Liabilities liquidity and cash management balancing financial risks phần 8 potx

A system of interest-rate risk controls elaborated by OTS: • Helps in setting prudent boundaries for the level of interest-rate risk chosen by the institution • Provides the capability t

system Security reasons, however, necessitate the identification of both parties to a transaction andthat the keeping of a record of every transaction for auditing.

Because electronic money offers both advantages and limitations, its development and widerimplementation will depend on whether consumers and merchants like it as a payment instrument

So far, from the early test of smart cards in Norway in the late 1980s, to the intensive tests in theUnited States in the late 1990s, the answer has been negative

It is appropriate to examine security connected to electronic money, because its absence is amajor roadblock to the acceptance of new forms of payments Theoretically, but only theoretically,smart cards provide a higher level of security Practically, however, this is not so If it were, smartcard crime would not have increased more than 25 percent in France in the year 2000

From time to time, some new approaches are adopted to improve security The latest is ric identification, which can be incorporated into a smart card One of the features in biometrics isthe fingerprint It can be stored as a binary data string or as a template Another biometric is the reti-

biomet-na Smart cards also can store signatures and voice None of these approaches is fool-proof.Visa and Mastercard, among others, have done trials in the United States using smart cards withfingerprint biometrics Other firms examined solutions for rewriting information with smart cards

in a way that cannot be read by unauthorized persons Any cryptographic code can be broken Allthese security measures, however, fail to consider the fact that smart cards can get easily lost orstolen When this happens, all biometrics information of the legitimate user is wide open to thieves Protection through the now-substandard personal identification number (PIN) is most unreliable,because these numbers easily fall into the hands of third parties On the positive side, PINs can bechanged easily, but fingerprints cannot be Once the smart card is in the hands of a gang, the trueowner of the new smart card—and his or her account—cannot be safe at any time, in any place.Security is a truly major challenge with electronic money, including network money Thus far nosolution available solves the security problem

When asked “What does one do with virtual money?” Walter Wriston, the former CEO ofCitibank, suggested: “One pays his bills.” But then he added: “The problem with this kind of money

is the security of the networks There exist too many 16-year-olds with gold chains around the neck,

who break into the data system.”

Wriston pointed out that it is possible to work on more secure solutions through an ingenious use

of hardware and software But technology changes so fast that it would be impossible to say whichsystem is really secure in the longer term The world today has become so transparent in an infor-mation sense that nothing can be properly secured anymore, much less secured in a lasting way

Mismatched Risk Profiles and Control

by the Office of Thrift Supervision

The events that led to the meltdown of the savings and loan (S&L) industry in the United States inthe late 1980s/early 1990s are recent enough that they do not need to be retold What is important

in connection with the salvage of the thrifts industry is the action that followed its restructuring—and, most particularly, ways and means established for controlling its interest-rate profile

Wise people learn from their mistakes, and the wisest people are able to capitalize on the takes of others to help them face challenges presented in the future Here is, as an example, howchroniclers described the way Romans reacted in the aftermath of their defeat in the third centuryB.C at the hands of the Gauls: “The ascendancy acquired by Rome in 100 years was lost in a sin-gle campaign But the Romans with characteristic doggedness set to work to retrieve their losses.With equally characteristic sagacity they studied their own failure and drew profitable lessons from

mis-it A great disaster was the prelude to far-reaching victories.1

This quotation applies to the action taken by the regulators of the S&L industry right after thedisastrous events of the late 1980s Guidelines set by the Office of Thrift Supervision (OTS) see to

it that senior management ensures the bank’s exposure to the volatility of interest rates is maintainedwithin self-imposed limits A system of interest-rate risk controls elaborated by OTS:

• Helps in setting prudent boundaries for the level of interest-rate risk chosen by the institution

• Provides the capability to set and control limits for individual portfolios, activities, and business units

The financial reporting system examined in this chapter ensures that positions exceeding limits,

or other predetermined levels, receive prompt management attention and are directly

communicat-ed to regulators Establishcommunicat-ed proccommunicat-edures ensure that senior executives of the institution are notificommunicat-edimmediately of any breaches of limits The OTS also has been instrumental in promoting clear poli-cies as to how the board and top management of a thrift must be informed so that timely and appro-priate corrective action is taken

To keep exposure under control, the OTS steadily monitors the entire S&L industry—and thismonitoring is proactive When supervisory authorities follow this policy, they help the banks theycontrol to confront their problems It is no coincidence that the best-managed financial institutions

Timothy J Stier, the chief accountant of the OTS, explained in a factual and documented ner why proactive information and experimentation is so important to the proper conduct of thethrifts’ business With the world of the mortgage loans changing and with interest-rate risk beingunder the spotlight more than ever before, the S&L (and all other credit institutions) always mustwatch out both for generalized exposure and for specific risks of individual investments.

man-INTEREST-RATE RISK MEASUREMENT AND OFFICE OF THRIFT

SUPERVISION GUIDELINES

After the events of the late 1980s, the Office of Thrift Supervision paid a great amount of attention

to interest-rate risk Ninety percent of the regulated 1,119 S&Ls, specifically the larger thrifts, file

a report providing the OTC with interest-rate risk information This report uses a regulatory pliance model

com-The concept behind this model is important to every financial institution It integrates what-if

hypotheses on the movement of interest rates and integrates maturity ladders The OTS runs the mitted results through Monte Carlo simulation Over the years, the thrifts have learned how to perform:

The following paragraphs describe in a nutshell what an interest-rate risk measurement systemmust assess First and foremost is the amount of interest-rate risk that has been assumed by type ofloan and interest-rate bracket The next most important issue is the effect of interest-rate changes

on both earnings and economic value Financial reporting required by the OTS addresses all rial sources of interest-rate risk including:

mate-• Repricing

• Yield curve

• Basis risk

• Option risk exposures

While all of a bank’s holdings should receive appropriate treatment, financial instruments whoseinterest-rate sensitivity may significantly affect the institution’s overall results must be subject tospecial attention For an S&L, for example, this is true of mortgages The same concept is valid withother instruments whose embedded options may have major effects on final results

The thesis of the OTS is absolutely correct: The usefulness of any interest-rate risk measurementsystem depends on the validity of the underlying assumptions Management assumptions have sig-nificant impact on accuracy; therefore they must follow a prudent methodology, and they should be

Mismatched Risk Profiles and Control by the Office of Thrift Supervision

validated through real-life data In designing interest-rate risk measurement solutions, banks mustensure that:

• The degree of detail regarding the nature of their interest-sensitive positions is commensuratewith the complexity and risk inherent in those positions, and

• Senior management assesses the potential loss of precision by determining the extent of gation and simplification used by the measurements and in hypotheses

aggre-Senior management, the OTS suggests, should see to it that all material positions and cash flows,including off–balance sheet positions, are incorporated into the interest-rate measurement system.Where applicable, this data must include information on coupon rates and cash flows of associatedinstruments and contracts

Few thrifts—only 76 out of 1,119—have entered the derivatives market “Once in a while wefind a thrift who bought a reverse floater, but the majority of the savings and loans keep out of thismarket,” said Timothy Stier

Regulators insist that management pay special attention to those positions with uncertain rities Examples include savings and time deposits, which provide depositors with the option tomake withdrawals at any time To increase sensitivity to factors of timing, basic assumptions used

matu-to measure interest-rate risk exposure should be re-evaluated at least annually:

• Hypotheses made in assessing interest-rate sensitivity of complex instruments should beexplained properly and reviewed periodically

• Any adjustments to underlying data should be documented, and the nature and reason(s) for theadjustments should be explicit

The OTS believes that all these basic policy steps are necessary for rigorous interest-rate riskmanagement For a commercial bank—and even more for a thrift—interest-rate risk significantlyincreases the vulnerability of the institution’s financial condition to market liquidity and volatility.2

Savings and loans, as well as practically all commercial banks, have experience with deposits andloans, but senior management does not always appreciate that while interest-rate risk is a part offinancial intermediation, an excessive amount of such risk poses a significant threat to an institu-tion’s earnings and capital:

• Changes in interest rates affect a bank’s earnings by altering interest-sensitive income andexpenses

• Such changes also impact on the underlying value of the bank’s assets, liabilities, and ance sheet instruments

off–bal-Future cash flows change when interest rates change, and the interest-rate risk banks are fronted with comes from several sources: repricing, yield curve, basis risk, and options risk Allthese are factors affecting the level of exposure and must be confronted in an able manner.Both the guidelines and the models developed by the OTS are, in their basics, quality controlmeasures They both complement and are complemented by the statistical quality control principlesand charts3as well as by approaches based on behavioral science

PRACTICAL EXAMPLE ON THE ROLE OF BASIS POINTS IN EXPOSURE

A risk point represents the amount of gain or loss that would result from a given movement in

inter-est rates In some cases this is a fixed movement; for instance, 1 percent In others, a changing inter-mate of likely movements is used, and it is regularly adjusted in light of recent historical data.Several banks have an overall risk point limit, which often is suballocated to different tradingdesks and portfolio positions Others find that this is not necessarily the best approach because theplanning and control of risk point limits is no exact science Instead, top management wants toknow the change in value in inventoried positions, if and when interest rates increase or decrease

esti-by x basis points or 1/100 of 1 percent

This concern is perfectly justified because interest rates are volatile They vary intraday, daily,weekly, and monthly, often upsetting the most carefully laid out plans, unless an entity exercisesutmost vigilance over its portfolio positions Macroscopically speaking, volatility is shown inExhibit 12.1 over a 60-year timeframe

The experimental method that has been implemented and applies to all thrifts takes current

inter-est rates and changes them 100, 200, 300, and 400 basis points up and down The adverse tion is the 200-basis-point shock level For the U.S banking industry, the Office of the Comptroller

condi-of the Currency also has developed models that assist in handling interest-rate risk

The OTS has developed a standard reporting methodology for S&Ls Prudential financial ing by the thrifts now distinguishes between:

The assumptions made by thrifts regarding the impact of interest-rate volatility on earnings andcash flow is not public knowledge, but basis points provide a good example Cisco’s 1988 AnnualReport elaborates a hypothetical change in fair value in the financial instruments held by the com-pany at July 25, 1998 While Management said that these instruments were not leveraged and wereheld for purposes other than trading; still, they have significant sensitivity to changes in interestrates The method used by Cisco is, to my judgment, an excellent paradigm for financial institutions

as well

The modeling technique used measures change in fair values arising from selected potentialchanges in interest rates The market changes entering this simulation reflect immediate paral-lel shifts in the yield curve of plus or minus 50 BPs, 100 BPs, and 150 BPs over a 12-monthtime horizon

• Beginning fair values represent the market principal plus accrued interest, dividends, and

cer-tain interest-rate–sensitive securities considered cash and equivalents for financial reportingpurposes

• Ending fair values comprises the market principal plus accrued interest, dividends, and

rein-vestment income at a 12-month time horizon

Exhibit 12.2 estimates the fair value of the portfolio at a 12-month time horizon There are ratherminor differences in valuation at the 50 BPs, 100 BPs, and 150 BPs level The importance of thisexample derives precisely from this fact, which demonstrates a well-balanced portfolio

In its 1998 annual report, Cisco observed that a 50-BPs move in the federal funds rate hasoccurred in nine of the last 10 years; a 100-BPs move has occurred in six of the last 10 years; and

a 150-BPs move has occurred in four of the last 10 years, with the last reference being on September

30, 1998 In other terms:

Exhibit 12.2 Estimated Fair Value of a Portfolio (in $Millions) at a 12-Month Time Horizon

Valuation of Securities Valuation of SecuritiesGiven an Interest Rate No Change Given an Interest RateIssuer Decrease of X Basis Points in Interest Rates Increase of X Basis Points

(150 BPs) (100 BPs) (50 BPs) 50 BPs 100 BPs 150 BPs

U.S Government $1,052 $1,050 $1,047 $1,045 $1,043 $1,040 $1,038notes and bonds

State, municipal, 3,530 3,488 3,488 3,409 3,369 3,330 3,292and county

government notes

and bonds

Foreign government 33 33 33 33 33 33 33notes and bonds

Corporate notes 810 809 809 807 806 805 804and bonds

• Volatilities of 50, 100, and 150 BPs are fairly frequent, and senior management must be alwaysready to face them.

• The 200 BPs volatility, which is an OTS benchmark, is not as frequent but neither is it an outlier

• By contrast, the 300 and 400 BPs volatilities (both plus and minus) used by the OTS model can

be seen as outliers; therefore they are benchmarks for stress testing

Notice that 100 BPs is not an extreme event but a reference value As the Russian meltdown ofAugust 1998 demonstrates, the sky may be the limit Exhibit 12.3 presents movements of yield spreads

in the bond markets and associated risk premiums for Russian, Brazilian, and Argentine bonds

• The risk premium for Russian bonds jumped 5.500 BPs practically overnight

• Argentine debt suffered a yield spread of 700 BPs, while neighboring Brazil saw a 1200 BPsjump

All three are extreme interest-rate events, although the Russian panic beats the Latin Americanones by a large margin As the figures show, this event threatened the Russian economy in its foun-dations at a time when some sort of economic and financial recovery was crucial, because suchrecovery was the only way to avoid a deep recession

A rigorous analysis of interest-rate risk exposure must consider not only extreme events in yield

spread but also risk-adjusted duration Risk-adjusted duration is a metric in which effective

dura-tion is augmented for negative convexity, interest-rate volatility, incremental prepayment risk,spread risk, currency risk, hedging, and gearing

For instance, spread risk estimates reflect percentage change in the portfolio’s market value

Exhibit 12.3 Change in Risk Premiums Through Extreme Events Characterizing Spreads in the Bond Market

because of changing yield spreads A growing yield spread reflects a risk premium demanded bythe market for holding securities of a lesser quality than risk-free U.S Treasuries Corporates are

an example

One of the reasons that led to the near bankruptcy of Long-Term Capital Management (LTCM)

in September 1998 was that its partners and Nobel prize–winning rocket scientists misjudged the direction of yield spreads.4Corporate bonds always feature a premium over credit-risk-freeTreasuries As shown in Exhibit 12.4:

• The premium demanded by investors is much higher for BBB-rated corporates than for AAAones

• In the second half of 1998, market nervousness saw to it that all premiums increased, and withthem the spread

Yield spreads are volatile They narrow and widen in response to a number of factors, includingliquidity, changes in credit quality, market volatility, supply and demand pressures, perceived futureconditions, and investor sentiment The bank that plans its loans and investments without payingattention to these factors prepares itself for major disappointments—and eventually for bankruptcy

SENSITIVITY TO MARKET RISK AND POST-SHOCK PORTFOLIO VALUE

The primary form of interest-rate risk to a deposit-taking bank that gives loans arises from timingdifferences in the maturity and repricing of assets, liabilities, and off–balance sheet positions Down

to the fundamentals, this is structural risk, or mismatch risk Mismatches are part and parcel of

com-mercial banking, and they can expose the institution’s income and economic value If interest rateschange, a credit institution that funded a long-term fixed rate loan with a short-term deposit is liable

to face a decline in both:

• Its future income arising from loans and investments

• Its capital position, which is of value to shareholders and society

Exhibit 12.4 Risk Premiums for American Enterprises with AAA and BBB Ratings

Repricing mismatches also can expose a bank to changes in both the slope and the shape of theyield curve Yield curve risk arises when unexpected shifts of the yield curve have adverse effects

on an institution’s income “Unexpected risks” is of course a misnomer Management should never

be taken by surprise when the yield curve changes significantly It should attack the issue head onthrough experimentation

Short-term and long-term bond yields may rise or plunge significantly at short notice As anexample of yield changes on U.S., German, and Japanese bonds, Exhibit 12.5 presents statistics for10-year government securities Bond yields have plunged over 1998, reflecting:

Exhibit 12.5 Yield Curves for 10-year Government Bonds

• Lower inflation expectations

• Investors’ flight from risky equities

Over the same timeframe, short-term yields also were generally lower because interest-rate cutswere in the offing Another source of interest-rate risk comes from imperfect correlation in theadjustment of the rates earned and paid on different financial instruments with otherwise similarrepricing characteristics

When interest rates change, these differences can cause changes in the cash flows and earningsspread among assets, liabilities, and off–balance sheet instruments of similar maturities or repric-ing frequencies For instance, funding a five-year loan that reprices quarterly based on the three-month U.S Treasury bill rate with a four-year deposit that reprices quarterly based on three-monthLIBOR exposes the institution to the risk that:

• The spread between the two index rates may change unexpectedly, and

• Without appropriate tools and real-time systems, management does not have time to hedge.Volatility has always been a characteristic of the financial markets, and the yield curve againstwhich interest-rate exposure is measured can change fairly rapidly before a bank is able to reposi-tion itself Exhibit 12.6 dramatizes how investor uncertainty alters the yield curve of U.S Treasurybonds within one day, one week, two weeks, and one month

Interest-rate risk also arises from options embedded in many financial instruments Productswith embedded options include bonds and notes with call or put provisions, loans that give bor-rowers the right to prepay balances, and adjustable rate loans with interest-rate caps or floors thatlimit the amount by which the rate may adjust

Exhibit 12.6 Yield Curves of Treasury Bonds at Different Time Intervals

Other examples of sources of exposure to interest-rate risk are various types of nonmaturitydeposits that give depositors the right to withdraw funds at any time, often without any penalties.While each one of these rexamples is different from the others, they all have in common exposurerelated to interest-rate risk.

The OTS has developed two tools to help the thrifts industry, and by extension commercialbanks, face the challenges resulting from interest-rate volatility, which is part of their core business:

Sensitivity to Market Risk (“S”-rating) and Post-Shock Portfolio Value Ratio, which is essentially a Net Present Value Ratio (NPVR) Rating a financial institution in terms of sensitivity to market risk

is based on two dimensions evaluated by OTS examiners:

1 The bank’s levels of market risk

2 The quality of its risk management practice

These tools are of interest to any financial system because they apply well beyond OTS Theyhave been elaborated by the Federal Financial Institutions Examination Council (FFIEC), whichrepresents the major regulators: Federal Reserve System, Federal Deposit Insurance Corporation,Office of the Comptroller of the Currency, Office of Thrift Supervision, and National Credit Union.The FFIEC is a U.S interregulatory agency that has provided the infrastructure for a uniform rat-ings system Its work has established several qualitative characteristics of risk and is used fordescribing the five levels of the “S” component ratings applied by the OTS in its supervisory model.These levels are:

OTS-reg-ty of risk management practices This matrix is for guidance; it is not mandatory

Examiners can exercise judgment in a number of issues Generally, however, an institution with

a post-shock portfolio value ratio below 4 percent is entering an area of turbulence An interest-ratesensitivity measure of:

• More than 200 basis points is ordinarily characterized as high risk—a danger zone

• 100 to 200 basis points tends to be more controllable through good management

• Zero to 100 basis points is an acceptable variation

A moderate-risk institution typically will receive a rating of 2 for the “S” component Providedthat the institution’s sensitivity to interest-rate changes is extremely low (an example being that

of Cisco discussed earlier), a rating of 1 may be assigned A condition for such a rating is that the

institution is not likely to incur larger losses under rate shocks other than parallel shocks depicted

in the OTS model (The next section explains the meaning of a rating of 1, 2, 3, and so on.)

By contrast, in the case of an interest-rate sensitivity measure of 100 to 200 basis points, theinstitution will typically receive a rating of 3 for the “S” component This is well below the rating

of 1 If the interest-rate sensitivity measure is more than 200 basis points, it will receive a 4 or 5 ing for “S,” which is very bad indeed

rat-LEVELS OF INTEREST-RATE RISK AND QUALITY OF RISK MANAGEMENT

The OTS has elaborated a set of quality control guidelines used by its examiners in assessing thelevel of risk taken by a savings and loan These guidelines include the quality of the S&L’s riskmanagement policies and practices as well as how prevailing conditions help to combine theseassessments into an “S” component rating for the institution A rating of 1 corresponds to an “A”rating in college grades, and it indicates that:

• Market risk sensitivity is well controlled by the thrift’s senior management

• There are few reasons to believe that earnings performance or capital position will be

adverse-ly affected

Market risk may not be very well controlled, but the examiner may consider that it is

adequate-ly managed or needs onadequate-ly minor improvement In this case, the institution does not qualify for acomponent rating of 1, but 2 might do The level of market risk, however, might be more than min-imal: moderate, significant, or high—leading, respectively, to ratings of 3, 4, and 5

Applying the same approach to the descriptions of the 2, 3, 4, and 5 levels of the “S” componentrating results in a framework of ratings guidelines These guidelines were presented in Exhibit 12.7,which summarized how to translate into a rating various combinations of examiner assessments

Exhibit 12.7 Guidelines for “S” Component Rating Evaluated Relative to an Institution’s Size, Complexity, and Level of Interest Rate Risk

Quality of Level of Interest Rate Risk

Risk Management

Practices* Minimal Risk Moderate Risk Significant Risk High Risk*Well Controlled S = 1 S = 2 S = 3 S = 4 or 5Adequately S = 2 S = 2 S = 3 S = 4 or 5Controlled

Needs S = 3 S = 3 S = 3 S = 4 or 5Improvement

Unacceptable S = 4 S = 4 S = 4 S = 4 or 5

* To get a component rating of 5, an institution's level of interest rate risk must be an imminent threat to its viability, having a high level of risk and being critically undercapitalized.

• Level of interest-rate risk and

• Quality of risk management practices

The results of an examination can be translated into a rating Notice, however, that in this

exhib-it the first two dimensions are not totally independent of one another, because the qualexhib-ity of riskmanagement practices is evaluated relative to an institution’s level of risk

A logical conclusion is that an institution’s risk management practices are more likely to beassessed as well-controlled if it has minimal risk Always subject to the examiners’ direction, theOTS also has established guidelines for level of interest-rate risk as a function of:

• Sensitivity measures

• Post-Shock Portfolio Value Ratio

These are shown in Exhibit 12.8 There are four graduations in NPVR: Below 4 percent; 4 cent to 8 percent; 8 percent to 12 percent; and over 12 percent Expressed in hundreds of basispoints, the sensitivity measure changes with each post-shock NPVR

per-Other things being equal, the higher the NPVR, the better the rating for the “S” component tends

to be For instance, if an institution has a post-shock NPVR between 8 percent and 12 percent, then

an interest-rate sensitivity of 400 basis points typically will receive a rating of 3 for “S.” This issummarized in Exhibit 12.8

The quantification of criteria just explained has made a significant contribution to objectivity interms of quality control evaluation related to interest-rate risk Typically examiners base their con-clusions about a bank’s level of interest-rate risk on the sensitivity of the bank’s net portfolio value

to interest rates, but thanks to standardization of the net portfolio value, measures are more readily

Exhibit 12.8 Office of Thrift Supervision Guidelines for Level of Interest-Rate Risk

Post-Shock Interest Rate Sensitivity Measure

Net Portfolio Value

(2) (3) (4 or 5) (4 or 5)

The numbers in parentheses represent the preliminary "S" component ratings that an institution would ordinarily receive barring deficiencies in its risk management practices Examiners may assign a different rating based on their findings.

Mismatched Risk Profiles and Control by the Office of Thrift Supervision

comparable across institutions in terms of exposure and earnings sensitivity Net portfolio value,according to the OTS, focuses on longer-term analytics than other methods

• Interest-rate sensitivity of earnings is usually measured in the short-term horizon of up to one year

• Interest-rate sensitivity alone is not enough to gauge a bank’s likelihood of survival

Because a bank’s risk of failure is closely linked to capital, which enhances its ability to absorbeconomic adversity, institutions with a high level of economic capital—hence high net portfoliovalue—are better positioned to support a higher sensitivity measure That is what the supervisors’requirements for capital adequacy are all about

In discussions, Stier pressed the fact that the post-shock net portfolio value ratio is a more prehensive gauge of risk than other sensitivity measures, because it incorporates estimates of thevalue of an institution’s portfolio in addition to the reported capital level and interest-rate risk sen-sitivity If the NPVR is low, it is risky The reasons for the risk may be:

com-• Capital inadequacy

• High interest-rate sensitivity

• A significant unrecognized depreciation in portfolio valueSeveral critical factors should be evaluated to establish the causes of the problem faced by seniormanagement: capital adequacy, asset quality, and earnings When an institution’s low post-shock ratio

is, in whole or in part, caused by high interest-rate sensitivity, an interest-rate risk problem is likely

In drawing conclusions about the quality of an institution’s risk management practices, which isthe other dimension of the “S” component rating, examiners assess all vital aspects of the institu-tion’s risk management practices To aid in that assessment, the OTS provides guidelines on soundpractices for market risk management, suggesting the methodology that institutions of varying lev-els of sophistication may utilize Such guidelines evolve as:

• The overall level of interest-rate risk at the institution expands

• The size of the institution increases

• The complexity of its assets, liabilities, and derivatives growsQuality of management criteria include awareness of market risk and credit risk at all manage-ment levels; establishment of and adherence to limits; a rigorous methodology for measuring netportfolio value sensitivity; and a system for earnings sensitivity based on database mining Financialanalysts will appreciate that these are also the criteria through which they evaluate the quality ofmanagement of a financial institution

SENSITIVITY MEASURES AND LIMITS ON DEALING WITH COMPLEX SECURITIES

It should be absolutely evident—even if it is not common practice—that the board and senior

and derivatives financial instruments The board and senior management also should understandand appreciate the metrics of exposure, associated sensitivities, and the testing procedures.

A sound policy requires that prior to taking an investment position or initiating a derivativestransaction, managers and traders ensure in a factual and documented manner that:

• The projected transaction is legally permissible

• The terms and conditions of the security are properly defined

• The proposed transaction is consistent with the institution’s portfolio objectives and liquidityrequirements

Throughout this exercise, bankers should prove due diligence in assessing the market value, uidity, interest-rate risk, and credit risk of their loans and other investments They also should con-duct a preexecution portfolio sensitivity analysis for any trade involving securitized loans, bonds,stocks, or derivatives This is particularly important with complex deals, which can be:

liq-• Significant transactions in monetary terms, and/or

• Complex securities structures and new, less-well-known instruments

A significant transaction is any transaction, including one involving simpler financial

instru-ments, that might reasonably be expected to increase an institution’s sensitivity measure by morethan 25 basis points The OTS requires that prior to undertaking any significant transaction:

• Management should conduct an analysis of the incremental effect of the proposed transaction

on the interest-rate risk profile of the institution

• This analysis should show the expected change in the institution’s net portfolio value, with andwithout the proposed transaction

A thorough evaluation would consider the change that would result from an immediate parallelshift in the yield curve of plus and minus 100, 200, and 300 basis points These are test levels makingfeasible stress analysis of the institution’s lending portfolio and other interest-sensitive instruments

Complex securities are a different ballgame An example is derivative financial instruments

beyond swaps, forwards, futures, and options, such as: exotic options, loopback options, swaptions,synthetic derivatives, long straddles, long condors, and all-or-nothing options The OTS requiresthat prior to taking a position in any complex security or financial derivative, a thrift institutionshould conduct a price sensitivity analysis of that instrument

At a minimum, this prepurchase analysis should show the expected change in the value of theinstrument that would result from an immediate parallel shift in the yield curve of plus and minus

100, 200, and 300 basis points Where appropriate, the yield curve analytics should encompass awider range of scenarios, including:

• Nonparallel changes in the yield curve

• Increases or decreases in interest-rate volatility

• Changes in credit spreads

• Changes in prepayment speeds in the case of mortgage-related securities

The general guideline by the OTS is that an institution should conduct its own in-house acquisition analysis Such analysis is doable; it is not always easy because many institutions lackthe appropriate skills Therefore, the OTS guidelines should also be interpreted as an invitation bythe regulators to the thrifts to acquire the needed know-how

pre-The OTS places great emphasis on the sensitivity to market risk because it reflects the degree towhich changes in interest rates, currency exchange rates, equity prices, or commodity prices canadversely affect a bank’s assets or earnings A major contributor to successful financial activities ismanagement’s ability to:

com-• 1 indicates sensitivity is well controlled

• 2 tells that sensitivity is adequately controlled

• 3 suggests that it needs improvement in sensitivity measures

• 4 says current practices are unacceptable

• 5 warns of an imminent threat to the thrift’s viability

Given the right know-how, this classification of sensitivity scores in terms of interest-rate riskcan be of invaluable assistance to the board and senior management But it cannot be repeated toooften that one of the problems the financial industry faces today is that, as a rule, significant trans-actions and investments in complex securities are not being matched by adequate risk:

thor-A similar statement can be made in connection to counterparty risk With the world of finance

risk for the specific risks of individual investments—whether these are loans, securities, or tives The proper evaluation and reevaluation of exposure may defy the past labels of prudence, sub-stituting for them new directives that need to be tested continually for efficiency and effectiveness.

deriva-TUNING EXAMINATION FREQUENCY TO THE QUALITY OF AN INSTITUTION

In April 1998 the Office of Thrift Supervision and other U.S federal banking regulators made final

an interim rule that permits less frequent examinations for relatively small but well-run thrifts andbanks This decision is significant because it essentially applies the concept of normal inspection,tightened inspection, and reduced inspection, which was developed by Columbia University for theManhattan Project, to provide a rigorous basis for statistical quality control.5

• When reduced inspection is applied, this rule shifts the exam cycle for eligible institutions toevery 18 months from every 12 months

• To be eligible for the 18-month frequency, a thrift or bank must have both first-class internalcontrol and $250 million or less in assets

• In the OTS case, the quality criteria will be a rating of 1 or 2 (as discussed earlier), good talization, and a first-class management

capi-These quality characteristics can be nicely plotted on a quality control chart by variables throughlong time series As far as the regulators are concerned, a longer examination cycle for less riskyinstitutions permits them to focus their resources on thrifts and banks that present the most imme-diate supervisory concerns

To guide the board and senior management toward sound banking practices, the OTS and theother U.S regulators have spelled out the six deadly sins of investment and trading decisions Thesupervisory agencies believe the practices identified by these managerial and financial misbehav-iors should not occur in available-for-sale or held-to-maturity securities portfolios:

When-Issued Securities Trading

In when-issued securities trading, securities are bought and sold in the period between theannouncement of an offering and the issuance and payment date of the securities; these are essen-tially arbitrage-type transactions