Posts

/by

Interest Rate Risk Policy Limits: One Big Misconception

,

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.

-30% NII volatility risk limit policy vs. ROA

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 using NCUA data as of 3Q/2015.

On average, if this group of credit unions experienced a 30% decline in NII in a +300 bp shock, the resulting ROA would be 6 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.

ROA for credit unions with assets >$1 billion
It is important to note that 46% 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.

/by

Concentration Risk in Non-Interest Income?

NCUA cited the Basel Committee on Banking Supervision when defining concentration risk in NCUA Supervisory Letter – Concentration Risk:

“A risk concentration is any single exposure or group of exposures with the potential to produce losses large enough (relative to capital, total assets, or overall risk level) to threaten a financial institution’s health or ability to maintain its core operations.”

In evaluating the level of concentration risk present in a credit union’s financial structure, many approaches – including the current risk-based capital proposal – operate under the assumption that the material risk to net worth resides in the asset structure of the balance sheet. Managing concentration risk by setting limits on only the balance sheet components of a credit union’s structure falls far short of addressing risk concentrations – which is any exposure that could threaten the ability of a credit union to continue “business as usual.” A reliance on non-interest income to generate earnings may expose many credit unions to the potential for large losses.

In our experience working with hundreds of credit unions, a significant portion of non-interest income (often well in excess of 50%) is derived from interchange revenue, overdraft/courtesy pay and mortgage origination/gains on sale. Even though some battles over interchange income have settled, the risk of non-interest income dropping materially in the future still remains. Consider the impact to earnings and net worth if courtesy pay/overdraft income is considerably altered in the name of consumer protection or if mortgage originations continue their sharp decline.

While the most recent economic downturn was certainly driven by asset-based credit risk exposures, an effective concentration risk management process, and (even more importantly) an effective aggregate risk management process, should include an evaluation of any material exposure that could threaten net worth. Because the ability of a credit union to raise and maintain capital levels is directly related to its ability to generate earnings, any exposure that materially impacts earnings could adversely impact capital levels. Concentration risk policies and procedures that overlook the impact of threats to non-interest income sources may lack a key component to addressing all material threats to net worth.

/by

c. bit: Please don’t “Frankenstein” your Asset/Liability Management Policy

Over the years we have reviewed many credit union A/LM policies. One of the biggest issues we’ve found is that often the policies are “Frankensteined” from various sources. We are reminded of this currently as credit unions are writing policy with respect to liquidity management and contingency funding plans.

Why does this happen? Our theory is twofold.

First, nobody wants to reinvent the wheel when it comes to A/LM policy. Let’s face it – policy writing is tedious. An informal survey of CFOs showed that many would equate writing a policy to having a root canal.

Second, quite often people wait until the last minute to put the policy together. So what do they do? A web search or call their credit union friends and ask for a copy of their policies.

The result is a “Frankensteined” policy that often has many conflicts throughout. And, because people are in a hurry, they don’t really think critically about what they are committing to do in policy. This can result in a distasteful experience if an examiner reads the policy start to finish.

If you are reviewing your policies as part of your normal cycle or updating them to include liquidity management and a contingency funding plan – please take the time to thoroughly review your policy to help ensure it reflects the true tolerances of your board and that there are no conflicts.

/by

Excerpt: The New IRR Rule – Be Prepared

The National Credit Union Administration recently issued its final rule requiring “federally insured credit unions to develop and adopt a written policy on interest rate risk management and a program to effectively implement that policy, as part of their asset liability management responsibilities.  The interest rate risk policy and implementation program will be among the factors NCUA will consider in determining a credit union’s insurability” (p. 5,155).

“Interest Rate Risk Policy and Program Final Rule” is effective as of Sept. 30.  Credit unions over $50 million in assets are required to have a written interest rate risk policy and an effective IRR program.  Credit unions over $500 million can expect their IRR policies and processes to be put under a microscope.  Credit unions from $10 million to $50 million with first mortgage loans and long-term investments equal to, or exceeding, 100 percent of net worth are subject to these new rules as well.

While we are not proponents of more regulation, this new rule provides a great opportunity – even if it is forced – for credit union managements and boards to ensure they are on the same page with respect to appetite for risk, risk quantification methodology and process.  The timing could not be better as we sit in the lowest rate environment our financial markets have experienced since the 1950s.

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

/by

The CFPB Starts Flexing Its Muscles

The CFPB is coming online and has begun proposing rules and examining financial institutions.  While questions still abound on the bureau’s stance and operations, credit unions should consider the potential impact of new regulations.  For example, most credit unions weathered overdraft protection regulations fairly well by getting members to opt-in.  However, the CFPB is currently examining the policies and practices of the nine largest banks to see if additional regulation is necessary (Office of Information and Regulatory Affairs and Consumer Financial Protection Bureau).  Depending on the findings, income from overdrafts could be under threat.

Mortgage statements are another example.  The CFPB has stated that it would like to increase transparency in the mortgage servicing industry.  To do this, it is proposing regulations for monthly mortgage statements that would include alerts for delinquent borrowings with information for housing counselors and options to avoid foreclosures.  For adjustable rate mortgages, institutions would have to send warnings of interest rate adjustments and list alternatives consumers can pursue to avoid the adjustment (CFPB Seeks to Enhance Consumer Protections by Targeting the Mortgage Servicing Sector, National Mortgage Professional Magazine, April 2012).  Such changes can increase expenses as a result of changing the statements as well as the possibility of additional paper and postage from warnings depending on how the regulation is worded.

While the CFPB has said it will consider credit unions’ unique needs, the cost of compliance could likely increase as a result of new regulations.