Bookletter Interest Rate Risk Management Guidance for ...



Type:BookletterSection Number:BL-071Section Title:Bookletter Interest Rate Risk Management Guidance for Farmer MacMarch 14, 2019To:Chairman, Board of DirectorsChief Executive OfficerFederal Agricultural Mortgage CorporationFrom:Dallas P. TonsagerChairman and Chief Executive OfficerSubject:Interest Rate Risk Management Guidance for Farmer MacThe purpose of this Bookletter is to provide guidance on interest rate risk management to the Federal Agricultural Mortgage Corporation (Farmer Mac). FCA Regulation § 652.30 requires the Farmer Mac Board of Directors (Board) to provide appropriate oversight and adopt an interest rate risk management policy. This regulation also establishes minimum requirements for the interest rate risk policy. Interest rate risk is the risk that changes in interest rates could adversely affect an institution’s financial condition and performance. Interest rate risk is generally measured as the sensitivity of an institution’s cash flows, earnings, and economic value to changes in interest rates. The Bookletter describes the policies, procedures, and internal controls that Farmer Mac should have in place to manage its exposure to interest rate risk. It also describes the necessary risk measurement, monitoring, and reporting systems that Farmer Mac should have in place for effective interest rate risk management oversight. Risk GovernanceThe Board has the ultimate responsibility for the risks undertaken by Farmer Mac. To carry out its responsibilities with respect to the oversight of interest rate risk, the Board is charged with the approval of major strategies and policies on interest rate risk to provide reasonable assurance that management effectively identifies, measures, monitors, and controls Farmer Mac’s exposure to interest rate risk. Therefore, the Board must be knowledgeable of the nature and level of interest rate risk taken. The Board should be adequately trained in interest rate risk concepts and be regularly informed by senior management about the level and trend of interest rate risk exposure. The Board or its designated committee of Board members is charged with overseeing the establishment, approval, implementation, and annual review of interest rate risk management strategies, policies, procedures, tolerances, and limits. Policies and ProceduresFarmer Mac’s Board must adopt an interest rate risk management policy that establishes appropriate risk exposure limits. Policies and procedures should include the integration of interest rate risk implications of new strategies, products, and businesses into the interest rate risk measurement and management processes. Policies and procedures should document and provide for controls over permissible hedging strategies and hedging instruments. Section 652.30 (c) establishes the minimum requirements of an interest rate risk management policy.The Board is charged with oversight of senior management’s appropriate execution of Board-approved strategies, policies, and procedures for managing interest rate risk within the designated lines of authority and responsibility. Among other things, senior management should:Maintain appropriate operating policies, procedures, and internal controls addressing interest rate risk management that include appropriate limits and controls over risk taking;Develop and implement comprehensive systems and standards for measuring interest rate risk, valuing positions, and assessing performance, including procedures for updating interest rate risk measurement scenarios and key underlying assumptions driving Farmer Mac’s interest rate risk measurements;Incorporate interest rate risk into enterprise-wide risk management assessments to facilitate understanding of the interrelationships between interest rate risk and other risks, such as liquidity risk and the impact on earnings and capital.Section 652.30 (d) outlines interest rate risk reporting requirements, including the requirement to identify deviations from the Board’s interest rate risk policy. Senior management and the Board, or a committee thereof, should receive reports at least quarterly on Farmer Mac’s interest rate risk profile. These reports should be sufficiently timely and detailed to allow senior management and the Board to:Evaluate the level and trend of interest rate risk being taken and compliance with established risk limits; Assess whether management’s strategies remain consistent with the Board’s expressed risk tolerance; andFully understand the potential impacts of interest rate risk exposures on earnings and capital, including important assumptions underlying those measurements.Interest Rate Risk Limits and ControlsWe expect risk limits to be set in accordance with a well-articulated risk tolerance policy established by the Board. Examples include limits on net interest income (NII) sensitivity, market value of equity (MVE) sensitivity, duration gap, and the MVE to book value of equity (MVE/BVE) ratio in response to the selected scenarios. When determining risk exposure limits, senior management should consider the nature of the Farmer Mac’s strategies and activities, its past performance, the level of earnings and capital available to absorb potential losses, and the Board’s tolerance for risk. The Board and senior management should consider, at a minimum, the following:Limits should not be set so far above actual risk exposures, or target levels of exposure, that they are meaningless or have no effect on risk-taking behavior. Target levels for risk exposure should generally be below the Board’s risk limits. Changes in risk limits should be approved by the Board and documented in the Board minutes.Farmer Mac should have a formal system to monitor interest rate risk exposures against established limits. Senior management should ensure that appropriate and prompt follow-up action is taken when limit violations occur. Senior management should also maintain a record of all limit violations and report limit violations to the Board. A strong internal control structure is vital to the interest rate risk management process. An effective system of controls includes the enforcement of official lines of authority and appropriate separation of duties. Additionally, internal review and audit of the risk limit structure, measurement processes, and compliance are all key elements of the control process.Measurement and MonitoringRobust interest rate risk measurement processes and systems are required to assess exposures relative to established risk tolerances. Such systems should be commensurate with the complexity of on- and off-balance sheet positions. The risk measurement system should enable Farmer Mac to identify and quantify the major sources of Farmer Mac’s interest rate risk in an accurate and timely manner. Although Farmer Mac may rely on third-party interest rate risk models, interest rate risk managers should fully understand the underlying analytics, assumptions, and methodologies. Scenario analysis is an integral component of interest rate risk management. Scenario analysis uses a model to predict a possible future outcome given an event or series of events, such as parallel and non-parallel changes in the yield curve and/or changes in borrower prepayment behavior. When conducting scenario analyses, management should evaluate a range of alternative future interest rate scenarios to assess interest rate risk exposure. The range should be sufficient to accurately identify basis risk, yield curve risk, and the risks of embedded options. We expect management to perform simulation analyses to determine the effects on earnings (including core earnings), MVE, capital surplus, NII, and net effective spread under the selected interest rate scenarios. If the analysis shows that performance would be unacceptable under one or more scenarios, then management should consider modifying, rebalancing, or hedging the portfolio so that performance would be acceptable under the identified scenarios. Scenario analysis not only prompts management to consider the risks inherent in maintaining its current portfolio mix, but also allows management to assess strategic alternatives for improving performance. Examples of such scenarios include: Instantaneous and significant changes in the level of interest rates (e.g., instantaneous parallel and nonparallel shocks); Substantial changes in the level of interest rates over time (e.g., prolonged rate shocks); Changes in the spreads between key market rates, including spreads relative to Farmer Mac funding costs (e.g., basis risk); Changes in the slope and the shape of the yield curve (e.g., yield curve risk); Changes in asset prepayment rates (e.g., contraction and extension risk); andChanges in interest rate volatility.Farmer Mac’s Board or designated Board committee should consider the results of scenario analyses when establishing and reviewing strategies, policies, and limits for managing and controlling interest rate risk. Accordingly, we expect reporting on scenarios to clearly identify any key assumptions that should be considered in interpreting results. The Board and senior management should periodically review the design of Farmer Mac’s scenario analyses to ensure that they include the types of market conditions under which Farmer Mac’s positions and strategies would be most vulnerable. Risk managers should regularly re-evaluate the reasonableness of assumptions that underlie Farmer Mac’s interest rate risk exposure estimates. Farmer Mac should document, monitor, and regularly update key model assumptions, such as prepayment speeds, interest rate spreads, and interest rate volatility. At a minimum, we expect the risk management process to include sensitivity testing of the key assumptions that exert the greatest impact on measurement results. When actual experience differs significantly from past assumptions and expectations, management should test a range of assumptions to appropriately reflect this uncertainty. When assumptions are adjusted from prior reporting periods, the changes and their effects on model outputs should be documented and clearly identified in policies and procedures. StaffingWe expect senior management to provide for adequate personnel to measure and manage interest rate risk accurately and efficiently. Staff should possess adequate knowledge to perform the functions required with a high degree of competence. If Farmer Mac elects to use an interest rate risk model designed and supported by an external vendor, the vendor’s services should include periodic staff training to promote full and productive use of the model. Key person dependencies should be identified and remediated in a timely manner. Management should provide for succession planning and identify possible options for replacement of key personnel. ConclusionEffective risk management requires an informed Board, capable management, and appropriate staffing. Additionally, an effective interest rate risk management framework requires a comprehensive risk management process that ensures the timely identification, measurement, monitoring, and control of risk. To carry out its responsibilities with respect to the oversight of interest rate risk, the Board must approve policies on interest rate risk that establish appropriate exposure limits based on Farmer Mac’s risk-bearing capacity. We expect the Board to ensure that management develops and implement procedures and practices that translate the Board’s goals, objectives, and risk tolerances into operating standards that are well understood by personnel involved in the risk management process and consistent with the Board’s intent.If you have questions about this Bookletter, please contact Joe Connor, Associate Director for Policy and Analysis, at (703) 883-4364 (connorj@) or OSMO Director Laurie Rea at (703) 883-4232 (real@). ................
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