On October 8, 2013, the FDIC published Financial Institution Letter FIL-46-2013 to re-emphasize the importance of prudent interest rate risk management.  The FDIC’s tone was sharper than in the Advisory on Interest Rate Risk Management collectively published by the financial regulators over three years ago on January 6, 2010.

The FDIC identifies the nationwide trend of institutions reporting “a significantly liability-sensitive balance sheet position” and says in the letter that it “is increasingly concerned that certain institutions may not be sufficiently prepared or positioned for sustained increases in, or volatility of, interest rates.”  That is strong language!  The FDIC is clearly signaling its intent to focus intensely on the issue in upcoming examinations.

Some of the FDIC’s specific concerns about banks with a liability-sensitive balance sheets in a rising rate environment include:

  • Decline in net interest income;
  • Run-off of deposits;
  • Rate sensitive liabilities (e.g., deposits) re-pricing faster than earning assets.
  • Severe depreciation in a bank’s holdings of long-duration bonds;
  • Liquidity shortfalls resulting from dependence on a long duration bond portfolio for liquidity;
  • Decline in regulatory and equity capital due to investment portfolio depreciation; and
  • Negative publicity from drops in GAAP equity.

One of the asset-liability management practices the FDIC expects banks to use is the consideration of risk management strategies.  The FDIC reminds banks of the full array of interest rate risk management options, including:

  • rebalancing earning asset and liability durations,
  • proactively managing non-maturity deposits,
  • increasing capital, and
  • hedging.

With respect to hedging, the FDIC took a much more cautious tone than was in the regulators’ earlier collective Advisory.  The Advisory emphasized that the board and management should understand the strategy and risks related to hedging.  The FDIC’s letter warns that banks should not undertake derivative-based hedging (such as an interest rate swap) unless the board of directors and senior management “fully understand these instruments and their potential risks,” a much more demanding standard.  A bank’s board of directors and senior management team may face a very difficult task if they must “fully understand” derivative instruments; a demand that could require board members to not only understand interest rate swap documentation, but also the complexities of derivatives regulation and swap accounting.  Interest rate swaps of the sort that most community banks use are referred to in many regulations as “plain vanilla” swaps because they are so common and the least complex of all derivatives.  Unfortunately, the effect of the FDIC’s stern warning about “fully understanding” derivatives may discourage banks from pursuing what is often the best possible option they have to mitigate their interest rate risk.

In any event, banks across the country should prioritize and document their attention to interest rate risk management to prepare for examinations that are likely to be particularly demanding in this area.  If a bank wants to begin or continue using interest rate swaps, it is advisable for them to implement an in-depth education program for their directors and senior management on that topic.