Mitigating Risk & Strengthening Model Framework with Good Governance

It's already been established (in our previous series here) that having a solid Interest Rate Risk (IRR) management strategy is extremely valuable for financial institutions, But, when it comes to maximizing your investments, risk management alone might not be enough. Putting solid governance, controls, and policies at the forefront of your risk model bolsters the reliability and effectiveness of the whole operation. In fact, regulatory guidance emphasizes the role of effective model governance in minimizing ongoing model risk.

What Constitutes a Solid IRR Policy?

A sound Interest Rate Risk policy encompasses every important element of the overall financial strategy. It establishes accountability and clarifies responsibilities while addressing each aspect of Asset/liability modeling (ALM); from systems to measurement methodologies and risk analyses. 

It should also take stock of the policy limits and expectations and include monitoring and risk-mitigating strategies. Lastly, it must keep track of approvals, validation and policy interrelation. In short, the IRR policy’s job is to carry out the full disclosure of the entire “Implicit Contract” between all stakeholders for Interest Rate Risk management.

Governance – on the other hand – will mostly affirm the Board’s acceptance of full responsibility for risk, as well as delegating the day-to-day management to Asset-liability Committees (ALCO).

Different duties and responsibilities are assigned to specific departments: 

• The Board of Directors will be in charge of the balance sheet & associated risks, defining risk appetite-limits, enforcing duties to control risk and reviewing policies.

• ALCO (the Asset-liability Committee) will be responsible for implementing the ALM process according to policy goals, the monitoring and reporting system overall, monitoring & assessing IRR metrics and establishing internal controls.

• Management will be in charge of running modeling activities and day-to-day processes, as well as presenting strategies, managing internal controls, and performing outcomes analysis.

There are three main approaches to IRR monitoring: IRR Measurement, Rate Scenarios, and Balance Sheet. Scenario stress-testing is carried out through basis risk testing. Regulatory guidance mandates the rate of interest rate scenarios be sufficient to identify basis risk, yield curve risk and risks of embedded options.

Defining Exposure Limits

Financial Exposure is the amount an investor can potentially lose in the case of failure. Defining the limits of this exposure helps to project a more accurate outcome. Policy limits for IRR should be aligned with the Board’s ‘appetite for risk’ – that is, the level of risk an organization is willing to take. Typically, the exposure can be categorized into zones of increasing levels; green to yellow to red.

Similarly, the Net Interest Income (NII) for IRR should capture the short-term impact of interest rates changes on balance sheet performance, whilst the Economic Value of Equity (EVE/NEV) IRR will focus on the longer-term and because of that the limits are typically larger than those for NII. 

Optionality (which can refer “to risks arising from interest rate options embedded in a bank assets, liabilities, and off-balance sheet positions,” according to the Federal Reserve bank of San Francisco,) also factors in the overall exposure limit strategy. In some instances, such as when material amounts of optionality are present, limit expansion should increase more significantly (and non-linearly). Impacts can be larger still beyond the 12-month mark.

Regulatory guidance suggests a number of exposure mitigating actions to bring back and maintain limits within a sustainable range. These include – but are not limited to – selling longer-term loans; additional long-term funding; and adjusting prices using derivatives. In exceptional instances, such as those presented by COVID-19, investors may refer to policy exception strategies aimed at identifying the necessary steps to take when stress results are beyond tolerance limits.

Model User Control & Documentation

User Control

A model user must show good governance with a number of control documents for their procedures. These form the basis for updating IRR models, as well as producing reports for the ALCO and/or Board, with transparency, confidence, accountability and flexibility. 

Whether an outsourced or in-house model, documentation should:

• start with a User Checklist, to formalize and document each key modeling step met; 

• include a Change Control Log to serve as a corporate memory of all notable developments and changes to setup, data, inputs & assumptions; 

• incorporate User Control, Model Admin and Back Up considerations, such as a model contingency plan; 

• ensure comprehensive Model Documentation ideally in one single guide with inventories, maintenance notes and process charts; 

• and lastly, not overlook Assumption Documentation as it relates to the IRR model, outlining sources, methodology and updates to the assumptions your model is based upon.

The importance of keeping well-maintained model documentation cannot be stressed enough. Ensure all of the above are thorough, updated, and detailed enough to explain limitations and variations, because without the proper documentation, your whole model could be ineffective.

Ongoing Model Monitoring Plan

To proactively verify the organization’s continued compliance with regulatory requirements, on-going model monitoring (OMM) is necessary. An OMM plan helps ensure that your IRR model is appropriately implemented and performing as intended.

The plan will consist of outcome analysis/backtesting, back-testing assumptions, sensitivity and stress testing for key assumptions, and benchmarking. 

Outcomes Analysis

Outcome analysis is a necessary step to test the accuracy of model predictions. It can vary from backtesting of NII – assessing model outputs against actual outcomes – as well as retrocasting (taking back-testing one step further) to Outcome Benchmarking – the latter consisting of comparing current IRR Profile to historical or last model run.

Time Optimization for Effective Model Monitoring

Although a potentially lengthy and meticulous project, effective model monitoring activity should be performed within a set time frame. To help this process, it is important to conduct a time-optimized production. This will help to track each step by spreading tasks throughout the year.

Monthly IRR should be carried out on an ad-hoc basis, when results deem it necessary (this means predefining when this would be triggered), taking into account elements such as change in interest rates, prior forecast accuracy, balance sheet size/structure, liquidity or credit risk profile position, economic/financial sector conditions, and requests from ALCO/Board.

As a rule of thumb, changes on any of the above variables should be monitored and reported back. Moreover, they should be readily available for review upon a stakeholder’s request.

The Bottom Line

Leading a strong model governance is the most effective strategy to ensure on-going model risk is minimized, attested to by regulatory guidance. Along with establishing a sound IRR Policy and setting up comprehensive user controls and model documentation, institutions must put implementing a hands-on ongoing monitoring plan at the forefront of their IRR processes. 

If you are willing to take the necessary steps to guarantee a strong governance over model framework and risk mitigation, that ensures reaping full value from your Interest Rate Risk models, contact us today.

Written for MountainView Risk and Analytics December 2021