Updates to Interest Rate Risk Supervisory Framework

The first half of 2022 experienced the sharpest increase in interest rates in decades.¹ A sharp rise in interest rates may amplify market risk exposure to earnings and capital. This occurs because a credit union’s assets and liabilities do not reprice equally or concurrently. This timing (or duration) mismatch, combined with a sharp rise in interest rates, may result in sharply lower net economic values (NEV) as measured using the NCUA’s NEV Supervisory Test (NEV Test) or the Estimated NEV Tool (ENT).

This letter revises the risk management expectations for credit unions over $50 million in assets described in Letter to Federally Insured Credit Unions 16-CU-08, Revised Interest Rate Risk (IRR) Supervision, effective January 1, 2017. This letter provides additional information and updates to the NCUA’s supervisory framework of interest rate risk (IRR).²

Due to the changing economic and interest rate environments during 2022, the NCUA reviewed the parameters and risk classifications of the NEV Test and overall IRR supervisory framework. As a result of this review, several updates are being made with the issuance of this letter. Part II of this letter describes these changes in more detail.

In summary, these changes include:

• Revising the risk classifications by eliminating the extreme risk classification and modifying the high risk classification;
• Clarifying when a Document of Resolution (DOR) to address IRR is warranted, including removing any presumed need for a DOR based on an IRR supervisory risk classification and related need for a credit union to develop a de-risking plan;
• Providing examiners more flexibility in assigning IRR supervisory risk ratings; and
• Revising examination procedures to incorporate updated review steps when assessing how a credit union’s management of IRR is adapting to changes in the economic and interest rate environment.

Exam staff should refer to the Examiner’s Guide for more information on examining and supervising IRR. If there is a conflict between the National Supervision Policy Manual (NSPM), the Examiner’s Guide, and this letter, exam staff must rely on this letter until the NSPM, and Examiner’s Guide are updated.³ This letter is intended to supplement existing resources on the supervision of IRR; it does not replace or supersede applicable laws and regulation.

Exam staff must remember that IRR is a major area of risk and, under certain market conditions, may expose credit unions to other related issues, such as liquidity risk, asset quality deterioration, unexpected losses to earnings, capital erosion, and strategic risk. The credit union system has experienced significant growth in complexity over the past two years with total assets growing by approximately 25 percent. As the system has grown, concentrations in longer maturity assets have significantly increased sensitivity to changes in interest rates.⁴

If you have any questions regarding the changes detailed in this letter, please direct them to your immediate supervisor.

I. Background

Review of a credit union’s IRR exposure has been a long-standing supervisory priority and part of the NCUA’s supervision program. Over the past decade, the NCUA has enhanced examination tools and issued periodic updates related to IRR for both staff and credit unions.

In 2012, the NCUA updated section 741.3(b) of the NCUA regulations to require credit unions with assets greater than $50 million to maintain a written policy and an effective IRR management program as part of asset liability management.⁵ The regulation includes Appendix A, which provides guidance for an IRR policy and an effective program.

The NCUA finalized derivatives rules providing more flexibility for federal credit unions to manage IRR in 2014 and revised the rules in 2021.⁶ The 2021 rule modernized the use of derivatives with a principles-based approach while retaining key safety and soundness components. This derivative authority added another lever for credit unions to consider in managing IRR.

In 2016, the NCUA issued Letter to Credit Unions 16-CU-08, Revised Interest Rate Risk Supervision, to interpret and communicate expectations for compliance with section 741.3(b) of the NCUA regulations. These procedures became effective in 2017 and updated and implemented four key changes to IRR supervision. The changes included:

1. The Interest Rate Risk Workbook to provide streamlined procedures for IRR reviews.
2. The Net Economic Value Supervisory Test, a capital-at-risk measurement that uses standardized values for non-maturity shares to assess the level of IRR. The test uses redefined risk classifications to categorize the supervisory risk level.
3. The Estimated Net Economic Value Tool, an automated measurement of the NEV Test. The ENT uses Call Report data and final IRR category rating for credit unions under a certain asset threshold subject to the Examination Scope Instruction.
4. The Examiner’s Guide revision to the IRR chapter to provide examiners with an in-depth resource describing how to assess IRR.

In 2021, the NCUA Board approved a final rule to enhance transparency and allow the NCUA and federally insured credit unions to better distinguish between liquidity risk (“L”) and sensitivity to market risk (“S”). The existing CAMEL rating system was expanded to CAMELS with the addition of “S” and redefinition of “L”.⁷ The “S” component reflects the exposure of a credit union’s current and prospective earnings and economic capital arising from changes in market prices and interest rates. The addition of the “S” CAMELS component became effective for exams and contacts starting on or after April 1, 2022.

Part II of this letter expands and revises the procedures NCUA staff will use to evaluate a credit union’s IRR.

II. Updated Supervision Procedures for Interest Rate Risk

This section describes the expanded and revised procedures for reviewing a credit union’s IRR. It also recalibrates the expectations of credit unions when preparing for an IRR examination, based on the additional review steps.

The appropriate corrective action for deficient risk management practices or high IRR depends on the level and source of IRR exposure. The level and source of IRR exposure will determine the degree of urgency in developing and implementing mitigation strategies.

When assessing how credit unions are proactively monitoring IRR and related issues, examiner oversight will increase until a credit union adopts an effective program, which includes safe and sound practices. Riskier strategies can present a significant threat to a credit union’s capital and earnings if not managed appropriately and potentially be an undue risk to the National Credit Union Share Insurance Fund (Share Insurance Fund).

A. Key Procedure Changes for Interest Rate Risk Supervisory Framework

The key procedural changes for IRR supervisory framework are described in the sections that follow.

Revising the Risk Classifications by Eliminating the Extreme Risk Classification and Modifying the High Risk Classification

Risk Classification	Current NEV Test Post-shock NEV (%)	Current NEV Test NEV Sensitivity (%)	Revised NEV Test Post-shock NEV (%)	Revised NEV Test NEV Sensitivity (%)
Low	Above 7%	Below 40%	Above 7%	Below 40%
Moderate	4% up to 7%	40% to 65%	4% up to 7%	40% to 65%
High	2% up to 4%	65% to 85%	Below 4%	Above 65%
Extreme	Below 2%	Above 85%	Eliminated	Eliminated

In Letter to Federally Insured Credit Unions 16-CU-08, Revised Interest Rate Risk Supervision, the NCUA committed to reviewing the parameters and risk classifications in the NEV Test and ENT to address changes in market conditions and potential shifts in credit union risk profiles.

In summary, the NEV Test measures IRR exposure relative to capital. It also establishes a uniform and transparent measure of market risk that allows exam staff to scale the IRR scope and review procedures to match the credit union’s level of risk. Both thresholds apply, so either measure triggers the risk classification.

As observed in 2022, credit unions are experiencing a significant increase in NEV Test risk classifications due to the combination of rapid changes in interest rates and lower starting point net worth ratios, which are tied to exceptional share growth experienced during 2020 and 2021. With an upward surge in interest rates in a short period of time, sharply lower asset values amplify the shocked NEV results given the starting point is much lower.⁸

The NCUA is updating the NEV Test risk classifications by removing the extreme classification, which was associated with a potential undue risk to the Share Insurance Fund. The high risk classification will now include any post-shock NEV below four percent or any post-shock NEV sensitivity higher than sixty-five percent.

The risk classifications will continue to determine the scope of review steps for the IRR examination.

Clarifying When a DOR to Address IRR Is Warranted

A DOR is not required for any NEV Test or ENT risk classification alone. Similarly, a credit union is not expected to have a plan of action just because their IRR classification is high. Instead, the need for a DOR and a written plan of action are to be determined on a case-by-case basis. The following are examples of when a DOR should be considered:

• The credit union’s level of IRR represents an undue risk to the Share Insurance Fund, and the credit union is not taking appropriate and prompt action to address its level of IRR.⁹
• The credit union has high IRR and has not adequately updated its approach to managing its interest rate, liquidity, and related risks for current market conditions.
• The credit union has a material governance deficiency (identify, measure, monitor, and control) relative to its level of IRR.¹⁰

The following are examples of when a DOR may not be necessary:

• The migration to a high risk classification in the NEV Test or ENT is primarily from a rapid change in interest rates. However, examiners should focus on how the credit union’s management of IRR has been adjusted to the new interest rate environment.
• The credit union has already acted or has an adequate plan to adapt to the current interest rate environment.¹¹

Providing Examiners More Flexibility in Assigning IRR Supervisory Risk Ratings¹²

Examiners will assign the IRR rating based on the quantitative NEV Test or ENT but may improve the rating on other factors. If the NEV Test or ENT show a high or moderate risk classification, examiners may adjust the IRR rating up or down. While these instances may occur, it would be unusual for an examiner to improve the IRR rating when the NEV Test or ENT results in a high risk classification. This scenario will most often result from borderline moderate- to high-risk classifications, though could occur in low- to moderate-risk classifications, as well. For example, in a borderline case, conservative assumptions in the IRR model combined with a low risk qualitative rating may be sufficient for the examiner to improve the credit union’s IRR rating, whereas the opposite may warrant a downgrade. When considering a change to the IRR rating, examiners will fully document the quantitative and qualitative factors that warranted the change to the rating.

The review of a credit union’s IRR may result in a high IRR rating and may also warrant a change in the “S” (Sensitivity to Market Risk) CAMELS component rating.

Revising Examination Procedures to Incorporate Updated Review Steps When Assessing How a Credit Union’s Management of IRR Is Adapting to Changes in the Economic and Interest Rate Environment

Examiners use the IRR Workbook as a job aid when considering topics and questions during the review of IRR. Recognizing the current volatility of economic and interest rate environments, the following topics will be integrated into the IRR Workbook along with a new resource tab (High IRR Job Aid) to understand the range of scenarios and mitigation strategies.

The integration of these topics will expand on existing review steps, when applicable for a credit union. For example, if a credit union holds total assets between $500 million and $10 billion with a high NEV Test risk classification, the examiner review will include the source of high IRR, risk management and controls, and potential impact on earnings and capital. Credit unions with total assets exceeding $10 billion require all review steps in the IRR Workbook, regardless of the risk classification.

Updates to the examination procedures will integrate the following topics with more information available in the revised IRR Examination Workbook Procedures.

Considering the Source of High IRR

Examiners must understand the source of high IRR and, through analytics, identify and describe the primary source of the high risk classification as measured by the NEV Test or ENT. This analysis should be supported by balance sheet and NEV trends, while highlighting what significant changes occurred over the timeframe of the analysis. By understanding the primary sources of IRR, the examiner will be better able to evaluate the credit union’s potential mitigation strategy, if needed. The source of high IRR will be factored into the examiner’s assessment of how the credit union is measuring, monitoring, and controlling IRR and related issues.

For example, a credit union’s risk may have shifted to a high risk classification due to any of the following factors (not an exhaustive list):

• Net worth ratio erosion. Regulatory capital ratios may have declined due to unexpected losses or because the credit union experienced strong and sustained asset growth that outpaced its ability to build regulatory capital. Lower regulatory capital can adversely impact the NEV ratio and resulting NEV Test risk classification.
• Shift in balance sheet concentrations. Recent changes to the credit union’s investment or lending practices may have increased sensitivity to changes in interest rates. A credit union may have invested in securities with longer maturities or increased its lending in long-term fixed-rate loans to enhance earnings by pursuing higher returns on assets. In the absence of an IRR hedging strategy, these changes will generate increased sensitivity to changes in interest rates.
• Market rate surge. The credit union may not have recently experienced any unexpected losses or changed investment or lending policies, but it has significantly lower economic values from the recent surge in interest rates. A significant and quick rise in interest rates will decrease asset valuations in the NEV Test, thus elevating the risk classification level.

The analysis should contain the appropriate account level details of assets, liabilities, and off-balance items extending back a minimum of 12 to 24 months or an appropriate period of time to demonstrate how the changes in interest rates or the change in balance sheet composition contributed to the shift to high risk.

Examples of IRR mitigation strategies can be found in the Examiner’s Guide.

Assessing Risk Management and Controls

An effective IRR program includes the following key risk management and control activities:

• Measuring the credit union’s overall level of IRR exposure,
• Communicating results to officials,
• Initiating action to remain within policy limits, and
• Controlling the potential impact of market risk.

A credit union’s board of directors and operational management is best served by a thorough understanding of the IRR implications of their business activities, products, and strategies. The board of directors is ultimately responsible for oversight of a credit union and for approving policy, major strategies, and prudent limits governing IRR.

Examiners review a credit union’s documentation of the adequacy of their IRR policies and the effectiveness of their IRR governance in managing changing economic or interest rate environment and other related risks.

As a reminder, credit unions have been subject to the IRR rule since 2012. This rule requires all federally insured credit unions with assets greater than $50 million to maintain a written policy and an effective IRR management program as part of asset liability management.¹³ The rule includes Appendix A, which provides guidance on how to develop an IRR policy and an effective IRR program.

Examiners will assess the experience, effectiveness, and actions taken by the credit union personnel who guide and supervise a credit union’s IRR management. This assessment speaks to the capability of a credit union’s leadership team, which is reflected in the Management (“M”) CAMELS component rating.

Analyzing Potential Impact on Earnings and Capital

Higher IRR can amplify related risk exposures, either from extending duration with long-maturity investments and lending programs, liability structure, or from rapidly rising market rates. Examiners will consider these factors as part of the risk management process and when assessing how market risks threaten earnings and capital.

With supporting scenario analysis, examiners will review the modeled impact of a changing interest rate environment on earnings and capital. At minimum, the analysis should include what the potential financial impact may be due to higher funding costs, higher credit allowances, and changing third party demand. The impact of projected cash flow changes to the credit union’s liquidity must also be considered.

The NCUA would expect credit unions to vigilantly monitor other related risks that can be created by changes in market rates with the potential to affect earnings and capital. As examples, related issues may include:

• Strategic Risk. If rates rise significantly, credit unions may experience a rising cost of funds and an extension in the average life of their assets, which limits opportunities to reinvest or generate additional loans at higher yields. If rates fall significantly, credit unions may experience a falling cost of funds but also may experience maturity calls and principal prepayments on investments and loans which creates unwelcome reinvestment risk. This incidental mismatch influences both income and risk.
• Liquidity Risk. A credit union should maintain adequate liquidity to manage both expected and unexpected cash flows from changes in interest rates without adversely affecting either short-term liquidity needs or the credit union’s financial condition. Changes in interest rates can impact a credit union’s primary source of funds (generally member shares), which can lead to a strain on liquidity.
• Asset Quality. Rising rates may accelerate loan defaults, such as in adjustable-rate products, resulting in lower net interest income and loan losses.

B. Use of Third-party Vendors

The NCUA will assess the extent of credit union management’s involvement as part of the IRR examination and whether a credit union understands the information provided by third-party vendors in supporting its analysis.

C. Additional Considerations when Assessing Credit Unions’ Interest Rate Risk Using the Estimated Net Economic Value Tool Model

The NEV Test and the ENT are distinct tools used to assess the quantitative component of IRR. Consistent with the changes to the NEV Test risk classifications, the ENT will generate risk ratings of low, moderate, or high, for both the post-shock NEV ratio and post-shock NEV sensitivity.

The ENT approximates an NEV measure by using a credit union’s Call Report data, as well as sensitivity estimates developed by the NCUA. The ENT does not assign any premium or discount value for the base case except for investments whose fair values are reported on the Call Report. The ENT requires no user input and is automatically generated each quarter with updated Call Report data and provided to applicable credit unions through the quarterly Financial Performance Report. The tool resides in MERIT Financial Analytics and automatically populates when an exam is created.

It should be noted that high risk classifications in the ENT sometimes result from inaccurate Call Report information. Thus, staff should review the Call Report for completeness and accuracy before reviewing ENT results. Examples of common errors are reporting of held-to-maturity investments when the fair value is not reported or is reported incorrectly.¹⁴

For credit unions with less than $500 million in assets, the ENT can be used as a resource to assess the credit union’s IRR exposure. If the credit union produces an NEV report, staff have the option of using the NEV Test and the Market Risk tab within the IRR workbook to assist with the assessment of IRR. At examiner discretion, scope of the IRR review can be expanded to complete part or all of the IRR Workbook.

III. Federally Insured, State-Chartered Credit Unions

NCUA staff will work with the State Supervisory Authorities in coordinating the examination scope for IRR.

IV. Appeals

Credit unions may appeal material supervisory determinations, as outlined in Part 746, Subpart A of the NCUA regulations.¹⁵

V. Additional Guidance Relevant to Interest Rate Risk

Additional references for IRR are in the IRR Examiner’s Guide Chapter under Workpapers and Resources.

If you have questions about the information presented in this letter, please direct them to your immediate supervisor or regional management.

Sincerely,

/s/

Kelly J. Lay
Director, Office of Examination & Insurance