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Static Income Simulation – Things To Consider

April 7, 2011

One of the traditional approaches to income simulation is to use a static balance sheet, which assumes that a credit union’s mix of assets and liabilities remains constant, regardless of external forces.  In other words, static analysis assumes that every dollar of mortgages that matures is immediately put back into a new mortgage at the current market rate.  It also assumes that the deposit mix of the credit union never changes.

While it may sound simple and straightforward enough to just assume the balance sheet structure never changes, these assumptions about new business can be very misleading.  Would you expect mortgage volumes to remain the same if rates increase 300 bps?  Would you expect to maintain the same percentage of your funding in low-cost regular shares if rates increase 300 bps?  The answer to both these questions is, of course, “it’s not likely.”

If you are doing static analysis at your credit union, consider running alternate scenarios slowing mortgage volumes if rates increase.  Also consider increasing member CDs to the levels you experienced as rates were increasing from 2004 to 2006.  These simple-to-run scenarios will likely give you a better picture of your risk to earnings and net worth in a rising rate environment.

Finally, the yield curve we are experiencing today is extremely steep.  We recommend that you also test out scenarios where the yield curve flattens to a more historical level of about 150 bps.  Remember, in 2003-2004 we also experienced a very steep yield curve.  However, when the Fed started raising short-term rates in 2004, long-term rates did not increase by much, flattening the yield curve.

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