6 minute read – The NCUA recently released an update to its Interest Rate Risk Supervisory Framework that specifically addresses the NEV Supervisory Test.  In short, while the update provides some relief for credit unions, it also increases the amount of judgement in the exam process.  This will require credit unions to make sure they have a strong understanding of their ALM results, earnings potential, and sources of risk. 

As a reminder, the test has created a challenge for many institutions, as rates have increased this year.  Their risk classifications increased significantly in the NEV Supervisory Test, which did not always align with the changes in their balance sheets and overall financial structures.  However, the increased risk classifications brought corresponding examiner pressure.  This was especially true for those in the extreme risk category where the NCUA manual would call for a DOR (or other supervisory action).  DORs would then require a de-risking plan.  (See:  https://www.cmyers.com/thought-leadership/ncua-nev-supervisory-test-heads-up-now/).  

In an effort to relieve this pressure, the NCUA removed the extreme risk classification (see below for updated classifications). 

The NCUA’s intention is to relieve pressure on the industry and to give credit unions time to adjust to this new environment.  However, this may cause a different pressure to emerge, as there is now more discretion in the exam process to determine the level of risk and what actions may be needed.  Indeed, many of the subtitled sections in the update speak to the increased discretion in the exam process: 

• Providing Examiners More Flexibility in Assigning IRR Supervisory Risk Ratings 
• Considering the Source of High IRR 
• Assessing Risk Management and Controls 
• Analyzing Potential Impact on Earnings and Capital 

As always, the heart of the NCUA’s concern is the risk any one institution poses, and even here there is some level of discretion when looking at the examples for when a DOR should be considered: 

• The credit union’s level of IRR represents an undue risk to the Share Insurance Fund, and the credit union is not taking appropriate and prompt action to address its level of IRR 
• The credit union has high IRR and has not adequately updated its approach to managing its interest rate, liquidity, and related risks for current market conditions 
• The credit union has a material governance deficiency (identify, measure, monitor, and control) relative to its level of IRR 

The bottom line is that there is now more burden of proof on the part of the credit union.  This also comes at a time when many in the industry, examiners included, don’t have experience going through a stress event like the one being experienced today with high inflation and rising rates.  It’s easy to imagine how these factors have the potential to create misunderstandings and increased examiner pressure.  This is why it is critical for credit union leaders to understand and be able to explain their IRR position from different angles, as well as the sources of risk and the associated return trade-offs that have been taken. 

This is where there is some silver lining to the new pressures created by the update.  The NCUA has, in many respects, provided a roadmap (and the impetus) for credit unions to be more prepared for their exams and, more importantly, better equipped for this environment.  

As a first step toward becoming better equipped, ALCOs should be highly engaged.  Committee members should be asking more questions and having deeper discussions about the institution’s structure, its sources of profitability and risk, and the risk/return trade-offs of different decisions.   

As part of these conversations, it could be helpful to ask:  Do we need to broaden our view of where rates will go?  Primarily focusing on rising rates can cause the organization to lose out on opportunity if rates go down.  This is where it’s helpful to turn the focus from one rate environment (think +300 bps) to a range of rate environments and think of optimizing for that range.  Expanding conversations in this way will help during the exam, as leaders will have a deeper understanding of IRR and their institution’s approach. 

Ensure that the focus is not limited to NEV, rather, the discussions should focus on understanding the impact to earnings and net worth.  This is especially true if there are concerns around insolvency.  In essence, the key is to show that even with high-risk NEV Supervisory Test results, the institution will remain a going concern, assuming it can demonstrate an ability to generate earnings and build or protect net worth.  Even in cases where an institution has negative earnings, it can often identify ways to protect net worth and remain solvent while it addresses its earnings issues.  A key to this is to have sufficient liquidity, so as to not have to turn unrealized losses into realized losses.  Testing and understanding liquidity strength along with contingent options is critical if the risk profile is tight.  Liquidity risk can change quickly, especially as institutions have seen assets lengthen and some have seen deposits decreasing. 

Internally, institutions may also face questions and pressure from different decision-makers, as there is no ‘right’ answer to appetite for risk.  Some may not like the level of risk indicated in the NEV Supervisory Test and push to de-risk.  It can be easy to request that risk be reduced quickly, but there are always trade-offs. Whether for the examiners or internal pressure, taking steps to de-risk can cost millions of dollars in earnings and net worth.  This is where it is important to have the board and ALCO understand the risk/return trade-offs so they can make informed decisions that help move their strategy and financial structure forward. 

Without understanding the risk/return trade-offs, decisions could be short-sighted, unnecessarily restricting earnings and impacting net worth levels.  This could then interfere with strategic initiatives and moving the business forward.  This is why decision-makers, with different areas of responsibility, will want to take the time to build a solid understanding of ALM, have productive conversations, and connect the decisions to the potential financial and strategic impacts.