Credit Union Board Training – Beyond the Basics10.02.2017
In their role of providing oversight and direction, board members must have a good understanding of the risks their credit unions face and how they are controlled. To maintain a credit union that is viable and provides products and services the membership desires, it requires managing a variety of risks, a key one of which is interest-rate risk.
The best place to start with tackling interest-rate risk is to set the policy and limitations on risk to establish the parameters within which the board and management are comfortable operating. Then the measurement system is put in place to manage these limitations. Next, it’s important to monitor the output to ensure the credit union is operating within those defined parameters. Finally, the credit union should revise this strategy, as needed, and revisiting risk limitations.
At Vizo Financial, we employ the two standard ALM measurement tools: Income Simulation Model and Net Economic Value Model. These tools, when used together, become a powerful source to understand the risks held on the balance sheet.
Income Simulation Model
This measurement tool projects future net interest income and how it changes as interest rates move. Focused on short-term earnings, the model starts with current items held on the balance sheet. Then, we layer in assumptions to dictate to the model how to reinvest the cash flow with new rates and terms. As the cash flows from the existing products are received, the model reinvests them into new products, rolling the balance sheet forward.
The model performs a base analysis of the outcome if market rates stay constant. Then, it conducts further analyses of what happens to net interest income as rates change in various scenarios. Each scenario’s net interest income is then compared to the base amount. Earnings at risk measures the volatility of net interest income over the next 12 months. The larger the decline in net interest income under various interest rate scenarios compared to a base rate scenario, the greater the credit union’s exposure to interest-rate risk. This change from the base amount is compared to the risk tolerance set by the board of directors. If the analysis shows a negative trend, even if the changes are within the established tolerance limits, the board might decide to take action to correct the trend.
Net Economic Value Model
This analysis measures long-term risk from a value perspective. It is an estimate of the balance sheet’s existing earnings capacity. For example, how does the value of loans, investments and shares change as market rates change? And what impact do those changes have on the capital position? The model calculates the present value of the future cash flows the credit union will receive, such as loan principal and interest payments, and subtracts the present value of future amounts the credit union will pay for its funds, such as dividends on share balances. The result is the Net Economic Value (NEV).
The larger the decline in the value of capital (value of assets less value of liabilities) compared to a base rate scenario, the greater the long-term interest-rate risk exposure. Assets with present values in excess of book value are contributing an earnings spread greater than those currently offered to members. Assets with present values less than book value provide an earnings spread below what is currently available. Liabilities with present values less than book value enhance earnings because the rates are lower than current offerings, whereas liabilities with present values greater than book value reduce earnings as the credit union is paying more than current offerings.
This concept can be simplified as follows: if member A has a loan at the credit union for 4% and the current issue rate is 6%, member A’s loan is not as valuable as that of member B, who takes out a loan today at 6%. Why? Because the credit union no longer finds as much value in member A’s loan due to the lower interest rate. The present valuation declines in relation to the term of the loan; the longer it takes to receive the cash, the more decline in value.
For board members who have been in the industry for any length of time, the ALM process is engrained into your management behavior, as is how the two reporting tools help to calculate these risks. But the questions we often hear are not about the steps of the risk process, but rather what the risk limitations should look like. The unpopular answer is “it depends.”
All credit unions are unique and have individual interest-rate risk to manage. It is not meant to be an ambiguous statement, but rather takes some practice to understand the specific risks in each balance sheet. With some high-level training, credit union directors should be able to ask relevant and significant questions of management to understand these risks. It all hinges on understanding the types of risk on the balance sheet and the impact of those specific products on both the long- and short-term interest-rate risk.
Take callable agency securities, for example. Often board members think that this is a risk-free investment. And while it is seen as a secure investment backed by a U.S. government enterprise (like Fannie Mae or Freddie Mac), it does not eliminate interest-rate risk. Board members should understand that when the yield curves are rising, these bonds will no longer be called because it is not advantageous to the issuer. Since it is not called, the life extends to maturity. This action impacts interest-rate risk, both short- and long term. ALM models can help us gauge the impact of this risk. On the short-term risk or income simulation side, the funds are not called and therefore are unable to reinvest, locking in the lower yielding bond and reducing interest income. This increases net interest income sensitivity. On the long-term risk measurement, or NEV, this scenario also impacts the risk to the institution. Since the bond is not called, the life extends and the cash is not received until maturity. This delayed cash flow increases the NEV sensitivity since it is calculating the present value those cash flows.
Not every product needs to be explored in detail, but rather focus on the large concentrations in the balance sheet and work from there to understand the interest-rate risk relationship. Inquiring which products are creating the risk is the starting point. Then, monitor risk changes, even within the established parameters, to aid in understanding the relationship between balance sheet shifts and interest-rate risk. The boards of tomorrow should be savvy about the high-level concepts of managing interest-rate risk to push their institution forward. When the focus is actively managing the changes to the risk profile, you will actually start to see the vast benefits of interest-rate risk modeling. This process will be critical as you manage the potential rising rate environment in the near future.
Melissa Scott is vice president of ALM services for Vizo Financial Corporate Credit Union.