/by

Risk-Based Capital Rule 2.0

Even though the Risk-Based Capital Rule 2.0 (RBC 2.0) has been watered-down, it is not good for the industry. Don’t forget a key component of the RBC 2.0 is NCUA’s consideration of adding a separate interest rate risk (IRR) component to risk-based capital.

Standardizing IRR, assumptions, and/or approaches to assumptions, guarantees that the unique risk of an individual credit union will not be captured appropriately. Standardization does not change the need for examiners and credit union decision‐makers to understand the unique risk of an individual credit union.

We will be posting a comprehensive draft of our comments on Tuesday, April 21, 2015.

/by

Evaluating Derivatives―Part VI: Why Use Derivatives?

,

With the derivatives rule that went into effect in 2014, NCUA gave credit unions access to a new tool to help mitigate interest rate risk. Although a derivatives pilot program has been around since 1998, derivatives are still a relatively new thing to the industry. Past blogs in this series have provided the reader with important things to consider about the cash flows and economic value of interest rate swaps. All this, and more, should be carefully evaluated if your credit union is considering derivatives.

So, with all these things to consider, why might a credit union enter into a derivatives contract? The answer is simple: to hedge interest rate risk. As with other hedging techniques, a derivative will cost something today, but will help if rates increase. Think of it like an insurance policy.

For example, let’s suppose a credit union’s ALCO has decided it would be desirable to reduce interest rate risk and has established an internal goal of remaining Well Capitalized if rates increase 500 bps, and maintaining an NEV volatility of not greater than 40%. However, as shown below, an interest rate risk simulation indicates that if rates increase 500 bps, the credit union is positioned to put net worth of 3.64% at risk, leaving 6.56% net worth remaining. In addition, net economic value volatility is 55.55% and the resulting net economic value is 6.08%.

In evaluating ways to reduce its risk, the credit union runs a what-if scenario on the following interest rate swap:

  • 7-year term
  • Notional Amount: $50 million
  • Pay Fixed Rate: 2.00%
  • Receive Floating Rate: 3-month LIBOR

The results are shown below.

An interest rate swap is expected to provide protection, or insurance, against a rising rate environment. As noted above, the cost of this insurance in terms of annual ROA is 13 bps in the current environment. The benefit shown is the improvement in long term net worth at risk. The simulation including the impact of the swap shows that:

  • Current ROA is reduced by 13 bps
  • Long-term net worth not at risk improved by 78 bps to 7.34%
  • The point at which the financial structure could now be positioned to fall below Well Capitalized has improved from when short-term rates are at 5% to when they now reach 6%

Note:  $s in 000s
Derivatives analytics provided by The Yield Book® Software.

The NEV results both with and without the impact of the derivatives are shown above. Notice that the resulting NEV ratio after layering in the derivatives has improved in the +500 shock from 6.08% to 8.24%. Similarly, NEV volatility for that rate environment has been reduced from 55.55% to 38.31%. The ALCO has achieved their desired results.

While there are many things to consider about derivatives, they can be a good tool for mitigating interest rate risk. The more analysis that is done and the better your credit union’s unique risks and risk tolerances are understood, the better equipped you will be to decide if derivatives are a good choice for your credit union.

/by

The Folly of a Poor Project Management Process

Credit unions are no longer what they were. At one time, they braved a new path in the banking world with the assistance of SEGs, and filled an open need for workers in America. That need is still there but many credit unions have grown from servicing singular employers into servicing entire communities. With that great responsibility, these credit unions have put training programs in place for their front-line staff – especially tellers – because this is where the members interact most.

What they are missing is training in other areas of the credit union that might have less direct member impact, yet greater indirect member impact. One of the best examples of this is the credit union’s project management process.

For any credit union that has ever tried to take on a meaty project (e.g., installing a new core, transitioning a loan origination system or relocating a facility) the strength of their project management process will never be more evident.

If that project was completed on time, in scope, and in budget, then the credit union employed a strong project management process.

If that meaty project was completed somehow, by the skin of their teeth, well past deadline and decidedly over budget, then that credit union employed a weak project management process.

Here are some of the key things that go wrong when credit unions are weak in project management:

  • There is not an executive sponsor or the executive sponsor is not appropriately engaged
  • The credit union does not develop a formal project plan for its bigger projects
  • A tracking system is not created that is capable of providing variance analysis data
  • No one attempts to manage project scope and or key stakeholders have different understanding of the scope, schedule or resource changes throughout the project’s life cycle

The above list of project management fails could be avoided if credit unions take time to train key people on successful project management – for the benefit of the credit union and its members.