Interest Rate Risk

Subject of IRR Policy? • assets < 10 mm  no action • >10mm assets <50mm  depends • >50mm  action required Supervisory IRR Threshold Ratio (SIRRT) SIRRT = (Total 1st Mortgages + Investments > 5yrs) Net Worth If SIRRT = or > than 100% (1:1) then action required ©2013 SWBC. All rights reserved. CONFIDENTIAL.

Why more IRR rules? NCUA “does not agree that (existing guidance) are sufficient in an environment of increased risk exposure and interest rate volatility.” “Credit unions have increased residential mortgage holdings and take on more interest rate risk in the process.” “Shifting interest rates pose a core risk that could jeopardize the liquidity and solvency of credit unions.” 12 CFR PART 71 ©2013 SWBC. All rights reserved. CONFIDENTIAL.

Appendix B to Part 741 - Guidance “Comprehensive guidance….specifies 8 policy items that must be addressed.” • Policy • Board Oversight • Management • Measurement methods • Measurement components • Internal Controls • Use of IRR results in decision making • Additional considerations for large/complex FICUs ©2013 SWBC. All rights reserved. CONFIDENTIAL.

Option risk is everywhere….. •formerly confined to your bond portfolio – callable bond, mbs or cmo • loans prepay when rates fall • members are yield sensitive when rates rise – early withdrawal of share certificates? ©2013 SWBC. All rights reserved. CONFIDENTIAL.

Earnings at Risk “EAR” •a measure of volatility of NII as a consequence of different interest rate environments. • assumptions include (a) balance sheet composition (b) embedded options analysis (c) repricing timing (d) current interest rate environment • specific time period, normally 1 and 2 years • a short term view of interest rate risk. • a variance greater than 20% in a shock up 300 basis points borders unacceptable (example 12 CFR 741) ©2013 SWBC. All rights reserved. CONFIDENTIAL.

Static or Dynamic Simulations ”Static simulation models are based on current exposures and assume a constant balance sheet with no new growth….dynamic simulation models rely on detailed assumptions regarding changes in existing business lines, new business, and changes in management and customer behavior.” – 2010 Interagency Advisory on Interest Rate Risk Management ©2013 SWBC. All rights reserved.

Static or Dynamic Simulations ” However, dynamic simulation is highly dependent on key variables and assumptions that are extremely difficult to project with accuracy over an extended period. Furthermore, model assumptions can potentially hide certain key underlying risk exposures. As such, when performing dynamic simulations, institutions should also run static simulations to provide ALCO or senior management a complete and comparative description of the institution’s IRR exposure.” –2010 Interagency Advisory on Interest Rate Risk Management ©2013 SWBC. All rights reserved.

Net economic value “NEV” • difference between NPV of assets and NPV of liabilities. more comprehensive as it considers every cash flow and option scenario on the asset and liability side of the balance sheet. • measures long-term IRR on balance sheet at a fixed point in time. Demonstrates that the projected fair value of the longer-term assets would decrease by much greater amounts if rates moved higher. • in theory, NEV is a current function of the balance sheet’s earning power. ©2013 SWBC. All rights reserved. CONFIDENTIAL.

Assumptions • rate shocks – slower grade of increases vs. one time • utilize prepayments in modeling – consider future prepayments as well as historical • use internal historical loan loss estimates • for share liabilities – take into account strategic pricing plans • monitor all uncertain maturities, rates, cash flows for all assets and liabilities. • document changes to initial assumptions Every time the economy changes, the model changes. ©2013 SWBC. All rights reserved. CONFIDENTIAL.

More on assumptions “NCUA does not take issue with using such (simplifying) assumptions or generic standards so long as these are consistent with the best practices described in the January 2010 FFIEC Advisory on Interest Rate Risk Management and take into account the size, complexity, and risk exposure of the credit union. NCUA recognizes the use of peer data may be appropriate.” 12 CFR PART 71 ©2013 SWBC. All rights reserved. CONFIDENTIAL.

Assumptions on NMD decay rates “Institutions should use assumptions that reflect the institution’s profile and activities and generally avoid reliance on industry estimates or default vendor assumptions. Some institutions, however, have difficultly measuring decay rates on NMDs because of limitations on their systems’ ability to provide necessary data, acquisitions or mergers, or possibly a lack of technical expertise. Industry averages provide an approximation but may not be a suitable estimate in every case.” – 2012 Interagency Advisory on Interest Rate Risk Management ©2013 SWBC. All rights reserved.

Complex characteristics…. • mortgage loans • cmos, mbs, callable agencies • balance sheet is large • balance sheet is growing • capital is low • funding is volatile • short term loans • bullet maturities • balance sheet is stable • capital is high • funding is basic ©2013 SWBC. All rights reserved.

Measurement is not enough Measuring your risk is not enough. • How do you know the risk profile and your assumptions are reasonable? • Is it short term or long term? • What are the cost/benefits of reducing the risk? • What is the pain/probability profile? • Are your action plans suitable? If your IRR policy reflected a risk beyond your limits, your examiner will want to know what you did to mitigate that risk. ©2013 SWBC. All rights reserved. CONFIDENTIAL.

Action on identifiable risk In general, • limit booking of 15yr and 30yr mortgages • sale of mortgage originations or existing loans • sale of long term investments • investing in short term maturities • employing shorter term loans ©2013 SWBC. All rights reserved. CONFIDENTIAL.

Disclaimer • This presentation is for informational purposes only, not an offer, solicitation, recommendation or commitment for any transaction or to buy or sell any security or other financial product, and is not intended as investment advice or as a confirmation of any transaction. Any market price, indicative value, estimate, view, opinion, data or other information herein is not warranted as to completeness or accuracy, is subject to change without notice, and SWBC accepts no liability for its use or to update or keep it current. • Any views or opinions are those of the individual presenter, not necessarily of Southwest Business Corporation (SWBC) and its subsidiaries. • Securities offered by SWBC Investment Services, LLC, member SIPC & FINRA. Advisory services offered by SWBC Investment Company, an SEC Registered Investment Advisor. ©2013 SWBC. All rights reserved. CONFIDENTIAL.

Thank You Marcel Theriot Director, Fixed Income Institutional Brokerage & Investment Advisory SWBC Investment Services, LLC Member FINRA & SIPC 866-270-4873 mtheriot@swbc.com ©2013 SWBC. All rights reserved. CONFIDENTIAL.

Interest Rate Risk