Posts

/by

Have You Reviewed Your Policies Recently?

,

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.

/by

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.

/by

Evaluating Investments

This post is a continuation of Investing At “Record” Low Rates… published February 10, 2012.

Investments with complex optionality are increasingly being added to credit union investment portfolios.  As such, it is critical that credit unions have a solid understanding of what they may be purchasing, before the transaction is executed.

First, make sure your broker is providing you with a complete picture of the characteristics of the investment in question.  In general, most brokers provide market value, and cash flow information for the current environment and a +300 basis point (bp) rate change.  However, some investments (in particular some CMOs) may look “okay” if rates go up 300bp, but have the potential for extreme extension risk if market rates go up 400 or 500bp.  Credit unions should ask their broker for cash flow and market value shock data for the +400 and/or +500bp rate change, particularly for investments with optionality.  Remember that short-term market rates were 500bp higher than they are today as recently as 2007.

In addition to cash flows, other optionality features can be very important as well.  For example, if the investment is variable rate, make sure that all of the repricing parameters are clearly understood: repricing frequency, margin, caps, floors, etc.  When the first repricing can occur is particularly important, especially with rates being so low.  For callables and step ups, consider call dates and potential repricing dates.  For step up investments consider if the future step protection warrants the lower starting coupon rate compared to a bullet or callable with the same final maturity.

Working with a trustworthy broker certainly helps in this process, but that does not absolve decision-makers of completing their own due diligence and ensuring an investment fits within their overall strategic objectives.  Keep asking questions until there is clarity on the investment and its structure, consider the other pertinent decision drivers (for example, policy, impacts to aggregate risk position, etc.) and consider the unexpected in the decision-making process.

/by

Proposed IRR Regulation Could Have Unintended Consequences

C. myers agrees with the objective that most institutions should have an effective interest rate risk (IRR) management policy supported by an effective IRR program.  However, we do not agree that it should be regulation.

Keep in mind as you read our comments that our business is to provide asset/liability management services to financial institutions.  We have worked with hundreds of credit unions providing long-term risks to earnings and net worth simulations, static and dynamic balance sheet analyses and net economic value (NEV) simulations.  A regulation of this nature would likely materially increase our business opportunities, yet we do not believe it is in the best, long-term interest of the industry.

One primary reason that we do not support the proposed regulation is that it is ambiguous.  We understand this ambiguity is necessary.  However, ambiguity will lead to subjectivity when implementing the regulation.  Whether a credit union has a written policy with adequate limits and an effective program addressing IRR may ultimately be determined by each credit union’s most recent examiner.

Please click here to read our full response to the proposed IRR regulation.

/by

Establishing Concentration Limits

, ,

Establishing concentration limits that enable you to make sustainable, sound business decisions while trying to satisfy new regulatory pressure is very tricky.

The supervisory letter on concentration risk states that examples of concentrations within an asset class include…

“Residential Real Estate Loans—collateral type, lien position, geographic area, non-traditional terms (such as interest-only, payment option, or balloon payment), fixed or variable interest rates, low or reduced underwriting documentation, and loan-to-value (LTV).”

If you are contemplating multifactor concentration limits as described above, consider the following example and how this approach could impact your strategy and business decisions.

Let’s assume:

8 real estate types, with
4 different LTV ranges for
20 ZIP codes (geographic areas) and
6 credit score ranges, would result in

3,840 total risk limits for the Residential Real Estate Loans

Keep in mind the above example is just for Residential Real Estate.  Imagine applying the same multifactor approach to other asset categories.  The number of limits can become daunting and unmanageable.

We recommend listing every limit on a single piece of paper to help decision makers understand the magnitude of their potential policy commitments.

Slicing and dicing portfolios absolutely is a key component of portfolio analysis and risk management.  However, we are concerned that the establishment of these limits in policy is being rushed in anticipation of the next exam or, during the exam process, examiners are pressuring credit unions to establish concentration limits quickly.

Rushing to establish concentration limits without appropriate analysis, including potential impact to strategy and business model, could result in unintended consequences with serious implications.  Not to mention the red flag noted in the supervisory letter regarding changing concentration limits if a credit union is outside of policy.

We highly recommend following a deliberate process to establish limits.  Test drive your limits under various economic scenarios to understand, in advance, how they will impact strategy and business decisions.  This includes the changes that may be necessary to the credit union’s business model in order to manage within the new limits.

This blog addresses only a sliver of the issues regarding concentration limits.  There certainly will be more to follow, such as the correlation between the speed with which concentration increases and poor financial performance.