Donald L Kohn: Focusing on bank interest rate risk exposure
Remarks by Mr Donald L Kohn, Vice Chairman of the Board of Governors of the Federal
Reserve System, at the Federal Deposit Insurance Corporation's symposium on interest rate
risk management, Arlington, Virginia, 29 January 2010.
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The views expressed here are my own and not necessarily those of my colleagues on the Board of Governors or
the FOMC. Jim Embersit and Egon Zakrajsek of the Board's staff contributed to these remarks.
I very much appreciate Chairman Bair's invitation to participate in this symposium. Interest
rate risk management is an especially important topic in light of current market realities.
Following its meeting earlier this week, the Federal Open Market Committee (FOMC)
repeated its expectation that rates would remain at exceptionally low levels for an extended
period. I will say little about the outlook for interest rates, particularly just a few days after an
FOMC meeting, but it is obvious that as the economic recovery gains traction, it will be
appropriate at some point for the FOMC to raise rates. One of my messages today is that the
response of interest rates across the maturity spectrum to an actual or expected tightening of
monetary policy is always hard to predict, but is especially so in current circumstances. The
usual uncertainty about changes in policy interest rates is compounded by uncertainties
related to the possible special effects of the historically low level of interest rates in the
current recession, as well as the unprecedented increases in the size of the Federal
Reserve's balance sheet and bank reserves as a result of our credit programs and
largescale asset purchases. This run-up in Federal Reserve assets and bank reserves will also
need to be unwound over time, with possible consequences for the structure of interest rates.
Another message I hope to convey today is that many banks, thrifts, and credit unions may
be exposed to an eventual increase in short-term interest rates. As the interest rate risk
advisory issued by each of the financial regulators earlier this month recognized, interest rate
risk is inherent in the business of banking. But it is especially important now for institutions to
have in place sound practices to measure, monitor, and control this risk. They must not
become distracted from this critical task by their efforts to deal with credit problems, nor can
they think that assuming greater interest rate risk is a sound strategy for compensating for
the losses they are taking on their loan portfolios. The recent crisis has been a stark
reminder that borrowing short and lending long is an inherently risky business strategy. As
the financial markets became disrupted, the liquidity risks of this strategy became painfully
evident. Intermediaries need to be sure that as the economy recovers, they aren't also hit by
the interest rate risk that often accompanies this sort of mismatch in asset and liability
maturities.
Interest rate movements
Interest rates are difficult to forecast in the most settled or normal of times, and their path is
especially uncertain in the current circumstances. Short-term rates will rise at some point, but
when, how quickly, and by how much will depend on the outlook for economic activity and
inflation as the Federal Reserve pursues its objectives of maximum employment and stable
prices. The historical record shows that short-term rates have moved in a variety of patterns
in economic recoveries from recession: Sometimes rates began to rise shortly after the
economy turned around; at other times it took a while for policy tightening to begin; and in
other instances, rates continued to decline even after the economic recovery took hold, as
during the 1991-92 period and, to a much lesser extent, during the 2002-03 period. We are
now just beginning to recover from the deepest recession since World War II. Most
economists expect only moderate growth and a slow decline in the unemployment rate over
the next few years, importantly because it will take time for banks to rebuild their capital and
begin competing more vigorously for loan business again. Clearly, we are in uncharted
waters for monetary policy and the financial markets.
When the Federal Reserve begins to raise short-term rates, the yield curve usually flattens -
but not always. Longer-term rates can respond in a multitude of ways, with important
implications for financial intermediaries. Recall that in 1994, long-term rates actually rose
more than short-term rates for a time, steepening the yield curve and imposing substantial
capital losses on market participants exposed to rising bond yields. By contrast, in the
second half of 2004, long-term rates hardly rose, and in 2005 they actually declined when the
Federal Reserve tightened monetary policy. In my view, the decline in long-term rates partly
reflected a strong demand for dollar-denominated assets, especially from countries running
current account surpluses, which were, in effect, greatly adding to the global pool of savings
seeking higher returns. Extremely low interest rate volatility probably also contributed to
investors' willingness to extend duration. No one knows what will happen to long-term rates
over coming years, but the Group of 20 leaders have focused on emerging from this
recession with better-balanced global growth, which suggests that foreign capital could be
less plentiful for the United States. And volatilities are unlikely to return to their previous
quiescent state. Banks and other investors cannot count on a repeat of the most recent
experience - the absence of capital losses when short-term rates rise.
In addition, the behavior of intermediate- and longer-term interest rates over coming years
could well be influenced by a number of unusual elements in the current circumstances.
Short-term rates have been close to zero for a year and, if the economy follows the trajectory
expected by the Federal Reserve, are likely to stay there for an "extended period." One of the
purposes of those very low short-term rates is to induce investors to buy longer-term and
riskier assets than they were buying over the past year, thus reducing borrowing costs for
households and businesses. How people will react to increases in expected, and then actual,
short-term interest rates after such a period is hard to tell. Moreover, to counter the financial
forces weighing on the economy, the Federal Reserve purchased large quantities of
longterm agency, agency mortgage-backed, and Treasury securities, putting significant
downward pressure on longer-term interest rates. We are now winding down those
purchases. The effects on rates of the cessation of our purchases are likely to be modest,
but that judgment is subject to considerable uncertainty. Moreover, the purchases created a
large volume of excess reserves in the banking system. The reserves themselves could
begin to affect the pattern of interest rates if depositories try to diversify out of reserves into
other assets. When it comes time to absorb those reserves and raise interest rates, the
Federal Reserve has a variety of tools at its disposal, ranging from increasing the rate it pays
on excess reserves, to absorbing reserves by engaging in reverse repurchase agreements or
offering term deposits to depository institutions, to selling the assets on its balance sheet.
The possible mix of and sequencing in the use of those tools is under active consideration by
the FOMC. We will choose the combination best suited to meeting our macroeconomic
objectives, and those choices will influence not only the general level of interest rates, but
also the relationships among them.
Finally, intermediate- and longer-term interest rates fluctuate in response to many forces in
addition to changes in the stance of monetary policy; yield curves have shifted considerably
at times in the past when monetary policy has been relatively inactive. For example, the path
of the federal budget deficit is likely to be an important influence over coming years. As you
know, under current law, the deficit is on track to remain quite large even as the economy
recovers, pushing up the ratio of federal debt to gross domestic product substantially. Unless
the trajectory is changed, the competition for savings between the government, on the one
hand, and households and businesses, on the other, could be significant as households and
businesses begin to borrow and spend in the recovery, putting upward pressure on interest
rates. Moreover, a number of institutions have an unusually large amount of debt to roll over
in the next few years as a consequence of the shortening of the maturity of borrowing that
naturally occurred under the pressure of financial market turmoil. I'm confident that sound
institutions will find credit readily available to them, but the cost could be affected by the
increasing competition for funds.
Interest rate movements and the performance of financial intermediaries
In light of the uncertain course of interest rates, financial intermediaries face significant
challenges in managing their interest rate exposures. Clearly, the impact of changes in
market rates depends on the maturity and re-pricing mismatches embedded in institutions'
assets, liabilities, and off-balance-sheet positions. In general, those institutions whose assets
are expected to re-price faster than their liabilities - referred to as "asset-sensitive" - would
be expected to benefit from a rise in rates, because higher rates, holding everything else
constant, should increase their net interest margins. Conversely, the net interest margins of
"liability-sensitive" institutions - those whose asset durations are longer than their liability
durations - would be expected to be negatively affected by a rise in market interest rates.
Of course, there are more than 15,000 U.S. banks, thrifts, and credit unions, and the interest
rate risk exposures faced by individual institutions are much more complex than these simple
characterizations might lead us to believe. Each institution has its own unique funding
structure and asset-liability re-pricing mismatches, based not only on the structural
characteristics of its particular market and product offerings, but also on the impact of the
current crisis and government countermeasures on its credit and liquidity risk exposures.
For example, many large banking organizations have publicly disclosed that they have
assetsensitive positions, suggesting an ability to benefit from increases in short-term rates. Such
characteristics are no doubt influenced by their significant holdings of excess reserves and
other short-term liquid assets taken on during the crisis. Monetary policy tightening will entail
draining excess reserves at some point, and as institutions reconsider their liquidity
management - subject to new, stronger liquidity requirements from supervisors, to be sure -
their current asset-sensitivity might be expected to decline. And the behavior of various types
of customers and instruments may be difficult to predict as the economy and financial
markets emerge from this highly unusual period. Thus, even larger asset-sensitive
institutions may need to deal with more complex and difficult interest rate risk issues than
might be thought.
On the liability side of the balance sheet, banks and other depositories may be facing
unusual uncertainties about the future behavior of non-interest-bearing and low-interest
deposits. As you are well aware, these types of deposits help boost the net interest income
of depository institutions. A number of institutions, both large and small, posted increases in
such deposits over the past two years as a result of a "flight to quality" by consumers and
small businesses from less-sound intermediaries, money market funds, and other short-term
investments. Moreover, banks themselves, aided by the expansion of deposit insurance,
have competed heavily for such deposits as potentially more stable sources of funds in a
crisis environment. Importantly, such newly acquired low-cost "core" deposits may not be as
stable or as interest rate insensitive as similar deposits may have been in the past. Without a
doubt, consumers and small businesses are eager to raise their returns on short-term
deposits, and institutions may have to compete even more strongly for such deposits once
short-term rates begin to move higher. Forecasting the behavior of depositors and the
business strategies of other intermediaries has always been a challenge for depository
institutions and will be even more challenging as we exit from the current policy and interest
rate environment.
These challenges would seem even greater for liability-sensitive institutions - and a
significant number of community banks appear to fall into that category. As competition for
low-cost deposits has increased, many community banks have been forced to increase their
reliance on wholesale funds, including brokered deposits, which are significantly more
interest rate sensitive and less stable than traditional core deposits.
At the same time, many community banks - in competition with securitization markets and
larger institutions for consumer and small business loans - face challenges in acquiring
good-quality short- and intermediate-duration assets to match their shorter-term liabilities.
Many community banks have increased their holdings of longer-term mortgage assets,
including mortgage securities guaranteed by Ginnie Mae and the government-sponsored
enterprises, in an effort to enhance both credit quality and earning asset yields. While such
holdings advance public policy interests in reviving the mortgage market, they nevertheless
pose the potential for increasing interest rate risk exposures, in part because of the
embedded options in residential mortgages.
Additionally, some banks appear to be assuming more-complex exposures to interest rate
risk through purchases of structured products. The recent crisis has focused attention on the
problems and complexity of structured products in the form of collateralized debt obligations,
which carved up the credit risk of underlying assets into various tranches - a product that, it
turned out, too few investors understood. But similar lessons were learned with regard to
interest rate risk management in the early 1990s when many institutions purchased various
types of structured collateralized mortgage obligations (CMOs) with embedded interest-rate
options that were not fully understood - and then incurred substantial and unexpected losses
when interest rates rose in 1994. Many CMOs turned out to have durations that fluctuated
sharply in response to even small changes in market rates, resulting in significant declines in
the value of the instruments and in many cases increasing the asset-liability mismatches they
were intended to mitigate. Capital losses as longer-term interest rates rise are a risk facing
even asset-sensitive banks. As bankers prepare to meet the uncertainties that lie ahead,
they must not forget these hard-learned lessons and must make sure they fully understand
how the securities they purchase will perform in different economic and financial market
environments, including an environment of rising short- and long-term interest rates.
Importance of robust interest rate risk management at all banking organizations
Because of the potential complexity of interest rate risk exposures at individual institutions,
supervisors have, for many years, pointed out the need for bankers to use sound practices
for managing these exposures. Employing sound practices becomes even more critical in
light of the current uncertainties surrounding the timing and impacts of changes in interest
rates. It was concern about the risks to banks from interest rate changes that led the
supervisors to issue the recent advisory on interest rate risk management. That advisory
reminded institutions of guidance dating back to mid-1990s. Other speakers at this
symposium will no doubt summarize and expand upon the guidance discussed in that
advisory, but the key principles of risk management apply to interest rate risk, as they do to
the management of other risks. These principles articulate the need for (1) appropriate
corporate governance, including actively engaged boards of directors and senior managers;
(2) adequate policies, procedures, and limits to guide the institution's interest rate risk
management process; (3) robust interest rate risk measurement and reporting systems that
focus heavily on stress testing of both alternative interest rate scenarios and the effect of key
behavioral assumptions on the results of such tests; and (4) strong internal controls
structured to ensure the integrity of all elements of the interest rate risk management
process.
As the recent crisis has emphasized, senior managers must actively engage in the
measurement and assessment of risk exposures. Given today's technology, even some
small banks are using reasonably sophisticated measurement techniques to assess the
impact of different interest rate scenarios on the different types of interest rate risk that these
institutions are exposed to. These risks include basic re-pricing mismatches that are most
sensitive to changes in the level of rates; exposures to different yield curve shifts, twists, and
slopes; basis risks, which arise from re-pricing differences in instruments with similar
maturities; and the risks that both explicit and embedded interest rate options can pose to the
performance and safety and soundness of an institution.
Clearly, every financial institution, regardless of size, must understand the risks it is taking,
and how to control and mitigate those risks. We have seen too well and too painfully in the
past several years, in the largest banks and in the smallest, what happens when systems
and management understanding are not commensurate with the risks being taken. The
consequences fall not only on bank owners, staff, and customers, but potentially on the
entire economy. We cannot allow that experience to be repeated, and this conference is one
step in making sure that interest rate risk does not undermine the safety and soundness of
our nation's most important lenders - banks, thrifts, and credit unions.