A high-risk area for consumer compliance examinations is the adequacy of institutions' practices and internal policies regarding flood insurance. When a loan is secured by a building (residential or commercial) located in a special flood hazard area (SFHA), section 208.25 of Regulation H requires member banks to notify the borrower that the property is in an SFHA and, where available, ensure that the borrower maintains adequate flood insurance for the term of the loan. If a borrower fails to maintain adequate insurance on a subject property, the bank is required to force place such insurance.
Preclosing loan documentation checklists, insurance calculation worksheets, and tickler systems to ensure policy renewal are some examples of procedures and internal controls that can aid compliance. To determine compliance, examiners review these and other policies and procedures, internal controls, and a sample of recently originated loans, as well as loans that require flood insurance. Common violations include: not providing borrower notice; originating loans without adequate insurance (particularly loans involving junior liens and cash-out refinances); and not force placing insurance. Compliance failures can subject a bank to financial loss, civil money penalties, and/or an adverse rating.
A primary focus for examiners is evaluating compliance with the Interagency Advisory on Interest Rate Risk Management, which was released on January 6, 2010 (SR Letter 10-1). While banking organizations across the Fifth District have taken positive steps to conform to many aspects of this guidance, other areas of the guidance have not received the required attention. One such area is sensitivity testing. On the plus side, many banks have coordinated with their interest rate risk model vendors to ensure that shock scenarios of significant magnitude exist (e.g., 300 and 400 basis points) and that earnings simulations are modeled over a two-year time horizon. However, a significant number of banks have not incorporated sensitivity testing into their risk management practices. Sensitivity testing serves to highlight which assumptions have the most influence on model output.
One key benefit of sensitivity testing is that it allows senior management and the bank's board of directors to see the linkage between a change in assumptions and the impact on interest rate risk model output. To properly conduct sensitivity testing, institutions should focus their efforts on verifying the assumptions that are most influential to their model results. These assumptions may vary by institution. Some key assumptions to think about include: adjusting the sensitivity of nonmaturity deposit pricing to changes in market rates (e.g., beta factors); changing the runoff of nonmaturity deposit account assumptions; and/or adjusting the prepayment speed on mortgage-related assets.
If you have any questions about any of these or other topics, please contact your Fifth District relationship manager or email BKSRCommunications.RICH@rich.frb.org.
Supervision, Regulation & Credit