[Federal Register Volume 63, Number 241 (Wednesday, December 16, 1998)]
[Notices]
[Pages 69285-69288]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-33339]
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FARM CREDIT ADMINISTRATION
[BM-10-DEC-98-02]
Interest Rate Risk Management
AGENCY: Farm Credit Administration.
ACTION: Final policy statement.
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SUMMARY: The Farm Credit Administration (FCA or Agency), through the
FCA Board (Board), is issuing a final policy statement that provides
guidance on interest rate risk management to Farm Credit System
(System) institutions, excluding the Federal Agricultural Mortgage
Corporation (Farmer Mac). The policy statement also describes the
Agency's approach to evaluating interest rate risk when making a
determination of capital adequacy. The policy statement identifies key
elements of sound business principles and practices for interest rate
risk management by a System institution. The policy statement also
provides criteria by which examiners will evaluate the adequacy and
effectiveness of a System institution's interest rate risk management.
EFFECTIVE DATE: December 10, 1998.
FOR FURTHER INFORMATION CONTACT:
Andrew D. Jacob, Senior Policy Analyst, Office of Policy and Analysis,
Farm Credit Administration, McLean, Virginia 22102-5090, (703) 883-
4498, TDD (703) 883-4444,
or
Wendy R. Laguarda, Senior Attorney, Office of General Counsel, Farm
Credit Administration, McLean, Virginia 22102-5090, (703) 883-4020, TDD
(703) 883-4444.
SUPPLEMENTARY INFORMATION:
I. Background
The Agency published a proposed policy statement on interest rate
risk management on May 21, 1998 (63 FR 27962). We received comments on
the proposed policy statement from the System's Presidents' Finance
Committee (System joint comments) and the Independent Bankers
Association of America (IBAA comments). The comments, discussed in
greater detail below, reflect the views of System banks and
associations and community banks, respectively. We carefully considered
the comments in the formulation of the final policy statement and have
adopted the policy statement substantially as proposed. The final
policy statement also includes minor technical, grammatical, and
syntactical changes.
II. System Joint Comments
The System provided six comments on the proposed policy statement.
First, the System expressed its concern that the policy statement does
not apply to Farmer Mac and requested an explanation for the exclusion.
The System banks and associations believe that the interest rate risk
management principles set forth in the policy statement also are
applicable to Farmer Mac.
[[Page 69286]]
The Agency did not make the policy statement applicable to Farmer
Mac because the subject of interest rate risk must be addressed in
risk-based capital regulations for Farmer Mac. The Farm Credit Act of
1971, as amended (Act), at 12 U.S.C. 2279bb-1, requires the Agency,
acting through the Office of Secondary Market Oversight (OSMO), to
issue regulations that will include a risk-based capital test which,
along with other factors, will include interest rate risk. We also note
that the statute precludes publishing these regulations prior to
February 10, 1999. In light of the statutory provisions and forthcoming
regulations, we decided not to apply this policy statement to Farmer
Mac.
In the last sentence of section IV.A. of the policy statement,
entitled ``Risk Limits,'' the System suggested that the phrase ``A
System institution's board and senior management'' be replaced with
``Each System institution.'' The System recommended this change because
it felt that System board responsibilities were adequately detailed in
section II. of the policy statement. We decided not to make this change
because we want to emphasize the responsibility of boards to set risk
limits prior to the introduction of new business approaches involving
new products, hedging activities, or position-taking strategies. We
believe this phrase is necessary to specifically identify that this
responsibility rests with the board and senior management.
In section IV.E. of the policy statement, entitled ``Additional
Guidance on the Interest Rate Risk Management Process,'' the System
wanted additional guidance on when or why a System association needs to
establish limits on market value of equity (MVE). The Agency expects an
association to establish an MVE limit when it implements decisions
regarding the duration of its equity position, such as by mismatching
the repricing or maturity of its assets or liabilities either directly
or through the use of a derivative instrument. We have revised the
first bullet of the second paragraph of section IV.E. of the policy
statement to explain when an association should establish an MVE limit.
Also, in the first sentence of the third paragraph of section IV.E.
of the policy statement, the System recommended replacing the phrase
``essentially all'' with the word ``primary'' in the sentence:
``Finally, a direct lender association that relies on its funding bank
to manage essentially all sources of interest rate risk and that has
minimal level of interest rate risk exposure should establish an
interest rate risk management program that includes . . .'' The System
commented that ``essentially all'' could be interpreted in a broad
number of ways, including the impact of changing interest rates on
earnings from an association's ``own funds position'' or spread
compression due to competition. The FCA Board agrees that the phrase
``essentially all'' could be interpreted to include interest rate risk
that is under the direct control of the association. The policy
statement has been changed to use the phrase ``primary sources of
interest rate risk.'' In the context of the policy statement, ``primary
sources of interest rate risk'' encompasses interest rate risk from
sources such as:
Maturity or coupon adjustment timing differences of
assets, liabilities, and off-balance-sheet instruments (repricing or
mismatch risk);
Changes in the slope of the yield curve (yield curve
risk);
Imperfect correlation in the adjustment of the rates
earned and paid on different instruments with otherwise similar
repricing characteristics (basis risk); and
Interest rate-related options embedded in assets,
liabilities, and off-balance-sheet instruments (options risk).
Finally, in the first and second bullets of the third paragraph of
section IV.E. of the policy statement, the System recommended replacing
the phrase ``tolerance for'' with ``philosophy regarding'' as well as
deleting the phrase ``and exposure levels.'' This section of the
proposed policy statement provides that an association should establish
an interest rate risk management program that includes: ``A policy that
establishes the board's tolerance for interest rate risk . . .'' and
``Procedures to ensure that the board and senior management understand
the sources and exposure levels of interest rate risk . . . .'' The
System suggests that its wording is more appropriate to reflect an
association's interest rate risk management responsibilities when
primary sources of interest rate risk are managed by its funding bank.
We believe that an association should establish interest rate risk
tolerances and quantify interest rate risk exposure levels under its
direct control. Therefore, we have not made the changes suggested by
the System. However, we have added the phrase ``within the
association's direct control'' in the first and second bullets of the
third paragraph in section IV.E. to make it clear that tolerance limits
and exposure levels need only be established for those interest rate
risks directly under an association's control. For example, although
the bank may manage primary sources of interest rate risk, an
association may still be exposed to risk from the following sources:
Repricing of administered rate loans;
Adjustments in loan spreads; and
Rate movements on an association's loanable funds
position.
We also have added to section IV.E in the second bullet of the
third paragraph the phrase: ``and the sources of interest rate risk
being managed by the funding bank.'' We added this phrase to emphasize
that even when the funding bank manages primary sources of interest
rate risk, it is still necessary for the association board and
management to maintain an awareness of such risk.
III. IBAA Comments
The IBAA commented that the guidance on interest rate risk
management developed by the FCA, particularly in the area of
examination criteria, is not as thorough as similar guidance provided
by other Federal financial institution regulatory agencies (see 61 FR
33166, June 26, 1996).\1\ The FCA policy statement is a flexible
document providing broad guidance on the subject of interest rate risk
management. Our policy statement includes all the subject areas
addressed in the joint policy statement issued by other Federal
financial institution regulatory agencies. We believe that the policy
statement appropriately covers all areas of interest rate risk
management for System institutions. Finally, like other Federal
financial institution regulators, we will include more detailed
criteria for examining interest rate risk management practices in our
publicly available FCA Examination Manual.
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\1\ Other Federal financial agencies that issued a joint policy
statement on interest rate risk management are the Office of the
Comptroller of the Currency, the Board of Governors of the Federal
Reserve System, and the Federal Deposit Insurance Corporation.
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The final policy statement, as adopted by the Board, is set forth
below in its entirety.
Policy Statement on Interest Rate Risk Management
[BM-10-DEC-98-02; FCA-PS-74]
Effective Date: December 10, 1998.
Effect on Previous Actions: None.
Source of Authority: Sections 5.9 and 5.17 of the Farm Credit Act
of 1971, as amended.
I. Purpose
Interest rate risk is the exposure of a Farm Credit System (System)
institution's financial condition to adverse movements in interest
rates. This policy statement provides guidance
[[Page 69287]]
to System institutions on principles for prudent interest rate risk
management. The policy statement also provides criteria by which the
Farm Credit Administration (FCA or Agency) will evaluate the adequacy
and effectiveness of a System institution's interest rate risk
management.
II. Board of Directors' Responsibilities
Effective board of directors' (board) oversight of an institution's
interest rate risk activities is the cornerstone of a sound risk
management process and a critical element of a board's asset/liability
management policy. A board should understand the nature and level of
interest rate risks and how such risks relate to the overall business
strategies of the institution. A board should also define its risk
tolerance levels and expectations for interest rate risk management. To
properly fulfill its responsibilities a board should, at a minimum:
Approve major business strategies and policies addressing
interest rate risk, including setting relevant risk limits, and
integrating such strategies and policies into the institution's overall
strategic and financial planning processes;
Ensure that senior management implements a sound risk
management process that facilitates the identification, measurement,
monitoring, reporting, and control of interest rate risk;
Monitor the institution's performance and overall interest
rate risk profile to ensure that risk is maintained at prudent levels;
and
Ensure that adequate resources and proper control systems
are devoted to interest rate risk management, including measurement
activities.
III. Senior Management Responsibilities
Senior management is responsible for ensuring that interest rate
risk is properly managed on both a long-range and day-to-day basis. In
managing the institution's activities senior management should, at a
minimum:
Develop and implement procedures that translate the
board's major business strategies and policies addressing interest rate
risk, including risk limits, into operating standards;
Ensure adherence to the lines of authority and
responsibility that the board has approved for managing, measuring, and
reporting interest rate risk exposures;
Oversee the implementation and maintenance of a management
information system and other systems that appropriately manage and
control interest rate risk; and
Establish proper internal controls and audits \2\ of the
interest rate risk management process.
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\2\ ``Audits'' refers to audits performed by either internal or
external auditors. An institution can rely on qualified internal
auditors to perform the audit functions. However, we encourage
institution boards to consider using external auditors if the
interest rate risk exposures are complex and appropriate interest
rate risk management practices are critical to controlling risk
exposures at prudent levels.
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An institution's board or senior management may delegate authority
for implementing many aspects of board policy on risk management to an
internal committee composed of qualified officers and staff members.
The risk management committee should be a decision-making body involved
in the acquisition, allocation, and pricing of the institution's
resources in a manner consistent with both the goals established in the
institution's business plan and the risk tolerances established by the
board.
IV. Interest Rate Risk Management Process
Effective control of interest rate risk requires a comprehensive
management process that includes the following elements:
Policies and procedures designed to control the nature and
amount of interest rate risk that the institution assumes;
A system for identifying and measuring interest rate risk;
A system for monitoring and reporting interest rate risk;
and
A system of internal controls and audits to ensure the
integrity of the overall risk management process.
Each of these elements is discussed below.
A. Risk Limits
Each System institution should establish appropriate controls to
effectively limit interest rate risk exposures within the risk
tolerances established by its board. Established risk limits should be
consistent with the institution's overall measurement of interest rate
risk and should consider capital levels and earnings performance. Risk
limits must be clearly defined, ensure that exposures will not lead to
an unsafe or unsound condition, be consistent with the nature and
complexity of the institution's activities, and be evaluated within the
institution's total risk-bearing capacity. The risk limits should
address the potential impact of changes in market interest rates on
both reported earnings and the market value of equity (MVE). Exceptions
to established risk limits should be appropriately controlled,
approved, and reported. In addition, risk limits should be reviewed at
least annually to ensure that they remain appropriate. A System
institution's board and senior management should further ensure that
adequate operational procedures, controls, and risk limits are in place
prior to introducing new business approaches. New business approaches
have the potential to increase materially an institution's interest
rate risk exposure, particularly when they involve new products,
hedging activities, or position-taking strategies.
B. Interest Rate Risk Identification and Measurement
Senior management should ensure the adequacy and completeness of
the interest rate risk identification and measurement system. The
quality and reliability of the identification and measurement system
depend on the type of system used, the quality of the data, and various
assumptions used in the model; therefore, close attention to these
areas is needed. Senior management should ensure that the
identification and measurement system:
Enables management to identify in a timely and accurate
manner risks arising from the institution's existing activities and
from new business activities;
Captures and measures all material sources of interest
rate risk in ways that are consistent with the scope of the
institution's activities \3\ and considers all relevant repricing and
maturity data such as current balances, contractual rates, principal
payments, interest reset dates, maturities, index rates, and rate caps
and floors;
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\3\ For a System institution with a high level of interest rate
risk or a complex risk exposure, interest rate risk should be
measured over a range of potential interest rate changes, economic
scenarios, and yield curve shifts so as to capture effectively all
material exposures (options, mismatch/repricing, basis, and yield
curve). For a System association where the funding bank manages the
majority of interest rate risk, any locally managed interest rate
risk should be measured at least annually as part of the
association's annual financial planning process.
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Utilizes assumptions that are clearly communicated to and
understood by risk managers and the board of directors; and
Measures an institution's vulnerability to loss under
stressful market conditions, including a breakdown of key assumptions.
When assessing the scope of an institution's exposure, risk
managers should consider the effect on earnings and, when appropriate,
MVE. The effect on earnings is important because reduced earnings or
losses can adversely
[[Page 69288]]
affect liquidity and capital adequacy. The effect on MVE is important
because adverse changes in the market value of assets, liabilities, and
off-balance-sheet instruments can affect the future performance and
liquidity of a System institution.
C. Monitoring and Reporting
Each System institution must have adequate information systems for
monitoring and reporting interest rate risk exposures. These systems
should provide the board, senior management, and any risk management
committee with clear, concise, and timely summaries of the
institution's aggregate exposures, compare current exposure to policy
limits, and allow for a determination of whether the institution holds
sufficient capital in relation to the level of risk exposure. Risk
reports should provide sufficient information for the board and senior
management to assess exposure. The frequency of internal reporting
should be determined by the board and senior management and should
depend on the amount and complexity of an institution's level of risk.
D. Internal Controls and Audits
Each System institution should maintain an effective system of
internal controls as part of its interest rate risk management process.
Controls should include a process for identifying and evaluating risk,
establishing appropriate exposure limits and approval processes, and
requiring reconciliations, audits, and other mechanisms designed to
provide reasonable assurance that interest rate risk is managed in a
safe and sound manner. The controls should clearly define official
lines of authority and the appropriate separation of duties to avoid
conflicts of interest, and should ensure that personnel follow
established policies and procedures.
An institution with more complex risk exposures should ensure that
its interest rate risk process is audited on a regular basis. Qualified
individuals who are independent of the function they are assigned to
audit or external auditors should conduct the audits. The audits should
test the effectiveness of controls and ensure appropriate follow-up
with management where risk limits have been exceeded or deficiencies in
interest rate risk management are identified. Audits of risk
measurement systems and models should include assessments of the
assumptions, parameters, and methodologies used. The audit results
should be reported to the board and senior management.
E. Additional Guidance on the Interest Rate Risk Management Process
The interest rate risk management process will vary among System
institutions in accordance with the level of interest rate risk
exposure. For instance, a System bank, direct lender association, or a
service corporation that is managing major sources of interest rate
risk should employ comprehensive interest rate risk management
techniques. Similarly, measurement practices should address all
applicable elements of an effective process for interest rate risk
management discussed in this policy statement. These practices should
help ensure the establishment and maintenance of adequate controls over
the identification, measurement, monitoring, and reporting of all
sources of interest rate risk.
The formality and comprehensiveness of the risk management process
will vary among System associations depending on the extent to which
the funding bank centrally manages interest rate risk. For instance, a
direct lender association that is managing some sources of interest
rate risk locally and that has the potential for a moderate level of
interest rate risk exposure should implement an interest rate risk
program that includes:
A policy that defines the board's interest rate risk
tolerance arising from the sources of interest rate risk being managed
locally and that sets risk limits from an earnings perspective and, if
appropriate considering the sources of interest rate risk being
managed, an MVE perspective. For instance, a System association should
impose an MVE limit when it implements decisions regarding the duration
of its equity position, such as by mismatching the repricing or
maturity of its assets or liabilities either directly or through the
use of a derivative instrument;
Procedures and practices established by senior management
that adequately identify, measure, control, monitor, and report
interest rate risk within the association's direct control;
Procedures and practices established by senior management
that ensure that the board is informed of the sources and exposure
levels of interest rate risk;
Reliable information systems and modeling capabilities
that are commensurate with the nature of the interest rate risk being
managed and that measure interest rate risk under various economic
scenarios; and
Consideration of interest rate risk exposures in the
capital adequacy plan as required by Sec. 1615.5200(b)(7).
Finally, a direct lender association that relies on its funding
bank to manage primary sources of interest rate risk and that has a
minimal level of interest rate risk exposure should establish an
interest rate risk management program that includes:
A policy that establishes the board's tolerance for
interest rate risk within the association's direct control;
Procedures and practices to ensure that the board and
senior management are informed of the sources and exposure levels of
interest rate risk within the association's direct control and the
sources of interest rate risk being managed by the funding bank;
Consideration of interest rate risk exposures in the
capital adequacy plan as required by Sec. 1615.5200(b)(7); and
An analysis, prepared at least annually, of potential
earnings exposure to changing interest rates.
V. FCA's Capital Adequacy Determination for Interest Rate Risk
FCA examiners will assess an institution's capital adequacy for
interest rate risk based on the evaluation of an institution's level of
interest rate risk exposure and its risk management practices. The
results of an institution's interest rate risk management process will
be considered when evaluating interest rate risk exposure levels in
accordance with the FCA's Financial Institution Rating System.
Dated: December 11, 1998.
Floyd Fithian,
Secretary, Farm Credit Administration Board.
[FR Doc. 98-33339 Filed 12-15-98; 8:45 am]
BILLING CODE 6705-01-P