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Some Examiner Requests Conflict With Written Guidance – Make Sure to Get Clarity of Reasoning

We are curious as to why some examiners are requesting that credit unions establish risk limits based on 12-month net income simulations.

This request is interesting in light of what was outlined in the Interagency Advisory on Interest Rate Risk Management.  The guidance states:  “When using earnings simulation models, IRR exposures are best projected over at least a two-year period.”  The guidance goes on to say:  “However, to fully assess the impacts of certain products with embedded options, longer time horizons of five to seven years are typically needed.”

If your examiner requests that you establish risk limits based on a 12-month simulation, consider asking:  “How will managing risks with such a short-term view protect our credit union and the insurance fund, especially in light of historically low interest rates?”

Your examiner may counter by saying they use NEV to look long-term.  However, remember that NEV is defined as the fair value of assets minus the fair value of liabilities and tells you nothing about your earnings today or how they can change as rates change.

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Proposed IRR Regulation Could Have Unintended Consequences

C. myers agrees with the objective that most institutions should have an effective interest rate risk (IRR) management policy supported by an effective IRR program.  However, we do not agree that it should be regulation.

Keep in mind as you read our comments that our business is to provide asset/liability management services to financial institutions.  We have worked with hundreds of credit unions providing long-term risks to earnings and net worth simulations, static and dynamic balance sheet analyses and net economic value (NEV) simulations.  A regulation of this nature would likely materially increase our business opportunities, yet we do not believe it is in the best, long-term interest of the industry.

One primary reason that we do not support the proposed regulation is that it is ambiguous.  We understand this ambiguity is necessary.  However, ambiguity will lead to subjectivity when implementing the regulation.  Whether a credit union has a written policy with adequate limits and an effective program addressing IRR may ultimately be determined by each credit union’s most recent examiner.

Please click here to read our full response to the proposed IRR regulation.

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Caution: NCUA’s Proposed Regulation On IRR Could Have Unintended Consequences

You think you are already doing everything required in the proposed Regulation.  You think your policy limits are appropriate for your strategy and business model—but will the examiner making the judgment as to whether your credit union is in compliance think the same?

NCUA’s proposed shift from Advisory to Regulation is concerning.

It raises several questions, such as:

  • What power will NCUA gain that they don’t currently have by implementing a Regulation on IRR management?
  • How will NCUA change their approach in the exam process once this Regulation is implemented?  If NCUA says there will not be a significant change in their approach, then why is there a proposal to shift from Advisory to Regulation?  In other words, what problem is NCUA trying to correct?
  • If the board believes the policy limits are adequate and they are managing to those limits, yet the examiner believes otherwise, will the credit union be deemed out of compliance with Regulation?
  • If so, what are the credit union’s options under this new Regulation?  Specifically, what options or control will the credit union no longer have once the Regulation is implemented?
  • Under the umbrella of the Regulation, will the examiner be able to require the credit union to conduct additional analyses or else be deemed out of compliance, even if the credit union feels the cost/benefit would not exist?

We agree with much of the underlying intent of the proposed Regulation.  We also agree with NCUA that it is impossible to establish specific regulatory requirements.  Therefore, by necessity, the proposed Regulation is ambiguous.  Ambiguity creates confusion and will make the Regulation difficult to reasonably implement.

If there is no identified, compelling reason to go from an Advisory to Regulation, then why do it?

Keep in mind as you contemplate our comments that our business is to provide asset/liability management services to financial institutions.  A Regulation of this type could greatly enhance our business opportunities, yet we believe that NCUA shifting from an Advisory position to a Regulation is wrought with undesirable, unintended consequences.

To read our full response, please click here.

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Establishing Concentration Limits

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Establishing concentration limits that enable you to make sustainable, sound business decisions while trying to satisfy new regulatory pressure is very tricky.

The supervisory letter on concentration risk states that examples of concentrations within an asset class include…

“Residential Real Estate Loans—collateral type, lien position, geographic area, non-traditional terms (such as interest-only, payment option, or balloon payment), fixed or variable interest rates, low or reduced underwriting documentation, and loan-to-value (LTV).”

If you are contemplating multifactor concentration limits as described above, consider the following example and how this approach could impact your strategy and business decisions.

Let’s assume:

8 real estate types, with
4 different LTV ranges for
20 ZIP codes (geographic areas) and
6 credit score ranges, would result in

3,840 total risk limits for the Residential Real Estate Loans

Keep in mind the above example is just for Residential Real Estate.  Imagine applying the same multifactor approach to other asset categories.  The number of limits can become daunting and unmanageable.

We recommend listing every limit on a single piece of paper to help decision makers understand the magnitude of their potential policy commitments.

Slicing and dicing portfolios absolutely is a key component of portfolio analysis and risk management.  However, we are concerned that the establishment of these limits in policy is being rushed in anticipation of the next exam or, during the exam process, examiners are pressuring credit unions to establish concentration limits quickly.

Rushing to establish concentration limits without appropriate analysis, including potential impact to strategy and business model, could result in unintended consequences with serious implications.  Not to mention the red flag noted in the supervisory letter regarding changing concentration limits if a credit union is outside of policy.

We highly recommend following a deliberate process to establish limits.  Test drive your limits under various economic scenarios to understand, in advance, how they will impact strategy and business decisions.  This includes the changes that may be necessary to the credit union’s business model in order to manage within the new limits.

This blog addresses only a sliver of the issues regarding concentration limits.  There certainly will be more to follow, such as the correlation between the speed with which concentration increases and poor financial performance.