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Interest Rate Risk Policy Limits: One Big Misconception

We initially published the blog below on January 28, 2016.  With interest rates having increased recently – and more increases seemingly on the horizon – we thought this a good topic to revisit as it has been coming up in model validations we complete.

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.

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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.

On average, if this group of credit unions experienced a 30% decline in NII in a +300 bp shock, the resulting ROA would be 3 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.

 Based on NCUA data as of 3Q/2016, excluding one credit union that had an exceptionally negative ROA

It is important to note that 47% 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.

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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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Operational Efficiency—Improving Earnings And Member Experiences While Driving Increases In Net Worth Dollars

In comments surrounding the new rule on Interest Rate Risk, the NCUA states that, “net worth is the best measure against which to gauge a credit union’s risk exposure.”  As credit unions are looking to improve earnings and grow net worth dollars in this historically low interest rate environment, yield on assets and cost of funds are only 2 of the 5 strategy levers that credit unions can pull.  In order to have an effective IRR management program, ALL levers that impact earnings and net worth should be evaluated, including operating expense, provision for loan loss and fee/other income.

Bottom-line results can be realized by evaluating operating expenses for operational efficiencies.  However, operational efficiency not only means looking for ways to cut expenses, it also includes evaluating current processes and practices to ensure that no opportunity to generate revenue is left behind.  For example:

  • Do your loan processes allow you to effectively capture every loan that you want to fund, or do inefficiencies in the process cause members seeking loans to ultimately go elsewhere?
  • Can your front line effectively turn interactions with your membership into educational or cross-sale opportunities, when appropriate, that deepen member relationships and enhance the member experience?
  • Does your in-branch advertising reflect the tactical (short-term) and strategic (long-term) objectives of the credit union?  If the credit union is targeting loan growth, are loan rates and promotions more prominently displayed and emphasized than current deposit rates?

Finding ways to revamp processes can improve member interactions and provide employees additional time that can be used to enhance member service or develop other areas of the credit union’s business.  Additionally, ensuring that the credit union is effectively utilizing its sources of revenue is just as important to operational efficiency as cutting un-needed expenses.

The creation of operational efficiencies in your structure can have a positive impact on earnings in all interest rate environments, which is an excellent way to drive increases in net worth without taking on additional risks.

Source:  Interest Rate Risk Policy and Program, NCUA, 2/3/12
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When is Worst Case?

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In risk analysis, it is important to make realistic assumptions about potential bad scenarios that could play out—large increases in interest rates and credit risk exceeding expectations are just a couple that come to mind.

While interest rates are at an all-time low, credit risk is at an all-time high for some credit unions. In preparing for your future, don’t mistake an all-time high with worst case.

For example: back in August 2007, the Associated Press reported that foreclosure filings had soared 93% from July 2006 to July 2007 and that the national foreclosure rate stood at 1 filing for every 693 households. Then in the first quarter 2008, CNN reported that, according to the Mortgage Bankers Association, the number of homes in foreclosure had topped 1 million.

Given this unprecedented level of foreclosure activity, it certainly felt like it couldn’t get any worse. However, according to RealtyTrac’s 2009 year-end report on foreclosures, there were over 2.8 million homes, or 1 in 45 households, with foreclosure filings in 2009 alone.

The bottom line is that, in risk planning, it can be very dangerous to assume that just because things are bad they can’t get any worse. It is important for your management team and board to understand the potential impact on your operations if things do get worse. It is likewise important for you to have well thought out plans—today—as to how you will pull your strategic levers to manage your credit union through even rougher times.

strategy levers

Hope for the best, but plan for the worst… or at least minimally prepare for the worst.