DEPARTMENT OF AUDIT
DIVISION OF BANKING
(307) 777-7797 Fax (307) 777-3555 Email: email@example.com
Jeffrey C. Vogel
TO: Chief Executive Officer
FROM: Jeffrey C. Vogel, Commissioner
SUBJECT: Interest Rate Swaps
recent period of historically low interest rates has created many interest rate
in the banking industry. As a result, interest rate swaps are becoming more common. Interest
rate swaps are off-balance sheet interest rate risk management tools that have been in existence
for many years. Banks commonly use swaps to reduce their general exposure to changing
interest rates and/or adjust their interest rate risk posture. While
chosen to utilize interest rate swaps to a large degree, it is a permissible activity provided that it
is consistent with bank policy and an adequate level of risk analysis has been completed.
banking organizations are actively marketing interest rate swaps. Our review of
this information has prompted our office to provide guidance to assist banks with the analysis
required to understand the potential risks and outline our expectations for pre-purchase analysis
and documentation. While the marketing materials indicate that an interest rate swap is a simple
transaction involving the exchange of variable and fixed rate interest streams, bank management
must consider, prior to engaging in a transaction, there are many risks involved. Additionally, a
high level of expertise, pre-purchase analysis, and ongoing monitoring are required to mitigate
the potential exposure to the bank. The purpose of this correspondence is to highlight some of
the potential risks as well as provide guidance in regard to the expected level of pre-purchase
analysis and documentation.
Banks are impacted by the risks associated with a specific
product or investment. These risks
include, but are not limited to operating risk, market risk, credit risk, liquidity risk, and legal risk.
The Board of Directors is responsible for identifying, measuring, monitoring, and controlling
these risks. As a result, policies and procedures set risk limits and measurement systems test
the risk limits and provide monitoring tools.
Interest Rate Swaps
It is imperative the bank have established policies with
risk limits and sufficient measurement
systems to capture the potential exposure and the Board of Directors understand the risks
associated with a swap transaction. Policies and procedures and measurement tools should
be commensurate with the potential exposures for specific products or investments and their
overall impact to the financial condition of the bank. The following describes how each
broad risk category is impacted by swap transactions.
Operating risk is the consideration of the bank’s ability
to manage and quantify the risks
associated in a swap transaction. This includes, but is not limited to adequate management
expertise, staffing levels, policies, measurement systems, ability to analyze and document
the purpose and need of the transaction, internal audits, and internal controls.
risk is the effect the swap will have on the net economic value of the
specifically, market risk is made up of interest rate risk, basis risk, and price risk. Interest
rate risk is the possibility of loss in the swap’s market value due to changes in interest rates.
This is the predominant market risk. Basis risk is the possibility of loss due to changes in the
relationship between two or more indices. Price risk is the possibility of loss due to changes
in the swap spread.
Credit risk is the exposure related to the ability of a counterparty to meet cash flow
obligations related to the swap. Credit risk should be measured by market value, and
not notional value. The degree of potential exposure depends on the term to maturity
and volatility of interest rates. Credit risk is typically greatest during the early part of
the contract because the credit standing of a counterparty is more likely to deteriorate
over a longer period of time.
risk is the potential a swap cannot be sold or replaced quickly at or close
to its economic value. Swaps are traded over the counter, and do not have an established
secondary market. However, the market is very broad. In addition, swaps having
customized features increase liquidity risk. Swaps with maturities greater than five years
are typically less liquid. The analysis of liquidity risk should include periods of market
stress or early termination of swap contracts by counterparties. In addition, the impact
of the swap on the overall liquidity position of the bank should be considered.
Legal risk is the potential a swap contract will not be
enforceable or legally binding on
the counterparty. This includes the adequacy of legal documentation. Legal documentation
should include confirmation from the broker specifying the terms of a particular agreement
and a master swap agreement specifying the terms for transactions involving the
counterparties. All contracts should be reviewed by bank legal counsel.
Management should analyze and document the review of
associated risks and potential
financial impact to the bank prior to entering a transaction. This analysis is crucial
because the value of a swap can be very volatile. The pre-purchase documentation
should clearly state the purpose for the transaction and the reason for choosing the
terms related to the transaction. The purpose for the transaction should be consistent
with the bank’s overall strategies. Additionally, documentation regarding the method
used to determine the volume and terms of the swap should be maintained. The main
goal of pre-purchase analysis is to determine the swap’s overall potential impact to the
bank. The degree of sophistication in this analysis should be commensurate with the
size of the proposed transaction.
PERIODIC MONITORING AND REPORTING
Management should monitor risks associated with a swap and
periodically report to
the Board of Directors. Periodic review should be done in the context of the bank’s
overall exposure to changing interest rates. Management should review the terms
of the swap and ensure that the performance in relationship to the overall performance
of the bank is commensurate with the original intent of the swap transaction. It is
important for management to reassess swap positions following changes in interest
rates to ensure that hedging strategies remain effective. Additionally, management
must consider the effect of interest rate swaps on the banks income.
RISK-BASED CAPITAL CONSIDERATIONS
Interest rate swaps are incorporated into risk-weighted
assets by converting the
swap into a credit equivalent amount and assigning it to the appropriate credit risk
category. A swap’s credit equivalent amount is its current replacement cost plus
an estimate of future credit exposure. Bank management should refer to outstanding
guidance on calculating potential credit exposure and ensuring the appropriate
reporting for risk-based capital purposes. It is important for bank management to
consider the potential impact on risk-based capital prior to entering a swap transaction.
The use of interest rate swaps for the management of
interest rate risk is permissible
an appropriate risk assessment and document the pre-purchase analysis of a swap
transaction. Prior to entering into swap transactions, the Board of Directors must
ensure internal operations are sufficient to properly manage the risks associated with
a swap transaction and bank policies are in place to limit the potential exposure
related to these transactions.
you have any questions, need additional information, or would like to discuss
bank’s strategies and policies with regard to off-balance sheet hedging activities,
please do not hesitate to contact our office at (307) 777-7797. Our office is interested
in allowing state banks to participate in activities that are beneficial to their overall
performance. Nevertheless, it is important to establish the proper controls to ensure
accurate calculation of potential exposure to minimize the risk to the bank.