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©2012 CliftonLarsonAllen LLP Gold Medal Interest Rate Risk Policies Credit Union Association of the Dakotas June 28, 2012
©2012 CliftonLarsonAllen LLP 2 Today’s Topic – Interest Rate Risk A Short History of Interest Rate Risk (IRR) The New Environment Best Practices Q&A
©2012 CliftonLarsonAllen LLP 3 Our perspective… CliftonLarsonAllen –Started in 1953 with a goal of total client service –January 2012 merger –Today, industry and service specialized CPA and Advisory firm ranked in the top 10 in the U.S. –Number 1 provider of Credit Union audit services (source: Callahan & Associates)
©2012 CliftonLarsonAllen LLP 4 CliftonLarsonAllen Presenters Greg Schwartz, CPA Thomas Danielson, CPA
©2012 CliftonLarsonAllen LLP 5 Start History of IRR Guidance
©2012 CliftonLarsonAllen LLP 6 Real Estate Lending and Balance Sheet Management 99-CU-12 Credit unions should complete a comprehensive balance sheet risk assessment. Prudent interest rate risk management should be in place now to avoid excessive risk exposure in the future.
©2012 CliftonLarsonAllen LLP 7 Asset Liability Management Examination Procedures 00-CU-10 New examination procedures over the credit union’s risk measurement system and the underlying assumptions used in the risk assessment.
©2012 CliftonLarsonAllen LLP 8 Liability Management – Highly Rate Sensitive & Volatile Funding Sources 01-CU-08 You should analyze objectives before making decisions about how to deploy the recent inflow of funds. It is risky to make asset decisions without proper analysis of liability considerations.
©2012 CliftonLarsonAllen LLP 9 Managing Share Inflows in Uncertain Times 01-CU-19 Credit unions should exercise diligent management practices as they analyze available options and objectives in managing potential increased inflow of funds.
©2012 CliftonLarsonAllen LLP 10 Non-Maturity Shares and Balance Sheet Risk 03-CU-11 Credit unions should adopt sound policies and procedures when measuring the behavior of non- maturity shares.
©2012 CliftonLarsonAllen LLP 11 Real Estate Concentrations and IRR Management for Credit Unions With Large Positions in Fixed-Rate Mortgage Portfolios 03-CU-15 The current interest rate environment offers credit unions unique member service opportunities, but also balance sheet management challenges. We strongly caution credit unions to avoid a strategy of "wait-and-see" on interest rates when holding excessive risk in portfolio.
©2012 CliftonLarsonAllen LLP 12 Interagency Advisory on Interest Rate Risk 10-CU-06 The adequacy and effectiveness of an institution’s IRR management process and the level of its IRR exposure are critical factors in the regulators’ evaluation of an institution’s sensitivity to changes in interest rates and capital adequacy.
©2012 CliftonLarsonAllen LLP 13 Interest Rate Risk Management FAQ 1/12/12 Covered Later
©2012 CliftonLarsonAllen LLP 14 Interest Rate Risk Policy and Program 2/2/12 The NCUA is issuing a final rule requiring Federally insured credit unions develop and adopt a written policy on interest rate risk management and a program to effectively implement that policy.
©2012 CliftonLarsonAllen LLP 15 Interest Rate Risk Policy and Program Issued February 2, 2012 Effective September 30, 2012 Needed because: 1.Changes in balance sheet composition 2.Increased uncertainty in the financial markets
©2012 CliftonLarsonAllen LLP 16 New Requirements Written policy on IRR management Written program to effectively implement the policy
©2012 CliftonLarsonAllen LLP 17 Applicability All Federally Insured Credit Unions (FICU) over $50 million in total assets All FICU between $10 and $50 million with a Supervisory Interest Rate Risk Threshold Ratio (SIRRT Ratio) over 100%
©2012 CliftonLarsonAllen LLP 18 Not Applicable FICU with less than $10 in total assets All FICU between $10 and $50 million with a SIRRT Ratio under 100%
©2012 CliftonLarsonAllen LLP 19 SIRRT Ratio First Mortgage Loans + Investments with Maturities Over 5 Years Divided by Net Worth
©2012 CliftonLarsonAllen LLP 20 Who’s Affected NCUA estimates this will apply to 3,246 FICUs NCUA estimates 2,446 FICUs already have an IRR Policy, so update/modification efforts will be needed Remaining 800 FICUs will need to create a new policy and program
©2012 CliftonLarsonAllen LLP 21 ©2012 CliftonLarsonAllen LLP IRR Policy
©2012 CliftonLarsonAllen LLP 22 IRR Policy - 8 Required Elements 1. Identify committees, persons or other parties responsible for review of the credit union’s IRR exposure.
©2012 CliftonLarsonAllen LLP 23 IRR Policy - 8 Required Elements 2. Direct appropriate actions to ensure management takes steps to manage IRR so that IRR exposures are identified, measured, monitored, and controlled.
©2012 CliftonLarsonAllen LLP 24 IRR Policy - 8 Required Elements 3. State the frequency with which management will report on measurement results to the board and in sufficient detail to assess the credit union’s IRR profile.
©2012 CliftonLarsonAllen LLP 25 IRR Policy - 8 Required Elements 4. Set limits for IRR exposures based on selected measures.
©2012 CliftonLarsonAllen LLP 26 IRR Policy - 8 Required Elements 5. Choose tests, such as interest rate shocks, that the credit union will perform using the selected measures.
©2012 CliftonLarsonAllen LLP 27 IRR Policy - 8 Required Elements 6. Provide for periodic review of material changes in IRR exposures and compliance with board approved policy and risk limits.
©2012 CliftonLarsonAllen LLP 28 IRR Policy - 8 Required Elements 7. Provide for assessment of the IRR impact of any new business activities prior to implementation.
©2012 CliftonLarsonAllen LLP 29 IRR Policy - 8 Required Elements 8. 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.
©2012 CliftonLarsonAllen LLP 30 IRR Oversight and Management Management responsibilities: Develop and maintain adequate IRR measurement systems Evaluate and understand IRR risk exposures Establish an appropriate system of internal controls Allocate sufficient resources for an effective IRR program Develop and support competent staff with technical expertise
©2012 CliftonLarsonAllen LLP 31 IRR Oversight and Management Management responsibilities (continued): Identify the procedures and assumptions involved in implementing the IRR measurement systems Establish clear lines of authority and responsibility for managing IRR Provide a sufficient set of reports to ensure compliance with policy
©2012 CliftonLarsonAllen LLP 32 IRR Measurement and Monitoring Risk Measurement Systems: Rely on assumptions that are reasonable and supportable Document any changes to assumptions based on observed information Monitor positions with uncertain maturities, rates, or cash flows Require IRR calculation techniques, measures, and tests to be sufficiently rigorous
©2012 CliftonLarsonAllen LLP 33 IRR Measurement and Monitoring Risk Measurement Methods: GAP analysis Income Simulation NCUA Asset Valuation tables NEV All are acceptable, depending on complexity
©2012 CliftonLarsonAllen LLP 34 Components of IRR Measurement Methods Chart of Accounts Should define a sufficient number of accounts to capture key IRR characteristics As complexity, risk exposure, and size increase – data should be increasingly disaggregated
©2012 CliftonLarsonAllen LLP 35 Internal Controls Separation of those responsible for the risk taking and risk measuring functions Periodically assess the overall IRR program Normally done by Internal Auditor
©2012 CliftonLarsonAllen LLP 36 Decision-Making Changing balance sheet structure Funding Pricing strategies Business planning
©2012 CliftonLarsonAllen LLP 37 Advisory on Interest Rate Risk Management January 6, 2010
©2012 CliftonLarsonAllen LLP 38 The Interagency Advisory on Interest Rate Risk Management - FAQ 1. How should financial institutions determine which IRR vendor models are appropriate? Consider: Ability to model current and planned products Automated vs. manual procedures Model transparency and validations Implementation and ongoing support
©2012 CliftonLarsonAllen LLP 39 The Interagency Advisory on Interest Rate Risk Management - FAQ 2. If an institution implements a new strategy and later finds that its IRR measurement model cannot capture the risk exposure, could this raise significant supervisory concerns. Yes – considered an essential part of the due diligence process.
©2012 CliftonLarsonAllen LLP 40 The Interagency Advisory on Interest Rate Risk Management - FAQ 3. What types of IRR measurement methodologies are institutions expected to use? Earnings focused Economic value of Capital New ones on a case-by-case basis
©2012 CliftonLarsonAllen LLP 41 The Interagency Advisory on Interest Rate Risk Management - FAQ 4. Should institutions with non-complex balance sheets use earnings simulations to measure risk to earnings? All institutions are encouraged to use earnings simulations
©2012 CliftonLarsonAllen LLP 42 The Interagency Advisory on Interest Rate Risk Management - FAQ 5. Should institutions perform rate shocks greater than +300 basis points Yes
©2012 CliftonLarsonAllen LLP 43 The Interagency Advisory on Interest Rate Risk Management - FAQ 6. Should all institutions analyze risk other than repricing risk? Basis, yield curve, and options risk should be analyzed annually, or more often if particularly sensitive.
©2012 CliftonLarsonAllen LLP 44 The Interagency Advisory on Interest Rate Risk Management - FAQ 7. Should institutions establish board-approved thresholds for monitoring each stress scenario they run? Management should establish limits, triggers, or thresholds for stress scenarios in order to compare risk measurement results with the institution’s risk tolerance.
©2012 CliftonLarsonAllen LLP 45 The Interagency Advisory on Interest Rate Risk Management - FAQ 8. When no growth scenarios for measuring earnings simulations are mentioned, can you clarify what no growth means. Stable balance sheet A growing balance sheet can hide IRR risk Sound practice – contrast growth with no growth scenarios
©2012 CliftonLarsonAllen LLP 46 The Interagency Advisory on Interest Rate Risk Management - FAQ 9. Most institutions use third-party tools to measure IRR. Can independent certifications/validations commissioned by model vendors satisfy supervisory expectations for model validations? No
©2012 CliftonLarsonAllen LLP 47 The Interagency Advisory on Interest Rate Risk Management - FAQ 10. Can you provide some examples of effective back- testing practices? Isolating how key drivers varied from model to actual
©2012 CliftonLarsonAllen LLP 48 The Interagency Advisory on Interest Rate Risk Management - FAQ 11. Can an institution use industry estimates for non- maturity-deposit decay rates? Generally avoid industry estimates Can contract with an outside party to assist Should be subject to back-testing
©2012 CliftonLarsonAllen LLP 49 The Interagency Advisory on Interest Rate Risk Management - FAQ 12. Regarding deposit decay-rate assumptions, what are some examples of a “market environment in which customer behaviors may not reflect the long- term economic fundamentals”? Flight to quality during times of stress (insured deposits). Deterrence value of prepayment penalties during times of near zero interest rates.
©2012 CliftonLarsonAllen LLP 50 Other - Best Practices Make it visual Use graphs and charts Use Green, Yellow, Red Light
©2012 CliftonLarsonAllen LLP 51 Quote “Data is not useful until it becomes information. We repeatedly underestimate how important a story is to help us make sense of the world” Seth Grodin – Marketing Guru
©2012 CliftonLarsonAllen LLP 52 IRR Report – Best Practice The current position The past position The average The variability The story
©2012 CliftonLarsonAllen LLP 53 The +400bp Shock – Best Practices Should we be modeling +400 parallel shifts? November 1980 Fed Funds went from 15.85% to 18.90% in one month. November 2000 Fed Funds went from 6.50 % to 1.82% by the end of the next year. At least six Fed Reserve Board Members are predicting a rapid rise in rates in 2015 or 2016.
©2012 CliftonLarsonAllen LLP 54 Stress-Testing Dos Know what you are measuring Leverage existing systems Summarize/benchmark the results Identify major assumptions Know what the assumptions are based on
©2012 CliftonLarsonAllen LLP 55 Stress-Testing Don’ts Think that you can predict it Obsess over precision Run more than a handful of tests Expect a right or wrong answer
©2012 CliftonLarsonAllen LLP 56 Summary Develop a IRR policy Develop a IRR program Prepare for the interest rate “Rise”
©2012 CliftonLarsonAllen LLP 57 Open Discussion and Questions
©2012 CliftonLarsonAllen LLP 58 ©2012 CliftonLarsonAllen LLP Thank You Greg Schwartz, CPA Partner
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