Make sure you also do ongoing, strategic asset/liability management.
Since the National Credit Union Administration put its Net Economic Value Supervisory Test into effect on Jan. 1, 2017, many credit unions have found the results to be uneventful. And that speaks volumes. This test is not intended to send up warnings for the vast majority. It is intended to standardize deposit values to help examiners compare across institutions to make it easier to identify outliers.
This means that it doesn’t provide the comprehensive decision information that credit unions need to run their businesses. Credit unions have bigger fish to fry, like how to remain relevant and profitable today—and what to do if rates change. That’s a big balancing act. But this is not the time to say, “If it’s good enough for NCUA, it’s good enough for me.”
The test for NEV (which equals the present value of assets minus the present value of liabilities, plus or minus the present value of the expected cash flows on off-balance-sheet instruments) is a broad-brush scoping tool that can help examiners focus their exams. By definition, any type of standardization means that the unique risks of an institution are not captured. That being the case, don’t stop your asset/liability management at the bounds of the NEV supervisory test.
Think about this. The NEV standardization ignores each credit union’s individual non-maturity deposit pricing and how it varies for each category, such as regular shares, checking, and money markets. Therefore, it does not uncover risks to earnings and ultimately risks to net worth.
Another consideration is that while many credit unions taking the test are falling into low and moderate risk classifications, the test has already gotten harder because rates have risen since it was put into place. It may continue to get harder if rates keep rising, and since nobody knows at this point how the standard values for non-maturity deposits may be modified, credit unions should actively discuss this in asset/liability committee meetings.
Again, don’t stop your ALM analysis at NEV, regardless of share values, because NEV ignores earnings and earnings do matter.
Risks and benefits are often viewed in silos. If interest rate risk is viewed separately from the earnings benefits of a particular portfolio, it’s difficult for stakeholders to understand the interplay. If they are shown only the interest rate risk and not the income potential of any given scenario, poor decisions could be made and earnings optimization could go by the wayside.
One way to combat siloed thinking is to combine interest rate risk and profitability in one view. Take, for example, the two assets shown below. Mortgages carry a relatively high potential for interest rate risk. The column labeled “% NI Impact vs Assets” displays the risk of each asset relative to the average risk of the institution.
In this example, the first mortgages have risk equal to about 160 percent of the credit union’s average risk, while the callable step up has risk equal to about 120 percent of the credit union’s average risk. For this credit union, then, first mortgages have more relative interest rate risk than the callable step up.
But understanding the risk is only one piece of the picture. The last column—“Volatility % of Yield”—relates the risk of the asset to its yield: the risk/return trade-off. This type of analysis lets the credit union see that all risk is not created equal. Yield relative to risk certainly does matter.
The interest rate risk of the callable step up is about 197 percent of its yield, whereas first mortgages have risk of about 77 percent of their yield. The interpretation is that while the callable step up carries relatively less risk for this credit union’s structure, the first mortgages represent the better risk/return trade-off.
The objective of this example is not to say that mortgages are always a better risk/return trade-off than callable step ups or to suggest that credit unions should load up on mortgages. The objective is to understand risk/return trade-offs. C. myers wrote a c. notes on this topic in 2016.
In summary, the NEV supervisory test is simply a scoping tool used by NCUA to help identify outliers that may threaten the insurance fund. It is wise to know your test results before NCUA knows them, but this test does not replace comprehensive ALM. The fact is that earnings matter. Earnings optimization and risks to earnings and net worth should be central to your ALM process.
Also remember that non-interest income and expense also affect earnings and can provide additional protection—or risk—regardless of rates. Well-informed decisions that take risks and rewards into account and are based on the credit union’s strategy can create sustainable membership benefits and credit union relevance in the long term.
Since 1991, c. myers has been helping credit unions understand and use ALM and interest rate risk management as a weapon. The company’s philosophy is to help clients ask the right, and often tough, questions required to create a solid foundation that links strategy and desired financial performance. C. myers has worked with over 550 credit unions, including 50 percent of those over $1 billion in assets and about 25 percent of those over $100 million, helping them think to differentiate and drive better decisions through ALM, financial forecasting, liquidity analysis, strategic planning, process improvement, project management, model validations, education.
