The distinctive sound of a clock ticking indicates to your subconscious that time is passing. When you think about interest rate risk, rising rates have historically meant the good times were back. This time might be different though and while we probably don't have to worry about upwardly moving rates for a few more years, the endless tick-tock of the clock reminds us all that it makes sense to begin preparations now to avoid future problems. This time is different for lots of reasons, but some of the most straightforward are that we have been at exceptionally low rates for a long time already. By the time another couple of years go by, pressure might be building enough to warrant a number of rate increases. Until we get to that time, issues center on the fact that banks are running higher than normal deposit balances and are seeing low loan demand in general. That is leading to an environment of lower margins and lower earnings than normal. It is also driving more growth in securities portfolios (bought at a premium if mortgages), for longer maturities (to get yield). This is all well and good right now, but what happens when the funding heads for the sidelines potentially, liquidity is squeezed, or even ignoring liquidity, funding costs begin to rise. Banks need to have a decent asset liability management (ALM) tool to understand dynamically what the impact can be and call report based methods just don't do enough anymore. That means regulatory scrutiny on the "S" in CAMELS or Sensitivity will be a key focus going forward. Regulators know many banks still use call report driven ALM systems and they also know that isn't going to be enough if you want to truly manage risk. These days, in fact, regulators want to see a more comprehensive and robust approach that measures the impact of rate movement on earnings and capital with both a short-term and long-term view (in dynamic settings). Technology is cheaper, systems are better and with rates so low for so long, the game has changed from the regulatory world. These days, banks need to simulate the impact of rate movement and strategies over a longer time horizon of 2Ys and up and down 600bp. To capture embedded options risk, examiners will be seeing how banks use economic value of equity (EVE) analysis and whether reports are making it to the Board for discussion as well. Beyond just ALM, stress testing to identify, measure, monitor and control exposures and problem areas is also critical. Using enough scenarios to thoroughly test the impact of rate movement on the bank is also expected. Regulators want to see reports that identify the impact to embedded options, yield curve movement and basis risk to name a few. Equally important as running reports, examiners want to see fully documented assumptions. That includes monitoring how the balance sheet changes over time (particularly deposit decay and prepayments), back testing results, updating assumptions and auditing the process periodically to surface issues.
Additionally, regulators expect banks to be able to adequately measure and manage earnings at risk. Given that earnings are so dear to banks these days, that extra scrutiny is to be expected. After all, the last thing anyone wants to see is an upward rate movement that erodes margin (as funding costs rise, but loans remain on floors) or leads to more credit problems down the road (as floating rate loans and rapidly rising rates lead to a problem with debt coverage ratios). Finally, consider some factors regulators commonly look for that may indicate your bank has a high level of potential interest rate risk. These include a mismatch in funding and assets that are significant and longer-term in nature, a potential exposure to earnings or capital that is significant under stressed scenario modeling and exposure to assets or liabilities that have material levels of embedded options. Finally, be aware that banks without enough stable nonmaturity deposits to offset risk from longer term repricing mismatches will also draw scrutiny. The list is certainly not comprehensive and you have time to address this issue, but the passage of time does tick louder.