Market Risk encompasses exposures associated with changes in interest rates, foreign exchange rates, commodity prices, equity prices, etc. While all of these items are important, the primary risk in most banks is interest rate risk (IRR), which will be the focus of this module. We will provide a simple overview, designed to familiarize new directors with basic aspects of IRR, including ways that you, as a director, can help oversee IRR management. This module will not turn you into an IRR expert. Our goal is to give you enough information to help you understand what your bank's asset/liability committee (ALCO) reports are saying and to introduce you to a few key aspects of the Joint Agency Policy Statement on Interest Rate Risk.

An extreme example of a repricing imbalance would be funding 30-year fixed-rate mortgages with 6-month CDs. You can see that in a rising rate environment the impact on the NIM could be devastating as the liabilities reprice at higher rates but the assets do not. Because of this exposure, banks are required to monitor and control IRR and to maintain a reasonably well-balanced position.

Your job as a director is to ensure that the level of risk taken is appropriate for the institution and to ensure that the risk is well understood. Regulators will take exception to a given level of IRR, if that exposure is imprudent relative to the level of earnings, capital, and the strength of IRR management. If the bank is taking on higher levels of IRR, it will need to maintain higher levels of capital and have higher levels of earnings. This is necessary to provide a buffer in case the position that the bank has taken (i.e. asset or liability sensitive) hurts instead of helps its margins. Additionally, as IRR increases, the quality of IRR management will need to improve commensurately.

The chart above shows a gap ratio of negative 23.7%, indicating a significant amount of liability sensitivity over the next 12 months. During this time, management will have to reprice approximately $152 million in liabilities but will have only $105 million in assets reprice. This chart suggests that a rising interest rate environment would have a negative impact on interest margins. Specifically, with an additional $46.8 million in liabilities repricing, the model predicts that a 100 basis point rise in rates would cost the bank an estimated $468,000 in income - a substantial amount for most community banks.

While this example does an excellent job of describing what IRR is, it does not necessarily provide an accurate assessment of the exposure. Most people familiar with IRR would suggest that this model has significantly overstated liability sensitivity. To make this model more accurate, they would recommend that management incorporate certain assumptions that reflect the true characteristics of these assets and liabilities. Those assumptions are similar to assumptions used in all types of IRR analysis, not just the simple gap model. For example, your bank's IRR model probably doesn't assume that all liabilities reprice at the same pace as adjustable rate assets, especially in a rising rate environment. This assumption and others listed below are necessary to make every IRR measurement tool more accurate.

1. Liabilities will reprice more slowly in a rising rate environment
2. Deposits in 2005 will reprice more slowly (or not at all) in a declining interest rate because interest rates are already so low
3. Some fixed rate assets (loans or investment securities) will reprice (refinance) when interest rates fall regardless of contractual maturity
4. Some loans may pay down more rapidly in a rising rate environment because borrowing is not as attractive - thereby hurting bank income by decreasing the amount of loans outstanding
5. Mortgages will payoff in 7 years regardless of contractual maturity
6. Callable securities will reprice if interest rates fall to a certain level
7. The yield curve will get steeper
8. The yield curve will get flatter

This is just a sampling of assumptions that could be detailed in an interest rate risk analysis. Your bank will have to decide what is appropriate, and you will need to regularly test the model to determine its accuracy (more on this later). Remember, you don't have to be a CFO to contribute. Think about these assumptions above. None of them is exceptionally complex, and each could have a material impact on your model's estimated IRR. The board and the management team will need to decide whether or not these assumptions are applicable to your bank, and this is where you can be the most help to an overtaxed CFO. Directors need to use the knowledge developed in their own personal and professional business dealings to improve the bank's IRR model by paying attention to the validity of the assumptions. Your model will never be 100% accurate, and it will constantly require changes as your institution and the marketplace evolve.