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Excerpt: A Few Things To Consider Before Purchasing A Derivative

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While many credit unions work on what seems to be a more immediate issue – increasing loan volume – it is important not to forget the looming issue of interest rate risk. Rates have been at historically low levels since the end of 2008 and the Federal Reserve has indicated it expects rates to remain low into 2015. We have said it a thousand times: The longer rates stay at these historically low levels, the more interest rate risk will be added to credit union financial structures (all else equal).

Concern over IRR was recently put front and center with the implementation of NCUA’s new Interest Rate Risk Policy and Program, and it has been a consistent message at conferences that this is one of NCUA’s top priorities. One tool available to credit unions for managing IRR is a derivative. NCUA has made derivatives available to credit unions through a pilot program since 1998. However, few credit unions have participated. Over the last couple of years NCUA has asked for public comment on the issue of expanding credit union access to derivatives. Additionally, NCUA said in a joint town hall meeting (2/5/13) with the Consumer Financial Protection Bureau that a proposed rule on derivatives could be released in the first half of 2013. While no specific changes were described, the intent of the pending proposed rule will be to make it easier for credit unions to purchase derivatives.

While derivatives can be an effective risk-mitigating tool, we encourage credit unions to thoroughly understand the accounting and financial implications before purchasing a derivative. The main objective of this article is to raise questions about financial impacts credit union boards and managements should consider before purchasing derivatives, not to lay out the accounting treatment.

To read the full c. notes article, please see our c. notes page, available here.

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Operational Efficiency—Improving Earnings And Member Experiences While Driving Increases In Net Worth Dollars

In comments surrounding the new rule on Interest Rate Risk, the NCUA states that, “net worth is the best measure against which to gauge a credit union’s risk exposure.”  As credit unions are looking to improve earnings and grow net worth dollars in this historically low interest rate environment, yield on assets and cost of funds are only 2 of the 5 strategy levers that credit unions can pull.  In order to have an effective IRR management program, ALL levers that impact earnings and net worth should be evaluated, including operating expense, provision for loan loss and fee/other income.

Bottom-line results can be realized by evaluating operating expenses for operational efficiencies.  However, operational efficiency not only means looking for ways to cut expenses, it also includes evaluating current processes and practices to ensure that no opportunity to generate revenue is left behind.  For example:

  • Do your loan processes allow you to effectively capture every loan that you want to fund, or do inefficiencies in the process cause members seeking loans to ultimately go elsewhere?
  • Can your front line effectively turn interactions with your membership into educational or cross-sale opportunities, when appropriate, that deepen member relationships and enhance the member experience?
  • Does your in-branch advertising reflect the tactical (short-term) and strategic (long-term) objectives of the credit union?  If the credit union is targeting loan growth, are loan rates and promotions more prominently displayed and emphasized than current deposit rates?

Finding ways to revamp processes can improve member interactions and provide employees additional time that can be used to enhance member service or develop other areas of the credit union’s business.  Additionally, ensuring that the credit union is effectively utilizing its sources of revenue is just as important to operational efficiency as cutting un-needed expenses.

The creation of operational efficiencies in your structure can have a positive impact on earnings in all interest rate environments, which is an excellent way to drive increases in net worth without taking on additional risks.

Source:  Interest Rate Risk Policy and Program, NCUA, 2/3/12
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How Do You Know Your Modeling Assumptions Are Right?

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Interest rate risk modeling requires the user to make assumptions about member and management/board behavior.  For example, some members will pay back their loans ahead of schedule and the rate of prepayment will increase if rates fall and decrease if rates go up, especially on mortgage-related products.  Likewise, the incentive for members to move some of their deposits from lower-cost products, such as regular shares, to higher-yielding CDs increases when rates go up (note: static income simulation ignores this important aspect of IRR management).  Assumptions must be made about the likelihood of these events occurring in the future.

Has your examiner asked “how do you know your modeling assumptions are right?”  If so, you answered correctly if you said you don’t.  Assumptions, as the name implies, are assumptions.  They are not facts.  A prepayment speed on a loan can be calculated with certainty when the prepayment occurs.  To put that prepayment speed into a model assumes that behavior will continue, but it may not.  How that behavior changes when interest rate changes is yet another assumption.  Despite this, the assumptions are an important and necessary part of modeling a credit union’s IRR exposure.

The new IRR rule, 12 CFR Part 741, Interest Rate Risk Policy and Program, says assumptions should be “reasonable and supportable” and that credit unions should “assess the sensitivity of results relative to each key assumption.”  We agree with these comments and work with our clients to develop reasonable assumptions, yet we realize there is no right assumption.  Therefore, we conduct literally thousands of stress tests annually to help our clients understand the impact of their assumptions to their IRR exposure.  For example, we often stress test early withdrawal speeds by making them 50% faster than what is in the base simulation.  Whether you are a client of ours or not, a recommended approach is to stress test assumptions to see how they may impact results.  Assumptions that have a material impact may require additional research and refinement whereas others may not.

The bottom line is stress testing and documenting—followed by assumption adjustments if appropriate—should help to satisfy the “reasonable and supportable” component of the new rule.