By Cynthia Walker, CEO
Life has a way of pestering you with issues from a myriad of directions, and sometimes it seems like the only response to the incessant and constant demands is to raise your voice and issue a command that does not leave room for further discussion. One of these issues we encounter at Mark H. Smith, Inc. is the request from regulators to value non-maturity shares (NMS) at par in the NEV analysis. While the results of this analysis can be added to the plethora of information and discussion, and may provide some sort of a starting point, I would hope that none of you are tempted or persuaded by the regulators to manage to the results of this analysis. When asked to do so, the response should be NO.
The “net economic value” (NEV) calculation explained in very simple terms is the net difference between the economic (or market) value of the assets and the economic (or market) value of the liabilities. The net economic value approach focuses on a longer time horizon than the income simulation, and captures all future cash flows. It takes a snapshot view of the balance sheet at the current time, and then looks at the value of that same balance sheet under alternative interest rate scenarios. The two analyses are compared, and the dollar change and percentage change in economic value net worth and resulting economic value net worth ratios are the conclusions. When the economic value of the net worth decreases from the current market valuation, there is interest rate risk. The appetite and tolerance for what is an acceptable level of interest rate risk is determined by policy.
Most of the time, understanding and assigning assumptions for the terms of the loans and investments are pretty straightforward. When most of the loan portfolio is comprised of fixed-rate automobile and consumer loans with original terms of 4 to 7 years, the payments or cash flow from these loans is fairly predictable. Fixed-rate real estate loans with terms from 10 to 30 years become a little more unpredictable, but in most cases there is still a defined payment schedule and maturity date that can assist with the repricing assumptions. The majority of investments a credit union holds also has defined terms, rates, and cash flows, which make modeling their earning and market value under alternative rates easier.
For non-maturity deposits, the ability of the credit union to change deposit rates at its discretion and the members’ option to withdraw all of part of their funds at any time with no penalty complicates modeling interest rate risk of the liabilities. Because of these complications, and the fact that the liabilities can and do mitigate and offset the interest rate risk of the assets, many regulators ask for the Net Economic Value with NMS to be held at par (or book). While this information may offer a starting point, I personally feel that management should not operate or structure the composition of their assets based on this analysis or attempt to keep the NMS at par results within regular policy limits. I would compare managing to NMS at par to riding a bike with the training wheels on.
In today’s financial world, if a credit union is going to make money and be successful long term, credit union managers must be allowed to manage their credit union within realistic parameters.
Some degree of interest rate risk is inherent in the credit union industry. The regulatory agencies recognize this risk and, in the current low-rate environment with the anticipation that rates are going to go up, they continue to stay laser-focused on this topic. Credit union managers and boards are required to have sound practices in place to measure, monitor, and control interest rate risk. Sound practices include understanding the underlying assumptions used in the risk measurement. NMS assumptions have a significant impact on the results of the NEV calculation and therefore receive a great deal of scrutiny.
Actual credit union share studies have shown regular share and share draft accounts, for the most part, to be a long-term, low-cost, relatively low-rate sensitive, funding sources. These accounts should therefore provide value to the credit union in the NEV analysis. Non-maturity shares at par will quickly show how much value is derived from these deposits, but should not be the analysis that is managed to. This topic has become a tiresome debate between credit union managers and regulators. There have been some hints the regulators are trying to come up with a solution to this debate. The NCUA’s Interest Rate Risk Program documentation states: ”NCUA does not seek to endorse certain IRR measures, measurement techniques, or assumptions over others.” Therefore credit unions can and should choose a set of assumptions that best fits their institution.
What, then, can be done to get out in front of this discussion?
- Adjust assumptions and run additional scenarios to address unexpected changes or to stress key assumptions such as: increase in rate sensitivities, decrease in average lives, possible surge shares, or migration from regular shares to other higher-yielding accounts.
- Understand the impact assumptions for NMS’s have on the results.
- Discuss and document the reasonableness of the assumptions and how they fit your credit union…not only historically, but how you think the credit union and members will behave in the future.
- Emphasize the importance of calculating interest rate risk including both assets and liabilities.
- Understand the implications of under-estimating interest rate risk and the negative impact on profitability (as deposits reprice more quickly) versus over-estimating interest rate risk and therefore keeping asset terms too short and missing out on yield.
When your team agrees on a set of assumptions for NMS that is reasonable, supportable, and fits your credit union, don’t let the regulators dictate assumptions to be used in your IRR analysis. They do not have this authority. If you do choose to manage to the risk exclusively on the asset side of the balance sheet, then separate policy limits for this scenario should be established. If you are faced with a situation where it is recommended, or even hinted, that you manage your balance sheet based on the results of the NEV analysis with NMS at Par, just say NO!