On Compliance: Revised Interest Rate Risk Framework Adopts a More Qualitative Approach

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4 minutes

NCUA should next consider revising its tests to mathematically consider risk mitigation strategies.

In September, the National Credit Union Administration issued new guidance on its updated interest rate risk supervisory framework. Interest rate risk is the risk to a financial institution that its interest-earning assets, such as loans or bonds, will decrease in value as interest rates and funding costs increase. NCUA’s updated approach to interest rate risk modifies what had previously been a strictly quantitative supervisory approach to add qualitative elements that should allow credit unions more flexibility to manage their interest-rate-risk exposures.

While this more principles-based approach is a step in the right direction, NCUA should next consider revising its quantitative interest-rate-risk tests to incorporate better credit unions’ risk mitigation strategies on a mathematical basis.

A History of Interest Rate Risk

Interest rate risk is a significant safety and soundness concern that has historically caused the failures of numerous depository institutions. The savings and loan crisis, for example, began when interest rates increased significantly in the early 1980s. Savings and loan associations, savings banks and other thrifts at that time were heavily invested in fixed-rate mortgages and faced increased funding costs as interest rates rose, resulting in net-interest-margin compression and retained earnings erosion. More than 1,000 institutions failed.

Until this year, NCUA had last updated its interest rate risk framework in 2016. The 2016 guidance revised the agency’s Net Economic Value Supervisory Test (for federally insured credit unions with more than $50 million in assets) and the Estimated Net Economic Value Tool (generally for smaller federally insured credit unions). After recent interest rate increases in the market, however, credit unions began to argue that NCUA’s 2016 approach to interest rate risk had become an overly burdensome, one-size-fits-all methodology that did not reflect a credit union’s true interest-rate-risk exposure.

One problem was that the 2016 NEV Supervisory Test as applied in practice often assumed unreasonably short average lives, as well as unrealistically high premiums, for credit unions’ non-maturity shares—even though these retail deposits are typically sticky and stable. In addition, credit unions criticized the NEV Supervisory Test because it assumed a parallel rate shock—i.e. long-term interest rates and short-term interest rates moving together—of 300 basis points, or a 3% increase, even if interest rates had already increased recently (i.e. it assumed that rates would keep going up and up), and did not fully consider credit unions’ interest-rate-risk hedging strategies, such as using interest rate swaps or caps. The NEV Supervisory Test also included an “extreme” risk category that, if triggered, effectively required the credit union to agree to documents of resolution, requiring it to exit the position even if the exposure was appropriately hedged, causing credit unions to forgo interest income they otherwise would have earned.

The Latest on Interest Rate Risk Regulation

NCUA responded to these concerns by eliminating the extreme risk category so that there are now only three categories: “low” (post-shock NEV above 7% with a NEV sensitivity below 40%); “moderate” (post-shock NEV of 4-7% with a NEV sensitivity of 40-65%); and “high” (post-shock NEV below 4% with a NEV Sensitivity above 65%). The guidance also clarifies that DORs and/or a written plan of action are not required because of the results of any NEV test alone. Instead, examiners must consider the need for a DOR and/or a written action plan on a case-by-case basis after considering relevant qualitative factors.

Examiners’ consideration of qualitative factors under the updated guidance includes assessing the credit union’s interest-rate-risk-mitigation strategy as well as interest-rate-risk modeling provided by the credit union or its third-party advisors and the source of the interest rate risk (such as, for example, a concentration of fixed-rate loans held in portfolio). These factors can influence a credit union’s “S”—sensitivity to market risk—grade under the CAMELS rating system. In addition, NCUA’s updated guidance states that examiners will evaluate a credit union’s interest-rate-risk mitigation strategy under the “M”—management—in CAMELS.

The updated guidance states that an effective interest-rate-risk management program includes the following elements: (a) it measures the credit union’s overall level of interest-rate-risk exposure; (b) the credit union’s staff reports these results to the credit union’s officials; (c) the credit union initiates action to remain within its interest-rate-risk policy limits; and (d) the credit union controls the potential impact of market risk.

Regarding a credit union’s use of third-party vendor modeling, the guidance says that “NCUA will assess the extent of credit union management’s involvement as part of the [interest-rate-risk] examination and whether a credit union understands the information provided by third-party vendors in supporting its analysis.”

NCUA’s updated interest rate risk guidance provides needed regulatory relief to credit unions even though it did not significantly update the NEV Supervisory Test itself beyond eliminating the “extreme” risk category. NCUA should next consider updating the NEV Supervisory Test itself to be more in line on a mathematical basis with the Basel Committee on Banking Supervision’s international standard Interest Rate Risk in the Banking Book, which better includes quantitative recognition of risk mitigation strategies like interest rate derivatives and involves more dynamic interest-rate shock scenarios. For now, NCUA placing a qualitative, principles-based overlay on the quantitative NEV Supervisory Test is a step in the right direction.

Michael S. Edwards is an attorney-at-law with extensive experience representing credit unions, community banks and credit union organizations in the United States and around the world on a wide range of regulatory, compliance and other legal matters. Now with his own law firm based in the Washington, D.C., area, Edwards previously served as SVP/advocacy and general counsel of the World Council of Credit Unions and was senior assistant general counsel in the regulatory advocacy section of the Credit Union National Association.

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