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Recent Uncertainty Highlights The Importance of Evaluating Strategic Net Worth Requirements

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The rapidly changing competitive environment and recent natural disasters are reminders of the importance of evaluating strategic net worth requirements.

Natural disasters, like the recent string of hurricanes that impacted the country, contribute to uncertainty and highlights the need to evaluate strategic net worth requirements.

A key component to understanding strategic net worth requirements is taking a deliberate approach to understanding aggregate risk.  In a previous blog post we outlined an approach to help with this process.

Two types of risks that should be included in any effective aggregate risk process are interest rate risk and credit risk.  While these two key risks need to be addressed, growing concerns on strategic risks to future earnings streams should also be discussed and incorporated into the aggregate risk estimate.

For instance, think about the potential reduction in future earnings as consumer usage of real-time financial management self-service alerts that can curb their spending increases.  And options for how consumers pay for their purchases continue to rapidly expand beyond the traditional financial services industry – Amazon could be the next big player in this space.

The Current Expected Credit Losses (CECL) standard is another example of how the environment is changing.  CECL should not be viewed as just an accounting issue because it has the potential to impact both earnings and net worth.  While 2021 may seem like a lifetime away, it is critical that decision-makers understand their credit union’s capacity to handle the impact of CECL.

Remember that being within individual risk limits does not necessarily indicate that the credit union is safe and sound.  As history repeatedly teaches us, bad things don’t usually happen in isolation.  The few pressures described above can occur while an unforeseen event comes out of left field, such as the Equifax data breach.

Another example of an unforeseen event is the string of natural disasters that have impacted the country in the past few months.  For those affected, it is still too early to understand the fallout from these events.  However, it is an unfortunate reminder that the unexpected can happen, and the net worth needs to be able to handle multiple risks happening simultaneously or bear the brunt of cascading events.

None of the risks above are easy to quantify, but that doesn’t mean risks should not be aggregated to gain an understanding of the aggregate risks relative to net worth.  Starting with a list of your management teams’ top concerns is a great way to get the ball rolling.  Keep in mind that the chance of being “exactly right” on your credit union’s aggregate risks is slim to none.  The value is in the strategic discussions and the allocation of net worth to strategic threats and unforeseen events.

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Strategic Budgeting/Forecasting Questions: Linking the Appetite for Risk

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The fifth entry in our 6 blog series about Strategic Budgeting/Forecasting Questions addresses the institution’s appetite for risk and how it should connect to the budget or forecast.

Question 5 – How is the budget and forecasting linking to our appetite for risk?

A few short months from now, every credit union will be going through the annual ritual of creating a budget for 2018.  Many leaders and boards not only struggle with this process, but may also consider it a drain on resources and time that take away from more important day-to-day business.  And yet, looked at from a long-term strategic view of the organization, strategic budgeting and forecasting is a key component of a high functioning organization.  Even so, one way boards and credit union leaders can make this coming year’s budget even more effective is to align the budget and forecasting with the credit union’s appetite for risk.

Step back and think through last year’s budgeting process and ask yourself some of the following questions:

  • Did you adequately capture the credit union’s appetite for risk and align the budget to support that appetite?
  • What are your concerns (both internally and externally) and are they being appropriately built into the budget?
  • Are your forecasts aligned with the risks that the credit union is willing to take?

Take, for example, a credit union that goes through a typical “Appetite for Risk” exercise and arrives at the end of the exercise realizing that there are some opportunities to take on additional interest rate and credit risk.  Further, consider that this credit union, like many others, wants to maintain their current earnings.  Given the relevancy concerns noted in the following table, taking on some of this credit risk might well serve some of the needs this credit union has.

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As you put yourself in this credit union’s shoes, consider some specific challenges that will play into their budget as they look to align their risk tolerances with their annual forecasts:

  • Does the budget account for potential increases in lower quality paper and additional losses from bringing on more credit challenges?
  • Do the yields on these loans adequately cover the additional risk the credit union is willing to bring on and are they being built into the budget?
  • If this credit union decides to combine some additional credit risk with some additional interest rate risk, will either of these impact the credit union’s current earnings?

Now, imagine if you have already walked through the multiple steps and questions required to analyze taking on additional credit or interest rate risk and you feel well positioned to move forward and finalize your budget.  Additionally, you feel as though you’ve fully vetted the budget for any potential weaknesses and believe that it’s aligned both with the credit union’s current strategy and appetite for risk.  At that point, the next logical question then becomes:  What’s next?  How do you really know if your budget and the things you are planning for are aligning with the appetite for risk?

Outside of letting the budget play itself out and seeing if it comes to fruition, one effective way of analyzing its potential impact on the organization is to test the budget and its assumptions in your risk model.  To do this, have the starting point of the risk model be the ending targets of the forecast.  This process can help you evaluate whether the forecast is adding too much risk or leaving room for more risk, enabling decision-makers to see and sign off on the potential risk before it is actually added to the structure.  It goes without saying, but it’s a lot easier to say no to a budget ahead of time than it is to unwind risks after they are added to the structure.

In effect, a process of presenting a budget along with the simulated risk, enables you to rehearse tomorrow today.  Doing so will position the credit union to be in a much better strategic position going forward.

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Derivatives – Another Option For Helping Mitigate Interest Rate Risk

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The Federal Reserve signaled their expectation to continue Fed Funds rate increases in 2017, but substantial uncertainty remains about when and where market rates will move.  Credit unions can find it challenging to achieve a desirable ROA today while maintaining an acceptable level of risk should market rates increase.  Decision-makers have a variety of options available for attacking interest rate risk challenges, and derivatives can be another useful arrow in the ALCO quiver.

Some of our clients are using or considering derivatives as a tool for mitigating interest rate risk.  While c. myers does not sell derivatives, we regularly model their impact on our clients’ financial structures to show the risk and reward trade-offs.

Derivatives can be thought of as purchasing insurance.  As an example, consider your purchase of an auto insurance policy.  You pay a premium to provide protection for your car from accidents, theft, etc.  The premium may be paid over the course of years.  If the car is never damaged or stolen, the insurance protection is never used or realized.  Overall of course, you’re probably happy that the insurance wasn’t needed.  Was the insurance valuable?  Was it worthwhile?

Derivatives operate similarly to protect against interest rate risk.  There are a variety of derivatives available to credit unions.  To illustrate some of the key attributes, let’s consider caps and swaps.

A cap is insurance purchased for a fixed price up front and provides protection for a specific time frame (the term) for market rates that go above a specific level (the strike rate).  Credit unions establish a notional balance, say $100 million, which never exchanges hands but is used like a principal balance for determining the interest payments.  If market rates increase to a point where they exceed the strike rate, the difference between the market rate and the strike rate is applied against the notional balance and paid to the credit union.  The cost of this insurance is largely determined based on the strike rate and term desired by the credit union, but again it is known and fixed up front.

Unlike a cap, an interest rate swap is not purchased for a fixed price.  In fact, there is no up-front cost for the swap.  Rather, two parties agree to pay each other different interest rates on a given notional amount for the term of the swap.  One party will pay a fixed rate, while the other will pay a variable rate based on an index such as LIBOR.  The idea is that as market rates increase, the variable rate could at some point exceed the fixed rate payment and offer protection to the fixed rate payer.  Consider the following interest rate swap example with a notional amount of $100 million, where the credit union pays a fixed 2.25% rate and receives
1-month LIBOR.

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In this example, for simplification, an instantaneous rate change was assumed.  However, the timing and direction of market rate changes will ultimately determine the resulting cost or benefit of the swap over its term.

Derivatives can be a valuable tool for credit unions to consider within their interest rate risk management strategy.  When deciding whether to use derivatives, it is important to understand both the expected interest rate risk protection, as well as the potential costs within a range of rate environments.  It also makes sense to ask how the protection may change over time and whether there are circumstances that might make the protection not as valuable.  For more detailed information about derivatives and understanding key considerations, please see our c. notes paper, Considering Derivatives?

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Interest Rate Risk Management: Timing of Earnings Matters

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Would it surprise you that some interest rate risk mitigation strategies actually add risk for a period of time?  In the end, these strategies may be effective at mitigating interest rate risk but it may take years for the effectiveness to be felt.  The challenge is that many methods used to test mitigation options, like NEV, don’t show decision-makers the full picture.  The reality is that earnings and the timing of earnings matter when understanding the impact of different decisions.

Take for example, a credit union that decides to sell $90.0 million of its 30-year fixed rate mortgages earning 3.61% and reinvest in auto participations earning 1.90% to mitigate interest rate risk.  No surprise that such a move hurts earnings today.  In fact, it would hurt earnings by 23 bps.

What is not obvious, though, is that in a +300 bp interest rate environment they would give up more cumulative revenue with a strategy to hold auto participations than with a strategy to hold fixed-rate mortgages over a four-year time horizon.  Year-by-year and cumulative revenues for both strategies are summarized below:

The credit union would earn more revenue holding fixed-rate mortgages than holding auto participations for each of the next three years.  It is not until Year 4 that the strategy change pays off and they earn more holding auto participations.  Over the four-year period, the credit union would earn a cumulative $15.0 million with mortgages versus $13.5 million with auto participations in the +300 bp increase.  Timing of earnings matters.

Using only NEV to evaluate this strategy might lead the credit union to pull the trigger on it.  In this case, the credit union is using NCUA’s NMS values from the NEV Supervisory Test.  When comparing the proposed strategy to the base, the NEV in the current rate environment is unchanged at 10.75% – meaning the restructure neither helps nor hurts the current NEV.

However, after selling the mortgages, the volatility decreased in the +300 bp environment leaving a higher NEV ratio (see example above).  An added benefit is that the credit union would now be considered low risk under NCUA’s NEV Supervisory Test thresholds.  Said differently, the NEV results show decision-makers would not have to sacrifice a thing in the current rate environment while significantly reducing risk in a +300 bp interest rate change.

Earnings (see Beginning ROA), on the other hand, show there is sacrifice in the current rate environment and more risk to earnings and net worth in a +300 bp rate environment over a four-year time frame.

The moral of this story is not that all credit unions should always hold mortgages because they will earn more than other alternatives.  Certainly, not.  It should be clear, though, that NEV provides credit union decision-makers with a limited picture.  Earnings and the timing of earnings matter.  In this particular example, the credit union may decide to execute the strategy, but decision-makers understand, in advance, that even if interest rates rise quickly, it could take about four years before the alternative strategy will contribute positive earnings and start to reduce interest rate risk.

For more in-depth ways to use ALM as actionable business intelligence, please click here for our c. notes.

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The Importance of Isolating Variables within Stress Tests

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Stress testing is an important function of long-term interest rate risk modeling and risk management processes. As with any long-term interest rate modeling, stress testing requires both skill as well as an ability to fully understand and determine which assumptions influence the outputs and which assumptions are driving the results of the stress test.

During a recent model validation we performed, the importance of isolating variables within stress testing was punctuated once again. The objective of this particular stress test was to understand the impact widening credit spreads would have on asset valuations within the net economic value (NEV) simulation. In looking at the impact of widening the credit spreads, we observed that the overall NEV ratio was not as adversely impacted as one would have expected and as the asset devaluation would have implied.

Given that the overall results were not adding up, a deeper dive into the inputs was necessary. In analyzing the inputs, we discovered the model setting that widened the credit spreads on the assets had also increased the rates on the borrowing yield curve, which were being used to value non-maturity deposits (NMDs). The increase in the borrowing yield curve rates was thereby offsetting the asset devaluation caused by widening the credit spreads.

It is perhaps both reasonable and defendable to say that an increase in asset credit spreads could also be strongly correlated with an increase in borrowing rates. Indeed, both the science and math behind this stress test could be wholly appropriate. That said, however, increasing the rates on the borrowing yield curve unnecessarily detracted from both the spirit and objective of the stress test, which was to understand the impact widening the credit spreads would have on asset valuations.

The importance, therefore, of isolating variables when running stress tests and doing sensitivity analysis cannot be underestimated. It is both a science and an art, and interpreting whether the results of the stress test accomplish the objective and make sense should not be lost within the analysis.