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Interest Rate Risk Policy Limits: One Big Misconception

We initially published the blog below on January 28, 2016.  With interest rates having increased recently – and more increases seemingly on the horizon – we thought this a good topic to revisit as it has been coming up in model validations we complete.

We often see interest rate risk policy limits that rely too much on net interest income (NII) volatility and miss the absolute bottom-line exposure. Such reliance can cause boards and managements to unintentionally take on more risk than they intended.  Why?  Because these types of policy limits ignore strategy levers below the margin.

Establishing risk limits on only part of the financial structure is a common reason for why risks are not appropriately seen. Setting a risk limit focused on NII volatility does not consider the entire financial structure and can lead to unintended consequences.

For example, assume a credit union has a 12-month NII volatility risk limit of -30% in a +300 environment. The table below outlines their current situation and the margin and ROA they would be approving, as defined by policy, in a +300 bp rate shock.

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By definition, the credit union is still within policy from an NII perspective but because of the drop in NII, ROA has now decreased from a positive 0.50% to a negative 0.43%. This example helps demonstrate that stopping at the margin when defining risk limits can result in a false sense of security.

Not All 30% Declines are Created Equal

To punctuate the point, let’s apply the 30% volatility limit to credit unions over $1 billion in assets.

On average, if this group of credit unions experienced a 30% decline in NII in a +300 bp shock, the resulting ROA would be 3 bps.

But each credit union’s business model and strategy are unique. So instead of looking at the average for this group, let’s look at the potential range of outcomes.

 Based on NCUA data as of 3Q/2016, excluding one credit union that had an exceptionally negative ROA

It is important to note that 47% of all credit unions with assets over $1 billion would have a negative ROA within 12 months if this volatility were to occur.

This enormous range of ROA, and with so many credit unions at risk of negative earnings, helps demonstrate that an interest rate risk limit along these lines could result in material risk with the unintended consequence of institutions being potentially blinded to the exposure of losses.

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Policy Limits And The Proposed Regulation For IRR

The following is an excerpt from our response to NCUA’s proposed regulation on IRR.  While the excerpt focuses on a potential issue with the proposed regulation, it also highlights a concern we have with the way certain policy limits are written that don’t look at the actual risk of an institution.

Appropriate Policy Limits

Another concern is the evaluation of appropriate policy limits to ensure “compliance” with the regulation.  The proposed regulation states:

  • Set risk limits for IRR exposures based on selected measures (e.g. limits for changes [emphasis ours] in repricing or duration gaps, income simulation, asset valuation, or net economic value); (Federal Register, Page 16575).

While NCUA has stated in the proposed regulation that these are examples of the types of limits to set and how to set them, the concern is that these examples will become the rule.

Our question is:  Why the focus on percent change versus focusing on the actual risk?

If a line in the sand is never drawn, then as long as a credit union continues to be within the percent change they identified, it would be acceptable for their risk profile to continue to deteriorate.  Also, these types of limits don’t address if the credit union has an adequate net worth ratio.

Consider the following example if the guidance NCUA provides to examiners regarding this proposed regulation is similar to that in the below excerpt from the IRR Questionnaire (click on image to see Table A):


If a credit union has a 1.00% ROA, to maintain a “moderate” level of risk to earnings, the ROA can’t fall below 0.25% (maximum 75% decline) in a 300bp change.  Whereas, a credit union with a 0.40% ROA can have their earnings drop to 0.10%.   What if, at the time of the next simulation, the credit union with a 1.00% ROA is at 1.25%?  Then their ROA can’t fall below 0.31%.  If the credit union that was earning 0.40% now earns 0.30%, then their earnings can’t fall below 0.08%.

In essence, using the percent change methodology, if an institution’s earnings increase in the future, the bar is raised.  Conversely, if earnings drop in the future, the bar is lowered.  Is this really a good measure of safety and soundness?

Additionally, a percent decline approach applied to earnings would never allow a credit union with positive earnings to make the business decision to allow for negative earnings.  There are several cases where external forces or strategic plans make negative earnings in the short term a reality in order to balance the long-term viability of the organization.

Using these guidelines would put any credit union with negative earnings out of policy.  Does that mean that every credit union losing money would automatically be “out of compliance”?  Note that, in 2010, approximately 40% of all credit unions had negative earnings after factoring additional NCUSIF expense.  The potential ramification of this path could be detrimental to the industry.

To see our full response, please click here.