Appeal of Sensitivity to Market Risk Component Rating – (Third Quarter 2001)

The ombudsman received a formal appeal concerning the ‘‘sensitivity to market risk’’ component rating.

Background

Bank management and the board stated that while the Report of Examination (ROE) concludes that interest rate risk is ‘‘high and stable,’’ they believed that interest rate risk was not high and was decreasing. The board believed the downgrade in the sensitivity rating from a 2 to a 3 rating was not appropriate. The bank’s submission noted that the risk profile of the bank was actually better than at the prior examination and that interest rate risk was incorrectly evaluated as being high. The appeal also noted that the supervisory office did not consider additional information provided during the examination and that peer standards for sensitivity assessment are not clear.

The supervisory office concluded in the ROE that the option features in the bank’s funding sources and investments contributed to the complexity and high quantity of risk, which warranted strong risk management systems. The ROE further stated that management of interest rate risk was weak because effective risk limits or board reporting processes were not in place and senior management did not effectively measure and monitor the risk. The previous ROE suggested that management obtain periodic stress testing reports to better gauge the potential impact of their decisions.

Discussion

In accordance with OCC Bulletin 97–1 (‘‘Uniform Financial Institutions Rating System’’), the sensitivity to market risk rating is intended to reflect the degree to which changes in interest rates can adversely affect the earnings and capital of a financial institution. Primary considerations in determining the sensitivity rating are management’s ability to identify, measure, monitor, and control market risk, the nature, and complexity of the institution’s activities, and the adequacy of the capital and earnings in relation to level of market risk.

In discussion with bank management and the supervisory office, there was a consensus that the bank had a significant level of interest-sensitive assets and liabilities at the time of the examination. Adding to the complexity of the balance sheet, several of the asset and liability categories had features (embedded options, caps and floors, etc.) that increase or decrease the level of risk in a changing rate environment. When these conditions are present, it is critical that risk management processes accurately identify, measure, monitor, and control the risk.

As a result of recommendations made in the previous ROE, management had improved the bank’s risk management process, specifically by measuring the effects of interest rate shocks on the balance sheet. However, the assumptions associated with this modeling were not well supported and hindered an accurate assessment of the risk. Management did not initiate changes to the assumptions until the examination. In addition, the model did not provide the degree of sophistication required to capture the risk, given the complexity of the balance sheet. Finally, risk management limits were not appropriately defined and board minutes did not reflect discussion of the issues associated with interest rate risk.

Conclusion

At the time of the examination, the bank had a significant level of re-pricing and options risk in its balance sheet. There was a concern that the level of earnings and capital would not adequately support the degree of market risk present, particularly when considering the increased level of credit risk from the bank’s lending activities. While management had taken steps to strengthen the tools used to measure the impact of interest rate risk, the modeling weaknesses identified during the examination warranted further action. Therefore, the ombudsman concluded that the 3 rating assigned during the examination was appropriate.