Interest-Rate Risk: What Goes Down Must Come Up?

July 23, 2010

If history is any guide, interest rates eventually will follow a kind of reverse Newtonian logic: What goes down must come up.

In the meantime, credit union management and boards are keeping two questions uppermost in their minds:

  • When and how quickly will they turn around?
  • What should we do now to prepare for the upturn?

A number of articles and advisories over the last several years have addressed the potential problems rising interest rates might pose, particularly in terms of mortgage exposure.

In September 2003, the National Credit Union Administration (NCUA) released its Letter to Credit Unions 03-CU-151, cautioning credit unions about significant mortgage exposure. A January 2010 advisory, published by a consortium of financial regulators, reaffirmed the caution.

The advisory implored all financial institutions, including credit unions, to ensure that their interest rate risk management process is adequate for the level of interest rate risk on the balance sheet.

While credit unions have been hearing about potential problems associated with rising interest rates, interest rates currently remain at historically low levels. But they’re expected to rise at some point in the future.

So the question all should ask is, “Is our balance sheet well-positioned if interest rates were to begin rising tomorrow?”

Being prepared is ultimately what NCUA regulators have been trying to drive home to credit unions for several years.

What’s your risk exposure?

A strong asset/liability management (ALM) program can help credit unions position the previous question relevant to two others: How much risk does a credit union have to rising rates? And what’s the credit union’s strategy when interest rates do change?

It’s important to quantify how much risk a credit union has to changes in interest rates. But understanding how and why credit union-specific risk exposures are embedded in the balance sheet is just as important.

Without knowledge of these key issues, how can a credit union devise a sound strategy to address risk exposure and avoid undue pressure on earnings and capital? The answer: It can’t!

Most credit unions have seen their mortgage portfolios increase extensively over the past few years, and to a large extent they’ve funded this growth with relatively short-term funds (less than two years). The resulting long-term risk exposures have trended higher and higher. But why?

The answer becomes clear by evaluating the ALM reports or even the resulting weighted average lives (WAL) of assets versus funds. Growth in long-term assets (such as mortgages) that are funded with short-term deposits (such as one-year certificates) is causing a widening of the mismatch between the WAL of assets and liabilities.

As the mismatch increases, risk increases. The heightened risk exposures shown in a credit union’s net economic value analysis suggest long-term earnings and capital risk to rising interest rates.

When interest rates begin to rise, maturing deposits may need to be replaced at what will be higher prevailing interest rates, while long-maturity mortgages remain on the balance sheet at the older, lower interest rates. This mismatch creates pressure on earnings and capital: funding costs rise faster than asset yields, reducing gross spread, return on assets, and projected capital contributions.

By employing a sound risk management process, a credit union can monitor risk exposures and then enact a balance sheet strategy to ensure that interest rate risk doesn’t become overly burdensome and threaten earnings stability and capital adequacy.

Elements of sound risk management

Key elements of a sound risk management process include:

  • Understand and the assumptions used within the ALM process;
  • Ensure the analyses measuring interest-rate risk are accurate and presented in a timely manner;
  • Designate senior management responsibility for managing the credit union’s risk exposure;
  • Ensure that credit union personnel understand and communicate the resulting risk exposures to examiners and the board.

Risk management is a continuous process that identifying, measuring, monitoring, reporting, and controlling risk. ALM is integral to a credit union’s risk management process, as it facilitates the first four components of the process and enables the fifth component.

When properly tuned, an ALM model addresses the identification, measurement, monitoring, and reporting of interest-rate risk exposures. Credit union senior management is ultimately responsible for managing that risk.

For this reason, examiners want to ensure credit unions understand ALM and incorporate ALM results into their risk management and decision-making processes.

For larger credit unions, these functions may be performed in-house. However, for smaller credit unions, outsourcing the ALM function generally is a much more cost-effective solution.

In-house vs. outsourced

Whether ALM is performed in-house or is outsourced, credit unions should ensure they satisfy the key elements addressed previously.

Credit unions that outsource the ALM function should consider whether the provider offers the ability to discuss the analysis in depth to ensure full understanding of risk exposures. If not, where can a credit union acquire that knowledge?

Likewise, for credit unions that perform ALM internally, do they have the staff available to accurately decompose and understand the risk analysis?

When evaluating risk reports, keep these factors in mind:

  • Be aware of the assumptions that drive risk analysis. Very important! Be familiar with and understand the assumptions used in the model, such as non-term share repricing, prepayments, etc.
  • Make realistic assumptions. Ensure that assumptions made in the risk identification and measurement process are reasonable and reflect courses of action the credit union is likely to take.
  • Identify and understand key risk exposures and drivers.
  • Comprehend the products under consideration before adding them to the balance sheet.
  • Diversify cash flows, collateral, and credit quality on the asset side of the balance sheet.
  • Recall the risk/return trade-off. In order to improve earnings, risks must be taken and managed. Remember, high returns come with high risk.
  • Evaluate all products on a risk/return basis; never evaluate products solely upon return.

Whichever method a credit union chooses, the key point to absorb from the regulatory advisories is that credit union managers must understand the ALM process and modeling their credit union uses.

Finally, be aware of all the risks inherent on the credit union’s balance sheet and understand how and why the components of risk arise and how they can be managed.

While measuring and managing interest-rate risk may not make credit union managers’ list of favorite hobbies, it can help shield credit unions from excessive risk exposures.

The textbook definition of ALM is, “The process of structuring assets and liabilities so earnings stability and capital adequacy is not materially affected by prolonged change in the level of interest rates.”

This means credit unions should use their knowledge of ALM and their ALM reports to manage the overall balance sheet composition to ensure that earnings and the subsequent capital contributions aren’t severely impacted by changes in interest rates. What has come down likely will go up.

While the Federal Reserve has indicated it doesn’t intend to raise interest rates for an “extended” period, economists predict that when it does happen, the upward trend could be rapid. Credit union managers would benefit from understanding ALM capabilities and how ALM can be used to manage interest-rate risk.

Mark DeBree manages the ALM Services group for Southwest Corporate Investment Services, which provides interest rate risk analysis, model validations and core deposit analysis for client credit unions. Contact him at 800-442-5763.