INTEREST RATE RISK Randy C. Thompson, Ph.D. Federation Webinar September 17, 2014
Definition • Interest Rate Risk is the risk to earnings or capital arising from movement of interest rates. It arises from differences between the timing of rate changes and the timing of cash flows . • For example, Base 2% Shock Income Yield 4.50% 4.50% Cost of Funds 0.50% 2.50% Margin 4.00% 2.00%
United States Interest Rate History
• 12 CFR Part 741 • IV. IRR Measurement and Monitoring • A. Risk Measurement Systems • Generally, credit unions should have IRR measurement systems that capture and measure all material and identified sources of IRR. An IRR measurement system quantifies the risk contained in the credit union’s balance sheet and integrates the important sources of IRR faced by a credit union in order to facilitate management of its risk exposures. The selection and assessment of appropriate IRR measurement systems is the responsibility of credit union boards and management. •
• 12 CFR Part 741 • Management should: • Rely on assumptions that are reasonable and supportable; • Document any changes to assumptions based on observed information; • Monitor positions with uncertain maturities, rates and cash flows, such as non-maturity shares, fixed rate mortgages where prepayments may vary, adjustable rate mortgages, and instruments with embedded options, such as calls; and • Require any interest rate risk calculation techniques, measures and tests to be sufficiently rigorous to capture risk. •
• 12 CFR Part 741 • B. Risk Measurement Methods • The following discussion is intended only as a general guide and should not be used by credit unions as an endorsement of a particular method. • An IRR measurement system may rely on a variety of different methods. Common examples of methods available to credit unions are GAP analysis, income simulation, asset valuation, and net economic value. Any measurement method(s) used by a credit union to analyze IRR exposure should correspond with the complexity of the credit union’s balance sheet so as to identify any material sources of IRR.
Guidance Letter 12-CU-05 May 2012 • Beginning on September 30, 2012 , certain federally insured credit unions (FICUs) will be required to adopt a written policy on interest- rate risk (IRR) management and a program to implement it effectively.1 • This rule affects only 45% of credit unions, yet covers 96% of credit union assets. Boards and management of affected credit unions must be vigilant and well-prepared before interest rates rise. Exposed credit unions without appropriate interest rate risk policies pose unacceptable and preventable risks to the National Credit Union Share Insurance Fund. • However, our standard for interest rate risk policies is not one-size-fits- all. We realize that exposed credit unions have different risk profiles. So while the rule provides guidelines for policies, we are also providing flexibility for credit union managers and board members to develop their own policy – and we are giving affected credit unions several months to comply.
Guidance Letter 12-CU-11 August 2012 Frequently Asked Questions • What should the policy include? • A written policy should: • Identify parties responsible for review of the credit unions IRR exposure. • Direct appropriate actions to ensure management identifies, measures, monitors, and controls IRR exposure. • State the frequency with which monitoring and measurement will be reported to the board. • Set risk limits for IRR exposure based on selected measurement. (for example GAP, NII or NEV) • Choose tests such as interest rate shocks, that the credit union will perform using the selected measures. • Provide for periodic review of material changes in IRR exposure and compliance with board approved policy and risk limits. • Provide for assessment of the IRR impact of any new business activities prior to implementation. • Provide for an annual review of policy to ensure it is commensurate with size, complexity and risk profile of the credit union. • When appropriate, establish monitoring limits for individual portfolios, activities, and lines of business.
Guidance Letter 12-CU-11 August 2012 Frequently Asked Questions • How should management implement the Board policy? • Management should: • Develop and maintain adequate IRR measurement systems; • Evaluate and understand IRR exposures; • Establish an appropriate system of internal controls (risk taker should be separate from those measuring. i.e. does the modeler also pick the investments?); • Allocate sufficient resources for an effective IRR program (should include competent staff with technical knowledge of the IRR program); • Identify procedures and assumptions involved in the IRR measurement system (i.e. the credit union’s IRR model inputs); • Establish clear lines of authority for managing IRR; and • Provide a sufficient set of reports to comply with Board approved policies
Definitions – Assets & Liabilities • Earning Assets are loans and investments • Deposits are typically all balances in member accounts • Yield is the rate of return on loans and investments • Cost of funds is the dividend rate paid on deposits • Net Interest Income (Margin) is the balance left after subtracting interest expense from interest income
Definitions - Repricing Schedule • Loans may be repriced based on the amortization of principal balances • Total of principal payments each month available to fund new loans • Investments repriced based on maturity or cash flow • Non-maturity shares (savings, checking, money markets, IRAs) reprice based on management discretion • Maturity shares (CDs) reprice at maturity. • Amount of increase is the discretion of the credit union.
Definitions - Shocks • Shock is an assumed shift of environmental interest rates affecting both earning assets and deposits • Shocks may range from negative to positive at differing levels • Credit Union policy should require at least minimum number of shocks such as +3% and down 1%. However, you can include other shocks to broaden your analysis.
Types of Shocks • Historically we can see two distinct types of shocks: • Immediate – short term • Pressures in the economy cause rates to jump quickly • Sustained/Stepped • Economic conditions result in multiple, continuous rate increases
Immediate Adjustment
Economics of Immediate Shocks • 1933 Regulation Q • Assigned deposit types to institutions • Set Maximum rates on deposits • Prohibited interest on checking • Promoted house lending due to minimal IRR • Reg Q created a stable cost of funds environment for long-term lenders, such as Savings and Loans.
Economics of Immediate Shocks • 1978-1983 • Inflation and high interest rates • Merrill Lynch Introduces Overnight Investments • Money Market Accounts • Interest Gap between Savings and Money Market rates • Disintermediation • Deregulation began in 1980 • Phased in over time • Interest rate caps eliminated in 1981
Immediate Adjustment
Results • Elimination of the interest cap • Savings rates increased to match Money Market rates • Cost of Funds increased • Margins at Savings and Loans evaporated • Example • Loans funded at 4.5% • Cost of funds now averaged 6.2% • Negative margin was unsustainable • Key was the long-term nature of earning assets • Minimal amortization of principal balances
Shock Effect – Immediate Shock • 3% Shock with no amortization and immediate deposit shock Loans 5.97% $ 30,512,568 $ 1,821,600 Investments 1.25% $ 22,564,812 $ 282,060 $ 2,103,660 Deposits 0.31% $ 58,326,791 $ 180,813 Margin $ 1,922,847
Shock Effect – Immediate Shock • 3% Shock with no amortization and immediate deposit shock Loans 5.97% $ 30,512,568 $ 1,821,600 Investments 1.25% $ 22,564,812 $ 282,060 $ 2,103,660 $ - Deposits 3.31% $ 58,326,791 $ 1,930,617 Margin $ 173,044
Shock Effect – Immediate Shock • 3% Shock with long-term amortization and immediate deposit shock Loans 5.97% $ 28,012,568 $ 1,672,350 Loans New 8.97% $ 2,500,000 $ 224,250 Investments 1.25% $ 21,064,812 $ 263,310 Investments New 4.25% $ 1,500,000 $ 63,750 $ 2,159,910 $ - Deposits 0.31% $ 58,326,791 $ 1,930,617 Margin $ 229,294 New Yield Loans 6.22% New Yield Invest. 1.45%
Shock Effect – Immediate Shock • 3% Shock with mid-term amortization and immediate deposit shock Loans 5.97% $ 23,012,568 $ 1,373,850 Loans New 8.97% $ 7,500,000 $ 672,750 Investments 1.25% $ 19,064,812 $ 238,310 Investments New 4.25% $ 3,500,000 $ 148,750 $ 2,284,910 $ - Deposits 3.31% $ 58,326,791 $ 1,930,617 Margin $ 354,294 New Yield Loans 6.71% New Yield Invest. 1.72%
Shock Effect – Immediate Shock • Summary of Impact Amortization Margin At Risk $ At Risk % Base $ 1,922,847 $ - None $ 173,044 $ 1,749,803 91.0% Long-term $ 229,294 $ 1,693,553 88.1% Mid-Term $ 354,294 $ 1,568,553 81.6%
Question What factors, that led to 1981 immediate shock, are present in our current economic condition? • Regulated interest rates? • High inflation? • Limited access to deposit types?
Shocks – Sustained/Stepped
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