Interest Rate Risk (IRR) policies are required by NCUA. Credit unions may choose to have only an ALM policy that covers interest rate risk or choose to have both an ALM and interest rate risk policy. The ALM policy can be thought of as an umbrella policy with the option of interest rate, liquidity, contingency funding, and concentration risk policies all stand-alone complementary asset liability management policies. If you have individual policies, the limits that are established for each of the different policies should be removed from the ALM policy and defined in their respective policies. It is important the policy limits for each of these areas are in only one place so that maintaining and updating limits are easier and the possibility of conflict is eliminated.
Interest rate risk policy, and the limits that are established to define and control potential risk, should be reviewed and re-evaluated annually. The two most common methodologies for estimating interest rate risk are income simulation and net economic value (NEV). Each of these methodologies will have their own limits. Current net interest income, net income, and net worth should be considered when setting policy limits.
Income simulation (IS) policy's limits define tolerances for forecasted changes in net interest income when interest rates change. If net interest income (NII) improves in the shock scenario over the base case scenario, there is no estimated interest rate risk by this short-term measure. If NII is forecasted to decrease in the shock scenario, there is potential interest rate risk and the policy should define what is acceptable. Current net interest income, non-interest income, non-interest expense, net income, and capital should be evaluated when deciding what is an appropriate net interest income at risk limit. A strong net interest margin and solid return on assets (ROA) allows for more tolerance to changes in NII before the health and long-term viability of the credit union is negatively impacted by a change in market rates. If current net interest margins and ROA are weak, even small decreases in NII may be damaging.
Prior to the financial crisis a common and acceptable IS limit was negative 20%. Most credit unions could withstand a 20% decrease in their NIM before net income would be eliminated. As net interest margins compressed when interest rates decreased, many credit unions could no longer tolerate a 20% decrease in NIM and the policy limits had to be reevaluated and tolerances reduced. A quick calculation determining how much NII could decrease before NI reaches zero is a good place to start when deciding what is an appropriate policy limit. If the credit union sets a limit that would allow for negative earnings for a period, the adequacy of the capital becomes part of the decision process. Higher capital allows for more risk and lower capital allows for less risk. The policy limit should be set for all up and down-rate scenarios. Often the up and down-rate IRR limits will be the same. The logic: if you are willing to accept a certain level of risk in the up-rate cycles, why would you not be willing to accept the same risk in the down-rate cycles, or vice versa?
Net Economic Value (NEV) policy limits define tolerances to changes in the valuation of the balance sheet in different interest rate scenarios. The first step in the NEV analysis is to calculate the value of the balance sheet at current market rates, and the resulting impact to the net worth ratio which becomes the current market adjusted net worth ratio (base case). The value of the balance sheet and resulting marked adjusted net worth ratio in each of the rate shock scenarios is compared back to the current market adjusted (base case) net worth ratio. When the percentage change in the net worth ratio is positive, there is no estimated IRR and when the percentage change is negative, there is potential IRR. The policy limits set for NEV will define the tolerable percentage decrease in net worth and an acceptable market adjusted net worth ratio. Prior to NCUA’s use of the NEV supervisory test and predefined premiums for non-maturity shares, a common policy limit allowed for a 50% decline, with a minimum of 4% as the market adjusted net worth value. Since NCUA began using the supervisory test to compare credit unions, examiners have begun to be more critical of the policy limits rather than the assumptions for non-maturity deposits. If assumptions are more liberal (even if they are well established), examiners are more critical of the policy limits. Management should use assumptions that are supportable and are in line with what they believe to be an accurate representation of their credit union. After which, risk limits can be established based on the credit unions risk appetite and current capital. Again, policy limits for both up-rate and down-rate shock scenarios should be established and often be the same.
If you have further questions or would like to review your current IRR policy and established limits, please contact us and we will schedule a time to discuss and review your IRR Policy.