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Interest Rate Risk (IRR) Regulation Overview -
Effective IRR Policy and Program
NCUA IRR Regulation Effective as of September 30, 2012
Presented by:
Prescott Ford, CFA
Managing Director of Regulatory Affairs
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Regulatory Views on Interest Rate Risk
NCUA Board Member Hyland:
In 1990, 65% of credit unions had no first mortgage real
estate exposure. Today, 60% have real estate exposure.
This is a big change and risk management practices need
to keep pace.
(March 2012 CUNA Government Affairs Conference)
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Regulatory Views on Interest Rate Risk (cont’d)
(Source: National Credit Union Association)
44
Regulatory Views on Interest Rate Risk (cont’d)
NCUA Chairman Matz:
Coming out of the Great Recession, credit unions keep on
their books too many mortgages at historically low rates.
We know that interest rates won’t stay low forever.
(March 2012 CUNA Government Affairs Conference)
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Risk Taking is not Risk Management
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Interest Rate Risk Regulation
Section 741.3 (b)(5)
National Credit Union Administration (NCUA)
Rules and Regulations – Requirements for Insurance:
Interest Rate Risk (IRR) Policy and Effective IRR Program
• Federally insured credit unions (FICUs) are required to
have as part of their asset/liability management unless an
exemption exists:
– Written interest rate risk policy
– An effective interest rate risk management program
• Appendix B to the regulation provides detailed guidance to
assist FICUs in meeting the regulatory requirement
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IRR Regulation: Scope
• FICUs with assets greater than $50 Million
– Must have a written policy and an effective IRR program
• FICUs with assets $10 Million to $50 Million
– Applies if the total of first mortgage loans and investments
greater than five years is 100.00% of net worth or greater
o Loans without intent and ability to sell within 120 days
o Investments over five years as per the Call Report
– Supervisory Interest Rate Risk Threshold Ratio (SIRRT)
o Does not limit purchasing investments or making loans; it only
means that the rule applies
• FICUs with less than $10 Million in assets
– Are not required to adhere to the rule
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IRR Regulation: Appendix B to Part 741
• Each credit union should formulate a policy that embodies
its own practices and metrics appropriate to its operations
– Some IRR exposure is a normal part of financial intermediation
– NCUA recognizes there are differences between credit unions
• NCUA “emphasizes” that limit examples are only illustrative
– Practices should be implemented with increasing rigor and
diligence as size, risk, and complexity increase
• An effective interest rate risk program:
– Identifies
– Measures
– Monitors
– Controls
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• Regulators expect all institutions to manage IRR exposures
using processes and systems commensurate with:
– Earnings and capital levels
– Complexity and risk profile
– Business model and scope of operations
• Senior management is responsible for ensuring:
– Appropriate policies, procedures and internal controls
– Comprehensive systems and standards for measuring IRR
– Procedures for updating IRR scenarios and key assumptions
– Sufficiently detailed reporting processes
Federal Financial Institutions Examination Council - Advisory on Interest Rate Risk Management (Jan 2010)
FFIEC 2010 Advisory on Interest Rate Risk
1010
NCUA IRR Regulation: Effective IRR Program
• All FICUs subject to the rule should incorporate the following five elements into the interest rate risk (IRR) program:
1. Oversight by the Board of Directors and implementation by management
2. Board-approved IRR Policy
3. Risk measurement systems assessing the IRR sensitivity of earnings and/or asset and liability values
4. Internal controls to monitor adherence to IRR limits
5. Decision making that is informed and guided by IRR measures
1111
• Board Responsibilities
– Approving policy, major strategies, and prudent limits
– Ensures management executes an effective IRR program
– Annually assess the policy and program
• Management Responsibilities
– Develop and maintain an adequate measurement system
– Evaluate and understand IRR exposure
– Establish appropriate system of controls
– Allocate sufficient resources, competent staff, and responsibility
– Identify measurement procedures and assumptions
– Provide sufficient reports to ensure compliance with Board Policy
Interest Rate Risk Management
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• Eight required aspects for the IRR Policy
1. Identify who is responsible for reviewing IRR exposure
2. Direct the management of IRR exposures
3. State the frequency of reporting results to the Board
4. Set risk limits for IRR exposures
5. Specify the tests that the credit union will perform
6. Provide periodic review of IRR compliance and changes
7. Require IRR assessment of new business/strategies
8. Provide for annual evaluation of policy
Note: Can be a separate policy or incorporated into other ALM policies
Interest Rate Risk Management (cont’d)
1313
• IRR Measurement and Monitoring
– Sufficiently rigorous to capture and measure all material IRR
– Reported at least quarterly
• Risk Measurement Methods
– Income Simulation and Net Economic Value
– Gap Analysis and NCUA Asset Valuation Tables
o “Simple Measures”
• Components of IRR Measurement
– Assumptions
– Chart of Accounts and Data Aggregation
Interest Rate Risk Management (cont’d)
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IRR Measurement: NII Simulation
1 Loan Income Year 1 Year 2 Year 3
+300 Shock $35,494 $38,112 $40,316
Total Assets $974,187 Flat Rate Scenario $32,874 $32,248 $31,767
Avg. Assets $954,115 -300 Shock $30,654 $26,962 $24,944
Total Earning Assets $930,808 + 2 Investment Income Year 1 Year 2 Year 3
Avg. Earning Assets $911,087 +300 Shock $8,929 $10,194 $11,187
1 Annualized Loan Income $33,205 Flat Rate Scenario $4,959 $4,579 $4,284
+ 2 Annualized Investment Income $5,273 -300 Shock $4,328 $3,639 $3,247
- 3 Annualized Interest Expense $8,777 - 3 Cost of Funds Year 1 Year 2 Year 3
= 4 Annualized Net Interest Income $29,701 +300 Shock $13,012 $18,870 $19,861
Net Interest Margin 3.26% Flat Rate Scenario $7,747 $6,961 $6,480
Annualized Net Income $6,497 -300 Shock $6,936 $5,333 $4,732
Return on Average Assets (ROA) 0.68% = 4 Net Interest Income Year 1 Year 2 Year 3
Statutory Net Worth $99,650 % Change from Flat 4.41% -1.44% 7.01%
Statutory Net Worth Ratio 10.23% +300 Shock $31,412 $29,436 $31,643
Flat Rate Scenario $30,086 $29,865 $29,570
-300 Shock $28,047 $25,269 $23,459
% Change from Flat -6.78% -15.39% -20.67%
Current Balance Sheet/Income Statement
NET INTEREST INCOME FORECAST
Income Simulation (“Earnings at Risk”): Forecasts the future interest income (on loans and investments) and interest expense (on shares, deposits and borrowings) to estimate future earnings under multiple interest rate scenarios.
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IRR Measurement: Net Economic Value
Net Economic Value at Risk: The estimated fair value of all assets minus the
estimated fair value of all liabilities, calculated under multiple interest rate scenarios.
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IRR Measurement: Asset Assumptions
• Investment Assumptions:
– It is usually easier to utilize an industry recognized information
provider (Bloomberg, BondEdge, FinSer, etc.) to model the portfolio.
– The key is that the optionality be accounted for in each rate
environment.
Call features
Step-ups
Variable rate securities: reset dates, periodic/lifetime “caps and floors”
Changes in amortizing securities’ cash flows and prepayments
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• Estimate the timing/amount of rate changes (“rate sensitivity”)− When interest rates have changed, how quickly (or slowly) does the
institution react by moving it’s rates, and by how much?
• Be sure to account for optionality− Variable rate: reset dates, periodic/lifetime “caps and floors”
− Using a historical analysis, estimate reasonable loan prepayments
Loan Portfolio
Flat Rate
Scenario
CPR
Monthly
Principal
Payment
% Decline in
CPR
+300Bps
Scenario
CPR
Monthly
Principal
Payment
Credit Card 20 CPR $1,008.215 7.00% 19 CPR $954.973
Unsecured 24 CPR $1,057.041 7.00% 22 CPR $1,009.135
Vehicle - New 30 CPR $3,044.679 7.00% 28 CPR $2,907.048
Vehicle - Used 32 CPR $6,009.021 7.00% 30 CPR $5,733.587
Mtg - 1st Fixed >15 yr 12 CPR $1,007.932 52.00% 6 CPR $540.887
Mtg - 1st Fixed <15 yr 8 CPR $664.829 52.00% 4 CPR $447.630
Mtg - Other 1st Fixed 7 CPR $14.096 52.00% 3 CPR $9.265
Fixed Business Loans 12 CPR $691.455 36.00% 8 CPR $554.668
Mtg - Fixed Rate HELOC 12 CPR $22.314 36.00% 8 CPR $15.849
Loans Available for Sale 12 CPR $39.493 52.00% 6 CPR $20.741
Lease Financing 14 CPR $12.452 7.00% 13 CPR $12.048
Other Consumer Loans 35 CPR $1,600.393 7.00% 33 CPR $1,515.613
Mtg - Balloon >5yr 10 CPR $220.808 52.00% 5 CPR $120.974
Var. Commercial Mortgages 12 CPR $443.939 36.00% 8 CPR $298.110
Mtg - 1st ARM <1 yr Reset 16 CPR $113.698 52.00% 8 CPR $60.270
Variable Business Loans 14 CPR $389.270 36.00% 9 CPR $261.653
2nd Mtg - Other Adjustable 16 CPR $46.630 36.00% 10 CPR $34.194
Mtg - Adjustable Rate HELOC 16 CPR $985.259 36.00% 10 CPR $753.693
Total Loans 20 CPR $17,371.524 Total Loans 16 CPR $15,250.340
IRR Measurement: Loan Assumptions
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IRR Measurement: Share Assumptions
• Use assumptions that reflect the institution’s profile and avoid
reliance on industry estimates or default assumptions
• Historical deposit rate sensitivity and lag analysis can help
determine and document reasonable assumptions
Rate Change Summary
Current
Rate
Avg
Move
Max
Move
Down
# Rate
Increase
Max
Single
Move UP
Max
Cumulative
Move UP
Checking 0.11% 0.03% -15 Bps 16 5 Bps 19 Bps Jun-04 Sep-07
Savings 0.37% 0.08% -22 Bps 15 12 Bps 73 Bps Mar-04 Sep-07
Money Market 0.41% 0.16% -69 Bps 14 28 Bps 230 Bps Mar-04 Sep-07
Time Deposits 0.92% 0.23% -97 Bps 17 41 Bps 343 Bps Sep-03 Sep-07
IRA & Keough 0.94% 0.18% -69 Bps 18 47 Bps 262 Bps Sep-03 Sep-07
Other Deposits 1.15% 0.24% -65 Bps 12 82 Bps 199 Bps Jun-04 Mar-06
Quarterly Cost of Funds 0.91% 0.15% -70 Bps 13 29 Bps 176 Bps Jun-04 Dec-07
Between
Rate Change Summary
Max
Cumulative
Move UP
Market
Rate
Change
Historical Rate
Sensitivity
Factor:
Checking 19 Bps 425 Bps 4.47%
Savings 73 Bps 425 Bps 17.18%
Money Market 230 Bps 425 Bps 54.12%
Time Deposits 343 Bps 425 Bps 80.71%
IRA & Keough 262 Bps 425 Bps 61.65%
Other Deposits 199 Bps 425 Bps 46.82%
Quarterly Cost of Funds 176 Bps 425 Bps 41.41%
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– Share Assumptions:
o Question: “Can an institution use industry estimates for non-maturity deposit
(NMD) decay rates?
o Answer: “Institutions should use assumptions that reflect the institution’s
profile and activities and generally avoid reliance on industry estimates or
default vendor assumptions.”
Industry averages provide an approximation but may not be a suitable estimate in
every case.
Customer types and behaviors are inconsistent across geographic areas and are
likely to produce very different deposit decay rates from one institution to another.
Industry estimates should be a starting point until sufficient internal data sets
can be developed.
An institution can contract with an outside vendor to assist with this process
2012 Frequently Asked Questions about Interagency Advisory on Interest Rate Risk Management
IRR Measurement: Interagency Guidance
2020
• More complex balance sheets will be expected to do more
“what-if” and “stressed scenarios” and do it more frequently
• Additional scenarios could include:
– More extreme Rate-Shocks: Assess IRR exposures beyond typical
industry conventions (e.g., up 400 basis points)
– Rate-Ramp Scenarios: Can give a more reasonable estimate of
future earnings; should not be the primary methodology
– Including growth and shifting the mix of assets/liabilities
– Assuming changes in the shape (slope) of the yield curve
• Regulators recognize that not all institutions will require the
full range of scenarios; non-complex may justify fewer
The FFIEC IRR Advisory (Jan 2010) and Frequently Asked Questions (Jan 2012)
IRR Measurement: Interagency Guidance (cont’d)
2121
• Other Considerations:
– Back-Testing: Many institutions back-test model outcomes by determining the key drivers of
differences between actual and modeled net-interest margin results.
Tracking these variances over time helps to determine when key assumptions
may need to be recalibrated.
– Sensitivity Analysis: Sensitivity analysis tests a model’s assumption parameters without relating those
changes to an underlying event or real world outcome.
– Validation: Each institution is expected to conduct an independent review and validation, and
perform ongoing monitoring and back-testing to confirm model appropriateness.
– Internal Controls: Use an internal party that is sufficiently removed from the primary IRR functions
or an external auditor to ensure the integrity of their risk management process.
The FFIEC IRR Advisory (Jan 2010) and Frequently Asked Questions (Jan 2012)
IRR Measurement: Interagency Guidance (cont’d)
2222
• Internal Controls
– Separation of duties
o Those responsible for risk taking separate from risk measuring
– Periodic assessment of IRR program and policy compliance
o Internal Audit
o Supervisory Committee
o Outside Expertise
Interest Rate Risk Management
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• Decisions guided by Interest Rate Risk Management
– Utilize the results of the IRR measurement systems in making
operational decisions
o Changing balance sheet structure
o Funding and pricing strategies
o Business planning
– Management should be prepared to identify steps, if necessary, to
bring risk within acceptable levels
– Use the results proactively as a tool to adjust asset/liability
management
Interest Rate Risk Management (cont’d)
2424
Regulatory Views on IRR and Liquidity Risk
NCUA Board Member Hyland:
When rates rise, will credit unions have the mechanisms in
place to manage the possible outflow of interest rate
sensitive accounts, given the large portfolio of fixed rate
real estate loans?
(March 2012 CUNA Government Affairs Conference)
25
Next Webinar: September 12 at 4:00 EST
Liquidity Management, Contingency Funding,
and the NCUA Proposed Rule for
Maintaining Access to Emergency Liquidity
2626
• Office of Regulatory Affairs
– Policy Review, Revision, and Creation
o Interest Rate Risk / Asset Liability Management Policy
o Liquidity Management and Contingency Funding Policy
o Concentration Risk Policy
o Investment Policy
– Assist in Establishing Risk Limits and ALCO Reporting
– Examination Support and Concern Resolution
• Asset Liability Management
– Offering comprehensive balance sheet analytics that help identify,
measure, monitor, and control risk
*These services are offered through Balance Sheet Management Services (BSMS), an affiliate of First
Empire Securities. BSMS is not a member of FINRA/SIPC. First Empire Securities is solely a member of
FINRA/SIPC.
Consultative Services Through our Affiliate:
Balance Sheet Management Services*
27
Thank You!
The information in this document has been obtained from sources we believe to be reliable, however, we do not guarantee it is accurate
or complete. From time to time officers, employees of the firm, or the firm itself holds a position in the securities referred herein, or acts
as principal in transactions referred to herein. Parts of this document are based on assumptions, which we believe to be reasonable and
supportable, however, future events may influence actual performance. The projections contained herein are hypothetical in nature, and
do not reflect actual balance sheet or investment results and are not guarantees of future results. This document is not and should not
be construed as an offer or solicitation of an offer to buy or sell any security or securities. Securities have inherent risk, including credit,
prepayment, extension and market risk. This information is subject to change without notice. First Empire Securities, Inc., Member
FINRA/SIPC.
For more information, please contact the Office of Regulatory Affairs at:
800-645-5424
Prescott Ford, CFA
