C. Myblog

Danger of Policy Limits on Net Interest Income

August 29, 2013

Establishing risk limits on only part of the financial structure is a common reason for why risks are not appropriately managed. Setting a risk limit focused on net interest income (NII) volatility does not consider the entire financial structure and can lead to bloated operating expense structures.

For example, assume a credit union has a 12-month NII volatility risk limit of -30% in a +300 environment. The table below outlines their current situation and simulated results in a +300:

The credit union performance in a +300 environment reflects a decrease in margin from 3.10% to 2.17%. This is a decrease in NII of 0.93% or a 30% decline in NII. Because of the drop in NII, ROA has now decreased from a positive 0.50% to a negative 0.43%.

The credit union is still within policy from an NII perspective but earnings decreased 0.93% and ROA is now negative in a +300 environment.

The risk of the credit union was not appropriately managed by neglecting to consider strategy levers below the margin and being overly focused on the change in risk versus the level of risk.

A board-approved policy that ignores operating expenses can lead decision-makers to take on more risk to earnings and net worth than they are truly comfortable taking.

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