WASHINGTON (MNI) – The following is an excerpt from guidance on
risk management that in an attempt to clarify points in the 2010
interagency Advisory on Interest Rate Risk Management, issued Thursday
by the U.S. bank regulators, including the Federal Reserve, represented
on the Federal Financial Institutions Council:

(These FAQs respond to common questions on several areas that are
critical to sound interest rate risk management, including appropriate
measurement and reporting, robust and meaningful stress testing,
assumption development reflecting the institutions experience, and
comprehensive model validation.)

Risk Management/Oversight

1. How should financial institutions determine which IRR vendor models are
appropriate?

Answer: Models can vary significantly depending on complexity, data
management, and cost. Achieving the proper balance among risk positions,
risk measurement processes, and cost is critical to a successful model
risk management program. When creating an IRR model or evaluating
third-party models, institution management should thoroughly assess the
model’s ability to reasonably capture risks in the institution.
Additionally, management should reevaluate the model’s appropriateness
as risk positions, strategies, and activities change. When reviewing
modeling options, management should at a minimum consider the following:

–The ability to reasonably model the institutions current and
planned on- and offbalance- sheet product types (on both income and
capital valuation bases). Material positions in highly structured
instruments or institution-specific products should be key
considerations. The model should support the level of data aggregation
and stratification necessary to properly measure these types of
products.

–The extent to which the model uses automated processes compared
with manual procedures. Management should consider whether the model has
automated interfaces with institution source systems. Management should
also consider the cost, hardware and software requirements, staff
resources, and expertise needed to run the model and integrate any
separate (manual) add-ons (also see question #2).

–The level of model transparency and the adequacy and
comprehensiveness of vendor model validations and internal control
reviews (also see question #9).

–The level of vendor implementation and ongoing support received,
including available training from the vendor. To better control
third-party model risk, financial regulators expect financial
institutions to have sufficient in-house knowledge in case vendors or
financial institutions terminate contracts for any reason, or if vendors
are no longer in business. Financial institutions should maintain
contingency plans for addressing how management should respond to such
lapses in vendor support.

2. If an institution implements a new strategy and later finds that
its IRR measurement model cannot capture the risk exposure, could this
raise significant supervisory concerns?

Answer: Yes. All potential risk exposures, including IRR, posed by
new products or strategies should be considered as part of the due
diligence for any new strategy. If a new strategy involves IRR that
cannot be adequately captured by existing measurement processes, steps
should be taken to ensure this risk can be adequately measured before
implementation of the strategy. The cost of measuring the change in
exposure from a new product or strategy also should be considered an
essential part of the due diligence process.

For example, if an institution were to implement a leverage
strategy using highly structured liabilities to fund fixed-rate mortgage
investments or whole loans, this type of strategy could introduce a
significant level of option risk to the institutions IRR risk profile.
If existing IRR measurement tools do not adequately capture the
potential volatility in cash flows and rate adjustments from the newly
acquired assets and liabilities, the model would not be able to
adequately capture this option risk. Therefore, management would not be
able to measure the IRR exposure accurately. This would likely be
considered a management weakness, and corrective actions could include
making the appropriate changes or enhancements to the model. In some
cases where on- or off-balance-sheet items cannot be effectively
measured in the primary IRR model, it may be appropriate to use
alternative means to measure the risk in such products, where the
alternative output is then incorporated into the primary model results
(i.e., add-ons). Financial regulators expect risk managers to consider
the ability of current systems to model risks posed by a new strategy in
advance to understand how new products or strategies affect overall IRR
exposure.

3. What types of IRR measurement methodologies are institutions expected to use?

Answer: Institutions should measure the potential impact of changes
in market interest rates on both earnings and the economic value of
capital.3 Measurement methodologies generally focus on either changes to
net interest income (NII)/net income (NI), or changes to the economic
value of capital over various time horizons. Income simulations are
typically used to measure potential volatility in NII/NI over various
time horizons (generally one to five years). Economic or market value of
equity models typically cover much longer time horizons and measure risk
to the economic value of capital. Institutions should use a combination
of both earnings-focused and economic value of capital-focused measures
to capture the full spectrum of IRR. Large and complex institutions as
well as model vendors continue to develop new approaches to IRR
measurement. Financial regulators will consider these new approaches on
a case-by-case basis to ensure that they meet the spirit of outstanding
guidance and effectively model IRR.

Since the original interagency guidance on IRR was issued by the
FRB, FDIC, and OCC in 1996,4 the number and availability of financial
products with embedded options has grown considerably. Such products,
which include but are not limited to collateralized mortgage
obligations, step-up notes, callable agency bonds, convertible Federal
Home Loan Bank borrowings, alternative certificates of deposit,
one-to-four family residential mortgage loans/securities, and commercial
real estate loans/securities, present significant challenges to IRR
measurement. The IRR measurement challenges arise because the timing and
size of the cash flows may change considerably, depending on how
interest rates vary over time. As a result, these products often carry
significant prepayment or extension risk.

** Market News International Washington Bureau: 202-371-2121 **

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