Asset/Liability Management (ALM) NCUA s Revised Interest Rate Risk Supervision (Letter to Credit Unions 16-CU-08)

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1 Asset/Liability Management (ALM) NCUA s Revised Interest Rate Risk Supervision (Letter to Credit Unions 16-CU-08) Dan Frilot Senior Vice President Balance Sheet Solutions, LLC

2 Background Balance Sheet Solutions, LLC (BSS) Founded in 2002 and is wholly owned by Alloya Corporate Federal Credit Union. Our staff averages 26 years of experience in institutional financial services and 13 years specifically working with and for credit unions. We help over 800 credit unions in the U.S. with balance sheet strategy, investment execution, and risk measurement. Dan Frilot, SVP - ALM Risk Management Experience: Over 25 years in financial services industry, 20+ years working directly with credit unions on balance sheet management strategies including liquidity and funding, loan portfolio analytics and loan participations, interest rate risk mitigation, and concentration risk. 2

3 Agenda NCUA s Letter to Credit Unions 16-CU-08 Revised Interest Rate Risk (IRR) Supervision IRR Supervision Scope & Expectations Are Interest Rates Headed Higher? 3

4 NCUA Letter to Credit Unions 16-CU-08 Revised Interest Rate Risk Supervision Development of the Net Economic Value (NEV) Supervisory Test Updated IRR tolerance thresholds for NEV Interest Rate Risk Review Procedures Workbook Creation of Estimated NEV Tool for Small CU s Revision of IRR Chapter in Examiner s Guide Effective January 1,

5 NEV Supervisory Test What Is It? Total balance sheet IRR metric Focus on capital at risk Creates uniform and consistent IRR NEV measure across all credit unions Shifts regulatory focus towards IRR outliers 5

6 Net Economic Value (NEV) The fair market value of assets minus the fair market value of liabilities equals NEV. NEV includes only existing balances and contracts as of the analysis date. NEV does not include projected new volumes. Market-based measurement = NEV Ratio 6

7 NEV Sensitivity Identify base case NEV at point in time If market interest rates rise or fall, what happens to the amount of NEV (i.e. the percentage change in NEV)? Percentage change in NEV = NEV Sensitivity 7

8 NEV Supervisory Test Mechanics Examiner will use credit union s internally-derived NEV information on assets, term share certificates, and other liabilities. 1% deposit premium benefit given to non-maturity shares (NMS) in base case. 4% benefit given to NMS (from new base) at +300 basis point rate shock scenario. NEV ratio and NEV sensitivity evaluated at +300 basis point rate shock scenario. 8

9 NEV Supervisory Test Why Developed? Large percentage (over 70%) of credit union funding in non-maturity share balances. Significant uncertainty surrounding non-maturity share valuation methods. Credit unions primarily use past behavior to predict future behavior of non-maturity accounts. Technology has made it easier to shift money between financial institutions. Historical deposit regression analysis may no longer be accurate. Standardization will allow NCUA to compare risk across the CU system. 9

10 Millions $180 $160 $140 $120 $100 $80 $60 Average Share Balance Composition - All CUs Nationwide Share Certificates IRA/KEOGH Shares Share Drafts Money Market Regular Shares Non-Maturity Shares 65% 4Q07 Non-Maturity Shares 81% 2Q16 $40 $20 $0 Source: Callahan Peer-to-Peer 10

11 NEV Supervisory Test-Risk Thresholds Risk Level Post-shock NEV NEV Sensitivity (%) Low Above 7% Below 40% Moderate 4% up to 7% 40% to 65% High 2% up to 4% 65% to 85% Extreme Below 2% Above 85% NOTE: NEV Supervisory Test risk level is determined by the most unfavorable or adverse risk level assessed from the two NEV measurements. 11

12 Prior (Old) IRR Thresholds LOW MODERATE HIGH Basis of Measurement RISK RISK RISK NII Earnings Simulation (after shock change of NII < -20 % -20 to -30 % > -30 % over any 12 month period) NEV Volatility (after shock change in < -25 % -25 to -50 % > -50 % market value net worth) Post-Shock Net Worth (after shock value of book net > 6.0 % % < 4.0 % worth)

13 Example Standard NEV Valuation vs. NCUA s NEV Supervisory Test 13

14 Standard NEV Valuation Standard NEV Valuation Test Account Book Balance Base +300 Regular Shares 100,000, Share Drafts 25,000, IRA Shares 15,000, Money Market 60,000, Total Shares $ 200,000, % Non-Maturity Share Valuation using CU s Parameters. Standard NEV Risk Profile ($ 000) BASE +300 Asset Value: $ 218,000 $ 203,830 Liability Value: 192, ,054 NEV: 25,200 21,776 NEV Sensitivity: % NEV Ratio: 11.56% 10.68% Low Risk 14

15 NCUA s NEV Supervisory Test NCUA NEV Supervisory Test Account Book Balance Base +300 Regular Shares 100,000, Share Drafts 25,000, IRA Shares 15,000, Money Market 60,000, Total Shares $ 200,000, % Non-Maturity Share Valuation using 1% / 4% Assumptions NCUA 1% - 4% Non-Maturity Shares ($ 000) BASE +300 Asset Value: $ 218,000 $ 203,830 Liability Value: 198, ,080 NEV: 20,000 13,750 NEV Sensitivity: % NEV Ratio: 9.17% 6.75% Moderate Risk 15

16 IRR Supervision Scope Total Assets under Total Assets between Total Assets of $50m $50m - $500m $500m or greater 3,681 CUs 1,779 CUs 493 CUs $55b $283b $903b Is "Supervisory Test" High or Extreme? Post 1 st Exam Cycle 1 st Exam Cycle No Yes Estimated NEV Tool IRR Workbook not required 15 Steps 25 Steps 35 Steps 16

17 17

18 NCUA s Reorganized IRR Workbook 18

19 Interest Rate Risk Workbook Market Risk (NEV) 1) Balance Sheet Valuations Review procedures and assumptions. Intent is to use CU s valuations for everything but the non-maturity shares. 2) NEV Supervisory Test Non-maturity share valuations: 1%/4% test. Assess NEV ratio and New sensitivity profile using new NEV risk threshold categories. 19

20 Interest Rate Risk Workbook Earnings at Risk (NII Simulations) 1) Static Balance Sheet 2) Dynamic Balance Sheet for Planning 3) Review/Update Reinvestment Rates 4) Non-Maturity Assumption Documentation 20

21 Interest Rate Risk Workbook Stress Testing 1) Forward Looking Stress Scenarios 2) Unlikely but Plausible Events 3) Change Key Assumptions and Understand 4) Validate Assumptions that Move the Risk Needle 21

22 Examples of Stress Testing Loan Prepayments Non-Maturity Share Decay Rates Non-Maturity Share Repricing Non-Maturity Share Final Maturity Term Interest Rate Ramps Yield Curves: Flattening, Steepening, etc. Loan or Investment Credit Impairment 22

23 Rate Scenarios Sensitivity Testing Stress Testing Review What are the interest rate (e.g. changing slopes and twist of the yield curve), and shocked rate scenarios (e.g. severe but plausible rate shocks relative to existing level of rates), the CU uses to evaluate the IRR exposure of the balance sheet? Specify the frequency of testing. Is the frequency of testing sufficient? For Baseline II review, does the credit union conduct interest rate stress testing, if so, describe and determine if commensurate with the size and complexity of the balance sheet? What assumptions has management determined to influence the model output most (RSF/Beta, Lag, Decay, Prepays)? Has the credit union performed sensitivity analysis to identify what degree of change in these assumptions cause model results to fall outside of management s risk tolerance level? Specify the frequency of testing. Is the frequency of testing sufficient? For Baseline II review, does the credit union conduct sensitivity stress testing, if so, describe and determine if commensurate with the size and complexity of the balance sheet? Limit Monitoring Does management evaluate stress tests that fall outside of policy limits? How relevant are these stress tests to the credit union and, what has management done to address stress tests that fall outside of limit? Are they discussed and reported to the board and/or ALCO? 23

24 Interest Rate Risk Workbook Measurement Systems 1) Platform Assessments 2) Data Controls 3) Sufficient Model Complexity 24

25 Measurement Systems Review Model Capability Model Validation Assumptions and inputs Controls Is the ALM model sufficient in its level of depth and capability to adequately capture the complexity and magnitude of the interest rate and liquidity risks being taken? ( i.e. Is the ALM model an appropriate fit for the credit union's asset/liabilities product types and characteristics?) Has the ALM model been validated by the credit union (i.e., mathematical integrity, user inputs, system output and reports, etc.) to confirm that the model produces accurate forecasts of earnings and valuations? If so, what documentation is available to support the validation? What are the credit union's procedures for assessing inputs and outputs for accuracy and relevancy? If the credit union relies on a model validation to complete this task, under what instances will the credit union verify accuracy and relevancy when periodic changes in the assumptions are made? What are the assumptions in the credit union's written Assumption Summary? Is the internal control process comprehensive enough to ensure the accuracy and completeness of the data inputs and assumptions? Changes Were there any significant changes to the model or functionality since last exam? 25

26 Interest Rate Risk Workbook Risk Management 1) Oversight 2) Policies and Reporting 3) Controls 4) Staff 26

27 Board and Sr. Management Review BOD/ALCO Meetings Policies & Procedures IRR Triggers & Tools What IRR information does the BOD and ALCO receive that demonstrates oversight of the IRR limits and policies? Are meeting minutes prepared and do they reflect the decisions made and discussions held? Who has the primary responsibility for IRR policies and does senior management or ALCO ensure that all policies and procedures are being monitored and are sufficient to identify risks? What triggers does management use to identify when IRR exposure is approaching or exceeding limits? What strategies and tools (e.g. balance sheet changes, derivatives, sales) are considered in managing IRR exposure within policy limits? 27

28 Risk Monitoring & Management Review Policy Limits What policy IRR limits does the CU use for management reporting purposes? Are the limits suitable for the size and potential risk exposures of the CU? Has there been any changes to the IRR Policy since the last exam and what was the basis of the changes? Policy Limits Violations Process Validation Reporting Were there any violations to the IRR limits since the last exam, what was the violation and what remedial action was taken in moving the risk back within limits? Does the CU obtain an independent validation of the IRR measurement process and assumptions that generate the IRR reporting? Did management implement the recommendations? How often do they generate IRR results and report them to ALCO and the BOD (with explicit IRR measurements against limits) and the comparative analysis on changes from period to period? Policies and Planning Is the CU budget forecasting consistent with the IRR risk limits? How does modeling the credit union's budget compare to the IRR limits? 28

29 Risk Monitoring & Management (cont.) Planning and Back Test How does the credit union's NII back test compare to actual results? Business Forecast Are there any future events forecasted by the credit union that may have a material impact on the balance sheet structure (e.g., new loan, share, or investment strategies, merger, aggressive growth strategy) and what interest rate risk analysis (e.g. What-if) was done to support the proposed changes? Qualified Staff Is staff capable of managing the IRR program including having the experience and capability to support the IRR modeling and reporting? Internal Controls BSRM Are the internal controls documented and approved (Governance by who?) and has a review of IRR internal controls highlighted any deficiencies? Are the staff responsible for inputs/assumptions independent from other major functions(e.g. Accounting, cash operations) in the CU? How does management consider the impact that other risks such as credit, liquidity, strategic, and operational may have on IRR? 29

30 All Eyes on Federal Open Market Committee (FOMC) 30

31 US Treasuries Remain Near Lows 31

32 Average Unemployment Rate by Quarter July-September Average 4.9% 32

33 Fed s Labor Market Indicator Trending Lower Sep 2016 = -2.2 Shaded area represents U.S. Recession. 33

34 95 Million Americans Out of Work Force Lowest Participation Rate in 4 Decades. 34

35 Inflation still below FOMC s 2% Target Inflation had continued to run below the Committee's 2 percent longer-run objective, partly reflecting earlier declines in energy prices and in prices of non-energy imports. Market-based measures of inflation compensation remained low Source: Minutes of the FOMC meeting on Sept 20-21,

36 36

37 Prior FOMC Rate Projections 37

38 Questions? 38

39 Thank you Dan Frilot Phone: (626) All information contained in this document is the confidential property of Balance Sheet Solutions, LLC. Distribution outside of the credit union is strictly prohibited. The information contained herein is prepared for general circulation and is distributed for general information only. This information does not consider the specific investment objectives, financial situations or particular needs of any specific individual or organization that may receive this report. Neither the information nor any opinion expressed constitutes an offer, or an invitation to make an offer, to buy or sell any securities. All opinions, prices, and yields contained herein are subject to change without notice. Investors should understand that statements regarding future prospects might not be realized. Please contact Balance Sheet Solutions to discuss your specific situation and objectives. Balance Sheet Solutions, LLC only transacts business in states where it is properly registered or notice filed, or excluded or exempted from registration requirements. Follow-up and individualized responses that involve either the affecting or attempting to affect transactions in securities, or the rendering of personalized investment advice for compensation, as the case may be, will not be made absent compliance with state investment adviser and investment adviser representative registration requirements, or an applicable exemption or exclusion. Balance Sheet Solutions, LLC is a SEC Registered Investment Advisor SEC# CRD#

NCUA E&I/ DCCM. Interest Rate Risk Supervision and Adding S to CAMEL. NCUA Webinar August 18, pm EDT

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