Considering the recent events around the failure of Silicon Valley Bank and other major banks, now is a good time to revisit your assessment of liquidity and interest rate risks and, even more importantly, validate your responses for mitigating those exposures. So, what should your credit union be looking at in its ERM profile?
Liquidity Risk
Most credit unions include one or more liquidity risks in their ERM risk profiles. We commonly see that credit unions assess these as minor events with assessed impacts based on a small increase in funding costs for a relatively small portion of the balance sheet.
- Challenge your ERM and Finance teams to ensure the assessed impacts of these risks are realistic given today’s funding environment, competition for deposits, and speed with which members can move funds to competitors to chase higher rates (or in response to financial services industry events).
- Ask about your current levels of liquidity, funding concentrations, any outflows of deposits being seen today, liquidity contingency funding plans, established borrowing arrangements, testing of the plans, and member communications on the strength of the credit union.
- Most credit unions assess that their liquidity responses mitigate almost all of their exposures to liquidity risks, but you should evaluate mitigation in light of the current environment.
The credit unions we have worked with typically also include in their ERM profiles liquidity risks with impacts based on net economic value (NEV) modeling results. The idea is that if the credit union were to experience a rate movement that would result in a decline in NEV, and the credit union needed to sell assets to raise liquidity, it might incur losses in selling the assets below their book values.
- Make sure you have updated these types of liquidity exposures in your ERM profile.
- Are they sufficiently severe to capture the exposure to not only future rate movements but the amounts by which the base case NEV modeling results might be below book values?
In NEV modeling, most credit unions attribute a large value to non-maturity deposits (NMDs). NMDs are valuable because they represent below-market-rate funding. However, how would your credit union use that value in a liquidity crisis?
- Consider also evaluating these risks using impacts based on your NCUA Supervisory Test NEV modeling or NEV modeling with NMDs at par.
- Again, revisit your liquidity responses that would help mitigate a liquidity shortage.
Interest Rate Risks
Credit unions typically include in their ERM profiles interest rate risks representing their modeled changes in net interest income (NII) in various rate scenarios. Many credit unions also include margin compression risks.
- Ask your team if the credit union is considering a reasonable selection of shock, rising, flattening, and twisting rate scenarios in its ALM modeling.
- Challenge your team to identify the responses in place to mitigate these risks. Responses like “lagging deposit rate increases behind market rate changes” don’t really mitigate a risk with an impact based on a change in modeled NII because the ALM modeling already considers basic pricing assumptions like lags in deposit rate increases. Real responses might include making fundamental changes in the balance sheet, decreasing operating expenses, or increasing fees.
- We usually find that the mitigation of risks with impacts based on modeled NII is much lower than the mitigation of risks based on modeled NEV, assuming the NEV scenarios are viewed through the lens of liquidity risk (some credit unions categorize the NEV rate shock scenarios as interest rate risks).
We encourage credit unions to set the impacts on risks related to net interest margins relative to budgeted net interest income.
- Remember that risks usually represent deviations from expected results.
- Of course, expected losses also might be risks that would demand action plans to address.
Regulatory examiners will ask your team about the interest rate and liquidity risks in your ERM profile and might compare those risks to the results of your NEV and NII modeling.
- Be prepared to discuss your ERM risks, explain why you chose them, and how you assess and mitigate them.
- Ensure you can explain that the impacts of ERM risks might be based on ALM modeling results, but you then apply likelihoods to the impacts, and consider how completely responses mitigate the risks in arriving at residual risk. Thus, residual liquidity and interest rate risk usually is much lower than the modeled changes in NEV and NII in various rate scenarios.
Conclusion
In today’s environment, it is more important than ever to ask the right questions about liquidity and interest rate risk exposures. Lean on our expertise to give you peace of mind. Start by contacting Rochdale at sales@reimaginerisk.com.