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.”
