Stealth Regulation Flies over Interest-Rate Risk

If you think the banking agencies really backed off of interest-rate risk, get ready for a shock In February, bank regulators announced they were dropping a standardized modified-duration rate-risk measure to evaluate banks. Bankers responded with relief. Was the relief premature? Readers should understand the implications of the new statement issued in place of the proposed rule on May 23, 1996. (See Board of Governors of the Federal Reserve System's "Joint Policy on Interest Rate Risk.") While this statement appears benign, the implicit moves contained within it are radical. Asset/liability managers interpret the joint policy statement on interest-rate risk to say that the burden of compliance has been made to go away, as a result of industry lobbying and the inherent complexity of the area in question. This is pure wish fulfillment. The responsibility explicitly charged to bank examiners to protect the FDIC insurance fund from future bank losses has not been altered at all. The only item that has been dropped is the standardized measure. Since the regulators will not be doing the task for the banks, banks had better be able to demonstrate that, regardless of circumstances, they will not be the cause of future FDIC losses. If they can't do so, the "case by case" implications could be difficult for those who assumed that examination strictures have simply evaporated. The future regulatory intent appears to be to squeeze interest-rate-risk levels that threaten the FDIC fund out of the banking system incrementally through an evolutionary process of examiner review. This is the directive of the FDIC Improvement Act (FDICIA) of 1991. Accordingly, the Federal Financial Institutions Examination Council in July proposed the addition of a market-risk component to the post-examination CAMEL rating to be given to banks (Federal Register, July 18, 1996). The end purpose is the same; only the means have changed. Managing value Superficially, the regulators' joint statement will require only a few changes. Banks must consider economic value at risk, as well as earnings at risk, and will be evaluated explicitly on terms that relate to capital adequacy. The new premises, drawn from the statement, are as follows: "Well-managed banks consider both earnings and economic value." "The adequacy of a bank's interest rate risk management process...[is a] critical factor in the agencies' evaluation of the bank's capital adequacy. A bank with material weaknesses in its risk management process...will be directed by the agencies to take corrective action. Such actions will include directives to raise additional capital, strengthen management expertise, improve management information and measurement systems, reduce levels of exposure, or some combination thereof." "Economic value" is conceptually equivalent to the familiar notion of "market value of portfolio equity," as shown by the statement's definition, which is: "The economic value of an instrument represents an assessment of the present value of the expected net future cash flows of the instrument, discounted to reflect market rates. A bank's economic value of equity represents the present value of the expected cash flows on assets minus the present value of the expected cash flows on liabilities, plus or minus the present value of the expected cash flows on off-balance sheet instruments." The reason for managing value at risk is that: "An adverse change in a bank's economic value of equity can signal future earnings and capital problems. Changes in economic value can also affect the liquidity of bank assets, because the cost of selling depreciated assets to meet liquidity needs may be prohibitive." So the focus in the interagency statement is to force banks to consider longterm time horizons, to prevent future liquidation and FDIC insurance depletion, usually resulting from longer-term asset positions, relative to possible future rate environments. …