Market Risk

Market risk is the risk to a financial institution's condition resulting from adverse movement in market rates or prices, such as interest rates, foreign exchange rates, or equity prices.

Regulatory Guidance

Joint Policy Statement on Interest Rate Risk offsite link

Interagency Advisory on Mortgage Banking Activities

Basel Committee Principles for the Management and Supervision of Interest Rate Risk (PDF)

Risk Committee Market Risk Observations

The Chicago Fed's September 2008 Risk Committee identified two key market risks facing Seventh District financial institutions:

Responding to Recent Financial Turmoil
Poor Implementation of Asset / Liability Models

Responding to Recent Financial Turmoil

Following the financial turmoil in recent months, banks are operating in a vastly changed and rapidly changing environment. Credit, market and liquidity risks have risen, and markets in general have become more volatile. Market sentiment has reacted sharply against the deterioration of credit standards over the past few years, especially in subprime and leveraged lending. This has prompted a flight from some risky assets and has led to de-leveraging (that is, investors and institutions cutting their levels of debt). Credit spreads in riskier asset classes have widened, and bond and equity markets have become more volatile. In addition, the absence of prices and secondary markets for some structured credit products, combined with transparency concerns about the location and size of potential losses, has disrupted money markets and created funding difficulties for a number of financial institutions. Finally, counterparties have been reluctant to lend to institutions they think are holding lower-quality, illiquid assets. See Chairman Bernanke's speech offsite link

of October 7, 2008, for further analysis of recent events and related Federal Reserve responses.

Banks should consider how recent events have affected and could affect them and attempt to estimate or model these effects. Possible effects on market risk include a breakdown of traditional correlations between market rates, asset-price uncertainty, ineffective hedge behavior, and adverse effects on collateral valuation. Following are examples of market risk developments noted at some District banks:

Due to their activities in structured finance markets, some companies that provide insurance on municipal bonds are under financial stress, including possible ratings downgrades. Such downgrades could have a direct impact on the market value and ratings of municipal securities owned by banks. Potential write-downs could be sizeable. In addition, these bonds could become less liquid.
In the current environment, where net interest margins are under pressure and quality loan growth may be difficult to find, banks may be tempted to "chase yield" in ways that increase investment risks. For example, some banks are investing in so-called "whole loan" or "private label" collateralized mortgage obligations (CMOs). Some banks may purchase these securities as an alternative to commercial loans due to the current high yields they carry, resulting from the market turmoil. These securities have higher credit and liquidity risks than U.S. Agency CMOs and may be difficult to value properly. Therefore, a heightened level of risk management (including pre-purchase and ongoing analysis) is appropriate.
Many financial institutions hold common or preferred shares of Fannie Mae or Freddie Mac. The value of these investments has been affected significantly by recent events. All institutions are reminded that investments in preferred and common stock with readily determinable fair value should be reported as available-for-sale equity security holdings, and that any net unrealized losses on these securities are deducted from regulatory capital.

Poor Implementation of Asset / Liability Models

Increasingly, District banks are migrating to more sophisticated modeling techniques via the purchase of new models, upgrade of existing models, or implementation of new features in existing models. Although increased availability of advanced interest-rate risk measurement techniques can enhance measurement systems, new techniques may be inappropriately implemented or applied. Before implementing a new model, institutions should conduct robust testing of the sensitivity of the model's assumptions. Before implementing a model, they should apply sound new-product due-diligence procedures, and they should also ensure strong model governance on an ongoing basis. They should provide training, as needed, to modeling staff on the new techniques involved. Finally, institutions should consider having new models validated to ensure that new techniques have been correctly implemented.

In the current environment, traditional relationships between market conditions and balance-sheet behavior have broken down in some cases. Banks should be aware of these anomalies and how they could affect model results. They should revisit model assumptions as needed and test them for sensitivity and performance.