Not at all sure where to put this but i think it is important.
totalnews.com
The feds' move away from scrutiny of mortgage-backed securities will force banks
to assess the impact of rate changes on cash flows. And for good reason, given all
the "optionality" on balance sheets
In many banks around the country, managers, as well as members of investment
committees and asset-liability committees, are about to go through a change in the way
they live, courtesy of the federal banking regulators. Unlike some regulatory changes,
however, this shift may keep a bank out of trouble should the current stable rate
environment change.
Earlier this year the Federal Financial Institutions Examination Council issued the new,
finalized version of its revised Supervisory Policy Statement on Investment Securities and
End-User Derivatives Activities (called the "1998 Statement" for short). The new policy
document took effect May 26.
This new policy statement provides guidance on sound practices for managing the risks
of investment activities. It rescinds the Supervisory Policy Statement on Securities
Activities published on Feb. 3, 1992 (referred to as the 1992 Statement).
Many elements of the 1992 Statement were retained in the 1998 Statement, while others
have been significantly revised or eliminated. The most notable change is the elimination
of the specific constraints in the 1992 Statement concerning investments in "high risk"
mortgage derivative products. Most institutions will recognize this requirement as the
"thumbs up, thumbs down" test which was required on mortgage derivative securities that
were purchased by an institution. This security-specific test, applied only to mortgage
derivative securities, has been replaced by broader balance sheet requirements that must
be applied to all investment securities.
According to the agencies, there are two purposes for this:
1. To eliminate the perception that the agencies were concerned only with the type of
instrument involved (i.e., mortgage derivative products, because they were the only
securities subject to the test), as opposed to the risk characteristics of the instrument.
2. To encourage institutions to address the risks involved in all types of investment
securities in relation to the entire balance sheet.
The agencies came to the conclusion that bank balance sheets had gotten much more
sophisticated, but management systems had not. Specifically, they were concerned
about the increasing "optionality" of contracts on both sides of the balance sheet-i.e., the
ability of one party to change a contract when rates change. Examples include callable
agencies, mortgage prepayments, and callable advances from the Federal Home Loan
Banks. The regulators are not against such practices-they recognize they are often
necessary-but they have a big concern that most banks, lulled by stable rates, are not
calculating what happens to cash flows when rates change. Most institutions can't do
this for each segment of their balance sheet.
Broader risk view required
Every institution, regardless of size, must be able to determine how each security activity
it engages in will affect the overall risk posture of its balance sheet.
While some may view this as just another regulatory burden, in fact it is nothing more
than a good management technique. However, for most institutions this will require a
different operating procedure than the one they typically follow.
Now, it's not unusual for a broker to call with an idea for the investment officer to
consider. Assuming the security fits investment policy guidelines, the investment officer
analyzes the proposed investment, which would generally include a price/yield
comparison to similar investments available; how the cash-flow characteristics of the
instrument might change in the event that rates were to either rise or fall; and the
risks/rewards of call features, if applicable. In the case of mortgage related products,
estimated prepayment speeds and their effect on the investment would also be
considered.
All of this data typically would be provided to the bank by the broker through the standard
"Bloomberg" analyses. After considering all of these elements, a decision is made.
The 1998 Statement points out five classes of risk that exist in all investment activity:
market risk credit risk liquidity risk operational risk, and legal risk
While banks have always considered these five risks in their analysis, changes in how
they must now look at "market risk" are going to force changes in the operating habits of
most institutions. Unlike today, where the market risk analysis has focused on the
characteristics of specific securities, this analysis must be broadened to include the
entire balance sheet. No longer will investment officers be limited to analyzing just the
characteristics of a specific security. Now they must understand how these
characteristics will mesh with the cash-flow characteristics of other components of the
balance sheet.
More work for the board
The 1998 Statement requires the bank's board to establish specific "market risk" limits
for the balance sheet that management must operate within. The new statement points
out that an institution's exposure to market risk can be measured by assessing the effect
of changing interest rates on either the earnings or the economic value of the institution.
As defined, these "market risk" limits are synonymous with the bank's interest rate risk
limits. These limits should specify how much exposure (dollar or percentage) to either
earnings or economic value or both the board is willing to accept. Management's
responsibility is to demonstrate compliance with these limits.
In other words, management must be able to provide the board with a list of securities
that were purchased and an analysis of the before and after effect that the purchases had
on the interest rate risk inherent in the balance sheet.
Going forward, investment officers must be able to answer (and demonstrate in reports to
the board) two specific questions for each security transaction:
1. Did the transaction increase or decrease the overall interest rate risk posture of the
institution?
2. If the transaction increased the interest rate risk exposure of
the institution, is the risk exposure still within the limits set by
the board?
Meeting the challenge
To answer these questions, banks must have systems that
allow investment officers to broaden their security analysis to
include the whole balance sheet. While a broker can give your
investment officer all he wants to know about any one security,
it is unlikely that the broker can provide him with information
on how any specific security will affect the overall risk posture
of the balance sheet. Yet such an analysis is critical because
the same security could increase rate risk for one bank and decrease it for another.
Investment officers will have to find new tools for measuring this risk. They need software
that allows them to track individual cash flows for different segments of their balance
sheet. Such programs exist, although some asset/liability software merely summarizes
data into a GAP report for regulatory purposes. Such reports are snapshots that don't
take into account the dynamics of newer instruments.
With the new statement, the regulators are taking the analysis out of the broker's hands
and placing it back with the institution. It will mean more work, but the time has come for
the implementation of better measurement systems. BJ
Callout: The agencies came to the conclusion that balance sheets had gotten much more
sophisticated, but management systems had not
By Robert Colvin, Director of Community Banking, Sheshunoff Business Information
Group. Mr. Colvin, a longtime community bank consultant, is based in Denver, Colo. |
