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Is Your Interest Rate Risk Model Incorporating the Risk of Deposit Mix Changes?

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Recently, we blogged about interest rate risk (IRR) modeling methodologies that can give credit unions a false sense of security. (See blog titled “Is Your Risk Methodology Giving You a False Sense of Security?” Posted on July 3, 2014.) We noted that traditional income simulation seldom incorporates the risk of non-maturity deposit withdrawals or member CD early withdrawals. Instead, it will either assume that the deposit mix never changes (static) or the forecasted deposit mix always comes true (dynamic) regardless of what happens to interest rates.

Let’s look at the reasonableness of assuming the mix of deposits remains the same by exploring the history of lower-cost deposits as a percent of total funds:

As shown above, history demonstrates the mix of deposits changes with the rate environment. There are two major exposures to the cost of funds if the rate environment increases: (1) having to pay more for deposits, and (2) lower-cost deposits leaving. Many institutions mistakenly think that the risk of deposits leaving is incorporated by using decay assumptions. This is typically not the case. Further, in many models, the decay assumptions are only applied to NEV.

Review the simulated balance sheet under various rate environments to see if the deposit mix is changing as rates change. If your income simulation modeling is ignoring this shift out of low-cost deposits, then your management and board may have a false sense of security caused by understating the cost of funds in higher rate environments.

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Risk/Return Trade-Off—Part II

In last week’s blog, we discussed the need to understand risk/return trade-offs and the concern in relying solely on net economic value (NEV) for decision-making. If the objective is to decrease NEV volatility and your strategy under consideration is to A) Sell 30-year mortgages or B) Sell a 3-year bullet, does NEV fairly represent the downside of this sale? The answer is “no” and we will explain with an example.

To keep the math simple, assume we have $100M in both recently originated 30-year mortgages and 3-year bullets. In evaluating the decision using only NEV, it is clear the answer is to sell the 30-year mortgages because they devalue the most in a +300 basis point (bp) rate shock, as shown below:

However, the analysis should not stop there. Consider the potential impact to earnings of holding $100M in each product versus holding that same balance in overnight funds. Over 12 months, the credit union is giving up $4M in revenue by selling the 30-year mortgages compared to $550K by selling the 3-year bullet.

There are different ways to incorporate the return component when evaluating strategies. In this approach, divide the 12-month revenue difference by the market value loss in a +300 bp shock to get the trade-off ratio.

The trade-off ratio reflects the foregone revenue associated with mitigating the NEV volatility. The smaller the ratio, the lower the revenue sacrifice per dollar of shocked value reduction. In this example, selling mortgages gives up revenue that equals 20% of the risk, while the bullet gives up only 6% of the risk. Said differently, the credit union could get more “bang for its buck” by selling assets with a lower ratio.

The objective here is to demonstrate that seeing only the change in NEV without seeing the change in return can result in misleading decision information. A tool or model that shows the impact to earnings is a critical piece of the decision-making. If you take this one step further and incorporate longer-term risk to earnings, the decision information becomes even stronger.

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Risk/Return Trade-Off—Part I

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Cliché? Yes. Often overlooked in decision-making? Also yes. This current long-lasting low rate environment has lulled some credit unions into ignoring the risk of things changing, such as an increase in rates. The focus on return without proper respect for potential risk has led to a material increase in interest rate risk in some institutions, thereby inviting more scrutiny from regulators.

What about the other side of the equation? We see many examples where the evaluation of risk ignores the return. A primary example is using net economic value (NEV) for decision-making. NEV can do a fair job of evaluating the risk of certain assets, such as marketable investments, but it does a bad job at evaluating the risk of the whole credit union. While NEV may capture the risk of an investment, does it appropriately represent the return for the institution?

Consider this, if you decide to reduce risk, you may test selling MBS investments and put the funds in overnight investments. When selling MBS investments, the risk in higher rate environments will go down, and NEV will typically improve. But what about the risk/return trade-off? Does the NEV show a difference in the credit union’s current position? No. The MBS will be sold at today’s value and then the funds would be invested at today’s value, resulting in the same current value of the institution. For example, an MBS may yield 2.00% today, while the overnights earn 0.25% at most. Did the return go down? Absolutely. Does NEV fairly represent the downside of this sale? No.

Only seeing the change in risk without seeing the change in return can result in misleading decision information. Understanding the potential impact to earnings (short term and long term) and the long-term risk to net worth in a wide range of rate environments is critical to decision-making.

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Concentration Risk in Non-Interest Income?

NCUA cited the Basel Committee on Banking Supervision when defining concentration risk in NCUA Supervisory Letter – Concentration Risk:

“A risk concentration is any single exposure or group of exposures with the potential to produce losses large enough (relative to capital, total assets, or overall risk level) to threaten a financial institution’s health or ability to maintain its core operations.”

In evaluating the level of concentration risk present in a credit union’s financial structure, many approaches – including the current risk-based capital proposal – operate under the assumption that the material risk to net worth resides in the asset structure of the balance sheet. Managing concentration risk by setting limits on only the balance sheet components of a credit union’s structure falls far short of addressing risk concentrations – which is any exposure that could threaten the ability of a credit union to continue “business as usual.” A reliance on non-interest income to generate earnings may expose many credit unions to the potential for large losses.

In our experience working with hundreds of credit unions, a significant portion of non-interest income (often well in excess of 50%) is derived from interchange revenue, overdraft/courtesy pay and mortgage origination/gains on sale. Even though some battles over interchange income have settled, the risk of non-interest income dropping materially in the future still remains. Consider the impact to earnings and net worth if courtesy pay/overdraft income is considerably altered in the name of consumer protection or if mortgage originations continue their sharp decline.

While the most recent economic downturn was certainly driven by asset-based credit risk exposures, an effective concentration risk management process, and (even more importantly) an effective aggregate risk management process, should include an evaluation of any material exposure that could threaten net worth. Because the ability of a credit union to raise and maintain capital levels is directly related to its ability to generate earnings, any exposure that materially impacts earnings could adversely impact capital levels. Concentration risk policies and procedures that overlook the impact of threats to non-interest income sources may lack a key component to addressing all material threats to net worth.

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

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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.