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+--------+---+--------------------------+--------+--------------------+---+
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+--------+---+--------------------------+--------+--------------------+---+
| ## Com |   |                          |        |                    |   |
| ptroll |   |                          |        |                    |   |
| er of  |   |                          |        |                    |   |
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|        |   |                          |        |                    |   |
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|  Banks |   |                          |        |                    |   |
+--------+---+--------------------------+--------+--------------------+---+
| ## Su  |   | ## E                     | ##     | Interest Rate Risk |   |
| bject: |   | mbedded Options and Long | Descri |                    |   |
|        |   | -Term Interest Rate Risk | ption: |                    |   |
+--------+---+--------------------------+--------+--------------------+---+

**TO**: Chief Executive Officers of All National Banks, Federal Branches
and Agencies, and All Examining Personnel

##### PURPOSE

This bulletin alerts banks to the importance of measuring the cash flow
and valuation risks for assets and liabilities with embedded
options.[^1] It emphasizes the steps banks should take in order to
effectively manage interest rate risk, and repeats the caution provided
in OCC Bulletin 2002-19 regarding the assumption of unwarranted levels
of risk in the investment portfolio. The guidance in this bulletin is
supplemental to the detailed supervisory expectations included in the
"Interest Rate Risk" booklet of the *Comptroller's Handbook*.

The Office of the Comptroller of the Currency (OCC) is concerned that
some national banks have not adequately identified, measured, and
controlled the potential exposure to earnings and capital that may arise
from a scenario of rising interest rates. Continued signs of strength in
the U. S. economy raise the possibility of higher interest rates. Banks
that have invested a significant portion of their earning assets in
products with embedded options at the generational low for yields on
fixed income assets may now be highly vulnerable to rising rates.

The OCC is concerned about the impact on earnings and economic equity
for both rising and falling interest rates. However, given ongoing
pressure on net interest margins and continued concerns about yield
chasing in the investment portfolio, the OCC is particularly concerned
about a repeat of the structural problems that faced a number of
institutions during the last period of materially rising interest rates.
Bank management and boards of directors should remember the lessons
learned in 1994. Although many interest rate risk models incorporate
scenarios with interest rate changes of 300 basis points or more, bank
management too often focuses exclusively on scenarios deemed to be "most
likely." Low probability events do occur and can have significant impact
on asset values and projected net interest margins. Assets with long
maturities, and assets expected to have short maturities but whose
maturities are designed to extend significantly as rates rise, can
deteriorate rapidly in value. Finally, the investor community looks at
depreciation in fixed income portfolios when evaluating the financial
health of a banking company. It is critical that bank managers fully
understand their institution's interest rate risk exposures and ensure
that their risk management framework incorporates the controls and tools
necessary to conduct asset/liability management activities in a safe and
sound manner.

##### BACKGROUND 

Identifying and measuring interest rate risk exposures can be
challenging due to the complexities of bank balance sheets and the
processes used to measure risk. Banks incur interest rate risk as a
natural consequence of managing the assets and liabilities that result
not only from customer preferences but also management\'s own
asset/liability management decisions. The OCC has a long-standing
expectation that national banks with significant amounts of assets or
liabilities with embedded options should have a robust interest rate
risk measurement process that includes, among other things, an economic
value of equity[^2] (EVE) model and appropriate systems for stress
testing. It is not inherently unsafe or unsound for banks to have
balance sheets with exposures to the risks of embedded options. It is
unsafe and unsound, however, to materially increase positions in
instruments with embedded options and/or higher sensitivity to interest
rate changes without an adequate understanding of the existing
vulnerability to rate changes and a meaningful process that identifies,
measures, and controls such risks.

Faced with weak loan demand and the prospect of declining net interest
margins, many banks have increased the size of their investment
portfolio to absorb excess liquidity and to improve yields. In
particular, many banks have increased their holdings of mortgage-backed
and callable securities. The volume of mortgage-related assets in the
banking system has increased from 10 percent of total assets in 1987 to
27 percent of total assets as of year-end 2003. Earnings pressures have
also enticed bank management at some institutions to pursue aggressive
investment strategies by using borrowed funds to finance its portfolio
holdings (leverage programs). These leverage programs often result in an
asset and liability management position in which the bank has sold
options on both sides of the balance sheet. For example, these
strategies typically involve the bank purchasing callable/prepayable
securities, funded by liabilities that allow the funds provider to
increase the rate as interest rates increase. The asymmetrical behavior
of the options can leave the bank's net interest margin exposed to
*both* rising and falling interest rates.

The sustained low interest rate environment has caused assets with
embedded options to prepay rapidly. With prepayments at very high
levels, and (until recently) expectations for a sustained period of low
interest rates, many bankers have not adequately considered the long
contractual lives of assets acquired with cash flows from prepayments,
since they believed that the assets were simply serving as a temporary
bridge until loan demand improved or the interest rate environment
changed.

Since the increase in longer-term interest rates that began in the
second half of 2003, some bank portfolios are now experiencing declining
portfolio cash flows and an extension in the portfolio's average life. A
security that an investment manager may have thought had a two-year
maturity when purchased might now have a much longer maturity because
rates have risen; the longer maturity results in heightened price
sensitivity. This is the "negative convexity" effect of securities with
embedded options. This extension risk can be especially problematic for
structured securities such as CMOs and callable bonds. The OCC is
particularly concerned that national banks may overlook the impact of
interest rate increases on the economic value of their equity, given
that for many banks the *initial* impact on earnings from a rise in
short-term interest rates could be positive. Deterioration in the value
of a bank's economic equity over time can have sharply negative
consequences for earnings and capital adequacy. It is important that
national banks with significant volumes of assets and liabilities with
embedded options measure their interest rate risk from both short-term
earnings, as well as a long-term economic value perspective.

##### RISK MANAGEMENT CONSIDERATIONS

Bank management should carefully consider the trade-off between actions
taken to retain or improve net interest margin, and the long-term risks
of building a significant position of assets or liabilities with
embedded options. Banks should review their potential exposure to rising
interest rates and implement risk control measures, as appropriate.
Banks that wait to take action until rates rise further may find
evaluating and implementing risk control measures, such as selling
assets and/or implementing derivatives hedges, difficult and expensive,
since many similarly positioned investors may be attempting to do the
same. It is unsafe and unsound to expose the earnings and capital of a
national bank to heightened levels of interest rate risk without
demonstrating a thorough understanding of the risk and an ability to
prudently manage the risk with an effective risk control process.

National banks should take a number of steps to ensure that they have
properly identified, measured, and controlled interest rate risks. The
following steps are important risk management actions that bank
management should consider to ensure a disciplined approach to assuming
interest rate risk.

-   **Risk Identification**

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-   Evaluate bank assets and liabilities to ensure that management has
    identified all assets and liabilities with embedded options. The
    balance sheet accounts most likely to hold significant amounts of
    embedded options include, but are not limited to, mortgage loans,
    mortgage-related securities, callable securities, structured notes,
    deposit liabilities, and Federal Home Loan Bank convertible
    advances. The source of much of the current compression in net
    interest margin is the increasing presence of options sold on both
    sides of the balance sheet. Options embedded in assets cause
    prepayments as rates decline, leading to reinvestment at lower
    yields (reinvestment risk). In a rising rate environment, these same
    options extend cash flows, depriving institutions of an opportunity
    to secure more attractive returns. Options embedded in liabilities
    (a phenomenon the OCC has noted with increasing frequency) result in
    high-cost funding when rates are falling but also result in higher
    funding costs when rates rise because the option to reprice is held
    by the funds provider. National banks should evaluate their exposure
    to embedded options and apply limits consistent with the board's
    risk tolerance.

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-   Identify assets with structural weaknesses. Because assets with
    structurally complex cash flow profiles pose special risks,
    management should conduct a detailed analysis of their potential
    performance under various rate scenarios. The cash flows of certain
    classes of CMOs, for example, may remain relatively stable within a
    specified range of prepayment speeds, but extend significantly when
    rates rise. As interest rates rise, these products will likely
    experience increased price sensitivity and diminished liquidity.
    Banks should identify any material positions in these products and
    carefully assess the long-term implications of such holdings, and
    consider risk mitigation strategies if risk exceeds approved risk
    tolerances.

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-   **Risk Measurement**

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-   Verify that the tools used to measure interest rate risk are
    appropriate. Banks with material amounts of embedded options should
    supplement their net income simulation modeling efforts with a
    long-term measure such as economic value of equity (EVE). An EVE
    model is particularly valuable for assessing the longer-term
    implications of decisions involving embedded options, as income
    simulation models alone may not adequately capture interest rate
    risk over the full term of existing exposures.

-   Obtain and review current investment portfolio valuations and
    conduct portfolio sensitivity analyses[^3] to estimate the potential
    exposure to interest rate changes, especially scenarios of
    nonparallel changes in the yield curve. Banks should ensure that
    portfolio sensitivity is consistent with the policy limits outlined
    in bank policy.

-   Review key modeling assumptions, e.g., pricing, deposit sensitivity,
    prepayment assumptions, and reinvestment assumptions to ensure that
    these assumptions are relevant for a scenario of rising rates.

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-   **Risk Control**

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-   Understand the risk to earnings and capital from a rising rate
    environment, and consider risk mitigation strategies, as
    appropriate. Bank managers should ensure that they understand their
    institution's exposure to rising interest rates under both
    parallel[^4] and selected nonparallel[^5] yield curve changes. Most
    bankers assess the impact of parallel interest rate changes.
    However, it is important to model nonparallel changes as well,
    because rates rarely change in a parallel fashion. Potential
    exposure to rising interest rates should be consistent with approved
    risk limits. Well-understood risk limits are an important control
    tool that should accurately reflect the board's risk tolerance.

-   Compare the original expected investment horizon for assets with
    embedded options to the likely investment horizon if interest rates
    rise. If a bank originally acquired material positions in securities
    with embedded options as a temporary holding, any changes to the
    investment horizon should be discussed formally with the asset
    liability management committee (ALCO) or the board of directors.
    Given the range of interest rates over the past 25 years, interest
    rates could rise significantly from current levels and yet remain
    low by historical standards. Bank management's decision to adopt a
    longer-term investment horizon should occur only after a complete
    evaluation of the risks involved, e.g., the potential for
    significant asset depreciation, much smaller portfolio cash flows,
    and deterioration in the net interest margin due to carrying a large
    volume of earning assets acquired at very low yields.

-   Obtain board approval for any material investment acquisitions that
    layer on additional interest rate risk as higher available yields
    might tempt incremental investments in this environment of
    compressed net interest margins. A higher risk strategy is only
    appropriate for national banks with well-controlled asset/liability
    management programs, and capital to support the bank's total risk
    profile. The OCC is concerned that some national banks may
    accelerate their investments in long-term securities without a full
    understanding of their existing risk profile. Incremental trades to
    increase net interest margin in the steep yield curve environment,
    particularly if done with long-term securities, may inappropriately
    exacerbate long-term risk exposure. Without appropriate
    consideration of the bank's overall asset/liability management
    position, and an assessment of a bank's capacity to assume
    incremental risk, such investment practices may represent
    inappropriate yield chasing and an unsafe and unsound banking
    practice.

The larger the institution, the more likely it is that day-to-day
interest-rate risk management is separated from executive management.
However, executive management remains responsible for setting the bank's
business strategy and monitoring the implementation of that strategy. To
accomplish this, a risk reporting system that effectively conveys the
magnitude and sources of the institution's risk must be in place.
Executive management should review key risk reports, e.g., earnings and
economic value of equity at risk, at least quarterly.

##### ACCOUNTING CONSIDERATIONS

National banks should consider the accounting requirements for
evaluating and recognizing "other-than-temporary" impairment in
securities, including recently issued guidance provided by the Financial
Accounting Standards Board (FASB) in Emerging Issues Task Force Issue
No. 03-01. This guidance is effective for reporting periods beginning
after June 15, 2004. (Disclosure requirements for investment securities
in an unrealized loss position were effective for annual financial
statements issued after December 15, 2003.) Specifically, management is
reminded that "other-than-temporary" impairment can result from changes
in interest rates as well as downgrades in credit ratings.

National banks contemplating the transfer of securities from
available-for-sale to held-to-maturity should obtain prior approval from
the board of directors. Some institutions have considered such transfers
in an effort to lower the visibility of deteriorating portfolio values
from equity accounts in published financial statements. Given the
significant loss of management flexibility associated with such a
transfer, banks should not make such transfers without board approval.
National banks are reminded that the OCC will consider depreciation in
the securities portfolio when evaluating capital adequacy.

##### SUPERVISORY REVIEW OF INTEREST RATE RISK

In light of the highly uncertain interest rate environment, OCC
examiners will evaluate how national banks have identified, measured,
and controlled interest rate risk. Examiners will assess the
appropriateness of the tools used to manage risk, the assumptions (and
any changes) used in the interest rate risk measurement process, and
banks' strategic responses to changes in the interest rate environment.
Examinations of asset/liability management activities will assess how
well and how accurately national banks have reported exposures to their
boards of directors, changes to investment horizons for assets with
embedded options, management's ability to operate within the board's
risk tolerance, and whether policies adequately control risks. Examiners
will also consider depreciation in investment portfolios in their
assessment of capital adequacy.

##### 

##### RESPONSIBLE OFFICE

Questions or concerns regarding this guidance should be directed to
National Bank Examiner Kurt Wilhelm or National Bank Examiner Ray Diggs
in the Treasury and Market Risk Division at (202) 874-5670.

Michael C. Drennan

Director, Treasury and Market Risk Division

##### 

[^1]: An embedded option is a provision in a financial instrument, such
    as a loan or a security, which allows one party to change the timing
    or amount of one or more cash flows associated with that contract or
    instrument. Examples include prepayment options on loans, early
    withdrawal options on certificates of deposit, annual and lifetime
    rate caps on adjustable rate mortgages (ARMs), and call options on
    bonds. Embedded options make both the projected return and the
    interest rate risk of a financial instrument difficult to evaluate
    because the probability that the option will be exercised must be
    evaluated and may vary with movements in rates.

[^2]: The economic value of an instrument represents an assessment of
    the present value of the expected net

    future cash flows of the instrument, discounted to reflect market
    rates. A bank's economic value of

    equity (EVE) represents the present value of the expected cash
    inflows minus the present value of

    expected cash outflows.

[^3]: Portfolio sensitivity refers to the changes in the investment
    portfolio's value over different interest rate/yield curve
    scenarios, and meaningful stress scenarios. OCC Bulletin 98-20,
    "Supervisory Policy Statement on Investment Securities and End-User
    Derivatives Activities."

[^4]: A parallel yield curve change is one in which the rate on all
    tenors along the curve change by the same amount.

[^5]: A nonparallel yield curve change is one in which short-term and
    long-term rates do not change by equal amounts.