Page 36 - September 26, Bulletin

BUSINESS PARTNERfeature article

Luke Mikles
Vice President
Financial Strategies Group
The Baker Group

Back Testing – What’s the Big Deal?

Beneath the wonderful world of interest rate risk (IRR) and asset bank’s activities.
liability management (ALM) lies a foundation that must be built
to ensure an effective and reasonable IRR process. A large part 3. The accuracy and completeness of the data inputs in the
of this foundation is developing an in-house independent review bank’s risk measurement system.
of the IRR system. The FDIC, along with other federal and
state banking agencies, has repeatedly stressed the importance of
an independent review for the IRR process. The FDIC defines 4. The reasonableness and validity of scenarios used in the
independent as “relying on internal audit staff, bank employees risk measurement system.
independent of the IRR management process, or third-party
consultants. Importantly, there is no requirement or expectation 5. The validity of the risk measurement calculations.
for a bank to hire a consultant, and most community banks
should be able to identify an existing qualified employee or Validating, or back testing, IRR model results is a crucial part
board member to periodically conduct this review.” of an independent review and directly hits on three out of the
five elements listed above. The back testing analysis is focused
The 1996 Joint Agency Policy Statement on Interest Rate Risk on earnings-at-risk and shows the impact of many underlying
lists five elements of an independent IRR review: assumptions, specifically repricing balances and rates of key
products within the IRR model and given rate environment.
When a back test is performed, it compares the IRR model
1. The adequacy of, and personnel’s compliance with, the
bank’s internal control system. results and projections against actual performance from the
institution for a one-year period. To validate the assumptions
and data inputs used within the model, a back test will often
2. The appropriateness of the bank’s risk measurement provide a percentage variance between the model’s calculations
system given the nature, scope, and complexity of the for projected net interest income versus actual performance.

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