[Federal Register Volume 63, Number 98 (Thursday, May 21, 1998)]
[Notices]
[Pages 27962-27965]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-13626]


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FARM CREDIT ADMINISTRATION

[BM-14-May-98-02]


Interest Rate Risk Management

AGENCY: Farm Credit Administration.

ACTION: Proposed policy statement with request for comment.

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SUMMARY: The Farm Credit Administration (FCA or Agency), through the 
FCA Board (Board), is issuing for comment a proposed policy statement 
that provides guidance on interest rate risk management practices to 
Farm Credit System (System) institutions and describes the Agency's 
approach to evaluating interest rate risk when making a determination 
of capital adequacy.
    The proposed policy statement identifies key elements of sound 
business principles and practices for interest rate risk management by 
a System institution. The policy statement also provides criteria by 
which the Agency will evaluate the adequacy and effectiveness of a 
System institution's interest rate risk management.

DATES: Written comments should be received on or before June 22, 1998.

ADDRESSES: Comments may be mailed or delivered to Patricia W. DiMuzio, 
Director, Regulation and Policy Division, Office of Policy and 
Analysis, Farm Credit Administration, 1501 Farm Credit Drive, McLean, 
Virginia 22102-5090 or sent by facsimile transmission to (703) 734-
5784. Comments may also be submitted via electronic mail to ``<a href="/cdn-cgi/l/email-protection#265443410b2c45494b4b6640454708414950">reg-
<span class="__cf_email__" data-cfemail="7f1c1012123f191c1e51181009">[email protected]</span></a>.'' Copies of all communications received will be available 
for review by interested parties in the Office of Policy and Analysis, 
Farm Credit Administration.

FOR FURTHER INFORMATION CONTACT:

Andrew D. Jacob, Senior Policy Analyst, Office of Policy and Analysis, 
Farm Credit Administration, McLean, Virginia 22102-5090, (703) 883-
4498, TDD (703) 883-4444,
    or
Wendy R. Laguarda, Senior Attorney, Office of General Counsel, Farm 
Credit Administration, McLean, Virginia 22102-5090, (703) 883-4020, TDD 
(703) 883-4444.

SUPPLEMENTARY INFORMATION:

I. Background

    The FCA's proposed Capital Phase III rule, in Secs. 615.5180 and 
615.5182, proposes that System banks and other System institutions 
(excluding the Federal Agricultural Mortgage Corporation) with interest 
rate risk implement appropriate risk management practices (see 62 FR 
49623, Sept. 23, 1997). Proposed Sec. 615.5181 provides that a System 
institution's board of directors (board) is responsible for maintaining 
effective oversight of interest rate risk management whereas senior 
management is responsible for ensuring that interest rate risk is 
properly managed. In the supplementary information to the proposed 
Capital Phase III rule, the Board stated its intention to provide 
additional guidance regarding sound interest rate risk management 
practices for A System institution.
    In addition, proposed Secs. 615.5350(b)(7) and 615.5355(a)(4) 
provide that the FCA may take action against an institution for failure 
to maintain sufficient capital for interest rate risk exposures. A 
System institution found to have high levels of exposure or weak 
interest rate risk management practices may be directed by the Agency 
to take corrective action, which may include raising additional 
capital, strengthening interest rate risk management expertise, 
improving interest rate risk management practices, reducing levels of 
exposure, or a combination thereof. The supplementary information to 
the proposed Capital Phase III rule states that a risk assessment 
approach will be used to evaluate a System institution's capital 
adequacy for interest rate risk and to determine what corrective 
action, if any, may be necessary. Additional guidance is now being 
provided by the FCA in this proposed policy statement.

[[Page 27963]]

    Over the past several years, FCA examiners have considered the 
level of interest rate risk exposure, as well as the effectiveness of 
interest rate risk management practices, when concluding on an 
institution's capital adequacy and compliance with the requirements of 
Sec. 615.5200(b)(7).\1\ Considering previous examination results, the 
Agency does not anticipate that a System institution will be required 
to hold additional capital or enhance existing risk management 
practices for interest rate risk based solely on the Agency's 
implementation of the criteria contained in the proposed policy 
statement.
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    \1\ Section 615.5200(b)(7) requires the board of directors of a 
System institution to consider other risk-oriented activities, such 
as interest rates risks, in developing its formal written capital 
adequacy plan.
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II. Discussion

    The proposed policy statement addresses prudent interest rate risk 
management principles that the FCA expects a System institution to 
consider in its interest rate risk management processes. The FCA has 
emphasized these principles over the past several years in its 
examination, supervisory, and regulatory efforts. Moreover, many System 
institutions have already implemented interest rate risk management 
practices consistent with the principles contained in this policy 
statement. The policy statement also provides criteria by which the 
Agency will evaluate the adequacy and effectiveness of a System 
institution's interest rate risk management. In addition, the 
principles discussed here are consistent with the joint policy 
statement issued by other Federal financial institution regulatory 
agencies on interest rate risk management principles as applied to 
federally insured and supervised commercial banks and savings banks 
(see 61 FR 33166, June 26, 1996).\2\
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    \2\ The Federal agencies that issued a joint policy statement on 
interest rate risk management are the Office of the Comptroller of 
the Currency, the Board of Governors of the Federal Reserve System, 
and the Federal Deposit Insurance Corporation.
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    Interest rate changes can affect an institution's earnings by 
changing net interest income and the level of other interest-sensitive 
income and operating expenses. Changes in interest rates also affect 
the underlying market value of an institution's assets, liabilities and 
off-balance sheet instruments. This occurs because the present value of 
a financial instrument's future cashflows, and in many cases the 
cashflows themselves, change when interest rates change. The combined 
effects of the changes in the present values of an institution's assets 
and liabilities reflect the change in an institution's underlying 
market value of equity.
    Interest rate risk results from:
    <bullet> Maturity or coupon adjustment timing differences of 
assets, liabilities, and off-balance sheet instruments (repricing or 
mismatch risk);
    <bullet> Changes in the slope of the yield curve (yield curve 
risk);
    <bullet> Imperfect correlation in the adjustment of the rates 
earned and paid on different instruments with otherwise similar 
repricing characteristics (basis risk); and
    <bullet> Interest rate-related options embedded in assets, 
liabilities, and off-balance sheet instruments (options risk).
    While interest rate risk is an inherent part of banking, it can 
become excessive and pose a significant threat to an institution's 
earnings and capital base. Accordingly, a well-managed risk management 
process that maintains interest rate risk within prudent levels is 
essential to the safety and soundness of a System institution.

III. Request for Comment

    The Board requests comment on the Agency's proposed policy 
statement on interest rate risk management as set forth below in its 
entirety.

Policy Statement on Interest Rate Risk Management

BM-14-May-98-02

FCA-PS-##

    Effective Date: None; Proposed Policy Statement with request for 
comment. Comment period is 30 days from publication in the Federal 
Register.
    Effect on Previous Actions: None.
    Source of Authority: Sections 5.9 and 5.17 of the Farm Credit 
Act of 1971, as amended.

I. Purpose

    Interest rate risk is the exposure of a Farm Credit System 
(System) institution's financial condition to adverse movements in 
interest rates. This policy statement provides guidance to System 
institutions on prudent interest rate risk management principles. 
The policy statement also provides criteria by which the Farm Credit 
Administration (FCA or Agency) will evaluate the adequacy and 
effectiveness of a System institution's interest rate risk 
management.

II. Board of Directors' Responsibilities

    Effective board of directors (board) oversight of an 
institution's interest rate risk activities is the cornerstone of a 
sound risk management process. The board should understand the 
nature and level of interest rate risks and how such risks relate to 
the overall business strategies of the institution. The board should 
also define its risk tolerance levels and expectations for interest 
rate risk management. To accomplish effective oversight, a board 
should, at a minimum, carry out the following responsibilities:
    <bullet> Approve major business strategies and policies 
addressing interest rate risk, including establishing relevant risk 
limits, and integrating such strategies and policies into the 
institution's overall strategic and financial planning processes;
    <bullet> Ensure that senior management implements a sound risk 
management process that facilitates the identification, measurement, 
monitoring, reporting, and control of interest rate risk;
    <bullet> Monitor the institution's performance and overall 
interest rate risk profile to ensure that risk is maintained at 
prudent levels; and
    <bullet> Ensure that adequate resources and proper control 
systems are devoted to interest rate risk management, including 
measurement activities.

III. Senior Management Responsibilities

    Senior management is responsible for ensuring that interest rate 
risk is properly managed on both a long-range and day-to-day basis. 
In managing the institution's activities, senior management should, 
at a minimum:
    <bullet> Develop and implement procedures that translate the 
board's major business strategies and policies addressing interest 
rate risk, including risk limits, into operating standards;
    <bullet> Ensure adherence to the lines of authority and 
responsibility that the board has approved for managing, measuring, 
and reporting interest rate risk exposures;
    <bullet> Oversee the implementation and maintenance of 
management information and other systems that appropriately manage 
and control interest rate risk; and
    <bullet> Establish proper internal controls and audits over the 
interest rate risk management process.
    An institution's board or senior management may delegate 
authority for implementing many aspects of board policy on risk 
management to an internal committee composed of qualified officers 
and staff members. Any such risk management committee should be a 
decision-making body involved in the acquisition, allocation, and 
pricing of the institution's resources in a manner consistent with 
both the goals established in a business plan and the risk 
tolerances established by the board.

IV. Interest Rate Risk Management Process

    Effective control of interest rate risk requires a comprehensive 
management process that includes the following elements:
    <bullet> Policies and procedures designed to control the nature 
and amount of interest rate risk that the institution assumes;
    <bullet> A system for identifying and measuring interest rate 
risk;
    <bullet> A system for monitoring and reporting interest rate 
risk; and
    <bullet> A system of internal controls, review, and audit to 
ensure the integrity of the overall risk management process.
    Each of the foregoing elements is discussed below.

A. Risk Limits

    Each System institution should establish appropriate controls to 
effectively limit interest rate risk exposures within the risk 
tolerances established by the board. Established risk limits should 
be consistent

[[Page 27964]]

with the overall measurement approach and should consider capital 
levels and earnings performance. Risk limits also should be clearly 
defined, ensure that exposures will not lead to an unsafe or unsound 
condition, be consistent with the nature and complexity of the 
institution's activities, and be evaluated within the institution's 
total risk-bearing capacity. The risk limits should address the 
potential impact of changes in market interest rates on both 
reported earnings and the market value of equity. Exceptions to 
established risk limits should be appropriately reported, approved, 
and controlled. In addition, risk limits should be reviewed at least 
annually to ensure that they remain appropriate. A System 
institution's board and senior management should further ensure that 
adequate operational procedures, controls, and risk limits are in 
place prior to introducing a new product, hedging, or position-
taking strategy that has the potential to increase materially the 
institution's interest rate risk exposure.

B. Interest Rate Risk Identification and Measurement

    Senior management should ensure the adequacy and completeness of 
the interest rate risk identification and measurement system. The 
quality and reliability of the identification and measurement system 
depends on the type of system used, the quality of the data, and 
various assumptions used in the model; therefore, close attention to 
these areas is needed. Senior management should ensure that the 
identification and measurement system:
    <bullet> Enables management to recognize and identify in a 
timely and accurate manner risks arising from the institution's 
existing activities and from new business activities;
    <bullet> Captures and measures all material sources of interest 
rate risk in ways that are consistent with the scope of the 
institution's activities \3\ and considers all relevant repricing 
and maturity data such as current balances, contractual rates, 
principal payments, interest reset dates, maturities, index rates, 
and rate caps and floors;
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     For a System institution with a high level of interest rate 
risk or a complex risk exposure, interest rate risk should be 
measured over a range of potential interest rate changes, economic 
scenarios, and yield curve shifts so as to effectively capture all 
material interest rate risk exposures (options, mismatch/repricing, 
basis, and yield curve). For a System association where the majority 
of interest rate risk is managed by the funding bank, any locally 
managed interest rate risk should be measured at least annually as 
part of its annual financial planning process.
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    <bullet> Contains assumptions that are clearly communicated to 
and understood by risk managers and the board of directors; and
    <bullet> Measures an institution's vulnerability to loss under 
stressful market conditions, including a breakdown of key 
assumptions.
    When assessing the scope of an institution's exposure, risk 
managers should consider the effect on earnings and, when 
appropriate, market value of equity. The effect on earnings is 
important because reduced earnings or losses can adversely affect 
liquidity and capital adequacy. The effect on market value of equity 
is important because adverse changes in the market value of assets, 
liabilities, and off-balance sheet instruments can affect the future 
performance and liquidity of a System institution.

C. Monitoring and Reporting

    Each System institution must have adequate information systems 
for monitoring and reporting interest rate risk exposures. These 
systems should provide the board, senior management, and any risk 
management committee with clear, concise, and timely summaries of 
the institution's aggregate exposures, compare current exposure to 
policy limits, and allow for a determination of whether the 
institution holds sufficient capital in relation to the level of 
risk exposure. Risk reports should provide sufficient information 
for the board and senior management to assess exposure. The 
frequency of internal reporting should be determined by the board 
and senior management and should depend on the amount and complexity 
of an institution's level of risk.

D. Internal Controls and Audits \4\
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    \4\ ``Audits'' is used here to refer to audits performed by 
either internal or external auditors. An institution can rely on 
qualified internal auditors to perform the audit functions by may 
wish to consider using external auditors if the interest rate risk 
exposures are complex and appropriate interest rate risk management 
practices and critical to controlling risk exposures at prudent 
levels.
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    Each System institution should maintain an effective system of 
internal controls as part of its interest rate risk management 
process. Controls should include a process for identifying and 
evaluating risk, establishing appropriate approval processes and 
exposure limits, and requiring reconciliations, audits, and other 
mechanisms designed to provide reasonable assurance that interest 
rate risk is managed in a safe and sound manner. The controls should 
ensure official lines of authority and the appropriate separation of 
duties to avoid conflicts of interest, and should ensure that 
personnel follow established policies and procedures.
    An institution with more complex interest rate risk exposures 
should ensure that its interest rate risk process is audited on a 
regular basis. The audits should be conducted by qualified 
individuals who are independent of the function they are assigned to 
audit. The audits should test the effectiveness of controls and 
ensure appropriate follow-up with management where risk limits have 
been exceeded or deficiencies in interest rate risk management are 
identified. Audits of risk measurement systems and models should 
include assessments of the assumptions, parameters, and 
methodologies used. The audit results should be reported to the 
board and senior management.

E. Additional Guidance on the Interest Rate Risk Management Process

    The interest rate risk management process will vary among each 
System institution in accordance with the level of its interest rate 
risk exposure. For instance, a System bank, direct lender 
association, or a service corporation that is exposed to and 
managing major sources of interest rate risk should employ 
comprehensive interest rate risk management and measurement 
practices that address all applicable elements of an effective 
interest rate risk management process discussed in this policy 
statement. These practices should ensure the establishment and 
maintenance of adequate controls over the identification, 
measurement, monitoring, and reporting of all sources of interest 
rate risk.
    The formality and comprehensiveness of the risk management 
process will vary among each System association depending on the 
extent to which interest rate risk is centrally managed by its 
funding bank. For instance, a direct lender association that is 
managing some sources of interest rate risk locally and that has the 
potential for a moderate level of interest rate risk exposure should 
implement an interest rate risk program that includes:
    (a) A policy that defines the board's interest rate risk 
tolerance arising from the sources of interest rate risk being 
managed locally and that sets risk limits from an earnings 
perspective and, if appropriate considering the sources of interest 
rate risk being managed, a market value of equity perspective;
    (b) Procedures and practices established by senior management 
that adequately identify, measure, control, monitor, and report 
interest rate risks within the association's direct control;
    (c) Procedures and practices established by senior management 
that ensure that the board understands the sources and exposure 
levels of interest rate risk;
    (d) Reliable information systems and modeling capabilities that 
are commensurate with the nature of the interest rate risk being 
managed and that measure interest rate risk under various economic 
scenarios; and
    (e) Consideration of interest rate risk exposures in the capital 
adequacy plan as required by Sec. 615.5200(b)(7).
    Finally, a direct lender association that relies on its funding 
bank to manage essentially all sources of interest rate risk and 
that has a minimal level of interest rate risk exposure should 
establish an interest rate risk management program that includes:
    (a) A policy that establishes the board's tolerance for interest 
rate risk;
    (b) Procedures to ensure that the board and senior management 
understand the sources and exposure levels of interest rate risk;
    (c) Consideration of interest rate risk exposures in the capital 
adequacy plan as required by Sec. 615.5200(b)(7); and
    (d) An analysis, prepared at least annually, of potential 
earnings exposure to changing interest rates.

V. FCA's Capital Assessment for Interest Rate Risk

    FCA examiners will assess an institution's capital adequacy for 
interest rate risk based on the evaluation of an institution's level 
of interest rate risk exposure and its risk management practices 
performed in accordance with the FCA's Financial Institution Rating 
System. The results of an institution's interest rate risk 
management measures will be considered when evaluating interest rate 
risk exposure levels.


[[Page 27965]]


    Dated: May 15, 1998.
Floyd Fithian,
Secretary, Farm Credit Administration Board.
[FR Doc. 98-13626 Filed 5-20-98; 8:45 am]
BILLING CODE 6705-01-P


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