©2012 cliftonlarsonallen llp 1 111 gold medal interest rate risk policies credit union association...

©2012 CliftonLarsonAllen LLP1 111

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Gold Medal Interest Rate Risk Policies

Credit Union Association of the Dakotas

June 28, 2012

©2012 CliftonLarsonAllen LLP2

Today’s Topic – Interest Rate Risk

• A Short History of Interest Rate Risk (IRR)

• The New Environment

• Best Practices

• Q&A


Our perspective…

• CliftonLarsonAllen– Started in 1953 with a goal

of total client service– January 2012 merger– Today, industry and service

specialized CPA and Advisory firm ranked in the top 10 in the U.S.

– Number 1 provider of Credit Union audit services (source: Callahan & Associates)


CliftonLarsonAllen Presenters

• Greg Schwartz, CPA

• Thomas Danielson, CPA


Start

• History of IRR Guidance


Real Estate Lending and Balance Sheet Management 99-CU-12Credit unions should complete a comprehensive

balance sheet risk assessment. Prudent interest rate risk management should be in place now to avoid excessive risk exposure in the future.


Asset Liability Management Examination Procedures 00-CU-10New examination procedures over the credit union’s

risk measurement system and the underlying assumptions used in the risk assessment.


Liability Management – Highly Rate Sensitive & Volatile Funding Sources 01-CU-08

You should analyze objectives before making decisions about how to deploy the recent inflow of funds. It is risky to make asset decisions without proper analysis of liability considerations.


Managing Share Inflows in Uncertain Times 01-CU-19Credit unions should exercise diligent management

practices as they analyze available options and objectives in managing potential increased inflow of funds.


Non-Maturity Shares and Balance Sheet Risk 03-CU-11Credit unions should adopt sound policies and

procedures when measuring the behavior of non-maturity shares.


Real Estate Concentrations and IRR Management for Credit Unions With Large Positions in Fixed-Rate Mortgage Portfolios 03-CU-15

The current interest rate environment offers credit unions unique member service opportunities, but also balance sheet management challenges. We strongly caution credit unions to avoid a strategy of "wait-and-see" on interest rates when holding excessive risk in portfolio.


Interagency Advisory on Interest Rate Risk 10-CU-06The adequacy and effectiveness of an institution’s IRR

management process and the level of its IRR exposure are critical factors in the regulators’ evaluation of an institution’s sensitivity to changes in interest rates and capital adequacy.


Interest Rate Risk Management FAQ 1/12/12

Covered Later


Interest Rate Risk Policy and Program 2/2/12

• The NCUA is issuing a final rule requiring Federally insured credit unions develop and adopt a written policy on interest rate risk management and a program to effectively implement that policy.


Interest Rate Risk Policy and Program

• Issued February 2, 2012• Effective September 30, 2012• Needed because:

1. Changes in balance sheet composition2. Increased uncertainty in the financial markets


New Requirements

• Written policy on IRR management• Written program to effectively implement the policy


Applicability

• All Federally Insured Credit Unions (FICU) over $50 million in total assets

• All FICU between $10 and $50 million with a Supervisory Interest Rate Risk Threshold Ratio (SIRRT Ratio) over 100%


Not Applicable

• FICU with less than $10 in total assets• All FICU between $10 and $50 million with a SIRRT

Ratio under 100%


SIRRT Ratio

• SIRRT Ratio

First Mortgage Loans + Investments with Maturities Over 5 Years

Divided by

Net Worth


Who’s Affected

• NCUA estimates this will apply to 3,246 FICUs• NCUA estimates 2,446 FICUs already have an IRR

Policy, so update/modification efforts will be needed• Remaining 800 FICUs will need to create a new policy

and program


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IRR Policy

IRR Policy


IRR Policy - 8 Required Elements

1. Identify committees, persons or other parties responsible for review of the credit union’s IRR exposure.



2. Direct appropriate actions to ensure management takes steps to manage IRR so that IRR exposures are identified, measured, monitored, and controlled.



3. State the frequency with which management will report on measurement results to the board and in sufficient detail to assess the credit union’s IRR profile.



4. Set limits for IRR exposures based on selected measures.



5. Choose tests, such as interest rate shocks, that the credit union will perform using the selected measures.



6. Provide for periodic review of material changes in IRR exposures and compliance with board approved policy and risk limits.



7. Provide for assessment of the IRR impact of any new business activities prior to implementation.



8. Provide for at least an annual evaluation of policy to determine whether it is still commensurate with the size, complexity, and risk profile of the credit union.


IRR Oversight and Management

Management responsibilities:• Develop and maintain adequate IRR measurement

systems• Evaluate and understand IRR risk exposures• Establish an appropriate system of internal controls• Allocate sufficient resources for an effective IRR

program• Develop and support competent staff with technical

expertise


IRR Oversight and Management

Management responsibilities (continued):• Identify the procedures and assumptions involved in

implementing the IRR measurement systems• Establish clear lines of authority and responsibility for

managing IRR• Provide a sufficient set of reports to ensure

compliance with policy


IRR Measurement and Monitoring

Risk Measurement Systems:• Rely on assumptions that are reasonable and

supportable• Document any changes to assumptions based on

observed information• Monitor positions with uncertain maturities, rates, or

cash flows• Require IRR calculation techniques, measures, and

tests to be sufficiently rigorous


IRR Measurement and Monitoring

Risk Measurement Methods:• GAP analysis• Income Simulation• NCUA Asset Valuation tables• NEVAll are acceptable, depending on complexity


Components of IRR Measurement Methods

Chart of AccountsShould define a sufficient number of accounts to

capture key IRR characteristics

As complexity, risk exposure, and size increase – data should be increasingly disaggregated


Internal Controls

• Separation of those responsible for the risk taking and risk measuring functions

• Periodically assess the overall IRR program• Normally done by Internal Auditor


Decision-Making

• Changing balance sheet structure• Funding• Pricing strategies• Business planning


Advisory on Interest Rate Risk Management

Advisory on Interest Rate Risk ManagementJanuary 6, 2010


The Interagency Advisory on Interest Rate Risk Management - FAQ1. How should financial institutions determine which

IRR vendor models are appropriate?

Consider:• Ability to model current and planned products• Automated vs. manual procedures• Model transparency and validations• Implementation and ongoing support


The Interagency Advisory on Interest Rate Risk Management - FAQ2. If an institution implements a new strategy and later

finds that its IRR measurement model cannot capture the risk exposure, could this raise significant supervisory concerns.

Yes – considered an essential part of the due diligence process.


The Interagency Advisory on Interest Rate Risk Management - FAQ

3. What types of IRR measurement methodologies are institutions expected to use?

Earnings focusedEconomic value of CapitalNew ones on a case-by-case basis


The Interagency Advisory on Interest Rate Risk Management - FAQ4. Should institutions with non-complex balance sheets

use earnings simulations to measure risk to earnings?

All institutions are encouraged to use earnings simulations


The Interagency Advisory on Interest Rate Risk Management - FAQ5. Should institutions perform rate shocks greater than

+300 basis points

Yes


The Interagency Advisory on Interest Rate Risk Management - FAQ6. Should all institutions analyze risk other than

repricing risk?

Basis, yield curve, and options risk should be analyzed annually, or more often if particularly sensitive.


The Interagency Advisory on Interest Rate Risk Management - FAQ7. Should institutions establish board-approved

thresholds for monitoring each stress scenario they run?

Management should establish limits, triggers, or thresholds for stress scenarios in order to compare risk measurement results with the institution’s risk tolerance.


The Interagency Advisory on Interest Rate Risk Management - FAQ8. When no growth scenarios for measuring earnings

simulations are mentioned, can you clarify what no growth means.

Stable balance sheetA growing balance sheet can hide IRR riskSound practice – contrast growth with no growth

scenarios


The Interagency Advisory on Interest Rate Risk Management - FAQ9. Most institutions use third-party tools to measure

IRR. Can independent certifications/validations commissioned by model vendors satisfy supervisory expectations for model validations?

No


The Interagency Advisory on Interest Rate Risk Management - FAQ10. Can you provide some examples of effective back-

testing practices?

Isolating how key drivers varied from model to actual


The Interagency Advisory on Interest Rate Risk Management - FAQ11. Can an institution use industry estimates for non-

maturity-deposit decay rates?

Generally avoid industry estimatesCan contract with an outside party to assistShould be subject to back-testing


The Interagency Advisory on Interest Rate Risk Management - FAQ12. Regarding deposit decay-rate assumptions, what

are some examples of a “market environment in which customer behaviors may not reflect the long-term economic fundamentals”?

Flight to quality during times of stress (insured deposits).

Deterrence value of prepayment penalties during times of near zero interest rates.


Other - Best Practices

• Make it visual• Use graphs and charts• Use Green, Yellow, Red Light


Quote

“Data is not useful until it becomes information. We repeatedly underestimate how important a story is to help us make sense of the world”

Seth Grodin – Marketing Guru


IRR Report – Best Practice

• The current position• The past position• The average• The variability• The story


The +400bp Shock – Best Practices

• Should we be modeling +400 parallel shifts?• November 1980 Fed Funds went from 15.85% to

18.90% in one month.• November 2000 Fed Funds went from 6.50 % to

1.82% by the end of the next year.• At least six Fed Reserve Board Members are

predicting a rapid rise in rates in 2015 or 2016.


Stress-Testing Dos

• Know what you are measuring• Leverage existing systems• Summarize/benchmark the results• Identify major assumptions• Know what the assumptions are based on


Stress-Testing Don’ts

• Think that you can predict it• Obsess over precision• Run more than a handful of tests• Expect a right or wrong answer


Summary

• Develop a IRR policy

• Develop a IRR program

• Prepare for the interest rate “Rise”


Open Discussion and Questions

©2012 cliftonlarsonallen llp 1 111 gold medal interest rate risk policies credit union association...

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