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Interest Rate Risk Modeling—Do The Results Make Sense?

Many credit unions are increasing the number of “What-Ifs” they run. It is important that decision-makers do a gut check on the results being presented.  It is also important to understand that various modeling methodologies may need to be used to ensure appropriate evaluation of the decision.
Take, for instance, a decision to expand auto lending into lower credit tiers.  This decision may prove beneficial to help preserve shrinking margins.  However, taking this potential scenario and running it through a traditional net interest income simulation and NEV will show there is virtually no risk in making this type of decision, assuming the loans are priced near the effective discount rate.
Net interest income and NEV will not address the credit risk component.  In this case, the question that must be answered is, “how will earnings and net worth be impacted by the shift in assets?”  In this example, provision expense should also be adjusted to represent the risk of the shift in assets.  If applicable, collections, legal and other expenses should also be adjusted, to capture the economic reality of increasing credit risk.
Ultimately, any decision that could result in a material change to a credit union’s financial structure should be simulated and all potential financial impacts should be considered, including net operating expenses.  The results should be shared with decision-makers and all should be asking “does this make sense?” and “is there any other impact not captured by the modeling?” to ensure that modeling results do not lead decision-makers astray.
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The Time To Comment Is NOW—Use Ours If Needed

Credit unions have a little more than a week left to submit comments for a Proposed Standards Update regarding liquidity risk and interest rate risk (click here to see our comments).   So far about 15 comments have been posted, but it is important for the Financial Accounting Standards Board (FASB) to know how this update may affect credit unions.  If you have not yet taken the opportunity, we encourage you to read the update and comment on it.  You may use some or all of our comments if you’d like.

The proposed update and the link to submit comments can be found here:   https://www.fafsurveys.org/se.ashx?s=4CA36E9200443005.

The deadline to submit comments is September 25.

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For Your Radar: Proposed FASB Update On Liquidity And IRR

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From now until September 25, the Financial Accounting Standards Board (FASB) has a Proposed Standards Update open for comment regarding liquidity risk and interest rate risk. The proposed interest rate risk disclosures, if passed, would provide dangerous and misleading information about the safety and soundness of a financial institution, and therefore, the financial services industry. With an interest in how this document could potentially impact the credit union industry, c. myers drafted a response and will issue it to FASB shortly.

To view the current draft of our comments, please click here:  http://www.cmyers.com/cnotes/cmyersdraftfasbresponse.pdf

Click here to view the proposed update on the FASB website.

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NCUA Beefs Up Insurance Requirements with New Emergency Liquidity Rule

Approved at NCUA’s July 24th board meeting, the proposed rule on maintaining access to emergency liquidity will require credit unions to create/maintain various levels of liquidity planning based on asset sizes.

Under $10 million in assets:  Maintain a written policy approved by the board with a list of contingent liquidity sources.

$10 million or more in assets: Establish a formal contingency funding plan (CFP) that clearly defines strategies for addressing liquidity shortfalls under adverse circumstances.  The CFP must address, at a minimum, the following:

  1. The sufficiency of the institution’s liquidity sources to meet normal operating requirements as well as contingent events
  2. The identification of contingent liquidity sources
  3. Policies to manage a range of stress environments, identification of some possible stress events and identification of likely liquidity responses to such events
  4. Lines of responsibility within the institution to respond to liquidity events
  5. Management processes that include clear implementation and escalation procedures for liquidity events
  6. The frequency that the institution will test and update the plan

$100 million in assets: In addition to maintaining a CFP as described above, demonstrate access to at least one of the following three sources:  becoming a member of the CLF, becoming a CLF member through a CLF agent, or establishing borrowing access at the Federal Reserve Discount Window.

Required For Federal Insurance
Perhaps more interesting to note is the placement of this proposed rule under Part 741 of the NCUA rules and regulations, which outlines requirements for Federal insurance.  This is the same Part that was revised to require formal IRR programs/policies earlier this year.

Liquidity Contingency Planning
When approaching liquidity planning, c. myers provides its clients with no less than 2 “what-if” scenarios based on an actual liquidity forecast:

  • What-if #1:  What’s our bad-case liquidity environment? Consider heightened loan demand, increased competition for low-cost deposits and potential cuts in lines of credit in order to stress the credit union’s liquidity position
  • What-if #2:  How will we respond to our bad-case liquidity environment? When addressing the bad-case environment, consider triggers the credit union can pull to protect its liquidity position, including slowing down/stopping lending, selling investments, raising rates to attract “hot” money, etc.

Exploring these scenarios on a regular basis can help credit unions be prepared for potential liquidity risks—and in light of the new proposed rule—will also help satisfy regulatory requirements for federal insurance if the rule is realized.

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Strategic Plans And Quantifying Risk

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In the recently issued Interest Rate Risk Questionnaire, the NCUA devoted an entire section to evaluating if decision-making is informed by interest rate risk measurement systems.  The guidance specifically references interest rate risk “what-if” testing in conjunction with strategic plans and operational decisions—and that “what-if” analysis outcomes should be documented within the strategic plan to either support or reject a decision.

The NCUA further states, “Whenever material changes in assets or liabilities are proposed, NCUA expects management to be proactive and perform what-if analysis before a new strategy is implemented.”  Understanding the potential impact that a strategic plan may have on the credit union’s risk exposures is key to effective asset/liability management.

In order to link strategic planning and desired long-term financial performance, decision-makers should ask themselves the following questions:

  1. How does this plan align with our long-term goals for financial performance?
  2. Is there a possibility that we will sacrifice financial performance in the short- or medium-term to fulfill long-term strategic and/or financial objectives?
  3. If everything goes according to our strategic plan, what will be the impact to the interest rate risk and credit risk exposure of the credit union?  Are there any other risks that may be present in the strategy that we don’t have today?  Specifically, how will those risks impact earnings and net worth levels?
  4. If external forces cause a deviation from our strategic plan, what contingencies are in place or what options do we have to get back on track?

A comprehensive strategic planning process incorporates the evaluation of interest rate risk.  Modeling the impact of strategic decisions beyond the traditional 1-year simulation is a must.