe the commenter's approach is 
sufficiently conservative given (1) the possibility of rapid changes in 
interest rates (not necessarily immediate shocks) of more than 200 
b.p., (2) the possibility of changes in the shape or the slope of the 
yield curve, and (3) inaccuracies in measuring risk.
m. Examiner Use of Guidelines on Level of Risk
    One commenter recommended that the guidelines in Table 1, of Part 
IV.A.3 of the proposed TB, should focus on more than one time period. 
Explicit procedures for analysis of multiple time periods would 
complicate the guidelines and would add to the unfounded perception 
that OTS is attempting to micromanage the examination process. The 
proposed TB stated that examiners should take into consideration any 
relevant trends in an institution's interest rate risk. Additional 
guidance is not necessary.
    One commenter recommended that OTS should warn its examiners that 
the NPV levels in the guidelines are ``for discussion purposes and not 
standards for assessing risk.'' The proposed guidelines are exactly 
that: guidelines. The proposed guidelines establish a common set of 
criteria for translating quantitative risk estimates into the 
categories described in the ratings descriptions (i.e., ``minimal 
risk'', ``moderate risk'', etc.). Rather than relying on hundreds of 
examiners to invent their own standards independently and hoping that 
those standards will be consistent with one another, the guidelines 
provide a common starting point for examiners. They are only starting 
points because examiners must consider many complex facts, both 
quantitative and qualitative, in their evaluation of the institution's 
risk level and in assigning the rating.
    Several commenters opined that examiners will not deviate from the 
guidelines. The final version of the TB emphasizes that the guidelines 
are only

[[Page 66360]]

a starting point in an examiner's assessment of the ``S'' rating. For 
example, New Directions Bulletin 95-10, a precursor to the proposed TB, 
stated that, ``Institutions with a [Post-shock NPV] Ratio below 4% and 
a Sensitivity Measure over 200 basis points will ordinarily receive a 4 
or 5 rating for the ``L'' component [rating].'' Yet, examiners did not 
assign ratings of 4 or 5 to all institutions that fit this description.
n. Calculation of NPV Ratios
    Several commenters discussed the calculation of NPV and the NPV 
Ratio. Two argued that the NPV Ratio should be redefined so that 
``deposit intangibles'' (i.e., the difference between the face value of 
deposits and their economic value) are not treated as assets. OTS 
initially presented deposit intangibles as assets on the Interest Rate 
Risk Exposure Report to resemble the presentation of core deposit 
intangibles on the balance sheet under GAAP. Commenters, however, 
pointed out that treating deposit intangibles as assets depresses NPV 
ratios. For example, the NPV ratio of the average institution in 
December 1997 would have been 10 basis points higher in the base case 
(10.34 vs. 10.24 percent) and 19 basis points higher (8.96 vs. 8.77 
percent) in the +200 b.p. rate shock scenario, if the deposit 
intangibles had been presented as contra-liabilities or if deposits had 
simply been shown at their present values. Removing the deposit 
intangibles from the asset side would also be more logically consistent 
with the purpose of the NPV ratio, which is to relate an institution's 
NPV to the size of the institution. An institution does not actually 
grow if it replaces a $100 borrowing with $100 of retail accounts, yet 
because the latter type of liability contributes to the deposit 
intangible, the denominator of the NPV ratio increases.
    Accordingly, OTS will study whether it should to move deposit 
intangibles to the liability side of the Interest Rate Risk Exposure 
Report by reporting deposits at their present value. Though NPV ratios 
would generally rise as a result of this format change, the amount of 
the change is so small that OTS would not modify the guidelines in 
Table 1 to compensate for it. There are many data processing 
considerations involved in making such a change, however. The small 
amount of improvement in the NPV ratios may not warrant the cost and 
potential confusion the change would entail.
    One commenter urged OTS to solve the analytical problems involved 
in estimating core deposit value sensitivity before finalizing the 
proposed TB. Refining the OTS Model is an ongoing activity. Among other 
issues, OTS is working on updating its modeling of core deposits. 
Examiners are currently using the results of the OTS Model during their 
safety and soundness examinations. There is no reason to wait for all 
revisions to be completed before finalizing the TB. While the OTS Model 
does not yet fully customize its treatment of core deposit behavior to 
individual institutions, a degree of customization is performed for 
institutions that report several items of additional optional 
information (on Schedule CMR, lines 659 through 661). Yet, relatively 
few institutions avail themselves of that opportunity.
    Another commenter argued that by valuing purchased goodwill as zero 
in the calculation of NPV, OTS disadvantages institutions that have 
been involved in mergers using purchase accounting. OTS disagrees with 
that criticism.
    NPV is defined as the economic value of an institution's existing 
assets, less the economic value of its existing liabilities, plus the 
net economic value of any existing off-balance sheet contracts. In 
other words, NPV is the net economic value of an institution's 
portfolio of identifiable assets and liabilities. If two institutions 
merge, the NPV of the resulting entity will consist of the combined net 
economic value of the two portfolios, or more simply, the combined NPV 
will be the sum of the individual NPVs. The value of the two portfolios 
will not change merely because the institutions have merged. Yet, that 
is exactly what would occur if goodwill were included as a component of 
the combined institution's NPV; the resulting NPV would be larger than 
the sum of the two constituent NPVs. The source of the confusion is 
that the commenter is attempting to measure more than just the value of 
the portfolio.
    Goodwill is defined as the amount by which the purchase price of an 
acquired entity exceeds the net fair value of its identifiable assets, 
liabilities, and off-balance sheet financial instruments. Thus, by 
definition, goodwill represents value over and above the net economic 
value of the acquired institution's portfolio of identifiable assets 
and liabilities. As a practical matter, goodwill reflects the buyer's 
(and seller's) assessment of the economic value of unidentifiable 
intangibles (such as a well-trained staff, a good franchise from which 
to conduct future business, etc.) at the acquired institution. All 
institutions, not just those involved in acquisitions, possess 
unidentifiable intangibles that may be expected to have economic value. 
Unfortunately, the economic value of such intangibles is extremely 
difficult to quantify, and determining how their economic value will 
change under different interest rate scenarios makes the task even more 
difficult. For those reasons, OTS limits itself to estimating the 
interest rate risk inherent in institutions' portfolios of identifiable 
financial and non-financial assets and liabilities. It is not that a 
broader measure is undesirable, but simply that such a measure is 
impractical as a regulatory measure of risk.
    Several institutions commented that the OTS Model does not 
accurately reflect every institution's circumstances, and that ratings 
based on those results are unfair. The OTS Model does rely on many 
generic, industry-wide assumptions and circumstances at individual 
institutions may differ from these assumptions. There will often be 
offsetting errors so that the ``bottom line'' result will still be 
reasonable for such an institution, but it is certainly possible that 
the OTS Model might materially over-or understate the level of risk at 
an institution. There are, however, two defenses against an unfair 
rating. The first is the judgment of the examiner. The second defense 
is the institution itself. The guidelines explicitly permit the use of 
institutions' internal results in assessing the level of risk in 
situations where the OTS Model is demonstrably incorrect.
o. Assessing the Quality of Risk Management
    One commenter recommended that in assessing the quality of risk 
management practices at an institution, discussed in Part IV.B of the 
proposed TB, examiners should consider the institution's historical 
earnings results. Examiners may well consider an institution's 
historical earnings stability in judging the quality of its risk 
management practices. All factors that an examiner considers relevant 
may bear on his or her assessment.
p. Combining Assessments of the Level of Risk and Risk Management 
Practices
    A number of commenters stated that the guidelines in Table 2, of 
Part IV.C of the proposed TB, place too much weight on quantitative 
factors and insufficient weight on qualitative ones (i.e., good risk 
management should be able to offset a higher level of risk). The 
proposed guidelines shown in Table 2 represent an accurate 
implementation of the interagency CAMELS rating system. Moreover, the 
proposition that good risk management can fully offset higher levels of 
risk is questionable. The interest rate sensitivity of NPV is a

[[Page 66361]]

measure of the amount of risk embedded in the current portfolio. There 
is little evidence that managers can successfully anticipate the 
magnitude or direction of movements in interest rates. While skillful 
management may be able to alter an institution's risk level quickly in 
response to changes in market conditions, it is not certain that 
management will actually take any action in such an eventuality. For 
example, during the interest rate shock that occurred in 1994, few 
institutions responded with swift portfolio restructuring.
    Practically speaking, however, both the assessment of risk 
management practices and the assignment of the S component rating are 
currently--and will remain--inexact processes that are heavily 
dependent on examiner judgment. Strong risk management practices cannot 
help but influence examiners to be inclined favorably toward the 
institution in assigning the ``S'' component rating. Accordingly, no 
change is being made to the guidelines in Table 2 of the proposal.
    The final Thrift Bulletin is set forth below.

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: Evaluating Prudence of 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 (63 Fed. Reg. 20191 [1998]) and OTS's final rule on 
financial derivatives at Section 563.172. 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.
    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

[[Page 66362]]

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. The 
hypothetical 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 The level of detail with which the 
limits are specified depends on the board's preferences. In their 
simplest form, the limits could specify a single minimum NPV Ratio 
which would apply to all seven rate scenarios, while more detailed 
limits might specify a different minimum NPV Ratio for each of the 
scenarios.
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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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    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. The board should also be aware that 
examiners will evaluate the institution's IRR limits as part of their 
assessment of the quality of the institution's risk management 
practices. See Part IV.B.2, Prudence of Limits, and Appendix A, 
Evaluating Prudence of Interest Rate Risk Limits, for discussion of 
this topic.
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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/quarter.html
_____________________________________-

 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

    Key elements in managing market risk are identifying, measuring, 
and monitoring interest rate risk. To ensure compliance with its 
board's IRR limits and to comply with OTS regulation Sec. 563.176, each 
institution must have a way to measure its interest rate risk. OTS 
guidelines for interest rate risk measurement systems are as follows, 
though examiners have broad discretion to require more 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 (see Glossary for definition) 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

[[Page 66363]]

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 is 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 a 
minimum, 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 is 
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 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 by 
using an earnings sensitivity approach, an NPV sensitivity approach, 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 exercise diligence in assessing the risks and 
returns (including expected total return) 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 this Thrift Bulletin, 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 non-callable, ``plain vanilla'' instruments of the 
following types: (1) mortgage-pass-through securities, (2) fixed-
rate securities, and (3) floating-rate securities.
    \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

[[Page 66364]]

transaction on the sensitivity of its net portfolio value.7
---------------------------------------------------------------------------

    \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:
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    \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 4 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 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
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    \9\ In June 1998, the FASB issued SFAS No. 133, ``Accounting for 
Derivative Instruments and Hedging Activities.'' Under SFAS No. 133, 
all ``derivative instruments,'' as defined therein, including those 
used for hedging purposes, would be accounted for at fair value. 
Accordingly, under that Standard, deferred gains and losses on 
``derivative instruments'' from hedging activities will no longer be 
reported.
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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

[[Page 66365]]

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 broad, 
descriptive 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 utilize them as starting points in their ratings 
assessments but have broad discretion to exercise judgment (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
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    \10\ According to the interagency uniform ratings system (61 
Fed. Reg. 67029 [1996]), 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 interest rate risk and will have 
other serious financial problems that place it in imminent danger of 
closure.
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    (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 unless the 
institution is 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 6% 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 6% and 10% 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 10% 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.


[[Page 66366]]

[GRAPHIC] [TIFF OMITTED] TN01DE98.005



    In Table 1 the numbers in parentheses represent the ``S'' component 
ratings that examiners would typically use as starting points in their 
analysis, assuming there are no deficiencies in the institution's 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's 
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's, the institution's 
results will be used to replace the OTS results for 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 
that the examiners 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 take the following eight factors, among others, 
into consideration in assessing the quality of an institution's risk 
management practices.
    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 have many facets, as described in 
Appendix B, Sound Practices for Market Risk Management.
    2. Prudence of Limits. Examiners will assess the prudence of the 
institution's board-approved interest rate risk limits.

[[Page 66367]]

Ordinarily, a set of IRR limits will raise examiner concerns if the 
limits permit the institution to have a Post-shock NPV Ratio and 
Interest Rate Sensitivity Measure that would ordinarily warrant an 
``S'' component rating of 3 or worse. (For examples of how examiners 
will make that determination, see Appendix A, Evaluating Prudence of 
Interest Rate Risk Limits.) Depending on the level of concern, such 
limits may result in examiner criticism or an adverse ``S'' component 
rating.
    3. Adherence to Limits. Examiners will assess the degree to which 
the institution adheres to its interest rate risk 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 types 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.
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    \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 examiners 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.
    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 the institution's ``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] \12\
---------------------------------------------------------------------------

    \12\ 61 Fed. Reg. 67029 (1996).

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.\13\
---------------------------------------------------------------------------

    \13\ 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

[[Page 66368]]

further in the next section, the ratings shown in Table 2 provide a 
starting point, but examiners have broad discretion to exercise 
---------------------------------------------------------------------------
judgment and deviate from them.

[GRAPHIC] [TIFF OMITTED] TN01DE98.006

D. Examiner Judgment

    Blind adherence to the guidelines is undesirable. 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 might 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 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 row and column boundaries of the 
cells in the table must be interpreted as transition zones or ``gray 
areas,'' rather than as 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. 
Open-ended cells are another instance where examiners will more 
commonly deviate from the guidelines. For example, in assessing an 
institution whose Sensitivity Measure is well beyond 400 b.p., an 
examiner might very well determine that its level of risk is higher 
than the guidelines in the rightmost column of Table 1. In applying the 
guidelines in Table 1, 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 re-submission. Examiners will document the corrective 
strategy and results and review progress at case reviewing meetings.
    For institutions with composite ratings of 4 or 5, the presumption 
of formal enforcement action generally requires a supervisory 
agreement, cease

[[Page 66369]]

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: Evaluating Prudence of Interest Rate Risk Limits

    The basic principle examiners will use in evaluating the prudence 
of an institution's risk limits is whether they permit NPV to drop to a 
level where 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).

[GRAPHIC] [TIFF OMITTED] TN01DE98.007




Examples of Evaluating the Prudence of Interest Rate Risk Limits

    The following examples illustrate how OTS examiners will evaluate 
an institution's interest rate risk limits. 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 has a detailed set of interest rate risk limits by 
which the board of directors specifies a minimum NPV Ratio for each of 
the seven rate shock scenarios described in Part II.A.1 of this 
bulletin.

                                  Institution A--Limits and Current NPV Ratios
 
                                                       Board limits  (minimum NPV     Institution's current NPV
            Rate shock (in basis points)                         ratios)                       ratios)
[a]                                                             [b]                           [c]
----------------------------------------------------------------------------------------------------------------
+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 assess the prudence of Institution A's interest rate risk 
limits, 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's 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 ``6% to 10%'' row and its current 
Sensitivity Measure falls into the ``100 to 200 b.p.'' column. The 
rating suggested by Table 1 is, therefore, a 1, and Institution A's 
risk limits would, thus, probably be considered prudent.14
---------------------------------------------------------------------------

    \14\ This example assumes there are no significant deficiencies 
in the institution's risk management practices.
---------------------------------------------------------------------------

Example Institution B

[[Page 66370]]



              Institution B--Limits and Current NPV Ratios
 
                                     Board limits        Institution's
  Rate shock  (in basis points)      (minimum NPV         current NPV
                                        ratios              ratios)
[a]                                         [b]                 [c]
------------------------------------------------------------------------
+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 at the present time. 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 ``6% to 
10%'' 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 3, and Institution B's risk limits would 
probably not be considered sufficiently 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
 
                                     Board limits
  Rate shock  (in basis points)      (minimum NPV        Institution's
                                        ratios)       current NPV ratios
[a]                                         [b]                 [c]
------------------------------------------------------------------------
+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. Its 
board of directors has established the institution's interest rate risk 
limits as a single minimum NPV Ratio of 6% that applies to all seven 
rate shock scenarios. In assessing the prudence of those limits, 
therefore, the Post-shock NPV Ratio permitted by the limits is 6.00%. 
The 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 either the ``4% to 6%'' or the ``6% to 10%'' 
row and its Sensitivity Measure in the ``Over 400 b.p.'' column of 
Table 1. The rating suggested by the table is, therefore, a 3 or a 4, 
and so Institution C's risk limits would also probably not be 
considered sufficiently prudent.

Example Institution D

              Institution D--Limits and Current NPV Ratios
 
                                     Board limits
  Rate shock  (in basis points)      (minimum NPV        Institution's
                                        ratios)       current NPV ratios
[a]                                         [b]                 [c]
------------------------------------------------------------------------
+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 quite a low base case level of economic capital, 
and its board limits recognize that fact by permitting 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 board's 3.50% minimum). While examiners

[[Page 66371]]

would be very likely to express concern about that aspect of the 
institution's risk management process, the limits themselves might 
still be viewed as 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 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 might well conclude that 
the risk limits are not sufficiently 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 polices 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

[[Page 66372]]

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 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 institution's 
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

[[Page 66373]]

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 
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; 
and
     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; and
     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

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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.
     Conduct an analysis of the incremental effect of any 
proposed transaction on the overall interest rate sensitivity of the 
institution.
    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; and
     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 15
---------------------------------------------------------------------------

    \15\ 61 Fed. Reg. 67029 (1996).
---------------------------------------------------------------------------

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.]

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-

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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 
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 non-callable, ``plain vanilla'' 
instruments of the following types: (1) mortgage-pass-through 
securities, (2) fixed-rate securities, and (3) floating-rate 
securities.
    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.''
    Structured Notes: Structured notes include fixed-income securities 
with embedded options or derivative-like features where the bond's 
coupon, average life, or redemption value is dependent on a reference 
rate, an index, or formula. The term ``structured notes'' includes but 
is not limited to: dual-indexed floaters, de-leveraged floaters, 
inverse floaters, leveraged inverse floaters, ratchet floaters, range 
floaters, leveraged cap floaters, stepped cap/floor floaters, capped 
callable floaters, stepped spread floaters, multi-step bonds, indexed 
amortization notes, etc. Standard, non-leveraged, floating rate 
securities (i.e., those whose interest rate is not based on a multiple 
of the index) are not considered structured notes for purposes of this 
Thrift Bulletin.
    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: November 20, 1998.

    By the Office of Thrift Supervision.
Ellen Seidman,
Director.
[FR Doc. 98-31672 Filed 11-30-98; 8:45 am]
BILLING CODE 6720-01-P