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Excerpt: The New IRR Rule – Be Prepared

The National Credit Union Administration recently issued its final rule requiring “federally insured credit unions to develop and adopt a written policy on interest rate risk management and a program to effectively implement that policy, as part of their asset liability management responsibilities.  The interest rate risk policy and implementation program will be among the factors NCUA will consider in determining a credit union’s insurability” (p. 5,155).

“Interest Rate Risk Policy and Program Final Rule” is effective as of Sept. 30.  Credit unions over $50 million in assets are required to have a written interest rate risk policy and an effective IRR program.  Credit unions over $500 million can expect their IRR policies and processes to be put under a microscope.  Credit unions from $10 million to $50 million with first mortgage loans and long-term investments equal to, or exceeding, 100 percent of net worth are subject to these new rules as well.

While we are not proponents of more regulation, this new rule provides a great opportunity – even if it is forced – for credit union managements and boards to ensure they are on the same page with respect to appetite for risk, risk quantification methodology and process.  The timing could not be better as we sit in the lowest rate environment our financial markets have experienced since the 1950s.

To read the full article, please see our c. notes page, available here.

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Operational Efficiency—Improving Earnings And Member Experiences While Driving Increases In Net Worth Dollars

In comments surrounding the new rule on Interest Rate Risk, the NCUA states that, “net worth is the best measure against which to gauge a credit union’s risk exposure.”  As credit unions are looking to improve earnings and grow net worth dollars in this historically low interest rate environment, yield on assets and cost of funds are only 2 of the 5 strategy levers that credit unions can pull.  In order to have an effective IRR management program, ALL levers that impact earnings and net worth should be evaluated, including operating expense, provision for loan loss and fee/other income.

Bottom-line results can be realized by evaluating operating expenses for operational efficiencies.  However, operational efficiency not only means looking for ways to cut expenses, it also includes evaluating current processes and practices to ensure that no opportunity to generate revenue is left behind.  For example:

  • Do your loan processes allow you to effectively capture every loan that you want to fund, or do inefficiencies in the process cause members seeking loans to ultimately go elsewhere?
  • Can your front line effectively turn interactions with your membership into educational or cross-sale opportunities, when appropriate, that deepen member relationships and enhance the member experience?
  • Does your in-branch advertising reflect the tactical (short-term) and strategic (long-term) objectives of the credit union?  If the credit union is targeting loan growth, are loan rates and promotions more prominently displayed and emphasized than current deposit rates?

Finding ways to revamp processes can improve member interactions and provide employees additional time that can be used to enhance member service or develop other areas of the credit union’s business.  Additionally, ensuring that the credit union is effectively utilizing its sources of revenue is just as important to operational efficiency as cutting un-needed expenses.

The creation of operational efficiencies in your structure can have a positive impact on earnings in all interest rate environments, which is an excellent way to drive increases in net worth without taking on additional risks.

Source:  Interest Rate Risk Policy and Program, NCUA, 2/3/12
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Have You Reviewed Your Policies Recently?

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Historically, credit unions may have been wary of making material changes to their policies, whether an A/LM policy, Liquidity policy, Investment policy or broader Financial Management policy – for fear of raising regulatory “red flags.”  However, with the adoption of the final rule on interest rate risk (§741.3(b)(5)(i)), and the effective implementation date of September 30, 2012, many credit unions are finding this a great time to revisit their policies.  While reviewing policy, some key questions must be asked:

  • How does the policy help promote safety and soundness, while also reflecting the risk appetite of the credit union’s board and senior management?
  • Have there been situations in recent history where policy limits or guidelines have “tied hands” with respect to making sound business decisions?
  • Conversely, are there limits or guidelines in policy that have aided in the decision-making process, potentially saving the credit union from less than favorable outcomes?
  • How can we effectively construct policy limits and/or guidelines to both satisfy regulatory requirements and aid in the decision-making process of the board and senior management?

With heightened industry awareness surrounding interest rate risk, and increasing regulatory pressure to mitigate the risk being taken by some credit unions today, would it possibly raise more regulatory “red flags” if a credit union did not revisit relevant policies prior to the September 30 implementation date?  A good policy has limits and guidelines intended to promote risk management and safety and soundness.  A great policy has limits and guidelines intended to promote risk management and safety and soundness, but most importantly, provisions that drive dialogue to aid in the decision-making process.  While revisiting policy this year, the above questions will help take your existing policy from “good” to great.

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What Is Your Alternative To OTS For Prepayment Information?

With the OTS having been merged into the OCC, credit unions are looking for alternative sources for loan prepayment information to use when quantifying interest rate risk (IRR).  Unfortunately, there are a limited number of publicly available sources for this information.  The Securities Industry and Financial Markets Association (SIFMA) is one publicly available source that provides a “street consensus” for long-term prepayments based on surveying institutions such as UBS, JP Morgan Chase and Morgan Stanley.

As discussed in our recent post, How Do You Know Your Modeling Assumptions Are Right?, whichever source institutions decide to use, the assumptions should be stress tested and documented in order to understand them better—as well as satisfy the “reasonable and supportable” component of the new NCUA rule on interest rate risk management and policy.

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Policy Limits And The Proposed Regulation For IRR

The following is an excerpt from our response to NCUA’s proposed regulation on IRR.  While the excerpt focuses on a potential issue with the proposed regulation, it also highlights a concern we have with the way certain policy limits are written that don’t look at the actual risk of an institution.

Appropriate Policy Limits

Another concern is the evaluation of appropriate policy limits to ensure “compliance” with the regulation.  The proposed regulation states:

  • Set risk limits for IRR exposures based on selected measures (e.g. limits for changes [emphasis ours] in repricing or duration gaps, income simulation, asset valuation, or net economic value); (Federal Register, Page 16575).

While NCUA has stated in the proposed regulation that these are examples of the types of limits to set and how to set them, the concern is that these examples will become the rule.

Our question is:  Why the focus on percent change versus focusing on the actual risk?

If a line in the sand is never drawn, then as long as a credit union continues to be within the percent change they identified, it would be acceptable for their risk profile to continue to deteriorate.  Also, these types of limits don’t address if the credit union has an adequate net worth ratio.

Consider the following example if the guidance NCUA provides to examiners regarding this proposed regulation is similar to that in the below excerpt from the IRR Questionnaire (click on image to see Table A):


If a credit union has a 1.00% ROA, to maintain a “moderate” level of risk to earnings, the ROA can’t fall below 0.25% (maximum 75% decline) in a 300bp change.  Whereas, a credit union with a 0.40% ROA can have their earnings drop to 0.10%.   What if, at the time of the next simulation, the credit union with a 1.00% ROA is at 1.25%?  Then their ROA can’t fall below 0.31%.  If the credit union that was earning 0.40% now earns 0.30%, then their earnings can’t fall below 0.08%.

In essence, using the percent change methodology, if an institution’s earnings increase in the future, the bar is raised.  Conversely, if earnings drop in the future, the bar is lowered.  Is this really a good measure of safety and soundness?

Additionally, a percent decline approach applied to earnings would never allow a credit union with positive earnings to make the business decision to allow for negative earnings.  There are several cases where external forces or strategic plans make negative earnings in the short term a reality in order to balance the long-term viability of the organization.

Using these guidelines would put any credit union with negative earnings out of policy.  Does that mean that every credit union losing money would automatically be “out of compliance”?  Note that, in 2010, approximately 40% of all credit unions had negative earnings after factoring additional NCUSIF expense.  The potential ramification of this path could be detrimental to the industry.

To see our full response, please click here.