A Graphical Framework for Assessing Interest

Rate Risk Exposure

Office of Thrift Supervision

Risk Management Division

_________________________

Anthony G. Cornyn, CFA

Director

Donald Edwards

Radu Filimon, Ph.D.

Eberhard Irmler

Robert Kazdin

Ramgopal Kurpad

_________________________

Office of Thrift Supervision

1700 G Street, N.W.

Washington, D.C. 20552

Introduction

The visual display of quantitative information can often clarify

complex financial relationships.

This Risk Management Release

i n t roduces a graphical framework for analyzing interest rate

exposure in the thrift industry.

Measures of IRR Sensitivity and

Exposure

An evaluation of the Intere s t

Rate Risk (IRR) position of a

thrift institution typically entails

an examination of two key factors:

1) sensitivity of the institution’s

balance sheet to changes in

interest rates, and

2) the capacity of the institution

to absorb losses re s u l t i n g

from movements in interest

rates.

The sensitivity of an institution’s

balance sheet depends on the

composition of the institution’s

assets, liabilities, and off-balance

sheet contracts. The capacity of

an institution to absorb losses

depends in large part on its capital position.

In evaluating the loss-absorption-capacity and the balancesheet-sensitivity of a thrift

institution, the OTS focuses on

Net Portfolio Value (NPV), which

is a proxy for the economic

value, or net present value, of an

institution’s worth. (NPV which

is defined as the present value of

assets, less the present value of

liabilities, plus the net present

value of off-balance sheet contracts.) OTS measures an institution’s vulnerability to intere s t

rate risk by examining three key

metrics: the pre-shock NPV ratio,

the post-shock NPV ratio, and

the sensitivity measure. 

• P re-Shock NPV Capital

Ratio. The pre-shock NPV

capital ratio is a leverage ratio

(equity-to-assets) expre s s e d

in present value terms, calculated by dividing an institution’s base-case NPV by the

present value of assets.

• Post-Shock NPV Capital

Ratio (Exposure Measure ) .

The post-shock NPV ratio,

also re f e r red to as the

Exposure Measure, is an estimate of what an institution’s

NPV capital ratio would be

after a hypothetical adverse

200-basis-point shock in interest rates.

• Sensitivity Measure. The sensitivity measure gauges the

magnitude of loss that an

institution would suffer from

a 200 basis point movement in

interest rates. The measure is

calculated as the diff e re n c e

between the post- and preshock NPV ratios, expressed

in basis points. A high degree

of balance sheet sensitivity is

not necessarily cause for conRisk Management Series

By Anthony G. Cornyn, CFA
Office of Thrift Supervision

page 2

cern. Whether it is depends

on the institution’s tolerance

for risk and its capacity to

absorb losses.

The NPV Sensitivity

Chart

Table 1 shows the pre- and postshock NPV capital ratios and

sensitivity measures of four

hypothetical thrifts. Those ratios

are used to determine the position of each thrift in Figure 1,

which is referred to as an NPV

Sensitivity Chart. The horizontal

axis re p resents a firm’s pre -

shock NPV ratio and the vertical

axis re p resents its post-shock

NPV ratio. The line which bisects

the horizontal and vertical axes

at a 45 degree angle represents

the zero sensitivity line. Firms situated on this line have pre- and

post-shock ratios that are equal. 

Which of the four institutions

has an interest rate risk problem?

As shown, Thrift A has a preshock ratio of 19 percent and a

post-shock ratio of 16 percent. Its

sensitivity measure is 3 percent,

or 300 basis points, which is relatively high by industry standards. 

Thrift A’s sensitivity measure is

depicted in the chart by a vertical

line from the point designating

Thrift A to the zero sensitivity

line. The longer the vertical distance between an institution’s

position on the chart and the

zero sensitivity line, the greater

is its sensitivity.

Thrift B has a pre-shock ratio of

11.4 percent and a post-shock

ratio of 10.0 percent. Thrift B is

less interest rate sensitive than

Thrift A. Its sensitivity measure

is only 140 basis points.

Thrift C’s pre-shock and postshock ratios are both 3.5 percent.

Thrift C sits on the zero sensitivity line, meaning that Thrift C’s

NPV capital ratio is “perfectly

hedged” for this particular rate

scenario (but not necessarily

other interest rate scenarios).

While Thrift C’s post-shock NPV

ratio is relatively low, it does not

have an interest rate risk problem; A 200 basis point rate shock

does not cause its NPV capital

ratio to decline. In short, Thrift C

has a capital problem. The lowpost shock ratio is merely a

reflection of its low pre-shock

capital ratio.

Thrift D has a pre-shock ratio of

5.0 percent, a post-shock ratio of

3.0 percent, and a sensitivity

m e a s u re of 200 basis points.

Table 1. Pre and Post-Shock NPV Capital Ratios

and Sensitivity Measures

Pre-Shock NPV – Post-Shock NPV = Sensitivity

Capital Ratio Capital Ratio * Measure

(in Basis Points)

Thrift A 19.0 % 16.0 % 300

Thrift B 11.4 10.0 140

Thrift C 3.5 3.5 0

Thrift D 5.0 3.0 200

* After adverse 200 Basis Point rate shock

Thrift C

0.0% 5.0% 10.0% 15.0% 20.0%

0.0%

5.0%

10.0%

15.0%

20.0%

Pre-Shock NPV Ratio

Figure 1. Net Portfolio Value Sensitivity Chart

4%

Thrift D

Thrift A

Sensitivity = 300 bp

Thrift B
Risk Management Series

page 3

Relative to Thrift A, Thrift D’s

interest rate risk profile is more

t roublesome even though it

exhibits less interest rate sensitivity than Thrift A. 

As a general rule, OTS views any

institution with a post-shock

NPV ratio below 4 percent as

giving cause for supervisory

concern. The NPV sensitivity

chart, therefore, has a horizontal

dashed line drawn at the 4 percent post-shock NPV level. An

institution that is operating

below this line either has a low

base-case capital position or a

sensitivity measure that is too

high in relation to its base-case

capital position. Thrifts operating below the 4 percent line

should consider reducing their

sensitivity or strengthen their

capital position.

The NPV Sensitivity Chart illustrates that the degree of interest

rate sensitivity that a firm can

p rudently tolerate depends

importantly on its capital

strength, as measured by its preshock NPV ratio. Firms with

strong capital positions are better positioned to operate further

below the zero sensitivity line

than those with weak capital

positions.

Industry Profile

The sensitivity chart can also be

used to monitor industry trends.

Figures 2 and 3 show the sensitivity and exposure profile of the

thrift industry at two different

points in time (March 31, 1995

and March 31, 1996).

Figure 2 shows that a significant

number of institutions – 84 institutions, or 6.0 percent of the

reporting institutions – had post-

-10% 0% 10% 20% 30%

-10%

0%

10%

20%

30%

Pre-Shock NPV Ratio

Figure 3. Distribution of Pre-Shock and PostShock NPV Ratios (1st Quarter, 1996)

4%

-10% 0% 10% 20% 30%

-10%

0%

10%

20%

30%

Pre-Shock NPV Ratio

Figure 2. Distribution of Pre-Shock and PostShock NPV Ratios (1st Quarter, 1995)

4%
Office of Thrift Supervision

page 4

shock NPV ratios of less than 4.0

as of March 31, 1995. A few also

had post-shock NPV ratios less

than zero. Many of these institutions have relatively low pre -

shock NPV capital levels. 

By the end of the first quarter of

1996, however, the number of

institutions below the 4 percent

line had decreased to 24, or 1.9

percent of the reporting institutions. Note that a significant

number of thrifts operating

below the 4 percent post-shock

ratio line as of March 31, 1996

exhibit excessive interest rate

s e n s i t i v i t y. Com-pared to the

industry profile a year earlier

(Figure 2) these institutions, for

the most part, have higher preshock NPV levels but operate

further below the zero-sensitivity line ■

— August, 1996