That’s why it’s important for credit unions to pay attention to new developments in each of the seven “risk factors” NCUA identifies in its Examiner’s Guide. Obviously, there aren’t clear demarcations between highly interrelated risks, so many of these developments could fall under several risk categories. While NCUA doesn’t recognize “concentration risk” as a separate category, that risk concern impacts a number of agency’s risk factors.
NCUA states that “interest-rate risk is the most significant risk the credit union industry faces right now.” Since 2012, federally insured credit unions with more than $50 million in assets must have an interest-rate risk (IRR) management program.
The framework of an effective IRR management program has five elements, according to NCUA: A comprehensive, written IRR policy; IRR oversight by the board of directors and management; appropriate IRR measurement and monitoring systems; good internal controls; and informed decision-making based on IRR measurement system results.
At the time the NCUA Board adopted this new regulation, interest rates were at (and generally remain near) historic lows. An NCUA board member asked staff why the agency needed a regulation at a time when interest-rate risk wasn’t of particular concern. Staff answered that credit unions need to be “repairing the roof before it rains.”
NCUA is concerned that the rain might come at any time and credit unions aren’t ready. Expect examiners to ask far more pointed questions this year about your credit union’s IRR program. For example, if a credit union’s real estate loan portfolio has a large concentration of fixed-rate mortgages (and perhaps also a large amount invested in mortgage-backed securities), expect the examiner to ask some tough questions.
Early this year, NCUA finalized a new regulation on derivatives as another tool to mitigate interest-rate risk—and only for this purpose. Federal credit unions with at least $250 million in assets and a composite CAMEL rating of 1, 2, or 3 can apply to NCUA for permission to use certain derivatives (interest-rate swaps, interest-rate caps, interest-rate floors, basis swaps and Treasury futures). The agency might allow smaller federal credit unions to use them, too. While state-chartered credit unions permitted under state law to use derivatives don’t have to apply for permission, they must notify NCUA 30 days before engaging in derivative activities, must follow NCUA-issued “guidance” on derivatives, and can expect a close regular review by NCUA.
Don’t expect many credit unions to have authority to use derivatives. NCUA believes that 30 to 60 federal credit unions will likely apply during the next two years, and agency approval will take many months. Adding in the state-chartered credit unions it expects to see using derivatives, NCUA says 50 to 100 credit unions likely will engage in derivative activities by year-end 2015.
Concerns about loan performance, rates of delinquencies, and charge-offs are always high on examiners’ minds, regardless of type of loan. Obviously, problems in the housing sector were a key cause of the Great Recession, and the Dodd-Frank Act mandated the Consumer Financial Protection Bureau adopt numerous regulations to restore order and balance to mortgage lending.
The CFPB’s ability-to-repay/qualified mortgage (QM) regulation, which became effective in January 2014, raises concerns about how examiners will respond to credit unions making non-QMs. NCUA specifically says:
“Whether your credit union originates QMs or non-QMs, field staff will evaluate credit risk, liquidity risk, and concentration risk. NCUA will not subject a mortgage to safety-and-soundness criticism solely because of the loan’s status as a QM or non-QM. But credit unions choosing to make non-QMs will need to take into account the potential new market and legal risks.”
It’s uncertain how many non-QMs will end up on credit unions’ books and if there will be a secondary market for non-QMs. So expect examiners to look at the composition of your mortgage portfolio, to evaluate if your credit union really understands risks of holding non-QMs, and to ask how you plan to address these risks if you hold a large amount of them.
And there’s another part of loan portfolios receiving additional examiner scrutiny: NCUA notes private student loans are the fastest-growing product in the credit union industry. Possible losses won’t occur for a number of years after the loan is made, so credit risks are hard to assess. More than 600 credit unions offer this product, and they should expect examiners to closely look at their planning, policies, and monitoring systems, as well as how they conduct due diligence reviews of third parties they rely upon and what steps they take to mitigate risk (such as the use of co-borrowers and purchase of default insurance). At year-end 2013, NCUA shared with credit unions not only its Supervisory Letter to examiners on this subject but also its AIRES questionnaire.
As the agency’s January 2014 risk-based capital proposal demonstrates, NCUA also is very concerned about a credit union holding a large concentration of its assets in member business loans (MBLs). So expect continued examiner scrutiny of MBL portfolios. In the “good news” category, the agency plans to revisit some of the restrictions in its MBL regulation this year.
NEXT: Liquidity risk