As we all know, credit union net interest margins have declined since 2009. Based on call report data the average net interest margin in 2009 was 363 basis points (bps) and in September 2016 was 311 bps. Investment portfolios fully matured and reinvestment options did not replace past yields. At the same time, loan rates declined and remained low amid stiff competition for the prime borrower. The average total interest income decreased 158 bps while interest expense decreased 106 bps during the same time frame. Costs of funds are almost as low as they can go and the rates are lower than many managers thought they would ever see.
NCUA recently introduced a new supervisory test for the NEV analysis and have updated their regulatory guidance. With the continued decline in net interest margins and redefinition of interest rate risk tiers by NCUA, now may be a good time for a credit union to review their IRR policies to ensure their limits are in sync with the credit union’s interest rate risk tolerance, current net interest margins, and the upcoming regulatory changes.
When reevaluating how much of a decline in the net interest margin is appropriate for a credit union in the rate shock scenarios, there are several factors that should be taken into consideration. The first is the current net interest margin. Historically a typical tolerance limit for a decline in the net interest margin was twenty percent. Most credit unions could absorb this decline and still preserve some level of earnings.
In 2009 the net interest margin in the system came very close to covering operating expenses when the NCUA assessment and the provision for loan loss were removed. Today the net interest margin falls over 40 basis points short of covering operating expenses excluding the assessment and PLL. Because net interest margins have decreased by almost 14% since 2009 it appears policy limits allowing for a further decrease in the net interest margin based on historical policy limits may not be appropriate. For credit unions that have not developed other income sources or reduced operating expenses, this statement would hold true.
Another factor to consider when setting policy limits for the income simulation is the credit union’s current level of net worth combined with growth trends. If the credit union has a strong net worth ratio and growth trends supported by a good ROA, the credit union is positioned to withstand larger amounts of interest rate changes and risk the possibility of forecasted negative earnings.
Credit unions that have increased fee and other income while also reducing operating expenses, thereby maintaining or restoring healthy ROA numbers are better able to absorb higher levels of risk to net interest margins in a rate shock scenario. A quick test to determine the credit union’s possible income simulation policy limit is to take current net income and divide it by the current net interest margin. The resulting ratio indicates how much the net interest margin could decline before net income would be eliminated. This quick test does not account for increased operating expenses, higher NCUA assessments or added PLL in a stress scenario. Policy limits exceeding this quick ratio could potentially expose the net worth of the credit union.
Historically, some credit unions set liberal policy limits for NEV to reduce regulatory criticism due to inconsistent examiner practices. With the implementation of the NEV supervisory test, NCUA indicates the interest rate risk assessment will be more transparent, effective, and efficient. Many credit unions recognize they have a long-term, low-cost funding source and model their IRR accordingly. A liberal policy may enable a credit union to hold substantially more long-term assets than management and the board are comfortable holding. Therefore, policy limits for NEV should be reevaluated to ensure they accurately reflect the board’s intent or tolerance for risk.
As we move into a new year and have seen significant increases in some of the treasury yields, we anticipate there will be continued scrutiny by examiners on the credit union’s IRR policies. The policy limits should accurately reflect the credit union’s practice for holding long-term assets and the board tolerance for the associated interest rate risk.