[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