When we talk with credit unions about the results of their interest rate risk analysis, we are often asked the question, how do my credit union’s results compare to my peers or to the industry? The answer is not always applicable because credit unions vary quite a bit from one another. The differences can include: What the starting net worth ratio is; how much of the credit union’s funding is in CDs or rate-sensitive money markets vs regular shares and share drafts; and how much of their assets are longer-term to name just a few of the variables.
With the implementation of the new Supervisory Test by NCUA, the question of how our clients compare to each other piqued our curiosity. While most of our clients fell into the low-risk classification (with a few in the moderate range), we did not know the exact ratios. After a review of the results of over 300 clients, we found that 92.4% are in the low-risk range, 7.3% are moderate-risk, and less than 1% fall in the high-risk category. Of the moderate-risk group, 45.5% of those started out with a current net worth ratio of less than 8%, another 36.4% had a current net worth ratio between 8% and 9%, and the remainder had a net worth ratio of 9% or above.
These statistics led me to another question. Are credit unions taking on enough risk, and can the results of the interest rate risk analysis be utilized to better manage the credit union? The IRR analysis should be a tool to help manage interest rate risk, not just avoid it. While the regulatory environment may be one of risk avoidance, the following actions will help the management team use the results of the IRR analysis to balance the risk/reward trade-off and possibly improve earnings:
- Thoroughly review and understand the assumptions.
- Ensure that accurate data is entered into the model.
- Make sure that the assumptions best reflect the balance sheet and repricing characteristics.
- Put a Back-test in place to compare the results to actual for reliability.
- Establish policy limits that correctly reflect risk tolerance.
Fully utilizing and incorporating the results of your IRR analysis into the management process will help management optimize the balance sheet composition while understanding the risk to earning and the value of net worth if interest rates change.
The major components contributing to the low level of risk with our clients and other credit unions are: the sizable percentage of deposits in regular share and share drafts that have low rate sensitivities; deposits that are stable and stay at the credit union for extended periods of time; shorter-term investment portfolios; and a substantial percentage of consumer loans with two-to-three-year turnover. When there is doubt that the low interest rate risk results are reliable, history has shown otherwise. In the last rates up cycle, credit union net interest income (NII) also increased. There was a lag in the improvement but it did improve due to the factors listed above.
To play with possible changes to a credit union’s balance sheet, I took a credit union with the following: a net worth ratio of 11.8%, a net interest margin of 271 basis points, an ROA of 42 basis points, moderate tolerance to interest rate risk based on their policy limits, and little to no interest rate risk in both the income simulation and the NEV analysis. With this data, I then tested how much their balance sheet could shift to cause their interest rate risk to approach policy limits and possibly raise regulatory concern. Their balance sheet would need to significantly change. By significantly, I mean moving over 50% of total assets into 15-year mortgage loans, shortening the average lives of all non-maturity deposits to 30 months or less, and assuming that at least 50% of all deposits are very rate sensitive with betas of .95% or 1.00%. Even in this scenario, the credit union’s IRR did not fall to alarming regulatory levels. There are two reasons why: 9% of total assets remained in overnight investments, and 17% and 12% of deposits are in regular shares and share drafts, respectively.
Common mistakes I see credit unions making in this area include keeping investment and loan portfolios too short, being risk avoidant instead of risk managers, having policies that do not accurately reflect credit union practices that are either too liberal to too restrictive, and not utilizing the IRR results to structure the balance sheet for better earnings.
It appears a majority of credit unions are in the low risk range and could possibly take on more exposure to improve earnings. It might be time to review your credit union’s balance sheet composition, identify its strengths and weaknesses, discuss your IRR analysis, and recheck the policy limits. Once this is complete, it would be valuable to evaluate whether your credit union has too much interest rate risk or not enough. Would it be beneficial to explore getting a little closer to policy limits for the possibility of increased earnings? Can the trends be tracked and adjustments made if necessary? Before any changes are incorporated, document the thought process and discussions and be prepared to have a conversation with your regulator if it comes up. Comprehensive Board and ALCO minutes, running some what-if scenarios through your IRR analysis, along with doing some sensitivity testing of key assumptions, will help support the credit unions actions. It will also help the credit union develop a plan for positive and prosperous performance in the future, regardless of what interest rates do.