Interest-rate risk: A core competency
Smith-Vandergriff says ‘its inherent to who we are as credit unions.’
Interest-rate risk is a core competency, not only for directors, but for their credit unions, says Brian Smith-Vandergriff.
“If you do interest-rate risk well, you can be a better credit union,” Smith-Vandergriff, a partner at Financial Management Services Inc., said during a breakout session at the 2019 CUNA Finance Council Conference in New York City on Monday. “It you don’t do it well, you might as well divide up the capital and return it to the members. It’s inherent to who we are as credit unions.”
Smith-Vandergriff says interest-rate risk should not be “a regulatory pacifier,” but something credit unions use to make decisions.
Credit unions are subject to several different types of risk, Smith-Vandergriff notes. They are:
- Mismatch risk: This risk results from the difference in the time to maturity of the pricing of assets and liabilities. A credit union with mismatch risk is exposed to changes in the general level of interest rates. “The nature of credit unions is that we borrow short and lend long,” Smith-Vandergriff says. “This is always going to be a challenge for us.”
- Basis risk: This is the risk that the changes in two rates within the same sector do not correlate. Perhaps the most-often used example for credit unions is the difference between the prime rate and the Treasury bill. Smith-Vandergriff says most basis rates are set by convention. “For example, the prime rates is 300 basis points above the Federal Funds rate,” he says. “It doesn’t have to be that. What’s worked in the past doesn’t always work in the future.”
- Option risk: This is the risk that earnings or market values will fall at an increasing rate or rise at a decreasing rate due to embedded options. Smith-Vandergriff suggests credit unions should more often model scenarios in which credit unions members redeemed long-term certificates of deposits early, despite penalties. “It’s not typical, but it is a real risk,” he says.
- Yield curve risk: This risk is the exposure to non-parallel shifts in the yield curve. Yields are generally higher the longer the term to maturity, Smith-Vandergriff says. An example is a credit union with both long- and short-term assets funded by medium-term liabilities.
“The real reason we want to take this training back our credit unions is because we have to make it work in the real world,” Smith-Vandergriff says. “In some cases, the membership is shifting. In other cases, we’re fixated on being market related. But in either case, we have to pay attention to why these changes are taking place.”
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