By Phil Lucas, Senior Balance Sheet Advisor
In early September the NCUA updated its interest rate risk supervisory framework to address concerns about the results of its NEV Supervisory Test. The NCUA Supervisory Test is intended to be used to measure asset sensitivity to rate changes by applying standardized market values to the credit union’s non-maturity shares. The test measures both NEV sensitivity and the NEV ratio in a +300-basis point shock simulation and establishes a framework for results to be interpreted as low, medium, high, or extreme risk.
Prior to the update, the extreme risk category was described as categorically unsafe and unsound, unacceptable, and requiring the institution to take de-risking actions. Under the previous framework, a credit union with extreme risk results could expect a DOR (Document of Resolution) based on these test results alone. In tandem with the rising interest rate environment and rapid balance sheet expansion of nearly 25% over two years, a significant number of credit unions have tested as high or extreme risk without materially altering their balance sheet strategy.
In the supervisory letter, the NCUA has made key updates to the NEV test as follows:
- Elimination of the extreme risk category: the previous thresholds for high risk remain and now represent the most severe tests result
- Elimination of the automatic DOR: the letter clarifies that a high-test result on the NEV test could be cause for more robust examination procedures but will not be trigger a DOR alone.
- IRR (Interest Rate Risk) Supervisory Ratings can be adjusted by the examiner: because the supervisory test is a component of the larger IRR examination process, the test results may be grounds for the examiner to adjust the overall IRR rating up or down, particularly in cases where the credit union is near the threshold of two risk categories (i.e., between moderate and high).
The updates to the IRR examination process should provide relief to some credit unions in specific circumstances but should not be interpreted as a green light to take more risk. Interest rate risk remains a supervisory priority in 2022 and is expected to make the list again next year. Further, the updated framework requires examiners to evaluate and describe the source of the high IRR classifications through the channels of net worth erosion, balance sheet concentrations, and increasing market rates over the past 12-24 months. In a recent Q&A webinar, representatives from the NCUA commented that higher levels of IRR due to market rate changes may be treated more leniently than IRR caused by management decisions to add duration to the asset portfolios. However, the decision to extend duration may also have been entirely appropriate if the credit union has an effective risk management program and strategy process.
The NCUA is guiding credit unions to review interest rate risk policy and adjust strategy to respond to evolving financial conditions. Consideration should be given to the risk of higher funding costs, tighter liquidity, higher credit allowances, and shifts in third-party volume (e.g., refinance demand or indirect channels). We expect additional updates to the IRR examination process and will provide additional guidance as supporting documentation is published.
Accolade is a wholly owned CUSO of Corporate One FCU that specializes in partnering with credit union management to drive effective risk management programs and balance sheet strategies. If you have concerns about your interest rate risk exposure, please contact us to set up a meeting.