C. Myblog

Is Your Risk Methodology Giving You a False Sense of Security?

July 3, 2014

A recent front page article in the Wall Street Journal caused quite a stir by claiming that credit unions are “piling into longer-term assets, exposing the firms to potentially significant losses if interest rates rise…”

The objective of this blog is not to debate whether there is or is not too much interest rate risk (IRR) in the industry. The facts are the facts: credit unions have operated in a historically-low rate environment for the last six years; credit unions have, on average, extended their loan and/or investment portfolios; and there has been a flight-to-safety. The ingredients are there. There is potential IRR built into the system, that, if not managed properly could present issues when rates do rise – depending on what level they rise to and how quickly. The question, then, is “is IRR being managed properly?” or are some decision-makers getting a false sense of security by IRR quantification methodologies that miss risk or allow users to assume away the risk?

In our experience of doing numerous model validations, we have seen many examples of a false sense of security being created either through the methodology or the assumptions needed for the methodology. The most common concerns that may hide risk from decision-makers include:

Traditional income simulation

  • Optimistic assumptions about growth in new business
  • Optimistic assumptions about new volume yields as rates change
  • Seldom incorporate the risk of non-maturity deposit withdrawals or member CD early withdrawals
  • Time horizon is too short, often only one year

Net economic value

  • Optimistic deposit values in current and shocked rate environments (the never-ending argument about deposit length and valuation)
  • Optimistic loan values showing large gains that ignore the market perspective on both credit concerns and liquidity risk

Risk limits

  • Policy limits that focus only on net interest income and net economic value ignoring the entire financial structure, which may hide the potential of negative net income and resulting decline in net worth

Are you at risk of being blindsided? Now is the time to evaluate your modeling methodologies and assumptions.

Comments
  • GDS

    The fact is, all the models have shortcomings. They are all based upon assumptions, and quite frankly an assumption on how Non-maturing shares will act is the biggest exposure cu’s face. Will they all walk out the door or just sit there in a rates up environment? In the past, NM shares have been ambivalent to rates, but this time it could be different. We can’t be ready for all outcomes and still run a profitable shop. However, after almost six years of this economy, a short portfolio has been a clear loser. Those that readied for rates up a while ago have given up too much current income to minimize the impact of the “any day now” rates up. Better to have earned while you can and use a well funded UE to balance the effects of an uncertain future.

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