Policy Risk Limits are Often a Moving Target
July 11, 2018
With market interest rates on the rise for the first time in nearly 15 years, comes a host of new considerations for the credit union industry. Among them is an understanding that many Interest Rate Risk (IRR) policy limits are in fact a moving target. Whether rates stay put, continue to increase, or possibly head back down, the same rate shocks performed in years past look much different in today’s higher environment.
First, it is important to acknowledge that not all A/LM policies are created equal. Some credit unions choose to focus on 300 basis point (bp) movement in rates while others may focus on rate changes beyond a traditional 300 bp movement. While every credit union needs to reach agreement on their own appetite for risk, we will use a 300 bp movement here to illustrate how policy IRR tests are changing.
For example, the table below reflects the changing rate environment. From 2009 to 2016, short-term market interest rates were essentially 0%. This means simulating a 300 bp increase in rates resulted in a 3% simulated short-term rate environment. With short-term market interest rates now at roughly 2%, that same 300 bp increase takes rates to a 5% simulated environment.
Why is this important to understand? Think about your credit union’s balance sheet. What is the auto portfolio yielding? How about the investments purchased over the past few years? Then consider how long before these lower yielding assets run off the books.
The difficult reality for many credit unions is that the lower yielding fixed-rate assets on the books just don’t perform as well in a 5% post-shock environment, versus a 3% or 4% post-shock environment. Naturally, the results of the IRR analysis may not look as favorable and could cause the credit union to run up against their IRR risk limits. The policy environment being tested is moving higher because the base rate environment is higher, therefore the IRR tests are getting more difficult.
The policy environment being tested is moving higher because the base rate environment is higher, therefore the IRR tests are getting more difficult.
The best thing credit unions can do in this challenging environment is to talk about it and not panic. If the IRR risk limits are becoming more of a concern, view it as a positive. The policy must be doing its job, making sure the institution is not on cruise control in a changing rate environment. As IRR requires more active management, ALCOs can consider a variety of options and perform what-if analysis to address policy concerns.
While every forecast has the ability to be wrong, the Federal Reserve Bank projects that the Federal Funds target rate could be 3% in 2019. You might already be doing the math and yes, that would take a 300 bp increase to a 6% short-term rate environment.
If you are concerned that interest rates will continue to increase, then it can be helpful to see an early warning of risks in the higher rate environments, before current rates move again. This advanced view is a big plus as it provides decision-makers more time to think and plan should rates continue to increase.
This early warning can help decision-makers understand, in advance, if there is significant risk in the higher environments and balance that with the reality that rates could stay the same or go down.