bank’s balance sheet. However, the assumptions testing practice (and others) would necessitate a fairly robust model that can input critical assumptions in the first place. Garbage in, garbage out. Make sure you’re using a top-shelf interest rate risk reporting system. Internal Control Interest Rate Risk processes must be periodically reviewed and measurement systems validated. The depth and formality of independent review will depend on the size and complexity of the bank, but even smaller banks should have an independent review of their IRR processes. For smaller institutions that lack auditing resources, this can be done “by having a qualified staff member – independent of the IRR process – perform the reviews.” With respect to model validation, an in-depth assessment of the mathematical and functional integrity of the model itself should be acquired. This is usually provided by the software vendor for institutions that outsource IRR modeling. Conclusion Interest Rate Risk and ALCO processes will require greater attention in the coming year. Bank managers and directors are advised to assess their current systems, policies, and practices. It is a good idea to revisit basic principles of interest rate risk management, perhaps with educational reviews for directors as well as ALCOmembers. This will help banks ensure the adequacy of asset/liability management reporting systems and the necessary processes for proper and prudent execution of strategy. Jeffrey F. Caughron is Chairman of the Board with The Baker Group. Caughron has worked in financial markets and the securities industry since 1985, always with an emphasis on banking, investments, and interest rate risk management. Contact: 800-937-2257, jcaughron@GoBaker.com. The depth and formality of independent review will depend on the size and complexity of the bank, but even smaller banks should have an independent review of their IRR processes. Corporate Governance – Management should provide internal controls and independent reviews to validate the robustness of forecasting models. This includes regular back-testing and model validation as needed to ensure the integrity of the output. Board Involvement – Directors should have an adequate understanding of interest rate risk generally and the appropriateness of strategies, policies, and processes used by bank management. The focus on stress testing of assumptions is important: “Robust measurement of IRR requires that management frequently assess the reasonableness of a model’s underlying assumptions.” One way to test the reasonableness of assumptions is backtesting. The point of a back-test is to learn where variance exists between actual and projected performance and adjust assumptions accordingly. Another method is assumption sensitivity testing, whereby key assumptions are changed, and the model is re-run to test the influence of critical assumptions. Regulators specify that as a best practice, “assumption sensitivity testing should be done at least annually, and results should be presented to the ALCO or a similar senior management committee, and the board.” To be sure, the degree of complexity of an interest rate risk model should be commensurate with the complexity of the 11
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