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NCUA IRR POLICY

NCUA IRR POLICY. August 14, 2012. Cullen Coxe Financial Advisor. Agenda. Interest rate risk policy Assumptions Net interest income Net economic value Non-maturing deposit analysis Prepayment sensitivity analysis Spread / basis risk Twisted yield curve. New IRR Policy.

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NCUA IRR POLICY

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  1. NCUA IRR POLICY August 14, 2012 Cullen Coxe Financial Advisor

  2. Agenda • Interest rate risk policy • Assumptions • Net interest income • Net economic value • Non-maturing deposit analysis • Prepayment sensitivity analysis • Spread / basis risk • Twisted yield curve

  3. New IRR Policy • NCUA passed a final ruling requiring federal credit unions to develop and adopt a written policy on interest rate risk management • Effective date - 09/30/2012 • Required for CUs that meet one of the below criteria • More the $50mm in assets • Assets between $10-50mm only if “Supervisory Interest Rate Risk Threshold Ratio” (SIRRT) is above 100% SIRRT Ratio Total first mortgages held + total investments with maturities greater than 5 years Total Net Worth

  4. IRR Policy Elements

  5. IRR Policy Highlights • Document responsible parties • Set content and frequency of reporting • Set IRR policy limits • Test IRR impact on new business activities • Document and regularly evaluate assumption and methodologies • Separation of controls • Action plan

  6. ALCO • Examining the impact of changing interest rates and economic conditions • Net economic value • Net interest income • Net income • Monitoring the liquidity position • Monitoring key ratios and statistics • Reviewing and monitoring the credit union’s competitive position

  7. Internal Guidelines • The credit union is responsible for setting internal policy guidelines that best secure the stated goals and objectives of the institution

  8. NCUA Risk Measurement

  9. NEV • NEV ratio: must be above 4.00% in all environments between the shock down 300 scenario and the shock up 300 scenario

  10. NEV • NEV Percent Change: must be within negative 40.00% in all environments between the shock down 300 scenario and the shock up 300 scenario

  11. NII • NII Percent Change: must be within negative 20.00% in each of the four tested scenarios

  12. IRR Measuring and Monitoring • Model Sufficiency • The model used to assess the risks of the credit union must employ sufficient techniques, analytical capabilities, and fundamental functionalities that properly capture the complexities of the balance sheet at hand • Model Maintenance • A sufficient chart of accounts • An appropriate level of data aggregation • Inclusion and use of account level data

  13. Assumptions • Play an important role in classifying the risk of the balance sheet • BOD must understand these assumptions and their impact on the model • The credit union is responsible for: • Documenting all assumptions that have a substantial impact on the credit union’s risk position and ensure that these assumptions are appropriate • Monitoring these assumptions regularly • Ensuring any assumption changes are properly recorded and fully disclosed in a transparent way

  14. Different Types of Rates • Weighted average book rate • Aggregate note rate as of a specific period of time • Reinvestment rate • Used in earnings simulation to depict the current rate at which cash flows will be reinvested • Discount rate • Used in value simulation to determine the present value of future cash flows

  15. NII Assumptions • Reinvestment rates should be product and term specific • Reinvestment rates • Loans: offering rates • Investments: market yields • Non-maturity deposits & certificates: offering rates • Borrowings: FHLB fixed-rate term advance rates • Reinvestment rates will be adjusted depending on the interest rate scenario • Base, rising, declining and shock up 300

  16. NEV Assumptions • Determine appropriate discount rate • Present value of projected future cash flows • Primary versus secondary market rates • Primary: current offering rate • Secondary: observable market rate

  17. NEV Assumptions Sources for discount rates • Offering rates for accounts without an actively traded secondary market • Unique loan types • Signature loans • Secondary market spread over an index for accounts with an actively traded secondary market • Auto loans • Credit card loans • Observable market rates • Home equity loans: closed-end second liens and HELOCs • Mortgage loans: fixed and adjustable

  18. Spread Relationships • Asset-backed securities (ABS) • Auto loans • Credit card loans • LIBOR / swap curve plus additional spread • Servicing • New versus used auto loans • Liquidity • Final spread is based on the average spread of observable ABS as published by multiple brokers

  19. Spread Relationships • Home equity • Bankrate represents comprehensive and objective average rate obtained in the primary market for home equity loans • Rate specific based on fixed versus floating • Example: 1/31/12 discount rates • Fixed 6.00% • Floating 4.71% • Discounting over a curve • 1st lien residential mortgage • FHLMC servicing retained, 30-day mandatory delivery price • Post-settlement delivery fees (loan-level pricing adjustments)

  20. NEV Assumptions - Investments • Obtain base prices from third-party pricing source • IDC, Reuters • Collect all security information • Bloomberg • Retrieve structured product cash flows • Moody’s, Intex

  21. Assumptions

  22. Assumptions

  23. NEV Assumptions - Liabilities • Share certificates • Federal Home Loan Bank fixed-rate term advance curve • Early redemption • Borrowings • Federal Home Loan Bank fixed-rate term advance curve • Call / put features modeled in ZMdesk • Non-maturity deposits • Federal Home Loan Bank fixed-rate term advance curve • X-coefficient, effective maturity, decay rate • Net non-interest costs

  24. Assumptions

  25. Net Interest Income Analysis • It is important to remember the purpose of any analysis • In the case of NII, the purpose isnot budgetary • That is, the primary goal is not to determine the projected income for the institution over a given time period • To do so would require balance and rate projections • The goal is to project the volatility of earnings in changing (rising / declining) interest rate environments • NII is then compared in alternative scenarios in order to evaluate interest rate risk

  26. NII Assumptions

  27. NII Scenarios • Possible scenarios include: • Base scenario - rates are held constant • Declining scenario - rates decrease 25 basis points per month for 12 months (resulting in a down 300 over 1 year) • Rising scenario - rates increase 25 basis points per month for 12 months (resulting in an up 300 over 1 year) • Shock up 300 scenario - rates shock immediately 300 basis points and hold at that level indefinitely • A non-parallel shift in rates (a “twisted yield curve”)

  28. Reinvestment Rates • Should be product and term specific • Reinvestment rates • Loans: offering rates • Investments: market yields • Non-maturity deposits & certificates: offering rates • Borrowings: FHLB fixed-rate term advance rates • Reinvestment rates will be adjusted depending on the interest rate scenario • Base, rising, declining and shock up 300

  29. NII Projected Outputs • Projected interest income • Projected interest expense • Projected NII and net income • Percent change from base model • Asset yields and costs of funding • Net interest spread • Net interest margin • Return on assets

  30. Reinvestment of Cashflows – ExampleCurrent Offering Rate = 3.00% Month 1 Month 2 Month 3 $600K Principal $400K Principal $375K Principal

  31. Net Interest Income Output – Nominal Values

  32. NII Output – Interpreting Interest Rate Risk

  33. What do NII Results Provide? • Breakdown of interest income and interest expense by category type • Projected earnings on a static balance sheet • Earnings at risk due to constant, rising or declining interest rates • Potential balance sheet problems prior to interest rate shifts

  34. What is NEV? • Evaluate interest rate risk from a value perspective • Economic value is calculated at a single point in time • Net economic value • The present value (PV) of the balance sheet Economic Value of Assets - Economic Value of Liabilities = NEV

  35. Purposes of NEV

  36. Why Calculate NEV? • Superior to cost accounting information • Captures interest and principal cash flows • Provides an analysis of options risk • Allows for comparisons between different scenarios • More complete than the income simulation • Properly managing NEV can reduce the volatility of earnings and net worth

  37. NEV Measurements • NEV percent change • The projected net gain or loss of net economic value assuming changes in interest rates, relative to the starting value • The sensitivity of capital to changes in interest rates • NEV ratio • A measurement of capital adequacy from an IRR perspective • Calculated as the NEV of equity / NEV of total assets

  38. Price Examples • There is an asset and it has a fixed rate of 3%, with a maturity of 5 years Current Market Rate 3% Current Market Rate 2% Current Market Rate 4% Price Par 100 Price Premium >100 Price Discount <100

  39. Calculating Prices • Example 30-year mortgage portfolio • Book value $30,000,000 • Book rate 4.55% • Market (discount) rate 3.96% • Market value $31,102,800 • Gain / (loss) $1,102,800 • Price 103.68

  40. Net Economic Value (Micro) Selected asset prices:

  41. Net Economic Value (Micro) Selected asset gains / (losses):

  42. Net Economic Value (Micro) Selected liability prices: We can see that the regular shares are priced above par in the base case (which is a detriment to the credit union as it reduces capital), whereas the share drafts are priced below par in the base case (which benefits the credit union by increasing capital)

  43. Net Economic Value (Micro) Selected liability gains / (losses): The gains and losses, based on the prices, are shown

  44. NEV- Macro

  45. Purpose of an NEV Analysis • Measure interest rate risk • Understand trade-offs between long term risk and short term return • Conduct “what-ifs”

  46. Break

  47. Non-Maturity Deposit Analysis Consists of two regression analyses • Financial institution’s dividend rate sensitivity • How does the financial institution’s dividend rate change with a given change in market rates • X-coefficient • Membership sensitivity • Calculate an effective final maturity for each deposit account • 10-year maximum maturity

  48. Non-Maturity Deposit Analysis • Should be updated every year • Regression analysis for final maturities • Regression analysis for dividend payments • Non-interest costs • Run sensitivity analysis • Discussion with ALCO on reasonableness of rate movements • These scenarios test maturity and sensitivity assumptions

  49. Non-Maturity Deposit Analysis Regular Shares • Dividend rate 0.50% • Coefficient 0.27% • Non-interest cost 1.39%

  50. Coefficient Materiality

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