Appendix A to Part 741 - Guidance for an Interest Rate Risk Policy and an Effective Program
12:7.0.2.3.26.2.11.28.24 : Appendix A
Appendix A to Part 741 - Guidance for an Interest Rate Risk Policy
and an Effective Program Table of Contents I. Introduction
A. Complexity
B. IRR Exposure
II. IRR Policy III. IRR Oversight and Management
A. Board of Directors Oversight
B. Management Responsibilities
IV. IRR Measurement and Monitoring
A. Risk Measurement Systems
B. Risk Measurement Methods
C. Components of IRR Measurement Methods
V. Internal Controls VI. Decision-Making Informed by IRR
Measurement Systems VII. Guidelines for Adequacy of IRR Policy and
Effectiveness of Program VIII. Additional Guidance for Large Credit
Unions With Complex or High Risk Balance Sheets IX. Definitions I.
Introduction
This appendix provides guidance to FICUs in developing an
interest rate risk (IRR) policy and program that addresses aspects
of asset liability management in a single framework. An effective
IRR management program identifies, measures, monitors, and controls
IRR and is central to safe and sound credit union operations. Given
the differences among credit unions, each credit union should use
the guidance in this appendix to formulate a policy that embodies
its own practices, metrics and benchmarks appropriate to its
operations.
These practices should be established in light of the nature of
the credit union's operations and business, as well as its
complexity, risk exposure, and size. As these elements increase,
NCUA believes the IRR practices should be implemented with
increasing degrees of rigor and diligence to maintain safe and
sound operations in the area of IRR management. In particular,
rigor and diligence are required to manage complexity and risk
exposure. Complexity relates to the intricacy of financial
instrument structure, and to the composition of assets and
liabilities on the balance sheet. In the case of financial
instruments, the structure can have numerous characteristics that
act simultaneously to affect the behavior of the instrument. In the
case of the balance sheet, which contains multiple instruments,
assets and liabilities can act in ways that are compounding or can
be offsetting because their impact on the IRR level may act in the
same or opposite directions. High degrees of risk exposure require
a credit union to be diligently aware of the potential earnings and
net worth exposures under various interest rate and business
environments because the margin for error is low.
A. Complexity
In influencing the behavior of instruments and balance sheet
composition, complexity is a function of the predictability of the
cash flows. As cash flows become less predictable, the uncertainty
of both instrument and balance sheet behavior increases. For
example, a residential mortgage is subject to prepayments that will
change at the option of the borrower. Mortgage borrowers may pay
off their mortgage loans due to geographical relocation, or may
increase the amount of their monthly payment above the minimum
contractual schedule due to other changes in the borrower's
circumstances. This cash flow unpredictability is also found in
investments, such as collateralized mortgage obligations, because
these contain mortgage loans. Additionally, cash flow
unpredictability affects liabilities. For example, nonmaturity
share balances vary at the discretion of the depositor making
deposits and withdrawals, and this may be influenced by a credit
union's pricing of its share accounts.
B. IRR Exposure
Exposure to IRR is the vulnerability of a credit union's
financial condition to adverse movements in market interest rates.
Although some IRR exposure is a normal part of financial
intermediation, a high degree of this exposure may negatively
affect a credit union's earnings and net economic value. Changes in
interest rates influence a credit union's earnings by altering
interest-sensitive income and expenses (e.g. loan income and
share dividends). Changes in interest rates also affect the
economic value of a credit union's assets and liabilities, because
the present value of future cash flows and, in some cases, the cash
flows themselves may change when interest rates change.
Consequently, the management of a credit union's pricing strategy
is critical to the control of IRR exposure.
All FICUs required to have an IRR policy and program should
incorporate the following five elements into their IRR program:
1. Board-approved IRR policy.
2. Oversight by the board of directors and implementation by
management.
3. Risk measurement systems assessing the IRR sensitivity of
earnings and/or asset and liability values.
4. Internal controls to monitor adherence to IRR limits.
5. Decision making that is informed and guided by IRR
measures.
II. IRR Policy
The board of directors is responsible for ensuring the adequacy
of an IRR policy and its limits. The policy should be consistent
with the credit union's business strategies and should reflect the
board's risk tolerance, taking into account the credit union's
financial condition and risk measurement systems and methods
commensurate with the balance sheet structure. The policy should
state actions and authorities required for exceptions to policy,
limits, and authorizations.
Credit unions have the option of either creating a separate IRR
policy or incorporating it into investment, ALM, funds management,
liquidity or other policies. Regardless of form, credit unions must
clearly document their IRR policy in writing.
The scope of the policy will vary depending on the complexity of
the credit union's balance sheet. For example, a credit union that
offers short-term loans, invests in non-complex or short-term
bullet investments (i.e. a debt security that returns 100
percent of principal on the maturity date), and offers basic share
products may not need to create an elaborate policy. The policy for
these credit unions may limit the loan portfolio maturity, require
a minimum amount of short-term funds, and restrict the types of
permissible investments (e.g. Treasuries, bullet
investments). More complex balance sheets, especially those
containing mortgage loans and complex investments, may warrant a
comprehensive IRR policy due to the uncertainty of cash flows.
The policy should establish responsibilities and procedures for
identifying, measuring, monitoring, controlling, and reporting IRR,
and establish risk limits. A written policy should:
• Identify committees, persons or other parties responsible for
review of the credit union's IRR exposure;
• Direct appropriate actions to ensure management takes steps to
manage IRR so that IRR exposures are identified, measured,
monitored, and controlled;
• State the frequency with which management will report on
measurement results to the board to ensure routine review of
information that is timely (e.g. current and at least
quarterly) and in sufficient detail to assess the credit union's
IRR profile;
• Set risk limits for IRR exposures based on selected measures
(e.g. limits for changes in repricing or duration gaps,
income simulation, asset valuation, or net economic value);
• 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
exposures and compliance with board approved policy and risk
limits;
• Provide for assessment of the IRR impact of any new business
activities prior to implementation (e.g. evaluate the IRR
profile of introducing a new product or service); and
• Provide for at least an annual evaluation of policy to
determine whether it is still commensurate with the size,
complexity, and risk profile of the credit union.
IRR policy limits should maintain risk exposures within prudent
levels. Examples of limits are as follows:
GAP: less than ±I 10 percent change in any given period,
or cumulatively over 12 months.
Income Simulation: net interest income after shock change
less than 20 percent over any 12-month period.
Asset Valuation: after shock change in book value of net
worth less than 50 percent, or after shock net worth of 4 percent
or greater.
Net Economic Value: after shock change in net economic
value less than 25 percent, or after shock net economic value of 6
percent or greater.
NCUA emphasizes these are only for illustrative purposes, and
management should establish its own limits that are reasonably
supported. Where appropriate, management may also set IRR limits
for individual portfolios, activities, and lines of business.
III. IRR Oversight and Management A. Board of Directors Oversight
The board of directors is responsible for oversight of their
credit union and for approving policy, major strategies, and
prudent limits regarding IRR. To meet this responsibility,
understanding the level and nature of IRR taken by the credit union
is essential. Accordingly, the board should ensure management
executes an effective IRR program.
Additionally, the board should annually assess if the IRR
program sufficiently identifies, measures, monitors, and controls
the IRR exposure of the credit union. Where necessary, the board
may consider obtaining professional advice and training to enhance
its understanding of IRR oversight.
B. Management Responsibilities
Management is responsible for the daily management of activities
and operations. In order to implement the board's IRR policy,
management should:
• Develop and maintain adequate IRR measurement systems;
• Evaluate and understand IRR risk exposures;
• Establish an appropriate system of internal controls
(e.g. separation between the risk taker and IRR measurement
staff);
• Allocate sufficient resources for an effective IRR program.
For example, a complex credit union with an elevated IRR risk
profile will likely necessitate a greater allocation of resources
to identify and focus on IRR exposures;
• Develop and support competent staff with technical expertise
commensurate with the IRR program;
• Identify the procedures and assumptions involved in
implementing the IRR measurement systems; and
• Establish clear lines of authority and responsibility for
managing IRR; and
• Provide a sufficient set of reports to ensure compliance with
board approved policies.
Where delegation of management authority by the board occurs,
this may be to designated committees such as an asset liability
committee or other equivalent. In credit unions with limited staff,
these responsibilities may reside with the board or management.
Significant changes in assumptions, measurement methods, tests
performed, or other aspects involved in the IRR process should be
documented and brought to the attention of those responsible.
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.
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 nonmaturity 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.
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.
GAP Analysis
GAP analysis is a simple IRR measurement method that reports the
mismatch between rate sensitive assets and rate sensitive
liabilities over a given time period. GAP can only suffice for
simple balance sheets that primarily consist of short-term bullet
type investments and non mortgage-related assets. GAP analysis can
be static, behavioral, or based on duration.
Income Simulation
Income simulation is an IRR measurement method used to estimate
earnings exposure to changes in interest rates. An income
simulation analysis projects interest cash flows of all assets,
liabilities, and off-balance sheet instruments in a credit union's
portfolio to estimate future net interest income over a chosen
timeframe. Generally, income simulations focus on short-term time
horizons (e.g. one to three years). Forecasting income is
assumption sensitive and more uncertain the longer the forecast
period. Simulations typically include evaluations under a base-case
scenario, and instantaneous parallel rate shocks, and may include
alternate interest-rate scenarios. The alternate rate scenarios may
involve ramped changes in rates, twisting of the yield curve,
and/or stressed rate environments devised by the user or provided
by the vendor.
NCUA Asset Valuation Tables
For credit unions lacking advanced IRR methods that seek simple
valuation measures, the NCUA Asset Valuation Tables are available
and prepared quarterly by the NCUA. These are available on the NCUA
Web site through www.ncua.gov.
These measures provide an indication of a credit union's
potential interest rate risk, based on the risk associated with the
asset categories of greatest concern - (e.g., mortgage loans
and investment securities).
The tables provide a simple measure of the potential devaluation
of a credit union's mortgage loans and investment securities that
occur during ±300 basis point parallel rate shocks, and report the
resulting impact on net worth.
Net Economic Value (NEV)
NEV measures the effect of interest rates on the market value of
net worth by calculating the present value of assets minus the
present value of liabilities. This calculation measures the
long-term IRR in a credit union's balance sheet at a fixed point in
time. By capturing the impact of interest rate changes on the value
of all future cash flows, NEV provides a comprehensive measurement
of IRR. Generally, NEV computations demonstrate the economic value
of net worth under current interest rates and shocked interest rate
scenarios.
One NEV method is to discount cash flows by a single interest
rate path. Credit unions with a significant exposure to assets or
liabilities with embedded options should consider alternative
measurement methods such as discounting along a yield curve
(e.g. the U.S. Treasury curve, LIBOR curve) or using
multiple interest rate paths. Credit unions should apply and
document appropriate methods, based on available data (e.g.
utilizing observed market values), when valuing individual or
groups of assets and liabilities.
C. Components of IRR Measurement Methods
In the initial setup of IRR measurement, critical decisions are
made regarding numerous variables in the method. These variables
include but are not limited to the following.
Chart of Accounts
Credit unions using an IRR measurement method should define a
sufficient number of accounts to capture key IRR characteristics
inherent within their product lines. For example, credit unions
with significant holdings of adjustable-rate mortgages should
differentiate balances by periodic and lifetime caps and floors,
the reset frequency, and the rate index used for rate resets.
Similarly, credit unions with significant holdings of fixed-rate
mortgages should differentiate at least by original term,
e.g., 30 or 15-year, and coupon level to reflect differences
in prepayment behaviors.
Aggregation of Data Input
As the credit union's complexity, risk exposure, and size
increases, the degree of detail should be based on data that is
increasingly disaggregated. Because imprecision in the measurement
process can materially misstate risk levels, management should
evaluate the potential loss of precision from any aggregation and
simplification used in its measurement of IRR.
Account Attributes
Account attributes define a product, including: Principal type,
rate type, rate index, repricing interval, new volume maturity
distribution, accounting accrual basis, prepayment driver, and
discount rate.
Assumptions
IRR measurement methods rely on assumptions made by management
in order to identify IRR. The simplest example is of future
interest rate scenarios. The management of IRR will require other
assumptions such as: Projected balance sheet volumes; prepayment
rates for loans and investment securities; repricing sensitivity,
and decay rates of nonmaturity shares. Examples of these
assumptions follow.
Example 1.Credit unions should consider evaluating the balance
sheet under flat (
i.e. static) and/or planned growth
scenarios to capture IRR exposures. Under a flat scenario, runoff
amounts are reinvested in their respective asset or liability
account. Conducting planned growth scenarios allows management to
assess the IRR impact of the projected change in volume and/or
composition of the balance sheet. Example 2.Loans and mortgage
related securities contain prepayment options that enable the
borrower to prepay the obligation prior to maturity. This
prepayment option makes it difficult to project the value and
earnings stream from these assets because the future outstanding
principal balance at any given time is unknown. A number of factors
affect prepayments, including the refinancing incentive,
seasonality (the particular time of year), seasoning (the age of
the loan), member mobility, curtailments (additional principal
payments), and burnout (borrowers who don't respond to changes in
the level of rates, and pay as scheduled). Prepayment speeds may be
estimated or derived from numerous national or vendor data sources.
Example 3.In the process of IRR measurement, the credit union must
estimate how each account will reprice in response to market rate
fluctuations. For example, when rates rise 300 basis points, the
credit union may raise its asset or liability rates in a like
amount or not, and may choose to lag the timing of its pricing
change. Example 4.Nonmaturity shares include those accounts with no
defined maturity such as share drafts, regular shares, and money
market accounts. Measuring the IRR associated with these accounts
is difficult because the risk measurement calculations require the
user to define the principal cash flows and maturity. Credit unions
may assume that there is no value when measuring the associated IRR
and carry these values at book value or par. Many credit unions
adopt this approach because it keeps the measurement method simple.
Alternatively, a credit union may attribute value to these
shares (i.e. premium) on the basis that these shares tend to
be lower cost funds that are core balances by virtue of being
relatively insensitive to interest rates. This method generally
results in nonmaturity shares priced/valued in a way that will
produce an increased net economic value. Therefore, the underlying
assumptions of the shares require scrutiny.
Credit unions that forecast share behavior and incorporate those
assumptions into their risk identification and measurement process
should perform sensitivity analysis.
V. Internal Controls
Internal controls are an essential part of a safe and sound IRR
program. If possible, separation of those responsible for the risk
taking and risk measuring functions should occur at the credit
union.
Staff responsible for maintaining controls should periodically
assess the overall IRR program as well as compliance with policy.
Internal audit staff would normally assume this role; however, if
there is no internal auditor, management, or a supervisory
committee that is independent of the IRR process, may perform this
role. Where appropriate, management may also supplement the
internal audit with outside expertise to assess the IRR program.
This review should include policy compliance, timeliness, and
accuracy of reports given to management and the board.
Audit findings should be reported to the board or supervisory
committee with recommended corrective actions and timeframes. The
individuals responsible for maintaining internal controls should
periodically examine adherence to the policy related to the IRR
program.
VI. Decision-Making Informed by IRR Measurement Systems
Management should utilize the results of the credit union's IRR
measurement systems in making operational decisions such as
changing balance sheet structure, funding, pricing strategies, and
business planning. This is particularly the case when measures show
a high level of IRR or when measurement results approach
board-approved limits.
NCUA recognizes each credit union has its own individual risk
profile and tolerance levels. However, when measures of fair value
indicate net worth is low, declining, or even negative, or income
simulations indicate reduced earnings, management should be
prepared to identify steps, if necessary, to bring risk within
acceptable levels. In any case, management should understand and
use their IRR measurement results, whether generated internally or
externally, in the normal course of business. Management should
also use the results proactively as a tool to adjust asset
liability management for changes in interest rate environments.
VII. Guidelines for Adequacy of IRR Policy and Effectiveness of
Program
The following guidelines will assist credit unions in
determining the adequacy of their IRR policy and the effectiveness
of their program to manage IRR.
NCUA acknowledges both the range of IRR exposures at credit
unions, and the diverse means that they may use to accomplish an
effective program to manage this risk. NCUA therefore does not
stipulate specific quantitative standards or limits for the
management of IRR applicable to all credit unions, and does not
rely solely on the results of quantitative approaches to evaluate
the effectiveness of IRR programs. Assumptions, measures and
methods used by a credit union in light of its size, complexity and
risk exposure determine the specific appropriate standard. However,
NCUA strongly affirms the need for adequate practices for a program
to effectively manage IRR. For example, policy limits on IRR
exposure are not adequate if they allow a credit union to operate
with an exposure that is unsafe or unsound, which means that the
credit union may suffer material losses under plausible adverse
circumstances as a result of this exposure. Credit unions that do
not have a written IRR policy or that do not have an effective IRR
program are out of compliance with § 741.3 of NCUA's
regulations.
VIII. Additional Guidance for Large Credit Unions With Complex or
High Risk Balance Sheets
FICUs with assets of $500 million or greater must obtain an
annual audit of their financial statements performed in accordance
with generally accepted accounting standards. 12 CFR 715.5, 715.6,
741.202. For purposes of data collection, NCUA also uses $500
million and above as its largest credit union asset range. In order
to gather information and to monitor IRR exposure at larger credit
unions as it relates to the share insurance fund, NCUA will use
this as the criterion for definition of large credit unions for
purposes of this section of the guidance. Given the increased
exposure to the share insurance fund, NCUA encourages the
responsible officials at large credit unions that are complex or
high risk to fully understand all aspects of interest rate risk,
including but not limited to the credit union's IRR assessment and
potential directional changes in IRR exposures. For example, the
credit union should consider the following:
• A policy which provides for the use of outside parties to
validate the tests and limits commensurate with the risk exposure
and complexity of the credit union;
• IRR measurement systems that report compliance with policy
limits as shown both by risks to earnings and net economic value of
equity under a variety of defined and reasonable interest rate
scenarios;
• The effect of changes in assumptions on IRR exposure results
(e.g. the impact of slower or faster prepayments on earnings
and economic value); and,
• Enhanced levels of separation between risk taking and risk
assessment (e.g. assignment of resources to separate the
investments function from IRR measurement, and IRR monitoring and
oversight).
IX. Definitions
Basis risk: The risk to earnings and/or value due to a
financial institution's holdings of multiple instruments, based on
different indices that are imperfectly correlated.
Interest rate risk: The risk that changes in market rates
will adversely affect a credit union's net economic value and/or
earnings. Interest rate risk generally arises from a mismatch
between the timing of cash flows from fixed rate instruments, and
interest rate resets of variable rate instruments, on either side
of the balance sheet. Thus, as interest rates change, earnings or
net economic value may decline.
Option risk: The risk to earnings and/or value due to the
effect on financial instruments of options associated with these
instruments. Options are embedded when they are contractual within,
or directly associated with, the instrument. An example of a
contractual embedded option is a call option on an agency bond. An
example of a behavioral embedded option is the right of a
residential mortgage holder to vary prepayments on the mortgage
through time, either by making additional premium payments, or by
paying off the mortgage prior to maturity.
Repricing risk: The repricing of assets or liabilities
following market changes can occur in different amounts and/or at
different times. This risk can cause returns to vary.
Spread risk: The risk to earnings and/or value resulting
from variations through time of the spread between assets or
liabilities to an underlying index such as the Treasury curve.
Yield curve risk: The risk to earnings and/or value due
to changes in the level or slope of underlying yield curves.
Financial instruments can be sensitive to different points on the
curve. This can cause returns to vary as yield curves change.
[77 FR 5162, Feb. 2, 2012, as amended at 77 FR 57990, Sept. 19,
2012. Redesignated at 83 FR 7964, Feb. 23, 2018]