[Federal Register Volume 76, Number 57 (Thursday, March 24, 2011)]
[Proposed Rules]
[Pages 16570-16579]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2011-6752]
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NATIONAL CREDIT UNION ADMINISTRATION
12 CFR Part 741
RIN 3133-AD66
Interest Rate Risk
AGENCY: National Credit Union Administration (NCUA).
ACTION: Proposed rule.
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SUMMARY: NCUA proposes to amend its regulations to require Federally
insured credit unions to have a written policy addressing interest rate
risk (IRR) management and an effective IRR program as part of their
asset liability management. NCUA also is proposing draft guidance in
the form of an appendix to its regulations to assist
[[Page 16571]]
credit unions in meeting the proposed regulatory requirement. NCUA
believes a written IRR policy and an effective IRR program is key to
maintaining safe and sound operations. NCUA believes credit unions will
find the guidance helpful in addressing this important area of their
operations.
DATES: Comments must be received on or before May 23, 2011.
ADDRESSES: You may submit comments by any of the following methods
(Please send comments by one method only):
Federal Rulemaking Portal: http://www.regulations.gov.
Follow the instructions for submitting comments.
NCUA Web Site: http://www.ncua.gov/RegulationsOpinionsLaws/proposed_regs/proposed_regs.html. Follow the
instructions for submitting comments.
E-mail: Address to [email protected]. Include ``[Your
name] --Comments on Proposed Rulemaking for Part 741'' in the e-mail
subject line.
Fax: (703) 518-6319. Use the subject line described above
for e-mail.
Mail: Address to Mary Rupp, Secretary of the Board,
National Credit Union Administration, 1775 Duke Street, Alexandria,
Virginia 22314-3428.
Hand Delivery/Courier: Same as mail address.
Public Inspection: All public comments are available on the
agency's Web site at http://www.ncua.gov/RegulationsOpinionsLaws/comments as submitted, except as may not be possible for technical
reasons. Public comments will not be edited to remove any identifying
or contact information. Paper copies of comments may be inspected in
NCUA's law library at 1775 Duke Street, Alexandria, Virginia 22314, by
appointment weekdays between 9 a.m. and 3 p.m. To make an appointment,
call (703) 518-6546 or send an e-mail to [email protected].
FOR FURTHER INFORMATION CONTACT: Jeremy Taylor, Senior Capital Markets
Specialist, Office of Capital Markets and Planning, National Credit
Union Administration, 1775 Duke Street, Alexandria, Virginia 22314, or
telephone: (703) 518-6620.
SUPPLEMENTARY INFORMATION:
A. Discussion
NCUA proposes to amend its regulations to require Federally insured
credit unions (FICUs) to have a written policy and an effective program
addressing interest rate risk (IRR) as part of their asset liability
management (ALM). NCUA believes FICUs need a written policy to
explicitly state the credit union's IRR tolerance. An effective IRR
program that identifies, measures, monitors, and controls IRR is an
essential component of safe and sound credit union operations. In the
past, NCUA issued guidance on ALM and IRR management in Letters to
Credit Unions and believes FICUs generally are managing IRR
adequately.\1\ NCUA's IRR questionnaire is also available at the
following location http://www.ncua.gov/Resources/ALManagementInvest/Review Procedures.aspx. However, IRR has risen at credit unions due to
changes in balance sheet compositions and increased uncertainty in the
financial markets. The Board therefore believes it is appropriate to
create a regulatory requirement addressing the policy and practice of
interest rate risk management at FICUs supported by clear and
comprehensive guidance. The Board believes the proposed regulatory
requirement and guidance will assist FICUs in understanding and meeting
NCUA's expectations regarding IRR policy and implementing an effective
program. NCUA anticipates that it would set a compliance date of three
months after the rule becomes effective.
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\1\ Letters to Credit Unions: 99-CU-12 Real Estate Lending and
Balance Sheet Management; 00-CU-10 Asset Liability Management
Procedures; 00-CU-13, Liquidity and Balance Sheet Management; 01-CU-
08, Liability Management--Rate-Sensitive and Volatile Funding
Sources; 01-CU-19 Managing Share Inflows in Uncertain Times; 03-CU-
11, Non-maturity Shares and Balance Sheet Risk; 03-CU-15 Real Estate
Concentrations and Interest Rate Risk Management for Credit Unions
with Large Positions in Fixed Rate Mortgages; 06-CU-16 Inter-Agency
Guidance on Non-traditional Mortgage Product Risk. Interagency
Advisory on Interest Rate Risk Management, January 6, 2010.
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The term ``interest rate risk'' refers to the vulnerability of a
credit union's financial condition to adverse movements in market
interest rates. Although some IRR is a normal part of financial
intermediation, IRR may negatively affect a credit union's earnings, or
net economic value, which is the difference between the market value of
assets and the market value of liabilities. 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.\2\
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\2\ Credit unions confront IRR from several sources. These
include repricing risk, yield curve risk, spread risk, basis risk,
and options risk. See the glossary of terms in Appendix B for
definitions of these risks.
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An effective IRR program allows a credit union to serve member
needs without incurring unreasonable levels of risk and make informed
decisions about balance sheet composition, growth and product mix,
while remaining within its defined tolerance level. An IRR program
enables credit unions to meet their liquidity needs and implement
flexible pricing strategies in response to changes in market interest
rates while maintaining adequate earnings and net economic value.
NCUA recognizes it is impossible to establish specific, regulatory
requirements for IRR that would be appropriate for all FICUs. IRR
management involves judgment by a FICU based on its own individual
mission, structure, and circumstances. Any rule must take into account
the diversity of FICUs and avoid a one-size-fits-all approach.
Accordingly, FICUs should devise a policy and risk management program
appropriate to their own situation.
The guidance in the Appendix does not identify specific metrics
because NCUA recognizes IRR programs will differ among credit unions.
There are, nevertheless, fundamental elements applicable to all credit
unions, as explained in the appendix. Developing a sound IRR program is
the responsibility of the board of directors, involving all relevant
phases of operation, and NCUA believes the proposed guidance provides a
helpful framework for directors. NCUA is presenting guidance in the
form of an appendix to the rule to assist FICUs in establishing a
written policy and effective program as part of asset liability
management.
B. Proposed Rule
Section 741.3 generally addresses the criteria NCUA will consider
in determining and continuing the insurability of a credit union and
paragraph (b) lists various factors and requirements for a credit
union's financial condition and its policies. Currently, Sec. 741.3(b)
includes requirements, among others, of written lending and investment
policies, 12 CFR 741.3(b)(2) and (3), and, therefore, placement of the
proposed amendment within this provision is appropriate. The Board
proposes to amend Sec. 741.3(b) to add the requirement of a written
policy on IRR and an effective program. This is an additional factor to
be considered in determining whether a credit union's financial
condition and
[[Page 16572]]
policies are safe and sound. 12 CFR 741.3(b).
C. Regulatory Procedures
Regulatory Flexibility Act
The Regulatory Flexibility Act requires NCUA to prepare an analysis
to describe any significant economic impact a rule may have on a
substantial number of small entities, those credit unions with less
than ten million dollars in assets. The proposed rule does not apply to
credit unions with less than ten million dollars in assets.
Accordingly, the Board determines that this proposed rule will not have
a significant economic impact on a substantial number of small credit
unions and that a Regulatory Flexibility Analysis is not required.
Paperwork Reduction Act
The Paperwork Reduction Act of 1995 (PRA) applies to rulemakings in
which an agency by rule creates a new paperwork burden on regulated
entities or modifies an existing burden. 44 U.S.C. 3507(d). For
purposes of the PRA, a paperwork burden may take the form of a either a
reporting or a recordkeeping requirement, both referred to as
information collections. NCUA has determined that the requirement to
have a written interest rate policy creates a new information
collection requirement. NCUA is applying to the Office of Management
and Budget (OMB) for approval of the proposed information collection
requirement.
As required by the PRA, NCUA is submitting a copy of this proposed
regulation to the OMB for its review and approval. Persons interested
in submitting comments with respect to the information collection
aspects of the proposed rule should submit them to the OMB at the
address noted below.
Written policy requirements
The proposed rule would require a written interest rate policy and
would apply to all Federally insured credit unions (FICUs) as follows.
FICUs with assets over $50 million must meet the requirement for a
written policy. FICUs with assets $10 million or over and less than or
equal to $50 million must meet the requirement for a written policy if
the total of first mortgage loans held plus total investments with
maturities greater than five years is equal to or greater than 100% of
its net worth. FICUs with assets $10 million or over and less than or
equal to $50 million are not required to have a written policy if the
total of first mortgage loans held plus total investments with
maturities greater than five years is less than 100% of its net worth.
FICUs less than $10 million in assets are not required by the rule to
have a written policy even if the total of first mortgage loans held
plus total investments with maturities greater than five years is
greater than 100% of its net worth.
A FICU is considered to hold a first mortgage loan for its own
portfolio when it has not demonstrated the intent and ability to sell
the loan to an independent third party within 120 days. Investments
with maturities greater than five years are defined as those reported
by the FICU to have maturities of 5-10 years and greater than 10 years
in the statement of financial condition of its most recent call report.
For example, Credit Union A has assets of $51 million. The
percentage of first mortgage loans held by Credit Union A plus its
investments with maturities greater than five years is 75% of its net
worth. It is required by the rule to have a written interest rate
policy because of its asset size. Credit Union B has $45 million in
assets. The percentage of first mortgage loans held by Credit Union B
plus its investments with maturities greater than five years is 75% of
its net worth. Credit Union B is therefore not required by the rule to
have a written interest rate policy since this percentage is less that
100%. Credit Union C has assets of $10 million and the percentage of
first mortgage loans held by Credit Union C plus its investments with
maturities greater than five years is 125% of its net worth. It is
required to have a written interest rate policy because it has assets
$10 million or over and less than or equal to $50 million, and the
percentage of first mortgage loans held by Credit Union C plus its
investments with maturities greater than five years is greater than
100% of its net worth. Credit Union D has assets of $9 million and the
percentage of first mortgage loans held by Credit Union D plus its
investments with maturities greater than five years is 125% of its net
worth. Credit Union D is not required by the rule to have a written
interest rate policy because its asset size is below $10 million, even
though the percentage of first mortgage loans held by Credit Union D
plus its investments with maturities greater than five years is greater
than 100% its net worth.
As of December 31, 2010, there were 7339 FICUs, of which 3184 had
assets over $50 million, or had assets $10 million or over and less
than or equal to $50 million, and total first mortgage loans plus total
investments with maturities greater than five years were equal to or
greater than 100% of net worth. NCUA estimates, however, that
approximately 75% of these credit unions already have interest rate
risk policies in place as part of their lending and asset management
policies. Therefore, they will not have to undertake any significant
additional burden as a result of this rulemaking. NCUA estimates that
those credit unions with existing policies will only need to undertake
a review of those policies to determine if they are in line with the
guidance accompanying this rule change. While minor adjustments to
existing policies may be appropriate, NCUA estimates that approximately
only 25% of the credit unions will need to prepare a written policy.
Therefore, NCUA estimates that approximately 800 credit unions will
need to develop a written interest rate risk policy to meet the
requirement for a written policy; NCUA notes that periodic review of
the policy, while included as part of the guidance, may require no
additional paperwork burden or engender very limited additional
paperwork.
The proposed rule requiring a written interest rate risk policy is
accompanied by guidance on how to establish this policy and the
guidance essentially provides a template or list of the eight points
the written policy should address. As provided in the guidance, the
points to be covered are:
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 annual evaluation of policy to determine
whether it is still
[[Page 16573]]
commensurate with the size, complexity, and risk profile of the credit
union.
The actual length of a policy may vary significantly depending on
the complexity of the credit union's activities. For example, a credit
union that offers basic share accounts, only short-term loans, i.e., no
mortgage loans, and makes relatively simple investments should be able
to establish a written policy in one to two hours. The policy could
establish maturity limits for loans, establish the minimum amount of
short-term funds, and basically restrict the types of permissible
investments (e.g. Treasuries). 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.
Burden Calculation
While the burden will vary depending on the complexity of credit
union activities, for purposes of providing an estimated average, NCUA
estimates each of the eight segments of policy will have a burden of an
equal weight of two hours. The maximum time for all segments of the
policy is therefore sixteen hours. NCUA estimates the burden associated
with this collection as follows: 800 x 16 hours = 12,800 hours.
Organizations and individuals that wish to submit comments on this
information collection requirement should direct them to the Office of
Information and Regulatory Affairs, OMB, Attn: Shagufta Ahmed, Room
10226, New Executive Office Building, Washington, DC 20503, with a copy
to Mary Rupp, Secretary of the Board, National Credit Union
Administration, 1775 Duke Street, Alexandria, Virginia 22314-3428.
The NCUA considers comments by the public on this proposed
collection of information in:
Evaluating whether the proposed collection of information
is necessary for the proper performance of the functions of the NCUA,
including whether the information will have a practical use;
Evaluating the accuracy of the NCUA's estimate of the
burden of the proposed collection of information, including the
validity of the methodology and assumptions used;
Enhancing the quality, usefulness, and clarity of the
information to be collected; and
Minimizing the burden of collection of information on
those who are to respond, including through the use of appropriate
automated, electronic, mechanical, or other technological collection
techniques or other forms of information technology; e.g., permitting
electronic submission of responses.
The Paperwork Reduction Act requires OMB to make a decision
concerning the collection of information contained in the proposed
regulation between 30 and 60 days after publication of this document in
the Federal Register. Therefore, a comment to OMB is best assured of
having its full effect if OMB receives it within 30 days of
publication. This does not affect the deadline for the public to
comment to the NCUA on the proposed regulation.
Executive Order 13132
Executive Order 13132 encourages independent regulatory agencies to
consider the impact of their actions on State and local interests. In
adherence to fundamental federalism principles, NCUA, an independent
regulatory agency as defined in 44 U.S.C. 3502(5), voluntarily complies
with the executive order. This rule will not have substantial direct
effects on the States, on the relationship between the national
government and the States, or on the distribution of power and
responsibilities among the various levels of government. NCUA has
determined that this rule does not constitute a policy that has
federalism implications for purposes of the executive order.
The Treasury and General Government Appropriations Act, 1999--
Assessment of Federal Regulations and Policies on Families
The NCUA has determined that this rule will not affect family well-
being within the meaning of the Treasury and General Government
Appropriations Act, 1999, Public Law 105-277, 112 Stat. 2681 (1998).
Agency Regulatory Goal
NCUA's goal is to promulgate clear and understandable regulations
that impose minimal regulatory burden. We request your comments on
whether the proposed rule is understandable and minimally intrusive.
List of Subjects in 12 CFR Part 741
Credit unions, Requirements for insurance.
By the National Credit Union Administration Board on March 17,
2011.
Mary F. Rupp,
Secretary of the Board.
For the reasons set forth above, NCUA proposes to amend 12 CFR part
741 as follows:
PART 741--REQUIREMENTS FOR INSURANCE
1. The authority citation for part 741 continues to read:
Authority: 12 U.S.C. 1757, 1766(a), 1781-1790, and 1790d; 31
U.S.C, 3717.
2. In Sec. 741.3, add paragraph (b)(5) to read as follows:
Sec. 741.3 Criteria
* * * * *
(b) * * *
(5)(i) The existence of a written interest rate risk policy and an
effective interest rate risk management program as part of asset
liability management in all Federally insured credit unions (FICUs) as
follows. FICUs with assets over $50 million must meet the requirement
for a written policy and an effective interest rate risk management
program. FICUs with assets $10 million or over and less than or equal
to $50 million must meet the requirement for a written policy and an
effective interest rate risk management program if the total of first
mortgage loans held plus total investments with maturities greater than
five years is equal to or greater than 100% of its net worth. FICUs
with assets $10 million or over and less than or equal to $50 million
are not required to have a written policy and an effective interest
rate risk management program if the total of first mortgage loans held
plus total investments with maturities greater than five years is less
than 100% of its net worth. FICUs less than $10 million in assets are
not required by the rule to have a written policy and an effective
interest rate risk management program even if the total of first
mortgage loans held plus total investments with maturities greater than
five years is greater than 100% of its net worth.
(ii) A FICU is considered to hold a first mortgage loan for its own
portfolio when it has not demonstrated the intent and ability to sell
the loan to an independent third party within 120 days. Investments
with maturities greater than five years are defined as those reported
by the FICU to have maturities of 5-10 years and greater than 10 years
in the statement of financial condition of its most recent call report.
(iii) For example, Credit Union A has assets of $51 million. The
percentage of first mortgage loans held by Credit Union A plus its
investments with maturities greater than five years is 75% of its net
worth. It is required by the rule to have a written interest rate
policy and an effective interest rate risk management program because
of its asset size. Credit Union B has $45
[[Page 16574]]
million in assets. The percentage of first mortgage loans held by
Credit Union B plus its investments with maturities greater than five
years is 75% of its net worth. Credit Union B is therefore not required
by the rule to have a written interest rate policy and an effective
interest rate risk management program since this percentage is less
that 100%. Credit Union C has assets of $10 million and the percentage
of first mortgage loans held by Credit Union C plus its investments
with maturities greater than five years is 125% of its net worth. It is
required to have a written interest rate policy and an effective
interest rate risk management program because it has assets $10 million
or over and less than or equal to $50 million, and the percentage of
first mortgage loans held by Credit Union C plus its investments with
maturities greater than five years is greater than 100% of its net
worth. Credit Union D has assets of $9 million and the percentage of
first mortgage loans held by Credit Union D plus its investments with
maturities greater than five years is 125% of its net worth. Credit
Union D is not required by the rule to have a written interest rate
policy and an effective interest rate risk management program because
its asset size is below $10 million, even though the percentage of
first mortgage loans held by Credit Union D plus its investments with
maturities greater than five years is greater than 100% its net worth.
(iv) Appendix B to this part provides guidance on how to establish
an interest rate risk policy and effective program. The guidance
describes widely accepted best practices in the management of interest
rate risk and it may therefore be helpful to all FICUs.
* * * * *
3. Part 741 is amended by adding Appendix B to read as follows:
Appendix B 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. Standards for Assessment 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 gives guidance to FICUs in the implementation of
an interest rate risk (IRR) policy and program as aspects to overall
asset liability management. 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 formulate 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 which 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 are comprised of
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 over $50 million, and all FICUs with assets $10
million or over and less than or equal to $50 million if the total
of first mortgage loans held plus total investments with maturities
greater than five years is equal to or greater than 100% of its net
worth, 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
either or both:
a. Earnings;
b. 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,
[[Page 16575]]
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 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 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 or Net Economic Value: After shock change in
book value net worth less than 25 percent or after shock value of
net worth greater than 6 percent.
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 their 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. IRR 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 that should be
based on observed information;
Ensure calculation techniques are appropriate in rigor
and use accepted financial concepts;
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 measures and tests to be
sufficiently rigorous to capture risk.
B. IRR Measurement Methods
The following discussion is intended only as a general guide and
should not be used by credit unions as a checklist. 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 and display 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 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 Office of Capital Markets (OCM).
These are located at http://www.ncua.gov/Resources/ALManagementInvest/Review Procedures.aspx.
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 credit
union's balance sheet long-term IRR 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.
[[Page 16576]]
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.
1. 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.
2. 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 aggregation and
simplification used in its measurement of IRR.
3. 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, discount
rate.
4. 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. Guidance on the evaluation of
nonmaturity shares is available in NCUA's Letter to Credit Unions
03-CU-11.
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. Standards for Assessment of IRR Policy and Effectiveness of
Program
The following standards will assist credit unions in determining
the adequacy of their IRR policy and assess the effectiveness of
their program to manage IRR. This section provides examples of
adequate and inadequate elements of IRR policies and programs based
on the preceding sections. Specific instances of inadequate policies
and programs are in some cases identified for purposes of
illustration.
------------------------------------------------------------------------
Adequate Inadequate
------------------------------------------------------------------------
Policy:
Board oversight......... Policy is consistent Policy is not
with credit union consistent with
strategy, and the credit union
board states complexity. Board
actions required to has not reviewed
address policy limits specified in
exceptions. policy and does not
require management
to take corrective
action when policy
limitations are
exceeded.
[[Page 16577]]
Responsible parties A committee or No committee or
identified. management is individual
designated to specified to review
review and monitor credit union's IRR
IRR. exposure.
Direct appropriate Policy states all Omissions in policy
action to measure, actions that are cause material
monitor, control IRR. sufficient to deficiency in
manage IRR. controlling risk
(e.g. method of
measuring IRR is
not identified or
risk measurement
not required with
stated frequency).
Reporting frequency Reporting of results Reporting is
specified. is required with infrequent and does
sufficient not provide
frequency to alert adequate detail to
management to control IRR (e.g.
emerging IRR. semi-annual
reporting on an
aggregate balance
sheet).
Risk limits stated with Risk limits are Key risk limit
appropriate measures. established and are omitted from policy
appropriate for the (e.g. NEV ratio or
size and complexity volatility post
of the credit union. shock, NII post
shock, or
sensitivity gap at
stated period), or
limit is not
reasonable (e.g.
limits allow IRR
measures to
approach
dangerously low
levels under
plausible interest
rate scenarios).
Tests for limits........ Tests substantially Tests do not
display the level indicate level or
and range of credit source of risk
union IRR. (e.g. NEV @ only +/-
100 bps, or
repricing gap only
at one month).
Review of material IRR Any changes beyond a Review is required,
changes. stated level are but need for
reported to compliance with
management and, policy limits and
where appropriate, corrective action
the Board. is unclear.
Impact of new business.. IRR impact of all The credit union
business does not evaluate
initiatives is the impact of new
required where business on its IRR
these will affect profile and is at
future IRR. risk from new
business booked.
Periodic policy review.. Review by Board Policy review is
required annually required only if
to ensure continued risks are
relevance and unchanged, at the
applicability of Board's discretion.
policy to
management of IRR.
IRR Oversight & Management:
Oversight............... Board approves Board is aware of
policy and the types of IRR
strategies and present to credit
understands IRR unions in general,
faced by its own but does not have
credit union. knowledge of the
IRR risks
associated with the
credit union.
Oversight assessment of Board periodically Board substantially
program effectiveness. evaluates program relies on annual
effectiveness by third party review
monitoring to determine the
management's IRR adequacy of
knowledge, using oversight and
professional advice. governance.
Choice of IRR Management selects Systems used by the
measurement systems. and maintains credit union do not
systems which are capture IRR (e.g.
able to capture the balance sheet
complexity of IRR contains material
risks. options in
investments,
mortgage loans or
core deposits,
which the system
cannot capture--
calls, prepayments,
or administered
rates).
Evaluation of IRR risk Credit union Management relies on
exposures. understands all outside parties to
material IRR evaluate credit
exposures and union's IRR and
evaluates these cannot effectively
accordingly explain the IRR
relative to credit measurement method
union strategy. or the results.
System of internal Internal controls Internal audit has
controls. encompass and not identified or
effectively addressed the
evaluate programs correction of IRR
that manage deficiencies (e.g.
elements of IRR at processes for
the credit union. tracking changes in
measurement
assumptions, such
as gap repricing of
core deposits).
IRR resource management. Credit union has Credit union IRR
allocated initial exposure has
or additional materially
qualified staff increased without
resources allocating
sufficient to additional,
manage IRR by means qualified staff,
that address consequently IRR
sources of risk. exposures are not
identified or
properly measured.
Expertise of IRR program Staff responsible Credit union relies
staff. correctly on staff who do not
identifies sources understand or are
of IRR and can not familiar with
quantify these IRR at the credit
risks. union (e.g.
management cannot
explain the impact
on IRR of
overstating core
deposit premiums).
Procedures and Credit union Management delegates
assumptions of IRR identifies assumptions to a
measurement systems. reasonable third party and has
procedures and no procedure to
supportable review the
assumptions. reasonableness of
the assumptions.
Accountability of IRR Responsibility for Responsibility for
management. managing IRR is managing IRR is too
specific and broad, or unclear,
clearly delineated. or not recognized
by management.
Transparency of changes Management requires Changes in
in assumptions, methods clear disclosure of assumptions are not
and IRR tests. relevant changes in tracked, or
all material monitored or
assumptions and transparent to
methods. those evaluating
efficacy of IRR
system.
[[Page 16578]]
IRR Measurement and
Monitoring:
Reasonable and Credit union Results are highly
supportable assumptions. carefully evaluates dependent on key
all assumptions and assumptions that
assesses the have not been
sensitivity of researched or
results relative to demonstrated to be
each key assumption. supportable (e.g.
mortgage
prepayments do not
reflect extension
risk and core
deposit premiums
overstate or do not
indicate reasonable
maturities).
Assumption changes from All material changes Assumptions are not
observed information. in assumptions are tested and changes
based on tested are not supported
internal data or by any associated
reliable industry data on which the
sources. credit union
relies.
Rigor of calculations Techniques used Methods to attribute
and conformity of appropriately cash flows, and
concepts. capture complexity rate sensitivities
of balance sheet are based on
instruments. incorrect
techniques (e.g.
misuse of
statistical
correlations).
Positions with uncertain Activity is Actual behavior is
maturities, rates and monitored on a not monitored or
cash flows. regular basis in compared to
order to validate projected behavior.
reasonableness of
modeling
assumptions.
Rigor of interest rate Measures and tests Measures and tests
measures and tests. employed capture employed do not
the material risks capture material
embedded in the risks embedded in
credit union's the balance sheet
balance sheet. (e.g. rate shocks
do not trigger the
embedded options in
some products).
Components of IRR
Measurement Methods:
Chart of accounts....... A sufficient number Accounts/products
of accounts have with different IRR
been defined to characteristics are
capture key IRR modeled as one
characteristics account/product
inherent within (e.g. 15- and 30-
each product. year fixed-rate
mortgages, with
various coupons and
prepayment
behaviors).
Data aggregation........ The level of data Data is combined for
disaggregation is similar products
sufficient given with a wide range
the credit union's of variables,
complexity and risk producing
exposure (e.g. misleading weighted
instrument level average terms (e.g.
processing). combining fixed-
rate mortgages with
coupons ranging
from 4% to 8%, and
modeling as a 6%
mortgage).
Account attributes...... Account set-up is Account set-up fails
appropriate to to identify key IRR
allow for the characteristic
capture of key IRR (e.g. adjustable-
characteristics. rate mortgages are
modeled without
periodic and
lifetime caps and
floors).
Discounting methodology. Methodology used Methodology used
properly calculates does not accurately
the value of the value assets or
asset or liability liabilities (e.g.
being modeled. discount rates or
maturities or cash
flows are incorrect
in discounting
calculations).
Assumptions............. Credit union Results are highly
carefully evaluates dependent on key
all assumptions and assumptions that
assesses the have not been
sensitivity of researched or
results relative to demonstrated to be
each key assumption. supportable (e.g.
mortgage
prepayments do not
reflect extension
risk and core
deposit premiums
overstate or do not
indicate reasonable
maturities).
Internal Controls:
Internal assessment of Staff are identified There is no
IRR program. and have annually specified review
assessed policy and action for
program to correct requiring periodic
any weaknesses. evaluation of IRR
program
effectiveness.
Compliance with policy.. IRR program is Exceptions to policy
evaluated semi- occur occasionally
annually for any and these are not
policy exceptions, noted by the
including internal control
compliance with process.
approved limits.
Timeliness and accuracy Reports that are Reports fail to
of reports. routinely provided specify some
to management and material risks, and
the Board some scheduled
successfully reports are not
communicate produced.
material IRR
exposure of the
credit union.
Audit findings reported IRR program IRR program
to board or supervisory deficiencies and effectiveness is
committee. policy exceptions not part of audit
are reported to the review. No findings
Board in accordance occur.
with the policy.
Decision-making and IRR:
Use of IRR measurement Measured IRR results IRR exposure
results in operational form part of the discussion occurs
decisions. credit union's only as deemed
ongoing business relevant in the
decisions and are annual strategic
substantive process.
considerations
routinely included
in the business
decision process.
Escalated use of results Procedure specifies IRR results are
when IRR exposure is review escalation secondary in
raised or approaching at specific levels addressing IRR
limits. with increasing contingencies.
contingency Credit union relies
triggers close to on ad hoc response
limits. driven by market
and customer
perceptions.
Application to reduce Credit union IRR system results
elevated levels of IRR. utilizes IRR are not used to
results to clearly address balance
define and structure, funding
formulate response or pricing
to increased IRR strategies.
levels.
------------------------------------------------------------------------
[[Page 16579]]
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 or significant losses under 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 Sec. 741.3 of NCUA's regulation.
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 NCUA insurance fund, NCUA will use this
as the criterion for definition of large credit unions for purposes
of the guidance. Given the increased exposure to the share insurance
fund, NCUA encourages the following standards at large credit
unions.
Responsible officials at large credit unions that are complex or
high risk should 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:
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 measurements that provide 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); or,
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
Glossary of terms
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.
[FR Doc. 2011-6752 Filed 3-23-11; 8:45 am]
BILLING CODE 7535-01-P