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Danger of Policy Limits on Net Interest Income

Establishing risk limits on only part of the financial structure is a common reason for why risks are not appropriately managed. Setting a risk limit focused on net interest income (NII) volatility does not consider the entire financial structure and can lead to bloated operating expense structures.

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 simulated results in a +300:

The credit union performance in a +300 environment reflects a decrease in margin from 3.10% to 2.17%. This is a decrease in NII of 0.93% or a 30% decline in NII. Because of the drop in NII, ROA has now decreased from a positive 0.50% to a negative 0.43%.

The credit union is still within policy from an NII perspective but earnings decreased 0.93% and ROA is now negative in a +300 environment.

The risk of the credit union was not appropriately managed by neglecting to consider strategy levers below the margin and being overly focused on the change in risk versus the level of risk.

A board-approved policy that ignores operating expenses can lead decision-makers to take on more risk to earnings and net worth than they are truly comfortable taking.

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Proposed Interest Rate Risk Regulation

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Newly proposed regulations would require federally insured credit unions to not only have an effective interest rate risk management program, but also a written policy addressing interest rate risk management.  The NCUA has taken this step due to concerns about the level of interest rate risk being taken by many institutions, as material concentrations in long-term, fixed-rate assets continue to be booked in this historically low rate environment—funded largely by short-term deposits.

Most often, managements and boards establish limits at the category or portfolio level, not at the enterprise/aggregate level.  It is not uncommon to see a credit union within their individual category or portfolio levels, yet have a relatively high level of risk at the enterprise level.  In other words, the combination of the individual risks can create an undesirable, aggregate risk profile.  Therefore, agreeing on and managing to aggregate risk levels is a key component of an effective risk management process.  However, establishing aggregate risk limits that make sense from a business perspective, as well as from a safety and soundness perspective, requires in-depth discussions and critical thinking.

These limits can also be a critical driver of financial success both today and as rates change.  So take your time and think it through.

While we believe it is prudent for decision makers to establish enterprise/aggregate risk limits, it is not intended as an endorsement for the proposed regulation.  We will write more on the proposed regulation soon.