Regulators Will Test Your IRR Using Their New NEV Model Don’t Panic – TCT Has You Covered Part 2

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 30 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.

There are some similarities between NEV and EAR. Cash Flows from loans, investments and deposits are the basis for both NEV and EAR. However, EAR adds Net Interest Income (NII) which is the purest measure of IRR. Determining NII at Risk is an important risk management process:

· Cash flows direct new yield on loans, investments, and deposits

· New yields cause change in Interest Income and Interest Expense

· Change in income and expense leads to new NII

· Change in NII provides a clear picture of IRR in each year

· Change in NII equals NII at Risk

 

NCUA’s new Supervisory Test underscores the need for a structured NII measurement approach. The selection and assessment of appropriate IRR measurement systems is the responsibility of credit union boards and management (12 CFR Part 741)

 

Credit unions should follow four steps to prepare for NCUA’s Supervisory Test:

Step One - Know the Regulations

· What is required/allowed

· Who is responsible for compliance

· What managers must do

 

Step Two - Establish the Credit Union’s Base Case Report

Key Indicators

  • NII at Risk
  • Equity at Risk
  • Minimum Equity

Know Sources of Outputs

  • Repricing Schedule
  • Simulation Income Statements

 

Step Three - Establish Valid IRR Limits

  • Minimum Equity (Matches Post Shock NEV)
  • Equity at Risk (Matches NEV Sensitivity)
  • NII at Risk (Primary indicator of IRR)

Limits must be correlated to your current financial condition to be valid and meaningful

 

Step Four - Use TCT’s Online A/LM Simulation Tools

  • Identify Anticipated New Products or Operational Changes

 

Before making any changes in operations that impact cash flows, a credit union should run simulations using empirically developed and validated A/LM models. TCT provides such as A/LM tools to accurately determine possible impacts on IRR. These steps include:

1. Identify the change(s) you contemplate making

2. Identify the impacted areas in the balance sheet

3. Input the changes

4. Run the simulation model

5. Read and compare the IRR indicators (NII at Risk & Equity at Risk)

6. Input data into the Liquidity Shock Test

7. Compute the liquidity measures

8. Make decision on the advisability of the change(s)

 

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.

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 analyses 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.

Contact Us

208-939-8366

www.tctrisk.com

 

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