Posts

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Have You Reviewed Your Policies Recently?

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Historically, credit unions may have been wary of making material changes to their policies, whether an A/LM policy, Liquidity policy, Investment policy or broader Financial Management policy – for fear of raising regulatory “red flags.”  However, with the adoption of the final rule on interest rate risk (§741.3(b)(5)(i)), and the effective implementation date of September 30, 2012, many credit unions are finding this a great time to revisit their policies.  While reviewing policy, some key questions must be asked:

  • How does the policy help promote safety and soundness, while also reflecting the risk appetite of the credit union’s board and senior management?
  • Have there been situations in recent history where policy limits or guidelines have “tied hands” with respect to making sound business decisions?
  • Conversely, are there limits or guidelines in policy that have aided in the decision-making process, potentially saving the credit union from less than favorable outcomes?
  • How can we effectively construct policy limits and/or guidelines to both satisfy regulatory requirements and aid in the decision-making process of the board and senior management?

With heightened industry awareness surrounding interest rate risk, and increasing regulatory pressure to mitigate the risk being taken by some credit unions today, would it possibly raise more regulatory “red flags” if a credit union did not revisit relevant policies prior to the September 30 implementation date?  A good policy has limits and guidelines intended to promote risk management and safety and soundness.  A great policy has limits and guidelines intended to promote risk management and safety and soundness, but most importantly, provisions that drive dialogue to aid in the decision-making process.  While revisiting policy this year, the above questions will help take your existing policy from “good” to great.

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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.

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Lower Earnings Or Increased Interest Rate Risk?

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If there is one thing to be said infallibly about risk management, it is never black and white.  The historically-low rate environment coupled with mostly-anemic consumer loan demand has put increased pressure on credit union margins across the nation; moreover, many are reaching their floor with regard to lowering deposit rates.  In light of the real threat of rising interest rates, decision makers must strike a delicate balance between the risk of reaching for yield and accepting lower ROA and net worth ratios in favor of managing interest rate risk.  Adding more urgency to the issue is the recent release of NCUA’s proposed rule/guidance amending regulations focused on protecting against interest rate risk.

If you’re feeling the squeeze on your margin like many in the industry, remember that current earnings are not an adequate indicator of success, safety or soundness.  As regulator scrutiny increases, it is critical to identify how your long-term risks to earnings and net worth could change considering your current strategy, potential decisions under consideration and bad-case stress tests.  Too much focus on the margin, and yield specifically, may invite excessive interest rate risk.