Set Your Interest Rate Risk Limits Using Empirical Methods
By Dennis Child
A credit union’s Asset/Liability Management process represents one of the most important functions in its operations. Paramount to any A/LM process are the Interest Rate Risk (IRR) and equity-at-risk limits recommended by its A/LM Committee and established by its board of directors. Limits are established so a credit union can continually measure to what degree it is placing its balance sheet and profitability at risk in changing rate environments. From those measurements credit union management can create strategies as needed. Setting limits to risk is too important to leave to guess work or simply by using peers’ numbers. Every credit union needs to set its IRR limits by using empirical, statistically-validated processes. Calculating and setting risk limits using empirical methods assures that a credit union is managing and monitoring its exposure to risk according to its unique objectives, equity, operations, and tolerance for risk.
Interest Rate Risk, its measurement and management, is a primary concern for regulators. IRR should be considered a primary risk by credit union managers as well. Reviewing important points of what IRR is and how it should be managed is probably appropriate before going further with the discussion on setting IRR limits using empirical methods.
Point 1: Managers and boards have responsibilities regarding IRR:
A credit union’s board and management needs to be able to answer the following questions affirmatively:
- Does the credit union use an independently validated IRR measurement process?
- Do the board and management understand how their A/LM model and process works?
Does the credit union apply its A/LM process consistently in its planning and operations?
Point 2: IRR is a critical issue for credit unions:
- IRR is the risk to earnings and capital arising from the movement of interest rates
- IRR arises from the differences between the timing of interest rate changes and the timing of cash flows
For most credit unions, the primary factor driving IRR is long-term loans
Point 3: IRR policies are required by regulation (NCUA Guidance Letter 12-CU-11 August 2012):
A credit union’s IRR policy should:
- Identify who is responsible for review of IRR exposure
- Direct actions to ensure management measures and controls IRR exposure
- State the frequency of IRR monitoring and measurement of IRR to the board
- Set risk limits for IRR exposure based on a selected measurement tool
- Choose tests such as rate shocks that a credit union will perform using selected methods
- Provide for review of changes in IRR exposure and compliance with policy and risk limit.
- Provide for assessment of IRR impact on business activity
- Provide for annual review of policy to ensure it is commensurate to risk profiles
- When appropriate, set limits for individual portfolios, activities, etc.
A credit union’s limits to risk exposure are an integral part of its IRR policy. These policy limits should reflect the actual conditions uniquely inherent to a credit union’s interest margin, equity and appetite for risk. For these reasons, using empirical methods to set IRR limits are important.
Setting IRR limits using empirical methods is no easy process. A credit union may be best served by relying on the expertise of a consulting firm specializing in such matters. Such a firm should be able to show that it has invested in studies and data gathering sufficient to have developed statistically reliable modeling processes. The firm should also be able to explain to the satisfaction of managers and regulators the components of its models and how these models have been statistically validated. When considering outsourcing the task of establishing IRR limits, credit union managers probably are best served by a firm that requires a minimum of data input from credit union staff. Most firms can load much of the information they need from NCUA 5300 forms.
A firm hired to provide IRR limit recommendations should be able to present at a minimum:
- The recommended Net Interest Income to be placed at risk
- The recommended equity to be placed at risk
- The recommended minimum equity ratio
The methodology and statistical testing used to arrive at its recommendations
Credit unions are in the risk management business. Effectively managing risk requires setting limits. IRR limits are critical in any financial institution’s A/LM process. Setting these limits using empirical methods that are statistically validated on a regular basis helps assure regulators that a credit union’s board and management are “on top of the game” when it comes to IRR management. More importantly, measuring and monitoring IRR against stochastically derived limits provides credit union management a meaningful method for assuring regulators they are planning and making adjustments in their balance sheets as risk conditions fluctuate. Managing IRR appropriately also assures that the credit union is in a position to take advantage of profitable opportunities when changes in interest rates present such opportunities.