Interest Rate Risk: Legitimate Threat or Scare Tactic?
The NCUA's sense of urgency on interest rate risk is overblown and many credit unions are feeling pressure to follow the advice of their examiners or face consequences.
That's according to George Darling, CEO of asset liability management group Darling Consulting Group in Newburyport, Mass.
“I think it's overblown but should they be concerned? Yes. Is it overblown to the point where you could say in some cases it almost seems hysterical? Probably,” Darling said. “You have a situation where to get any kind of income in the environment that's been created, the economic environment, people are reaching for yields, so they are putting on longer term investments.”
The NCUA may not have the tools that allow it to truly understand some of the positions of these credit unions, Darling suggested. As a result, it's easier for the financial institutions to be adverse to all long term assets than it is to take the time to try to develop the expertise and tools they need to truly assess the real position, he said.
CU Times was informed that some credit unions are selling off long-term assets under pressure from the NCUA to address interest rate risk.
“I don't know if they told them they need to specifically sell off certain securities but that they just need to re-calibrate the risk on their books,” NCUA Board Chairman Debbie Matz said after the agency's monthly board meeting in June.
Matz said the NCUA currently has a rule requiring credit unions to develop a policy to consider interest rate risk and make sure it's within viable parameters.
“Some credit unions have not done that or have made faulty assumptions and so examiners have been trained. We have not really yet implemented the policy of having examiners go out there and tell credit unions they need to take actions to modify their books based on interest rate risk,” Matz said. “In some cases where examiners have been extremely concerned, I’m sure they have made suggestions that credit unions take some action before it's too late.”
Darling said each credit union's situation depends on the individual examiner involved.
“My sense is sometimes the recommendation from the examiner is viewed as a mandate and it depends on how strong the credit union feels about wanting to push that particular issue,” Darling explained. That's always the issue–was it really a recommendation or was I told to do that?
Many people believe if the regulators suggest something, they better do it before examiners come back in again or they will be in trouble, he said.
“Our job is to manage risk, not to eliminate it. Regulators want to mitigate risk, instead of manage it,” Darling said.
Dan McGowan, CFO at the $180 million Pioneer West Virginia Federal Credit Union in Charleston, W.Va., said the current flat interest rate environment is actually working against his credit union. Pioneer's IRR program has primarily consisted of using ALM shock and scenario analysis with the Profitstar software from Jack Henry & Associates.
“As an anticipatory philosophy, we’ve been keeping our book of business pretty short. That even extends to our mortgage portfolio,” McGowan said. “We’ve been doing brisk business in the 10 to 15 year terms, but aren't holding anything beyond that on our books. Our asset sensitive position is positioned to actually take advantage of a mildly rising rate environment quite nicely.”
He added, “In fact, we’ve been hoping to see that happen for some time. A continuation of this flat rate environment isn't doing anything for us. By the way, one of the downsides of keeping a short-term loan portfolio is that we have to work double hard to generate new loans to counteract the rapid rate of pay downs.”
McGowan said he is not personally aware of the details of credit unions apparently being required to sell assets at a loss to reposition themselves.
“As a generalized observation, it's difficult, in my mind, to lock in a loss weighed only against a possibility of loss only if certain future events unfold,” he noted. “A credit union with an adequate ALM program shouldn't have a need to ever make radical changes to its balance sheet composition in a short period of time. There's always a cost to do that.”
For this reason, Pioneer monitors such things on an ongoing basis, McGowan said. It's much more efficient to make rather minor adjustments with the ebb and flow of the business climate as good judgment and sound practice dictate, he explained.
“Probably the worst thing that can happen–not only to credit unions, but to the whole world economic system–is a sharp and sustained rate rise,” McGowan said.
Pete Duffy, managing director at investment banking firm and broker-dealer Sandler O’Neill & Partners LP based in New York, said an interest rate simulation typically takes into account, somewhat in a vacuum, what is going to happen when rates change and some key factors are left out.
In particular, Duffy said a credit union's competition should be taken into consideration when deciding the best way to address interest rate risk.
“What's the competitive marketplace going to do and what's your balance sheet's ability to deal with not only the rate shift but the competitive environment in your local market,” Duffy asked. “What we did is we lined up all of the banks and credit unions that this particular credit union competes with and we looked at 10 years of history on all the key ratios of the competitors and that particular credit union.”
Duffy's firm also looked at the concentrations of the various assets and determined that while this particular credit union had a little more long term asset concentration, it wasn't that different from the average institution in its market. However, the credit union had a better concentration of core deposits, more liquidity from the bond portfolio and a lower operating expense ratio.
Based on these findings, Duffy concluded that in a stressed environment his client would be able to withstand upward rates better than the market of competitors.
“A properly constructed investment portfolio typically leans more heavily on the right kind of mortgage-backed securities that have reliable cash flow and some good income as opposed to an overreliance on callables because with callables, the option is in the hands of the issuer; the agency that issues the callable and therefore the option, is not in the hands of the investor,” Duffy said.
He noted that like an auto loan, the right mortgage-backed securities pay principle and interest each month.
“The regular cash flows allow the credit union to be always active with that cash flow into the new rate environment so if rates go up, the cash flows are coming in and they’re reinvested in higher yielding loans or investments, whereas when rates go up on callables, the bond doesn't get called and you’re getting no principle until the end,” Duffy said.