How Do You Mitigate Long-Term Interest Rate Risk?
Our efforts to mitigate interest rate risk are a combination of state-of-the-art modeling and old-fashioned common sense.
Thanks to our friends at ALM First, we have the benefit of a full array of highly sophisticated modeling tools, which help us understand the degree of risk that exists within our balance sheet. These same tools help us predict how those risks might change under varying strategies and changes in market interest rates.
While these modeling tools are extremely valuable, we also realize that the real world doesn’t always behave exactly as the models may predict. For example, the challenging and uncertain economic conditions here in Nevada tell us that high levels of liquidity and flexibility in our balance sheet are well advised. Also, the relatively flat yield curve (at least in the shorter maturities) and record low levels of market interest rates strongly argue against lengthening loan and investment maturities.
During the past few years, we’ve also become more focused on noninterest income and expense control as additional means to lessen our dependence on net interest income.
This combination of high tech and common sense has served us well in mitigating our credit union’s exposure to interest rate risk.
Nevada Federal Credit Union
Part of the mission at Alliant is to provide great rates over time. In order to fulfill its mission, it is necessary to properly manage interest rate risk. Like many other types of risk, interest rate risk is not necessarily avoided but, rather, managed to maximize risk-adjusted returns to Alliant over time while avoiding significant volatility that could impair the credit union. Interest rate risk is one of the risks that is closely measured, managed and reported. Alliant integrates interest rate risk management into its enterprise risk management program.
Alliant mitigates interest rate risk and volatility by incorporating scenario planning, which takes into account many economic and rate environments. Various scenarios are run in order to understand how balance sheet risk will change under different conditions or events. If appropriate, actions would be taken to mitigate the potential negative impacts to its balance sheet. This is done to ensure the balance sheet is positioned properly.
In early 2010, Alliant found that its interest rate risk level was over acceptable risk limits set by the Alliant board. Some of the tools Alliant uses from its tool box to reduce interest rate sensitivity include: sell newly issued fixed-rate mortgage loans (flow sale); sell existing longer dated fixed-rate mortgage loans (bulk sale); price adjustable-rate mortgages more aggressively; sell collateralized mortgage obligations securities that had significant extension risk; purchase floating-rate securities; and price longer dated share certificates more aggressively to increase liability duration. In addition, Alliant mitigates interest rate risk by having third-party providers verify internal analysis. This is done in order to ensure internal modeling and reporting is accurate.
Senior Vice President
Alliant Credit Union
Our primary mitigation activity involves not putting 30-year or 20-year fixed-rate conventional first-mortgages in our portfolio. This has not assisted our loan growth goals, but we feel it is the prudent thing to do. We are keeping high-balance, jumbo loans and of course, ARMs.
Product mix is another tool for us. We have a good balance of variable-rate loans with over 66% of our first-mortgages and 42% of all our loans being variable-rate. A rising rate environment will increase the rates and income on many of these loans. We also are very careful in setting rates for our products. More than 63% of our deposits are in core accounts, which will not be as helpful as certificates of deposit are when rates rise.
Our investment portfolio serves several functions as usual, and managing its duration is also providing mitigation assistance. We are well prepared for rising rates with both our income and NEV shock percentages being in the low risk NCUA category. However, we monitor and report our IRR monthly as a large balance sheet. It’s very fluid, and external factors like the yield curve change constantly.
As always, the question is, what will be the timing, frequency and magnitude of the interest rate changes? Right now, I’d keep an eye on developments in Japan. They are the second largest holder of U.S. Treasuries behind China. Should Japan need to pump money into their current, unfortunate crisis, their demand for Treasuries could weaken. Should the supply for Treasuries exceed the demand, prices will fall and rates will rise.
Patelco Credit Union
As a financial institution, we manage many forms of risk, of which interest rate risk is just one component. Often, the management of one form of risk helps mitigate other forms of risk. Managing concentration risk helps to mitigate interest rate risk.
Managing IRR not only includes measuring the risk but monitoring and controlling our exposure given the complexity of our balance sheet and our organization's risk tolerance levels. At Golden 1, we measure and report interest rate risk on a quarterly basis to the asset-liability committee. We manage within a risk tolerance level established by board policy and implement specific actions as our exposure approaches these levels. Certain transactions are analyzed mid-quarter to quantify the impact to ensure compliance within our IRR guidelines.
Mitigating IRR is a constant endeavor as we operate in a very dynamic market. To mitigate IRR, we diversify our loan, deposit and investment portfolios with fixed-rate and variable-rate products as well as varying durations. We manage the macro balance sheet.
With investments, we purchase floating-rate instruments with different caps and floors and durations. We also spread out the timing of investment purchases to not get trapped in any daily anomalies or cycles. We recently started buying investment instruments tied to different market indices. In a rising rate environment, we also look to attract longer-term fixed-rate deposits and variable-rate loans. For first mortgage loans, we employ a strategy that includes both holding and selling new originations.
We do not have a crystal ball so we prepare for various interest rate scenarios.
The Golden 1 Credit Union
My credit union is staying very short on investments, avoiding the long term because we foresee the next direction of rates is heading up, now down. In that scenario, we are staying short in regard to retaining liquidity on overnight options. We don’t deal with banks in placing our investments but stick with corporates. In this kind of market of staying short, we have been following a practice that I have followed for 29 years, and it's one that has worked well.
We try to stay short in line with yields, and where there are special opportunities, we can still pick up a decent yield. For example, those very large mortgage pools of corporate relocations have looked attractive, and we bought some of them.
Arthur J. Wood III
Railroad & Industrial FCU
It is extremely important that effective interest rate risk management not only involves identification and measurement of IRR, but it must also provide for appropriate actions to control this risk. At Clearview, we follow a sophisticated asset-liability and liquidity management policy that works in conjunction with our interest rate risk policy, investment policy and concentration risk measurements. It is very important that these areas work in unison.
In addition, we have developed policies and procedures, risk measuring and monitoring systems, stress testing and internal controls related to our level of exposure. Our asset-liability committee meets weekly to determine the need for any shifts in our theories, based on the current economic climate, including future forecasting. Plus, we have set control limits that are routinely monitored to ensure that prompt management attention is given, if predetermined levels are exceeded.
Clearview has also invested significant dollars in software and tools that provide us with data in a timely manner, permitting us to be proactive rather than reactive. We have identified a myriad of ratios and benchmarks that permit us to routinely monitor specific risk areas that trigger a more sophisticated analysis when necessary. Five years ago, we hired a full-time financial analyst who continuously analyzes data.
We have determined that the adequacy and effectiveness of our IRR management process is critical and absolutely essential to protect the credit union’s sensitivity to changes in interest rates when compared to our capital adequacy. We have always placed a high importance on building capital, which has permitted us to weather the economic downturn that has plagued the industry over the past several years.
Chief Financial Officer
Clearview Federal Credit Union
Moon Township, Pa.
We do many things to mitigate rate interest risk, but it starts with being very careful in where you invest your funds. We do not tie our money up long term. And we do not chase yield because that almost always means long term.
As long as you do not focus on yield alone, usually you will do okay.
I’ll be honest, I do not worry that much about interest rate risk. When you have been in this business long enough you have seen a lot of crazy rates. I remember when we were paying out 12% on CDs! Knowing how to manage interest and associated risks is part of the business.
We know rates will rise. We do not know when. What we hope is that rates will rise slowly.
We plan for that time. You need to. When a credit union gets in trouble is when it hasn’t planned for the changes that happen, and we all know interest rates will go up. There needs to be planning around that.
Motorola Employees CU
We converted our credit card portfolio to variable-rate in 2010. Fifty-three percent of our loan portfolio, not including first mortgages, is now adjustable-rate. Twenty-seven percent of our first mortgage portfolio is adjustable, with an additional 13% that have original terms of 15 years. We have not added any significant volume of 30-year fixed-rate instruments to our mortgage portfolio in the past two years. Virtually all of our investment portfolio is comprised of amortizing securities that provide monthly cash flow of approximately $4 million to reprice at current rates. Thirty-seven percent of our investment portfolio, not including inverse floaters, is adjustable-rate product.
CFO & COO
Fairfax County FCU