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Some Examiner Requests Conflict With Written Guidance – Make Sure to Get Clarity of Reasoning

We are curious as to why some examiners are requesting that credit unions establish risk limits based on 12-month net income simulations.

This request is interesting in light of what was outlined in the Interagency Advisory on Interest Rate Risk Management.  The guidance states:  “When using earnings simulation models, IRR exposures are best projected over at least a two-year period.”  The guidance goes on to say:  “However, to fully assess the impacts of certain products with embedded options, longer time horizons of five to seven years are typically needed.”

If your examiner requests that you establish risk limits based on a 12-month simulation, consider asking:  “How will managing risks with such a short-term view protect our credit union and the insurance fund, especially in light of historically low interest rates?”

Your examiner may counter by saying they use NEV to look long-term.  However, remember that NEV is defined as the fair value of assets minus the fair value of liabilities and tells you nothing about your earnings today or how they can change as rates change.

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Weighing Credit Union Investment Strategies

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Given the flight to safety combined with sustained low loan demand, threats to non-interest income and NCUSIF assessments, many credit unions are reevaluating their investment strategy.

The problem is not enough credit unions are evaluating their investment strategy in light of their entire financial structure and strategic objectives.  They are evaluating one investment at a time. In other words, this investment seems to be a good deal today. But how long will it be a good deal?  And, if/when the decision needs to be unwound, what will be the viable options?  How does it fit with the credit union’s strategic objectives and financial structure?

Let’s take an example using callable bonds.  We are seeing credit unions purchase callable bonds with final maturities of 10 and 15 years.  The reasoning too often is, we need to do something, and they are going to be called anyway, so we may as well get the extra yield today.

Typically, people say they will sell it before rates become unfavorable, therefore they won’t be stuck with it.  The only reliable way that this could happen is if the credit union could accurately forecast rates.  A strategy assuming that you know what will happen in the market, before the market occurs, is fraught with danger and has burned many institutions.

Some say that if rates go up they won’t need to sell low-yielding investments because loan demand will be so good, the yields on new loans will offset the risk of the lower-yielding investments.  This could happen.  However, it is important to keep in mind that rates can go up without economic recovery.

Stating the obvious, there is a tremendous amount of uncertainty—there always has been.  Yet decisions have to be made.  Just make sure your decision framework is sound.  Stick with the basics:

  • Make decisions in light of your entire financial structure.
  • Agree on how long you are willing to live with your decision if things don’t go as planned.  In the above example, answer:  are we willing to live with this decision for the next 10 or 15 years?  If not, how are we going to know it is time to unwind before it results in unacceptable risk for our credit union? This thought process should be followed when making any decision with potential long-term consequences.
  • Don’t assume that the future will be brighter or more forgiving than the present.  Isn’t that part of the mindset that got us here in the first place?
  • Document the rationale for major decisions.  Memories are short, so it’s important that key players remember why the decision was made in the first place.  Especially if the changes in the environment result in unfavorable financial performance.
  • Test drive your investment strategy before you implement it by using your A/LM model.  Don’t just look up +300 basis points either.  Remember, rates were 500 basis points higher just three years ago.  By rehearsing tomorrow today, you can understand the potential risk of what you are buying and can decide if that risk is worth today’s reward.
  • Agree on your appetite for risk for your entire enterprise, stick with it and manage to it.

This writing is not intended to say that callable bonds are bad, we are using them for example purposes only.  Our philosophy is that every decision has a trade-off; it is critical to understand the trade-off before implementing decisions.  It is up to decision makers to understand how each investment they purchase works not only today, but as the environment changes.  Decision makers must also understand how investments complement or compound issues in their entire financial structure and risk profile.