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

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.

Background

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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?

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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, 2017

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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

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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

Net Economic Value (NEV)

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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

NEV Sensitivity

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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.

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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.

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$0

$20

$40

$60

$80

$100

$120

$140

$160

$180

Mill

ion

s

Share Certificates

IRA/KEOGH Shares

Share Drafts

Money Market

Regular Shares

Source: Callahan Peer-to-Peer

Non-Maturity Shares 65%

4Q07

Non-Maturity Shares 81%

2Q16

Average Share Balance Composition - All CUs Nationwide

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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%

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NOTE: NEV Supervisory Test risk level is determined by the most unfavorable or

adverse risk level assessed from the two NEV measurements.

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 % 6.0 - 4.0 % < 4.0 % worth)

Prior (Old) IRR Thresholds

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Example

Standard NEV Valuation

vs.

NCUA’s NEV Supervisory Test

“Standard” NEV Valuation

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Account Book Balance Base +300

Regular Shares 100,000,000 95.81 88.69

Share Drafts 25,000,000 95.02 90.02

IRA Shares 15,000,000 96.71 91.04

Money Market 60,000,000 97.89 95.34

Total Shares 200,000,000$ 96.40 91.03

-5.57%

($ 000) BASE +300

Asset Value: 218,000$ 203,830$

Liability Value: 192,800 182,054

NEV: 25,200 21,776

NEV Sensitivity: -13.59%

NEV Ratio: 11.56% 10.68%

Standard NEV Risk Profile

Standard NEV Valuation Test

Non-Maturity Share Valuation

using CU’s Parameters.

Low Risk

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Account Book Balance Base +300

Regular Shares 100,000,000 99.00 95.04

Share Drafts 25,000,000 99.00 95.04

IRA Shares 15,000,000 99.00 95.04

Money Market 60,000,000 99.00 95.04

Total Shares 200,000,000$ 99.00 95.04

-4.00%

($ 000) BASE +300

Asset Value: 218,000$ 203,830$

Liability Value: 198,000 190,080

NEV: 20,000 13,750

NEV Sensitivity: -31.25%

NEV Ratio: 9.17% 6.75%

NCUA NEV Supervisory Test

NCUA 1% - 4% Non-Maturity Shares

NCUA’s NEV Supervisory Test

Non-Maturity Share Valuation using 1% / 4% Assumptions

ModerateRisk

IRR Supervision ScopeTotal 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

Estimated NEV ToolIRR Workbook not required

35 Steps

Is "Supervisory Test" High or

Extreme?

15 Steps 25 Steps

No Yes

Post 1st Exam Cycle 1st Exa

m C

ycle

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NCUA’s Reorganized IRR Workbook

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Interest Rate Risk Workbook

Market Risk (NEV)

1) Balance Sheet ValuationsReview procedures and assumptions.

Intent is to use CU’s valuations for everything but the non-maturity shares.

2) NEV Supervisory TestNon-maturity share valuations: 1%/4% test.

Assess NEV ratio and New sensitivity profile using new NEV risk threshold categories.

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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

Interest Rate Risk Workbook

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Stress Testing

Interest Rate Risk Workbook

1) Forward Looking Stress Scenarios

2) Unlikely but Plausible Events

3) Change Key Assumptions and Understand

4) Validate Assumptions that Move the “Risk

Needle”

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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

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Rate Scenarios

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?

Sensitivity Testing

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?

Stress Testing Review

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Measurement Systems

Interest Rate Risk Workbook

1) Platform Assessments

2) Data Controls

3) Sufficient Model Complexity

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Measurement Systems Review

Model Capability

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?)

Model Validation

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?

Assumptions and

inputs

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?

ControlsIs the internal control process comprehensive enough to ensure the accuracy and

completeness of the data inputs and assumptions?

ChangesWere there any significant changes to the model or functionality since last exam?

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Risk Management

Interest Rate Risk Workbook

1) Oversight

2) Policies and Reporting

3) Controls

4) Staff

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Board and Sr. Management Review

BOD/ALCO

Meetings

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?

Policies &

Procedures

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?

IRR Triggers

& Tools

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?

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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

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?

Process Validation

Does the CU obtain an independent validation of the IRR measurement

process and assumptions that generate the IRR reporting? Did

management implement the recommendations?

Reporting

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

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

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?

BSRMHow does management consider the impact that other risks such as credit,

liquidity, strategic, and operational may have on IRR?

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All Eyes on Federal Open Market Committee (FOMC)

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US Treasuries Remain Near Lows

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July-September Average 4.9%

Average Unemployment Rate by Quarter

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Fed’s Labor Market Indicator Trending Lower

Shaded area represents U.S. Recession.

Sep 2016 = -2.2

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95 Million Americans Out of Work Force

Lowest Participation Rate in 4 Decades.

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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, 2016.

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Prior FOMC Rate Projections…

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Questions?

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Thank you

Dan Frilot Phone: (626) 543-1774

dan.frilot@balancesheetsolutions.org