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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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We Are Outside of Our A/LM Risk Limits. Should We Change Them?

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There is tremendous pressure on earnings from increasing costs due to regulations, compliance, technology and delivery channels to name a few. Margins are also tighter than in the past. To help compensate for reduced profitability, credit unions often take on more risk, such as interest rate risk and credit risk, to protect current earnings. However, this can lead to the credit union being outside of the risk limits they have outlined in policy. When this happens, the question, “Should we change our A/LM risk limits?” frequently gets asked.

Before you decide to change your risk limits and simply accept more risk, it is important to have a healthy debate and discussion focused on what the true line in the sand should be and to make sure that stakeholders fully understand the consequences. Many credit unions have found it valuable to place themselves in a scenario where rates have increased to their risk limit scenario to understand, ahead of time, the viable options they may have to unwind their risk. For some, this exercise has been very comforting – in other words, they have many viable options. Others have discovered that the options they thought they had were not enough to mitigate the additional risk in a timely fashion. Those credit unions may choose not to increase risk and address earnings issues from a different angle.

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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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Net Interest Margin and Risk Limits

A/LM measurement systems, policies and defined risk limits are intended to help ensure that credit unions do not take unacceptable risks relative to their insurance—which is net worth. While this sounds straightforward, much depends on the measurement system and policies in place.

Consider the example of a credit union that uses net interest income (NII) to manage risk and has established NII limits in policy. These types of limits are typically based on a percent volatility compared to today’s NII (click here for a related c. notes article on this topic).  By taking more credit risk, the credit union could improve their NII today—as a result of higher asset yields—thus reducing their volatility and, in some cases, putting them back within policy limits.

However, NII misses an important piece of the risk puzzle—the impact of increasing credit risk.  Recall that NII ignores any losses due to increasing credit risk since it is calculated before dealing with net operating expenses.  As a result, the credit union could be within its volatility limits yet unintentionally increase risks to net worth to unacceptable levels when accounting for credit risk.

Ultimately, the risk management process should help decision-makers understand threats to bottom-line earnings and most importantly, net worth.  Therefore, taking a comprehensive approach to taking, managing and aggregating risk is essential. This comprehensive approach should include all strategy levers—yield on assets, cost of funds, operating expense, PLL and non-interest income.

This approach also ties to the NCUA IRR Rule, which stated that “net worth is the reserve of funds available to absorb the risks of a credit union, and it is therefore the best measure against which to gauge the credit union’s risk exposure.”

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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.