Risk/Return Trade-Off—Part I
July 17, 2014
Cliché? Yes. Often overlooked in decision-making? Also yes. This current long-lasting low rate environment has lulled some credit unions into ignoring the risk of things changing, such as an increase in rates. The focus on return without proper respect for potential risk has led to a material increase in interest rate risk in some institutions, thereby inviting more scrutiny from regulators.
What about the other side of the equation? We see many examples where the evaluation of risk ignores the return. A primary example is using net economic value (NEV) for decision-making. NEV can do a fair job of evaluating the risk of certain assets, such as marketable investments, but it does a bad job at evaluating the risk of the whole credit union. While NEV may capture the risk of an investment, does it appropriately represent the return for the institution?
Consider this, if you decide to reduce risk, you may test selling MBS investments and put the funds in overnight investments. When selling MBS investments, the risk in higher rate environments will go down, and NEV will typically improve. But what about the risk/return trade-off? Does the NEV show a difference in the credit union’s current position? No. The MBS will be sold at today’s value and then the funds would be invested at today’s value, resulting in the same current value of the institution. For example, an MBS may yield 2.00% today, while the overnights earn 0.25% at most. Did the return go down? Absolutely. Does NEV fairly represent the downside of this sale? No.
Only seeing the change in risk without seeing the change in return can result in misleading decision information. Understanding the potential impact to earnings (short term and long term) and the long-term risk to net worth in a wide range of rate environments is critical to decision-making.
