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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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Budgeting Tips For 2013

As the 2013 budgeting season gets into full swing, things have not changed much for most credit unions.  The industry is still facing the challenges of weak loan demand, robust deposit growth and declining asset yields.  Here are a few things to keep in mind as you put together your budget:
  • Make it as realistic as possible.  Unrealistic budgets result in poor decisions and unhappy surprises later in the year
  • Look at recent trends in loan and deposit growth.  If your budgeted loan and deposit growth are very different from trend, you should be able to point to concrete reasons why the trends will change
  • Incorporate balance runoff.  If your budget model doesn’t calculate runoff, try to build in reasonable assumptions to capture how fast portfolio yields will change (most are declining)
  • Don’t stop with 2013.  Carry major trends forward to get a 3-5 year view.  This shows the impact of those trends continuing, which may not have much effect over just one year
  • Do “what-ifs” that focus on assumptions you’re not sure about and have the highest impact such as loan and deposit growth and provision for loan loss.  This is especially important if net worth is an issue.  If the results are unsatisfactory, identify and model solutions so you will know what triggers to pull if things don’t go as planned
  • Consider doing “what-ifs” showing different rate environments. Think about how loan and deposit growth might change if the rate environment changes
  • Evaluate the budget in terms of asset liability management by modeling the resulting interest rate risk if the budget comes true
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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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Annual Long-Term Financial Planning Process: Include A Deflation Scenario

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We strongly recommend that credit unions annually invest the time to forecast financial performance for at least three future years.  The baseline forecast should compliment the strategic plan and include the cost of major initiatives, as well as expected growth trends.  If the baseline does not produce satisfactory performance, determine what changes could be made.  Once a baseline is established, senior management should identify the issues they feel could have the biggest impact on future financial performance and then test each issue as a what-if.  Typical what-ifs include:

  • Provision for loan loss doubles from the baseline plan for 24 months
  • Non-interest income decreases 50%
  • Lending volume declines significantly
  • NCUSIF assessments are twice the level in the baseline
  • Interest rates increase to the credit union’s self-defined, worst-case scenario

We recommend that a deflation scenario be included as well.  Many management teams have not discussed the possible impact of a sustained period of deflation, and even fewer have taken the time to forecast the possible financial impact of such a scenario.  Following a structured strategic thinking exercise on deflation could be helpful to explore the issue.  Create the what-if forecast by evaluating the impact on all major components of the financial structure and updating assumptions.  Often these forecasts include lower long-term rates including loan rates and investment rates, an increase in loan and investment prepayments, decreased loan demand and an increase in deposits.  While this may sound similar to today’s economic environment, the magnitude of such conditions may be greater.  For example, long-term rates could fall to 2% or lower and loan growth could decrease materially due to accelerated prepayments and consumers postponing purchases.

Management teams are often surprised by the possible significant, negative financial impact of a deflation scenario.

As with all of the what-ifs tested in this process, if the financial performance is not acceptable, determine what actions could be taken and test the impact of these actions.  At the conclusion of the exercise, decide if any of the actions to address the risks in the what-ifs should be implemented in the baseline plan.