Interest Rate Risk Management – What Regulators want in 2015

Thursday, 16 July 2015 11:30 AM PST | 2:30 PM EST

By Craig M. Taggart

Learning objectives: Evaluate the elements necessary for an effective training program that will define income at risk and differentiate between the various measurement systems to assess income at risk. Interest rate risk exists in an interest bearing asset, such as a loan or a bond, due to the possibility of a change in the asset’s value resulting from the variability of interest rates. Interest rate risk management has become very important, and assorted instruments have been developed to deal with interest rate risk.

Areas Covered in the Session:

• • Why Interest Rate Risk (IRR) should not be ignored• • Forward Rate Agreements (FRA’s) Forwards, Futures• • Swaps, Options• Why Bank Regulators continue to have a poor handle on

interest rate risk• • Interest Rate Caps, floors, Collars• • LIBOR and UBS & Barclays rigging rates• • How should Financial Institutions determine which

IRR vendor models are appropriate?• IRR Measurement methodologies are institutions

Target Audience• • Bank and financial institution auditors• Controllers and corporate managers• Bank CEO’s , CFO’s and Regulators• Board Members• Forensic and management accountants, financial analysts• Governance, risk management and compliance officers• Internal and external auditors• Community banks and credit unions• Securities attorneys• Fraud professionals

Instructor Profile• Craig Taggart has almost a decade of experience in the fields of mergers and acquisitions and

business financing. Mr. Taggart works strategically with his clients to achieve the highest value for their business within the capital markets. His experience with BCC Capital Partners in the M&A industry has greatly contributed to his understanding of transaction structure, strategic

• placement of buyers, and the attainment of maximum market value for his clients. He has represented and sold many businesses in a number of different industries and has significant experience working with companies in: continuing education, transportation, software and professional services. Mr. Taggart is currently working in the clean energy sector that covers multiple initiatives within M&A and corporate development.

• He is a certified merger and acquisition advisor, accredited valuation analyst as well as an active member of Alliance of Mergers and Acquisition, and The National Association of Certified Valuators and Analysts (NACVA). His knowledge and expertise also extends to systems such as: Software as a Service (SaaS), and ERP and CRM systems (Netsuite, Salesforce, Sage 100, 500, X3 ERP). Mr. Taggart has been a certified fraud examiner since 2011 and has previously worked at Deloitte with their quality risk management team.

• He earned his MBA from the San Diego State University specializing in financial management. Mr. Taggart graduated from the California State University Northridge with a bachelor’s degree majoring in organizational psychology.

Regulators in the dark for how long?

• The latest report on risk to the banking sector which is released by the Office of the Comptroller of the Currency gives a good summary

• The real problem is that the OCC report is 40 pages, with only three pages devoted to interest rate risk

• The fact is regulators still do not have the data or reporting to systematically report on interest rate risk profiles of commercial banks. Continuing to rely on overly simplistic maturity gap measures and outside vendor’s assessments.

• The inability to build sophisticated analyses of risk sensitivities and use a more meaningful metric such as duration continues to leave all of us waking one morning to a major interest rate risk event.

• The OCC is reporting that a 2% increase in rates would lead to a 24% reduction in market value equity or (MVE). This is double what is was in 2008, the year of the great credit crisis and fall of Lehman Brothers among others.

• With the OCC absorbing the Office of Thrift Supervision in 2012, these agencies need to develop capabilities to assess this risk with industry standard methodologies

• In its latest 2014 annual report the Office of Financial Research cited interest rate risk as a major emerging threat to the financial system, citing significant gaps in data gathering

• The Fed’s Comprehensive Capital Analysis and Review stress test process does indeed provide good detailed data on bank positions.

• The current system in place is currently leaving the door wide open to our next financial crisis due to a lack of a systematic process.

• A real world example of this was the mortgage crisis and bank regulators have used enormous resources in plugging gaps, on the financing and servicing side. Many experts have called this similar revising a building code to allow for greater spacing between buildings after the Great Chicago Fire!

• Question for webinar attendees? What lessons did we learn from the great recession and the credit crisis? Are the financial markets set to collapse again?

Types & Charts

Types of Interest Rate Risks• Risk Repricing: Unfortunately, once a market correction occurs,

investors will often realize that they have been exposed to more risk in certain investments than originally anticipated. Because higher risk investments yield potentially higher returns, the market goes through an adjustment period during which relevant investments will be repriced to account for the extra risk. Investopedia

• Basis Risk: The risk that offsetting investments in a hedging strategy will not experience price changes in entirely opposite directions from each other. This imperfect correlation between the two investments creates the potential for excess gains or losses in a hedging strategy, thus adding risk to the position. Investopedia

Types of Interest Rate Risks• Yield Curve Risk: The risk of experiencing an adverse shift in market

interest rates associated with investing in a fixed income instrument. The risk is associated with either a flattening or steepening of the yield curve, which is a result of changing yields among comparable bonds with different maturities. When market yields change, this will impact the price of a fixed-income instrument. When market interest rates, or yields, increase, the price of a bond will decrease and vice versa. Investopedia

• Embedded Option risk: An embedded option is a component of a financial bond or other security, and usually provides the bondholder or the issuer the right to take some action against the other party. There are several types of options that can be embedded into a bond. Some common types of bonds with embedded options include callable bond, puttable bond, convertible bond, extendible bond, exchangeable bond, and capped floating rate note. A bond may have several options embedded if they are not mutually exclusive. Investopedia

3 Sectors That Could Benefit From Rising Interest Rates

• Consumer Discretionary "The early part of a rate hike cycle should be beneficial to the consumer discretionary sector. Higher rates are presumably the result of a pickup in economic growth that is flowing from higher levels of employment, which creates a stronger sense of job security, higher wage growth and increased lending activity, and that leads to higher levels of spending,"

• Financial "Financials benefit from rising interest rates because the interest margin expands, creating more profit, and the increased economic

activity that caused the rate hike generally means more loan demand," • Technology Rising yields generally mean that the economy is improving,

which should be good for tech companies that depend on corporate spending. Think Cisco or Microsoft."

UBS & LIBOR• In May of this year the U.S. Justice Department announced

five of the world’s largest banks will plead guilty and pay fines of almost $5.8 billion.

• One of those banks UBG AG will plead guilty for breaching an earlier non-prosecution agreement in connection with a long-running investigation into manipulation of the London Interbank Offered Rate (LIBOR) and other benchmark interest rates. UBS will pay a $203 million fine

• It has found that “The Cartel” traders allegedly coordinated their trading of U.S. dollars and euros to manipulate the benchmark rates set at the 1:15 p.m. and 4:00 p.m. fixes in an effort to boost their profits.

Review of Terms

• Forward Rate Agreement: An over-the-counter contract between parties that determines the rate of interest, or the currency exchange rate, to be paid or received on an obligation beginning at a future start date. The contract will determine the rates to be used along with the termination date and notional value. On this type of agreement, it is only the differential that is paid on the notional amount of the contract. Investopedia

• Swap: A swap is a derivative in which two counterparties exchange cash flows of one party's financial instrument for those of the other party's financial instrument. The benefits in question depend on the type of financial instruments involved. For example, in the case of a swap involving two bonds, the benefits in question can be the periodic interest (coupon) payments associated with such bonds. Specifically, two counterparties agree to exchange one stream of cash flows against another stream. These streams are called the legs of the swap. The swap agreement defines the dates when the cash flows are to be paid and the way they are accrued and calculated

• Options: A financial derivative that represents a contract sold by one party (option writer) to another party (option holder). The contract offers the buyer the right, but not the obligation, to buy (call) or sell (put) a security or other financial asset at an agreed-upon price (the strike price) during a certain period of time or on a specific date (exercise date).

Call options give the option to buy at certain price, so the buyer would want the stock to go up.

Put options give the option to sell at a certain price, so the buyer would want the stock to go down.

• An interest rate cap is a derivative in which the buyer receives payments at the end of each period in which the interest rate exceeds the agreed strike price. An example of a cap would be an agreement to receive a payment for each month the LIBOR rate exceeds 2.5%.

• Similarly an interest rate floor is a derivative contract in which the buyer receives payments at the end of each period in which the interest rate is below the agreed strike price.

• Caps and floors can be used to hedge against interest rate fluctuations. For example a borrower who is paying the LIBOR rate on a loan can protect himself against a rise in rates by buying a cap at 2.5%. If the interest rate exceeds 2.5% in a given period the payment received from the derivative can be used to help make the interest payment for that period, thus the interest payments are effectively "capped" at 2.5% from the borrowers point of view.

FOMC 2015The Federal Open Market Committee continues its march towards raising interest rates for the first time in nine years.• Fed Reserve Chair Janet Yellen continues to weigh in on an assortment of

economic data that will justify her decision and the committee’s during their next meeting in September 2015.

• All indications are the economy is improving, inflation is maintaining a 2.0% level and that the data dependent Fed will raise the Fed Funds rate .25% in the coming months

• There is obvious debate about this as the financial markets could be easily disrupted, shocking the system….

• Many people believe that this historically low interest rate environment coupled with three rounds of Quantitative Easing was a mistake during the past seven years. Research has shown that it benefitted the few, while many Americans realized any benefit from these policies

• Question for the attendees? What are your thoughts on FOMC policy during this time? Was QE good for the economy or just inflate the balance sheet of the federal government?

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