IRR Tops the List of Regulators’ Concerns
For the past 6 years, financial institutions have been lengthening the duration of their loans and investments to slow the shrinking of their interest margins.
As a result, NCUA has become more concerned about Interest Rate Risk (NCUA Letter to Credit Unions 14-CU-02) and is focusing more on each credit union’s method of measuring and addressing Interest Rate Risk (IRR).
The recent run up in interest rates has further stoked IRR concerns among CEOs and regulators and has sharpened the debate among these parties as to the robustness of different approaches to Asset/Liability Management (A/LM) modeling.
That debate revolves around key issues such as:
- The assumptions (quantity and quality) that are being used as a basis for a credit union’s A/LM modeling process
- The depth of understanding of A/LM modeling concepts on the part of managers, boards, and examiners
- Using past experiences as a basis for assumptions fed into an A/LM model
- The efficacy of traditional A/LM modeling processes (particularly Net Equity Value)
- The lack of proper consideration for operational expenses and non interest income in some A/LM models
- The accuracy and fairness of examiners’ criticism of A/LM modeling outcomes used by managers who are trying to balance profitability with safety
Clearly, in volatile times like now, a financial institution’s future could well depend on the A/LM model it uses, the accuracy of that A/LM model’s conclusions, and how management uses those conclusions in its planning and forecasting.
This article compares two distinct approaches to A/LM modeling.
The Net Equity Value A/LM Model
The traditional method for measuring IRR is an AL/M modeling tool that relies on estimating the “Net Equity Value” (NEV) of a financial institution’s balance sheet.
There are inherent weaknesses in NEV that need to be taken into consideration by managers and regulators.
These weaknesses include:
- The level of dependency on assumptions to estimate the “maturity” of non maturity deposits
- Using discounted cash flows to arrive at the present value of a credit union’s balance sheet (a credit union’s “liquidation value”)
- The assumption that discounted cash flows of a balance sheet can be used to estimate changes in net worth and earnings resulting from changes in market rates
- The assumption that a credit union’s loan portfolio is equivalent to bond portfolios that are widely traded
- The assumption that a credit union’s deposit accounts can be treated like bonds which have contractual maturities and are widely traded
- Small inaccuracies in the assumptions used that could lead to erroneous A/LM conclusions that can result in perilous management decisions
The Earnings at Risk A/LM Model
A more accurate and easier to understand A/LM model uses Earnings at Risk (EAR) to measure a credit union’s IRR.
EAR does not rely on assumptions to the extent that NEV does and therefore has greater value for CEOs and CFOs who are trying to forecast the effects potential changes in interest rates will have on profitability.
The best EAR models project cash flows and impacts on profitability using actual payments coming from individual loans and investments in a credit unions balance sheet.
Robust EAR models also take into account additional factors that affect profitability such as fee income, maturing CDs and operating expenses. EAR A/LM models assure validity by holding constant the assets and liabilities in a balance sheet so as to measure the actual IRR in the current balance sheet.
Once the “base” IRR is established an EAR model can also be used for multiple simulations where management can vary inputs and view the impacts each change or combination of changes has on IRR, income and equity.
Simulations may include: (1) increasing or decreasing loans and/or investments; in combination with (2) increasing or decreasing deposits (specific types or general) including changing the mix of deposits.
AL/M models need to include the effects of interest rate “shocks” that measure the impact possible changes in interest rates will have on balance sheets and profitability.
Better models measure the impact of two distinct possible rate shock scenarios: (1) an immediate, extreme (typically 500 basis points) increase or decrease in rates; and (2) small but sustained changes in interest rates (sometimes referred to as Stepped Shocks).
One A/LM model that is gaining recognition and support from state and NCUA examiners as well as credit union managers is the EAR A/LM model developed by Dr. Randy Thompson of Thompson Consulting and Training (TCT).
Dr. Thompson’s A/LM model utilizes all the concepts described in the EAR section of this article including multiple interest rate shock scenarios and is proving to be a far better A/LM model compared to other models on the market.
About the Author
Dennis Child is a 40 year veteran credit union CEO recently retired. He has been associated with TCT for 25 years. Today, Dennis enjoys providing solutions and training for credit union managers. He also uses his financial credentials and advisory skills to assist the Boomer generation plan and prepare for their retirement years. He and his wife, Geri, live in Logan, Utah. Dennis can be reached at email@example.com.