Each depositor insured to at least $250,000 per insured bank

• To establish and guide the bank's tolerance for interest rate risk, including approving relevant risk limits and other key policies and ensuring adequate resources are devoted to interest rate risk management
• To monitor the bank's overall interest rate risk profile and ensure that the level of interest rate risk is maintained at prudent levels

In order to carry out these responsibilities, you need to ensure that your bank has a sound risk management process for IRR. Effective control of interest rate risk requires a comprehensive risk management process that includes the following elements:

• Policies and procedures that include risk limits designed to control the nature and amount of IRR the bank takes
• A system for identifying and measuring IRR
• A system for monitoring and reporting risk exposures
• A system of internal controls, review and audit to ensure the integrity of the overall risk management process

An important responsibility for you as directors is to ensure that the management team has adequate resources to manage sensitivity. For example, the complexity of the model chosen to measure IRR should match the complexity of operations. If you have callable securities, long-term assets/liabilities, a significant derivatives portfolio, etc., your bank will likely require an IRR measurement tool with more complexity than the simple gap analysis above. In this type of situation, your management team would need to utilize a model that would account for variances in price and cash flow, such as a duration or simulation analysis.

Also, the board needs to ensure that management documents the assumptions utilized in the IRR measurement tool and that the assumptions are reasonable. Again, this is where you, as a director, can have a significant impact on IRR management. Did you refinance your personal and/or corporate debt in the last five years because interest rates fell so dramatically? It's likely that you did and it's also likely that the longer-term commercial credits in your bank's portfolio did the same. Make sure that the bank's model accounts for the depositors' and borrowers' likely behavior in addition to contractual terms.

Finally, the board needs to ensure that the IRR program is subject to a periodic independent review, and that the findings of the review are presented to the directorate on an annual basis. This means that someone who is not affiliated with IRR measurement (and does not work for the officers responsible for IRR measurement) reviews the model to determine its appropriateness and accuracy. In many cases, particularly at smaller banks, this activity is outsourced to a third party; however, if the resources are available, this can be an excellent opportunity to cross train employees. Most importantly, variance analysis should be done at least annually to identify material differences between actual and forecasted results.

• A substantial change in the NIM - Look for substantial decreases or increases in the NIM. Changes in both directions could indicate that the model is inaccurate and that the bank is taking on more IRR than expected or allowed by policy. Keep in mind, however, that significant changes in the NIM are not necessarily related to IRR. Changes in the balance sheet such as changing the percentage of earning assets, changing the risk profile, or changing the quantity of non-interest bearing funds can all affect the NIM.



• IRR exposure that regularly exceeds board established limits - In this case, the board should require that the exception be documented and explained, and corrective action should be detailed.



• Failure to adhere to the SOP - Particularly the items listed above.

Let's try to apply some of this to our subject bank. Please read the sensitivity to market risk comment in our sample Report of Examination.

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