Interest Rate Risk Policy and Program

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By Emily Hollis

The NCUA has issued a final rule requiring federally insured credit unions to develop and adopt a written policy on interest-rate risk management, as well as a program to implement that policy.  The rule will be effective Sept. 30, 2012.

According to the NCUA, the IRR policy “identifies, measures, monitors, and controls IRR and is central to safe and sound credit union operations.” NCUA states “each credit union should use the guidance in this appendix to formulate a policy that embodies its own practices, metrics and benchmarks appropriate to its operations.”

NCUA’s guidance on an IRR policy is very similar to the ALM policy. The major difference is the IRR policy solely focuses on interest rate risk of the entire balance sheet and doesn’t include verbiage that might address capital growth, income goals or concentration limits. Credit unions have the option of creating a separate IRR policy or incorporating the required components into the ALM policy.

Most of our larger credit unions are incorporating a separate IRR policy, which references items in the ALM policy. ALM First Financial Advisors starts with a sample IRR policy, then customizes it for each client to either include the credit union’s pre-established ALM guidelines or to reference items from the ALM policy. The NCUA is providing guidelines for what the Agency wants included in the IRR policy. Within these guidelines, NCUA suggests limits set by conducting the Gap, net interest income (NII) changes, and net economic value (NEV) analyses, emphasizing that the examples are for illustration only and that “management should establish its own limits that are reasonable supported.”

Working with Examiners 

In the Federal Register, Vol. 77, No. 22, NCUA cites guidelines for the IRR policy, including that it does not “seek to endorse certain IRR measures, measurement techniques, or assumptions over others. For example, NCUA does not prescribe valuing non-maturity shares at par, but it acknowledges that such measures and the use of historical rates scenarios may provide useful information.”

Part 741.3 lists the criteria required for a written IRR policy. Appendix B to Part 741 gives guidance, and embedded in it is a questionnaire that lists guidelines to include in the policy. In the register, NCUA “the commentary in the questionnaire emphasizes that the guidance items are not mandatory. Credit unions are encouraged to review and discuss these guidance items with their examiners.”

There is another interesting change; remember those five ALM tests that were cited in an examiners’ guideline paper? ( They don’t exist in Appendix B, which we applaud. Appendix B cites IRR policy limits with examples using Gap, NII, asset valuation, and the NEV percent change and NEV ratio in the shock up 300 scenario. They do not list what is low or high interest rate risk, but just use these measures as examples. They also do not include net income volatility as an example, which we applaud.

What to Include in the IRR Policy

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The NII simulation replicates earnings over a period of time. It does not capture cash flows beyond the initial horizon period of the simulation. Therefore, market value volatility of longer-term cash flows is not taken into consideration and, subsequently, its impact is not shown.  Maximum rates that are embedded in loans and investments, such as adjustable-rate mortgages (ARMs), may not affect income projections if the modeled scenarios do not generate interest rate paths higher than the contractual cap or level of rate restriction. Market value analysis captures the effects of embedded caps even when they are out of the money.

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Because of this and other balance sheet traits, one test might show a minimal interest rate risk profile and the other shows high. (Intuitively, this seems flawed; examiners have written up credit unions as such, however, it is not.) While both should be performed, ALM First believes that more credence should be put in the NEV analysis; without it, long-term cash flows and embedded options (i.e., caps) are not adequately tested and

Because the NCUA does not have prescriptive IRR measurements listed in the Federal Register, we strongly suggest adopting a measurement that is based upon the old Office of Thrift Supervision (OTS) method. The OTS adopted a measurement table that defines different degrees of interest rate risk. The OTS selected the NEV ratio as the sole measure of risk exposure for institutions within its jurisdiction.  While the OTS no longer exists, the concept of modeling and risk measurement used in this guideline is ideal, because it captures both the size of economic capital and its sensitivity to changes in interest rates.

ALM First believes that more credence should be put in the NEV analysis; without it, long-term cash flows and embedded options (i.e., caps) are not adequately tested and measured.

As an example, an institution that has a base NEV ratio of 10 percent and a post 200 bps shock. (The OTS risk measurement table assumes a 200bp after shock value.) NEV ratio of 7 percent would be deemed to have a moderate amount of interest rate risk. When using this table, the institution would locate the corresponding range for its post 200 bps NEV shock in the first column of the table and follow the line to the right, locating the column that corresponds to its respective interest rate risk sensitivity measure. In the case of this example, the 300 bps (10 percent – 7 percent = 3 percent 300bps) result falls in the 201 – 400bp column and dictates a moderate amount of risk.

Summary of OTS Guideline for the “Level of Interest Rate Risk”

We suggest that the table be modified to up 300 bp movement with more categories as shown below.

Suggested NCUA Guideline for the “Level of Interest Rate Risk”

This table tackles both the size of economic capital and its changes to interest rates in one test and eliminates the question of two NEV tests and the potential of two separate outcomes.

Additional Guidance for Large Credit Unions 

The NCUA gives additional guidelines for larger credit unions, which they define as having assets greater than $500 million. Again, the Agency cites examples that credit unions should consider. These include validations and IRR tests using a variety of interest rate scenarios.  Other suggestions include a separation between risk-taking and risk measurement.

The NCUA believes credit unions have increased exposure to interest rate movements. This increased risk has heightened the importance of having strong policies and programs addressing the credit union’s management of interest rate risk.

Emily Hollis, CFA, is a Partner with ALM First Financial Advisors, LLC.