Compliance Blog

Greetings, compliance folks! As a compliance professional, and I’m naturally a risk-averse person. Apparently, the apple does fall far from the tree, as my six-year-old son seems to be a daredevil. He loves running at full speed, climbing, and jumping off of things. My wife and I can often be heard shouting “don’t do that! It’s not safe!”

Much like a concerned parent, the National Credit Union Administration (NCUA) has its own ideas of what is safe for credit unions and has mechanisms for warning credit unions when certain practices are deemed too risky. One particular area of concern is Interest Rate Risk (IRR), which is included in NCUA’s 2022 Supervisory Priorities. NCUA recently published letter to credit unions 22-CU-09 and an accompanying supervisory letter, which both discuss changes to the Interest Rate Risk (IRR) framework. Let’s review this topic:

What is Interest Rate Risk?

According to the NCUA Examiner’s Guide, “[i]nterest rate risk refers to the current and prospective risk to a credit union’s capital and earnings arising from movements in interest rates.” In other words, it is a risk that arises due to changing interest rates, which affects all credit unions to some degree. NCUA has noted that riskier practices regarding IRR can present a “significant threat” to a credit union’s capital and earnings, and can “potentially be an undue risk to the National Credit Union Share Insurance Fund.”

Section 741.3(b)(5) of the NCUA regulations requires all federally-insured credit unions with assets of over $50 million to have a written IRR policy and to implement an effective IRR program. Appendix A to Part 741 provides guidance for credit unions on how to develop an IRR policy and an effective IRR program. A credit union’s exposure to changes in market prices and interest rates is considered during the “S” component of the CAMELS rating, which was added in 2021 and which became effective for exams earlier this year. For more information on the change from CAMEL to CAMELS, see this post in the Compliance Blog.

As the Examiner’s Guide explains, changes in interest rates can change “the underlying value of a credit union’s assets, liabilities, and off-balance-sheet items and thus its overall net economic value” and can affect a credit union’s earnings by having an effect on “interest-rate sensitive income and expenses.”  For more information on IRR, credit unions may want to review the various sections of the Examiner’s Guide, which describe the different types and sources of IRR, how IRR relates to other risks, and more.

Why is the NCUA Releasing New Guidance on IRR?

In the new letters, NCUA acknowledges that “[t]he first half of 2022 experienced the sharpest increase in interest rates in decades,” and those changes could result in “sharply lower” net economic values (NEV). According to the Examiner’s Guide, NEV measures the “changes in the economic value of net worth caused by changes in interest rates.” NEV can be measured through NCUA’s NEV Supervisory Test or Estimated NEV Tool. More information on NEV and the tests to measure NEV can be found in this guidance (however, note that this guidance was released prior to 2022 and does not discuss these most recent changes).

Given the major changes to interest rates in 2022, NCUA decided to review “the parameters and risk classifications of the NEV Test and overall IRR supervisory framework,” and to make certain changes. According to NCUA, the changes should provide increased “clarify and flexibility” to credit unions.

What is Changing?

The Supervisory Letter lays out several changes that NCUA is making to the IRR framework.

First, NCUA has revised the risk classifications, and the supervisory letter provides a helpful chart that summarizes the changes. Whereas the previous risk classifications include an “extreme” category, the revised classifications have removed that category altogether and instead expands the “high” category to include NEV figures which previously would have been in the “extreme” category. NCUA states that they made these changes because there has been a “significant increase” in the risk classifications in 2022 due to the rapidly rise interest rates and “lower starting point net worth ratios.” This increase could mean that more credit unions would have been found to be in the “extreme” classification, which was originally intended to cover potential undue risks to the share insurance fund.

Secondly, NCUA clarifies that a document of resolution (DOR) will not be required based solely on a NEV Test or risk classification, and that credit unions will not be expected to have a plan of action simply because their IRR classification is “high.” Instead, NCUA explains that whether a DOR will be requires will be decided on a case-by-case basis. A DOR may be required in certain situations, such as when a credit union’s IRR presents an “undue risk” to the share insurance fund and the credit union has not taken “prompt and appropriate action” to address it, a credit union has high risk and has not updated its approach to managing its IRR accordingly, or when a credit union “has a material governance deficiency” in relation to its IRR. Conversely, NCUA states that a DOR might not be appropriate in situations where a high classification results from rapidly changing interest rates but the credit union has adjusted its program accordingly.

Third, NCUA is giving examiners flexibility in assigning IRR supervisory risk ratings. For example, the supervisory letter notes that “[i]f the NEV Test or ENT show a high or moderate risk classification, examiners may adjust the IRR rating up or down.” However, NCUA does note that it would be “unusual” for an examiner to lower a risk rating when the NEV classification is high. Examiners will consider whether things such as how conservative the assumptions in the model are, and whether the qualitative rating is low or high risk when determining whether an adjustment to the rating is appropriate.

Finally, the supervisory letter also states that the following topics will be worked into the IRR Workbook that examiners use as a job aid:

• Considering Sources of High IRR. Examiners should be able to understand and identify the source of high IRR, which should be supported by balance sheet and NEV trends.
• Assessing Risk Management and Controls. NCUA states that an effective IRR program should include “measuring the credit union’s overall IRR exposure, communicating results to officials, and initiating action to remain within policy limits and controlling the potential impact of market risk.”
• Analyzing Potential Impact on Earnings and Capital. NCUA states that examiners will “review the modeled impact of a changing interest rate environment on earnings and capital,” with supporting scenario analysis.

Finally, NCUA notes that if there are any conflicts between the supervisory letter and the National Supervision Policy Manual or the Examiner’s Guide, that examiners should follow the supervisory letter, at least until the Policy Manual and Examiner’s Guide are updated.

NCUA will host a webinar on Interest Rate Risk later this week, on September 15^th. Credit unions can register here.

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