Interest-Rate-Risk Supervision Should Not Result in Micromanagement

by J. Mark McWatters, NCUA Board Member

NCUA is set to roll out a revised interest-rate- risk supervisory tool that agency examiners will employ beginning in the first quarter of 2017. Because a revised approach for evaluating interest rate risk is just a few months away, it’s important for me to make certain that credit unions are aware of the new tool and have sufficient time to anticipate its implementation.

No one truly knows where interest rates are headed, if anywhere, in the coming months. Rates will go up at some point, and as we know, credit unions must mitigate rate increases as an integral part of a sound risk-management strategy.

As I have indicated in the past, however, the inevitability of interest rate increases at some future date does not mean that NCUA should micromanage credit unions’ efforts to address interest rate risk, and that includes the agency’s actions incorporated through the implementation of the new interest-rate- risk examination tool.

As we indicated at the June 2016 Board meeting, in addition to inaugurating a new interest-rate-risk tool for examiners in 2017, the agency is considering adding an “S” to the CAMEL rating system. This was also highlighted during an NCUA staff webinar in August in which staff discussed the interest-rate- risk examination tool. Rather than relying on an assessment of interest rate risk as part of liquidity management—the “L” component—which is the current approach, the separate “S” component would highlight a credit union’s ability to anticipate and respond appropriately to market changes in interest rates.

Much work remains regarding interest rate risk should the agency elect to revise the CAMEL system in this manner. The ensuing rulemaking and implementation process would most likely take a year or two. Changing the CAMEL system to reflect a separate focus on interest rate risk would enhance the agency’s capabilities to evaluate interest-rate-risk management and exposure by a credit union, as well as the credit union system.

However, we must design any such approach in a thoughtful and prudently targeted manner. Moreover, in developing this approach to interest-rate-risk assessment and remediation we must coordinate on a periodic basis with credit union officials. It’s imperative that the agency not wait until we have formulated a formal proposal before we reach out for broader credit union input and guidance.

Moreover, the new interest-rate-risk tool that examiners will implement next year, along with the guidance developed by the agency, was released earlier this month as a Letter to Credit Unions. A key objective of the tool is to focus on outliers, which should mean less time spent in well-managed credit unions that prudently and reasonably assess and manage interest rate risk.

Under this new supervisory approach, an NCUA examiner will assign a risk rating to a credit union’s interest rate risk that is based on a traditional Net Economic Value, plus or minus a 300 basis-point shock test. A credit union’s NEV measures capital at risk and takes into account the institution’s total balance sheet. At its essence, the new supervisory approach for interest rate risk will establish four categories of risk: low, medium, high and extreme, based on post-shock NEV ratios. NCUA data shows that NEV is used throughout the credit union system for modeling risk. As such, NCUA examiners will use a credit union’s own valuations of its assets and liabilities—except for non-maturity shares, which the examiner will use the agency’s valuations.

In theory, the new approach is designed to benefit NCUA and credit unions. It is intended to offer examiners clearer directions and promote consistency in the way the agency handles interest-rate-risk issues, but without undermining credit unions’ prudent and reasonable decision-making or discretion. In addition, the new approach should provide NCUA examiners with a consistent method to evaluate an individual credit union’s interest rate risk. Further, the information the supervisory tool generates should place the agency in a much better position to evaluate interest rate risk throughout the credit union system.

For credit unions, the new tool should mean they receive interest-rate-risk management evaluations as part of their examinations that are data driven and that minimize an examiner’s subjective conclusions.

Yet, as we know, good intentions do not always result in the best implementation. I appreciate that the new approach is an important change in the way we will conduct interest-rate-risk examinations and may create some uncertainty as examiners begin to apply the revised guidance in the field. The new interest-rate-risk exam approach must not be used to second-guess prudent and reasonable credit union decisions that may differ from those of the examiner. I intend to monitor the implementation of the new interest-rate-risk tool, and I encourage credit union officials to let me know whether they agree the tool has helped with the overall fairness and transparency of the examination process.

Consistent application of reasonable requirements under the law is the hallmark of good regulatory practices. Yet, we must leave room for credit union management to reach their own conclusions and develop their own courses of action. NCUA must make sure those principles are maintained as we seek to improve how we examine for interest-rate-risk management.