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contact@cmyers.com
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Voice your concerns NOW about NCUA’s consideration of adding a separate IRR component to RBC
Interest Rate Risk Blog PostsIf RBC 2.0 passes as written, each credit union defined as complex will be required to quantify their unique risks and maintain adequate capital to back those risks, all of which is to be supported by a written strategy.
RBC 2.0 also advises that because the rule no longer proposes including interest rate risk, NCUA will consider alternative approaches to account for IRR at credit unions. These alternatives could include “adding a separate IRR standard as a subcomponent of the risk-based net worth requirement to complement the proposed risk-based capital ratio measure.”
Our question is: Why further muddy the waters by incorporating the complex issue of attempting to standardize the quantification of IRR into rule making?
Taking a one-size-fits-all approach by standardizing assumptions, or approaches to assumptions, guarantees that the unique risk of an individual credit union will not be appropriately captured.
It is important for credit unions to invest time to think critically about this issue and voice their concerns about the impact of adding a separate IRR component to the proposed credit-based RBC – before it is too late!
Evaluating Derivatives―Part V: Economic Value Declines Over Time
Investments and Derivatives Blog PostsCredit unions purchase derivatives to receive value: interest rate risk protection. This blog series set out to help decision makers understand the variety of outcomes they could observe over the life of a derivative, and how those outcomes will ultimately determine the value realized.
Over its life, derivative economic value is impacted by two forces:
Prior blog articles discussed the impact of changing rate environments on economic value. Regardless of the rate environment, economic value of a derivative will converge to zero at maturity. The value of the protection diminishes as the remaining time to maturity becomes less. Using our prior example of the 7-year swap, the chart below shows the economic value on day 1 and each year thereafter:
Note: $s in 000s
Derivatives analytics provided by The Yield Book® Software.
The chart demonstrates the economic values for the various rate shocks as the time until maturity shortens. Compare the highest shocked environment shown, +500, the initial value of $26.4 million to the year 1 shocked value of $22.8 million. The year 1 value is materially lower because the swap only offers 6 remaining years of protection. Independent of the rate environment, by the end of year 7 the swap no longer has value since it matures.
Why is this important? If the swap was originally purchased to address a volatility issue in the credit union’s financial structure and that volatility persists, then over time the credit union will need to either adjust the underlying structure or will need to purchase additional swaps to maintain the same level of protection. It can be important to be clear about the objectives of the derivatives. Is the purchase designed to offset an existing risk and buy time until the root interest rate risk can be addressed? On the other hand, is the intent to, ongoing have, a business model incorporate additional interest rate risk and perpetually utilize derivatives to offset the risk?
Capital Planning and Stress Testing
Strategic Planning Blog PostsAs the first round of NCUA supervisory stress tests are being completed, NCUA’s capital planning and stress testing rule for the largest credit unions might have you asking if you should be doing capital planning and stress testing too. Even if you are not a federally insured credit union with assets of $10 billion or more, it’s reasonable to ask if it’s a good practice.
Understanding risk exposures and being structured to survive a certain level of risk is key. All credit unions do some form of capital planning via their budgeting process (although not at the rule’s level), but stress testing is often lacking. If you’re interested in performing NCUA’s stress testing, they publish stress test scenarios for baseline, adverse and severely adverse scenarios. These are macro-economic scenarios that include the unemployment rate, market interest rates, GDP, etc., and must be translated into assumptions that affect the credit union’s projections.
NCUA is conducting the stress testing for the first three years and results aren’t public at this time. But the Federal Reserve’s approach to stress testing for banks, which NCUA’s stress tests were modeled after, shows that those macro-economic scenarios are turned into stress test assumptions by using the financial institution’s data, historical information and other regional and national data. If it’s overwhelming to think about creating assumptions for individual loans, step back to the bigger picture. The Federal Reserve’s emphasis is on how such assumptions should be justifiably tied to the economic stresses being modeled, rather than loan-level detail. In fact, banks commonly model portfolios segmented by such characteristics as product line, lien position and sometimes down to loan-to-value and credit score for material portfolios rather than at the individual loan level.
Whether you choose to follow NCUA’s stress scenarios or not, keep the bigger picture in mind. It’s not only about credit losses. Consider how high deposit growth and prolonged low loan demand continued to affect credit union profitability and net worth long after credit losses from the last recession subsided. Along with loan and deposit growth, assumptions for non-interest income and operating expense must also be constructed. How could regulatory changes affect fee income? What might be the cost of a security breach? What are the credit union’s unique risks?
It’s important to identify, quantify and aggregate key risks, recognizing that multiple risks can be realized at the same time. Ultimately, you want to know if the credit union can survive the identified risks and take appropriate action depending on the answer.
In capital planning and stress testing, as with any analysis, it is the process of thinking through the possibilities, causes and effects that yields good decision information. Credit unions can benefit from using a common-sense approach to stress testing with a level of sophistication that is supportable and which can be refined over time. The real value is when the results are understood by leadership and incorporated into business models, strategic planning and other areas of decision making.
Evaluating Derivatives―Part IV: The Relationship Between Value and Cash Flow
Investments and Derivatives Blog PostsOur last post on derivatives explored the relationship between rate shocks and changes in value. Inherent to this was a caution that improvement in value due to changes in the implied path of interest rates doesn’t guarantee cash flows will be positive in the future.
The economic value analysis is typically limited to assuming an implied path. When performing cash flow tests (earnings), however, that limitation is not necessary or warranted. Since there are virtually an unlimited number of paths that can occur, consider paths that could expose risk. Recent history has demonstrated that the risk of rates remaining flat should not be ignored.
Forward curve analytics provided by The Yield Book® Software.
For each rate environment, communicating the potential of rates going to that level and staying there can often expose potentials that won’t be seen from the economic value. Note that in this example, while rates change instantly, the earnings lag the initial year due to the quarterly reset.
Note: $s in 000s
It can also be beneficial to understand the impact of rates changing over time. Consider the difference of a 12-month rate change.
Note: $s in 000s
Note in this example that, if rates ramp up 200 bps over 12 months and stay at that level, the credit union earnings from the derivative do not break even until the 6th year. This is in contrast to the +200 instant change showing a break even in the 3rd year.
In order to reduce the risk of being blindsided from an earnings perspective, institutions should review the earnings potential of rate shifts that hold steady at the simulated level. Institutions should also understand the potential impact of slower rate changes.
Compare this to the economic value displayed in the previous blog where there is no hurt in the current environment and there are material gains in the other environments.
Derivatives analytics provided by The Yield Book® Software.
Considering New Systems? How to Improve Chances for Success
Process Improvement Blog PostsMany credit union management teams are considering changes to their mobile platform, home banking, loan origination system (LOS) and/or account opening system (AOS). The following are just a few (of many) tips to consider:
Installing a new home banking, LOS or AOS is a venture that should not be taken lightly. There is more on the line than just a successful implementation—the credit union’s reputation could ultimately be at stake. It will be critical to weigh and measure every decision with the gravitas these projects deserve.