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A bank supervised by the Office of the Comptroller of the Currency appealed to the Ombudsman the supervisory office’s (SO) conclusions noted in a recent supervisory letter (SL). Specifically, the bank appealed the liquidity component rating and liquidity and interest rate risk assessment system (RAS) conclusions.
The appeal disputes the assessment of high quantity and aggregate level of liquidity risk and contends the quantity and aggregate level of liquidity risk should be moderate. The appeal also argues that the direction of liquidity risk should be stable instead of increasing. The appeal states that changes to the bank’s funding structure are not “likely” to yield a continued decline in the bank’s net interest margin (NIM) as this conclusion assumes interest rates will certainly rise. The appeal further asserts that the quantity of liquidity risk should not be affected by the quality of liquidity risk management.
The appeal disagrees with the liquidity rating of 3 and states the rating should be 2 as the bank has sufficient liquidity with minimal risk of inability to access funding sources or manage fluctuations in funding levels.
The appeal contends that the quantity and aggregate level of interest rate risk (IRR) should be moderate instead of high, and that the direction should be decreasing instead of increasing. The appeal asserts that the quantity of IRR should not be affected by the quality of IRR management. The appeal also asserts that the SO should have considered updated asset liability model (ALM) results when concluding on the direction of IRR. The appeal argues that the SL’s conclusion that economic value of equity (EVE) exposures is outside the board’s limits is factually incorrect as ALM results for EVE were always within limits.
The Ombudsman conducted a comprehensive review of the appeal using the supervisory standards in the following booklets of the Comptroller’s Handbook in effect at the time of the examination:
The Ombudsman concurred with the SO for all issues appealed but required additional edits to the SL for accuracy.
The Ombudsman concurred with the quantity and aggregate level of liquidity risk as high and the direction of liquidity risk as increasing. The bank’s liability structure and use of higher-cost funding sources have increased liquidity risk and negatively affected the bank’s ability to generate sufficient earnings and maintain adequate capital levels. Since the prior examination, the bank materially increased its reliance on wholesale funds. This shift resulted in the bank operating outside of five of its seven board-established liquidity targets over the one-year period, including targets controlling wholesale funding levels. This indicates that the bank is operating with a higher level of liquidity risk than the board’s risk appetite.
Additionally, relying too much on wholesale and market-based funding sources elevates a bank’s liquidity risk profile. Refer to page 4 of the “Liquidity” booklet. This increased reliance on noncore and higher-cost funding sources contributed to marked decline in the bank’s NIM, which compares unfavorably with the bank’s uniform bank performance report peer group. Rising or high funding costs, especially compared with peer and market rates, may be a sign of potential liquidity problems. Refer to page 3 of the “Liquidity” booklet. These conclusions support a high quantity of liquidity risk.
In assessing the aggregate level and direction of risk, examiners are instructed to consider both the quantity of liquidity risk and the quality of liquidity risk management. Refer to page 192 of the CBS booklet. Examiners assessed the quality of liquidity risk management as weak, and the appeal did not dispute this conclusion. The high quantity of risk combined with weak quality of risk management support a high level of aggregate liquidity risk. Additionally, rollover risk is high as management must replace a material portion of the bank’s liabilities in one year or less. The board and management must also correct a liquidity matter requiring attention (MRA) to accurately identify, measure, monitor, and control liquidity risk. This includes developing a plan to reduce the wholesale funding reliance and control funding costs assumed with the shift in funding structure described above. These factors support an increasing direction of risk.
The Ombudsman concurred with the bank that examiner conclusions should not imply certainty regarding future changes in market rates. Accordingly, the SL will be revised for accuracy.
The Ombudsman concurred with the 3 rating for the liquidity component. The BSP booklet states, “A rating of 3 indicates liquidity levels or funds management practices in need of improvement. Institutions rated 3 may lack ready access to funds on reasonable terms or may evidence significant weaknesses in funds management practices.” The bank’s liquidity levels need improvement. The appeal states the bank has sufficient access to sources of liquidity but identifies only its access to wholesale funds to support this assertion. To bolster liquidity, the bank is continuing to rely on higher-cost funding sources that have reduced its NIM and contributed to the bank’s declining earnings performance. Additional use of wholesale funds would further negatively affect earnings and capital adequacy and increase liquidity risk. Many of these sources of funds may either become unavailable or severely restricted if the bank’s condition does not improve or deteriorates.
Funds management practices also need improvement. Examiners identified concerns related to board and management oversight, management information systems and reporting, the contingency funding plan, and liquidity stress testing. As a result of these findings, the SO assessed liquidity risk management as weak and cited a new liquidity risk management MRA during the examination. As noted earlier, the appeal did not dispute the weak quality of liquidity risk management.
The Ombudsman concurred with the quantity and aggregate level of IRR as high and the direction of IRR as increasing. According to page 26 of the BSP booklet, “IRR is the risk to current or projected financial condition and resilience arising from movements in interest rates.” The quantity of IRR to the current and projected financial condition of the bank is high. Earnings and capital levels do not support the level of IRR taken. High levels of repricing, yield curve, and options risks have significantly contributed to the bank’s low and declining NIM and declining earnings performance. Historically low-cost nonmaturity deposits declined over the past year, and the bank replaced them with higher cost time deposits, brokered deposits, and borrowings. This shift in the composition of the balance sheet has increased the bank’s vulnerability to increasing rates and the current inverted yield curve. These conclusions support a high quantity of IRR.
On page 189 of the CBS booklet, examiners are directed to consider both the quantity of IRR and the quality of IRR management to derive the direction and aggregate level of IRR. Examiners assessed the quality of IRR management as weak and the appeal did not dispute this conclusion. The high quantity of risk combined with the weak quality of risk management support a high level of aggregate IRR. The effect of the projected IRR exposures to the bank’s income and equity positions, weak IRR management, and use of more rate-sensitive wholesale funds support an increasing risk profile over the next 12 months. The Ombudsman also determined that the bank did not provide updated ALM results to the SO in a timely manner for inclusion in the SL.
The Ombudsman concurred with the bank that ALM results for EVE exposures were within the board’s limits. Accordingly, the SL will be revised for accuracy.
