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Understanding Interest Rate Risk

Wade Oliver Senior Vice President Director of Asset/Liability Management Vining Sparks IBG woliver@viningsparks.com

November 8, 2012

Understanding IRR • • • •

What is “Interest Rate Risk”?

Goals of the ALCO process Expectations of the NCUA Practical Application

NCUA guidance “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.”

Understanding IRR what is IRR? “Asset/Liability Management” incorporates all aspects of managing the structure of the balance sheet. In a more narrow focus, the term is used to reference the management of interest rate risk.

The NCUA defines interest rate risk (“IRR”) as “the vulnerability of a credit union’s financial condition to adverse movements in market interest rates” 3

Understanding IRR what is IRR? In March of 2011, the NCUA Board approved a new rule to require a written interest rate risk policy and an interest rate risk program as a requirement for insurance for all federally insured credit unions.

The new guidance is estimated to be applicable for 3,184 FICUs. Of these, approximately 25%, or 800 will need to prepare written policies and procedures.

The guidance also sets best practice for those FICUs that already have formal policies and programs. Whether you are developing an ALM process for the first time, or updating your current process, the foundations are the same.

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Understanding IRR what is IRR? • Asset/Liability Management – Risks that are inherent to a financial intermediary – Not credit related

• Quantifies Risks to the Balance Sheet – Over a defined period of time – Both short term and longer term

• Action oriented, take actions to – Control the risks – Improve the Credit Union’s performance

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Understanding IRR what is IRR? • Interest Rate Risk management quantifies: – Risks to Earnings (short & long term) – Risks to Net Economic Value – Risks to Liquidity and Strategic outlook

• Should also identify opportunities to improve the Credit Union’s performance • To quantify risks and opportunities, the CU must “simulate” financial performance over different interest rate environments.** ** Certain very small or basic CUs may be exempt

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Understanding IRR what is IRR?

A Simulation Model • Combines current financial information with management assumptions about future events.

• Simulates financial performance – – – – –

Balances over time Income statements Rate/yield statements Cash flows Economic/market values

• May be in-house or outsourced 7

Understanding IRR • • • •

What is “Interest Rate Risk”?

Goals of the ALCO process Expectations of the NCUA Practical Application

Understanding IRR Goals of the ALCO  Measuring and Monitoring Interest Rate Risk - inherent in the business of credit union.  Apprising Directors of the magnitude and direction of IRR.  MANAGING interest rate risk, not eliminate it.  Improved financial performance ----

Better returns for our members!

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Understanding IRR Goals of the ALCO There are three “core” measurements that should be quantified and managed: – GAP position – Earnings at Risk – Net Economic Value – Other ratios are often used as well • • • •

Loans to Shares Capital ratios Etc. Normally more beneficial as a trend

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Understanding IRR Goals of the ALCO GAP • Compares the amount of assets that re-price in a given time period to the amount of liabilities that re-price during that same period. The missmatch is the “gap”. Historically, positive gap values (more assets re-pricing than liabilities) have been interpreted as an indicator that the balance sheet would benefit from rising rates. A negative gap would be interpreted the opposite.

• Gap calculations can be raw dollar amounts, or adjusted to estimate the relative sensitivity of the account type.

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Understanding IRR Goals of the ALCO

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Gap Analysis

Understanding IRR Goals of the ALCO GAP Analysis Gap analysis “can suffice for simple balance sheets that primarily consist of short-term bullet type investments and non mortgage-related assets.”

The designation of “simple” and “primarily” are a matter of opinion, the burden of establishing your balance sheet as “simple” will fall on you.

Few credit unions larger than the $50mm threshold for formal policies would likely be determined to be non-complex enough to rely solely on GAP analysis.

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Understanding IRR Goals of the ALCO Earnings at Risk or “EAR” Calculates net interest income over specific time period, normally 1 and 2 years, based on the current balance sheet, pricing assumptions, and the current interest rate environment.

This earnings calculation with rates unchanged serves is referred to as the “base case”, and should reasonably reflect the current earnings expectation for the credit union.

The primary purpose for the simulation is NOT the forecast of income – it is the identification of risks.

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Understanding IRR Goals of the ALCO Earnings at Risk or “EAR” • The earnings simulation is repeated under different assumed interest rate scenarios.

• The primary purpose of the simulations is not to forecast actual performance, but to establish exposures and trends.

• The difference in the calculated net interest income of this simulation from the base case NII is the risk to the credit union’s earnings, or the “EAR” 17

Earnings at Risk

The EAR would be expressed as -3.82% +/- 100bps year 1

Understanding IRR Goals of the ALCO

Net Economic Value or “NEV” • measures the effect of interest rates on the market value of net worth by calculating the present value of the assets minus the present value of liabilities.

• NEV calculations are not specifically required by the NCUA for the those FICUs that are “not complex” Most FICUs that have formal policies and procedures will have NEV risk limits incorporated.

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“NEV� defined Example 1:

Agency: 8% coupon, due May 2022 To yield 3%, approximate price

143

Example 2:

Agency: 2% coupon, due May 2022 To yield 3%, approximate price

91

The dramatically higher price is the present value of the difference in future revenues. ** price and yield are for example purposes only

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“NEV” defined Accounting equation: Book Value

Economic Value

Assets $200

Assets $205

- Liabilities

180

- Liabilities

175

Equity

20

Equity

30

Book Capital 10.0% Economic Capital 14.6% 21

“NEV” defined For today’s discussion, think of “Economic Value” as the present value. The EV of any asset or liability related to its’ revenue stream, or the earning power of that asset or liability.

Therefore, Net Economic Value, or NEV is a function of the current earning power of your balance sheet. (at least theoretically)

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“NEV� defined Calculated Economic Values Dn 300

Current

Up 300

Assets

$212

$205

$180

Liabilities

180

175

158

Equity

32

30

22

+2

( 6.7%)

-8 (-26.7%)

The change in the NEV equates to a change in the earnings power of your balance sheet.

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NEV at Risk

“NEV” defined Understanding your exposure to rising rates mandates a well rounded look using various tools. Historic short term NII simulations may not be sufficient.

Net Economic Value at risk or “NEV” takes a comprehensive, long term view, considering every cash flow and option on both sides of the balance sheet. An understanding of NEV at risk analysis will help you identify structural mismatches in your balance sheet, and improve your performance.

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Understanding IRR Goals of the ALCO Other Measures Other measures traditionally used in the measurement of IRR may still be useful. These traditional ratios are normally tracked and analyzed by examiners, and should be monitored as secondary measures.

These ratios are best reviewed over time, and can establish or highlight trends that indicate pressures.

It is perfectly acceptable to track these ratios without establishing a policy or risk limit for them.

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Understanding IRR

• • • •

What is “Interest Rate Risk”?

Goals of the ALCO process Expectations of the NCUA Practical Application

Understanding IRR NCUA Expectations In March of 2011, the NCUA Board approved a new rule to require a written interest rate risk policy and an interest rate risk program as a requirement for insurance for all federally insured credit unions.

This statement clarified expectations on the measurement and management of IRR, and in conjunction with the FFIEC joint policy statement established several new areas of expected best practice.

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Understanding IRR NCUA Expectations “The regulators recognize that some degree of IRR is inherent in the business of (the credit union).” you “are expected to have sound risk management practices in place to measure, monitor, and control IRR exposures.” “..effective IRR management not only involves the identification and measurement of IRR, but also involves appropriate actions to control this risk”

Understanding IRR NCUA Expectations 1. Board-approved IRR policy 2. Oversight by the board of directors and implementation by management; 3. Risk measurement systems assessing the IRR of either or both: • Earnings • Asset and liability values 4. Internal controls to monitor adherence to IRR limits; 5. Decision making that is informed and guided

by IRR measures 30

Understanding IRR NCUA Expectations “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 as well as its complexity, risk exposure, and size.

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Understanding IRR NCUA Expectations

Complexity “A function of the predictability of the cash flows” The example used? Residential mortgages which are subject to prepayments and investments that are collateralized by mortgage loans.

There is also a recognition of the “unpredictability” of non-maturity shares, which vary at the discretion of the depositor.

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Understanding IRR NCUA Expectations Mortgage loans in portfolio Securities portfolio contains CMO MBS, or callable agencies The balance sheet is “larger� or growing Capital is relatively low Funding has been volatile

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Understanding IRR NCUA Expectations Loan portfolio has SHORT finals Securities portfolio bullet maturities The balance sheet is stable Capital is relatively high Funding is very basic If you plan to use more simplistic measures and policies because you are not complex, you must explain why your balance sheet is not complex.

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Understanding IRR NCUA Expectations

Understanding IRR NCUA Expectations

Understanding IRR NCUA Expectations Measuring your risk is not enough.

• How do you know the risk profile is reasonable?

• Is it short term or long term?

• What are the cost/benefits of reducing the risk?

• What is the pain/probability profile?

If your IRR management reflected a risk, your examiner will want to know what you did to mitigate that risk.

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Understanding IRR

• • • •

What is “Interest Rate Risk”?

Goals of the ALCO process Expectations of the NCUA Practical Application

Understanding IRR Practical Application International Economics

Internal Dynamics / Trends

Strategies

Local Conditions Interest Rate Risk Profile

Understanding IRR Practical Application

Your asset/liability tools should reveal risks from several perspectives.

•NII at Risk – Short Term –Basis, Production, Assumptions •NII at Risk – Longer Term –NEV Analysis, Gap Reports •Value at Risk –Economic Exposure –Asset Value Exposure Perception, Collateral, Liquidity

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Understanding IRR Practical Application

Remember that many things affect your actual performance in changing rate environments: • • • • •

Other markets Demographics of your marketplace Absolute level of interest rates Beginning slope of the yield curve New competitors and product alternatives

Manage those risks you can now, your options in the future may be limited.

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Understanding IRR Practical Application

Reduce the asset price risk actively: • •

•

Adding new assets (leverage) with short durations, offset by longer funding. * Selling assets with more exposure to rising rates, and replacing them with more stable structures.

Other asset sales?

Reduce the asset price risk passively: •

Reducing the tenors of new assets as they come due * May be at negative spreads 42

Understanding IRR Practical Application Add longer term funding: • “Core” non maturity shares are the best defense against value exposure, but how quickly can they be added?

• Longer retail funding raised quickly rarely adds value.

• Wholesale term funding has better “staying power”, and is much more efficiently priced. CDs for long term, save collateral for liquidity needs.

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Understanding IRR Practical Application 1. Why do you run the model? To show how well you can perform, or to identify risks?

Although most managers focus on risks from an income perspective, changes in value can tell you a lot about your balance sheet.

2. Don’t neglect the exposures revealed by your EV at Risk profile. Income simulations can mask structural mismatches. Can you actually “manage your way through” an exposure?

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Understanding IRR Practical Application 3. Remember the options your hold.

Investment portfolio management is the key to managing EV at risk, and preparing for rising rates: •

The Investment Portfolio

•

Wholesale Funding

•

Leverage Capacity

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Understanding IRR NCUA Expectations Your IRR program should be centered around the decision making process. The risk measurement, the control process, and the reporting process should be centered around answering that one basic question:

If this is where we are, what do we need to do?

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Questions?

For further information, contact your account representative or Wade Oliver woliver@viningsparks.com INTENDED FOR INSTITUTIONAL INVESTORS ONLY. The information included herein has been obtained from sources deemed reliable, but it is not in any way guaranteed, and it, together with any opinions expressed, is subject to change at any time. Any and all details offered in this publication are preliminary and are therefore subject to change at any time. This has been prepared for general information purposes only and does not consider the specific investment objectives, financial situation and particular needs of any individual or institution. This information is, by its very nature, incomplete and specifically lacks information critical to making final investment decisions. Investors should seek financial advice as to the appropriateness of investing in any securities or investment strategies mentioned or recommended. The accuracy of the financial projections is dependent on the occurrence of future events which cannot be assured; therefore, the actual results achieved during the projection period may vary from the projections. Interest rate swaps and derivatives are offered and sold via Vining Sparks Interest Rate Products, LLC. The firm may have positions, long or short, in any or all securities mentioned. Member FINRA/SIPC.