Regulators Will Test Your IRR Using Their New NEV Model Don’t Panic – TCT Has You Covered
By Dennis Child, Research Specialist, TCT Risk Solutions, LLC
The National Credit Union Administration Office of Examinations and Insurance has introduced a new standardized Net Economic Value “NEV Supervisory Test” that will be phased in over the next six months. NCUA plans to distribute a Letter to Credit Unions within the next 60 days that will provide a workbook and explain the testing process more clearly. This standardized NEV test will be used to determine the relative interest rate risk each credit union poses to the NCUA Share Insurance Fund. Credit unions under $50 million are exempt from NCUA’s standard NEV test. NEV is a model typically used to determine the liquidation value of a financial institution. Even though NCUA will perform their IRR evaluations using their NEV model, credit unions will be expected to perform IRR tests using their own, statistically validated A/LM models. It has always been a debate within the credit union industry as to which type of A/LM modeling best reflects the real IRR in credit union operations. The most common A/LM model credit unions use to test their IRR is some form of an NEV (or Value at Risk) model. Dr. Randy Thompson, founder of TCT Risk Solutions, LLC, as well as this author have long argued that Earnings at Risk (EAR) is a better model for measuring IRR (for credit unions). NEV is of little value to determine the Interest Rate Risk (IRR) exposure of an “on-going” credit union. EAR is an operational measure. As a result of years of research and testing, TCT has designed, and provides to credit union clients, an IRR model that uses EAR. TCT will continue to provide clients its EAR reports for measuring IRR. However, as a result of NCUA’s announcement that NCUA will be using a standard NEV test to determine IRR in credit unions, TCT will also provide an NEV (Value at Risk) report in addition to its EAR report to its clients. In this way, client credit unions will be prepared for IRR conversations with NCUA.
TCT has a number of concerns with credit unions relying on NEV as their primary model for measuring IRR. A comparison between NEV and EAR follows:
The Net Equity Value A/LM Model
The traditional method for measuring IRR is an AL/M modeling tool that relies on estimating the “Net Equity Value” (NEV) of a financial institution’s balance sheet. There are inherent weaknesses in NEV that need to be taken into consideration by managers and regulators. These weaknesses include:
1- The level of dependency on assumptions to estimate the “maturity” of non-maturity deposits
2- Using discounted cash flows to arrive at the present value of a credit union’s balance sheet (a credit union’s “liquidation value”)
3- The assumption that discounted cash flows of a balance sheet can be used to estimate changes in net worth and earnings resulting from changes in market rates
4- The assumption that a credit union’s loan portfolio is equivalent to bond portfolios that are widely traded
5- The assumption that a credit union’s deposit accounts can be treated like bonds which have contractual maturities and are widely traded
6- Small inaccuracies in the assumptions used that could lead to erroneous A/LM conclusions that can result in perilous management decisions
The Earnings at Risk A/LM Model
A more accurate and easier to understand A/LM model uses Earnings at Risk (EAR) to measure a credit union’s IRR. EAR does not rely on assumptions to the extent that NEV does and therefore has greater value for CEOs and CFOs who are trying to forecast the effects potential changes in interest rates will have on profitability. The EAR model provided by TCT projects cash flows and impacts on profitability using actual payments coming from individual loans and investments in a credit union’s balance sheet. The TCT EAR model also takes into account additional factors that affect profitability such as fee income, maturing CDs and operating expenses. EAR A/LM models assure validity by holding constant the assets and liabilities in a balance sheet so as to measure the actual IRR in the current balance sheet. Once the “base” IRR is established an EAR model can also be used for multiple simulations where management can vary inputs and view the impacts each change or combination of changes has on IRR, income and equity. Simulations may include: (1) increasing or decreasing loans and/or investments; in combination with (2) increasing or decreasing deposits (specific types or general) including changing the mix of deposits. Simulations can include the effects of changing interest rates.
For the past year, TCT Risk Solutions, LLC has been preparing for NCUA’s standardized IRR testing announcement. As a result of these preparations, TCT has:
- Added online tools (limits calculation and Simulation)
Completed independent validations of tools
Run external simulations to test applications
Begun to add a Value at Risk Page to the EAR Base Case report
TCT is carefully watching the IRR testing performed by NCUA. TCT will continually:
- Re-validate its EAR tool and reporting including the Value at Risk component
Conduct analysis to confirm calibration to NCUA’s NEV process
Continue to train CU staff and leaders
TCT client credit unions need not panic over the NCUA NEV announcement – TCT has them covered.
Amy Rapp, Virtual Corps.