Interest Rate Risk, 16570-16579 [2011-6752]

Agencies

• National Credit Union Administration

[Federal Register Volume 76, Number 57 (Thursday, March 24, 2011)]
[Proposed Rules]
[Pages 16570-16579]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2011-6752]


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NATIONAL CREDIT UNION ADMINISTRATION

12 CFR Part 741

RIN 3133-AD66


Interest Rate Risk

AGENCY: National Credit Union Administration (NCUA).

ACTION: Proposed rule.

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SUMMARY: NCUA proposes to amend its regulations to require Federally 
insured credit unions to have a written policy addressing interest rate 
risk (IRR) management and an effective IRR program as part of their 
asset liability management. NCUA also is proposing draft guidance in 
the form of an appendix to its regulations to assist

[[Page 16571]]

credit unions in meeting the proposed regulatory requirement. NCUA 
believes a written IRR policy and an effective IRR program is key to 
maintaining safe and sound operations. NCUA believes credit unions will 
find the guidance helpful in addressing this important area of their 
operations.

DATES: Comments must be received on or before May 23, 2011.

ADDRESSES: You may submit comments by any of the following methods 
(Please send comments by one method only):
     Federal Rulemaking Portal: https://www.regulations.gov. 
Follow the instructions for submitting comments.
     NCUA Web Site: https://www.ncua.gov/RegulationsOpinionsLaws/proposed_regs/proposed_regs.html. Follow the 
instructions for submitting comments.
     E-mail: Address to regcomments@ncua.gov. Include ``[Your 
name] --Comments on Proposed Rulemaking for Part 741'' in the e-mail 
subject line.
     Fax: (703) 518-6319. Use the subject line described above 
for e-mail.
     Mail: Address to Mary Rupp, Secretary of the Board, 
National Credit Union Administration, 1775 Duke Street, Alexandria, 
Virginia 22314-3428.
     Hand Delivery/Courier: Same as mail address.
    Public Inspection: All public comments are available on the 
agency's Web site at https://www.ncua.gov/RegulationsOpinionsLaws/comments as submitted, except as may not be possible for technical 
reasons. Public comments will not be edited to remove any identifying 
or contact information. Paper copies of comments may be inspected in 
NCUA's law library at 1775 Duke Street, Alexandria, Virginia 22314, by 
appointment weekdays between 9 a.m. and 3 p.m. To make an appointment, 
call (703) 518-6546 or send an e-mail to OGCMail@ncua.gov.

FOR FURTHER INFORMATION CONTACT: Jeremy Taylor, Senior Capital Markets 
Specialist, Office of Capital Markets and Planning, National Credit 
Union Administration, 1775 Duke Street, Alexandria, Virginia 22314, or 
telephone: (703) 518-6620.

SUPPLEMENTARY INFORMATION: 

A. Discussion

    NCUA proposes to amend its regulations to require Federally insured 
credit unions (FICUs) to have a written policy and an effective program 
addressing interest rate risk (IRR) as part of their asset liability 
management (ALM). NCUA believes FICUs need a written policy to 
explicitly state the credit union's IRR tolerance. An effective IRR 
program that identifies, measures, monitors, and controls IRR is an 
essential component of safe and sound credit union operations. In the 
past, NCUA issued guidance on ALM and IRR management in Letters to 
Credit Unions and believes FICUs generally are managing IRR 
adequately.\1\ NCUA's IRR questionnaire is also available at the 
following location https://www.ncua.gov/Resources/ALManagementInvest/Review Procedures.aspx. However, IRR has risen at credit unions due to 
changes in balance sheet compositions and increased uncertainty in the 
financial markets. The Board therefore believes it is appropriate to 
create a regulatory requirement addressing the policy and practice of 
interest rate risk management at FICUs supported by clear and 
comprehensive guidance. The Board believes the proposed regulatory 
requirement and guidance will assist FICUs in understanding and meeting 
NCUA's expectations regarding IRR policy and implementing an effective 
program. NCUA anticipates that it would set a compliance date of three 
months after the rule becomes effective.
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    \1\ Letters to Credit Unions: 99-CU-12 Real Estate Lending and 
Balance Sheet Management; 00-CU-10 Asset Liability Management 
Procedures; 00-CU-13, Liquidity and Balance Sheet Management; 01-CU-
08, Liability Management--Rate-Sensitive and Volatile Funding 
Sources; 01-CU-19 Managing Share Inflows in Uncertain Times; 03-CU-
11, Non-maturity Shares and Balance Sheet Risk; 03-CU-15 Real Estate 
Concentrations and Interest Rate Risk Management for Credit Unions 
with Large Positions in Fixed Rate Mortgages; 06-CU-16 Inter-Agency 
Guidance on Non-traditional Mortgage Product Risk. Interagency 
Advisory on Interest Rate Risk Management, January 6, 2010.
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    The term ``interest rate risk'' refers to the vulnerability of a 
credit union's financial condition to adverse movements in market 
interest rates. Although some IRR is a normal part of financial 
intermediation, IRR may negatively affect a credit union's earnings, or 
net economic value, which is the difference between the market value of 
assets and the market value of liabilities. Changes in interest rates 
influence a credit union's earnings by altering interest-sensitive 
income and expenses (e.g. loan income and share dividends). Changes in 
interest rates also affect the economic value of a credit union's 
assets and liabilities, because the present value of future cash flows 
and, in some cases, the cash flows themselves may change when interest 
rates change.\2\
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    \2\ Credit unions confront IRR from several sources. These 
include repricing risk, yield curve risk, spread risk, basis risk, 
and options risk. See the glossary of terms in Appendix B for 
definitions of these risks.
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    An effective IRR program allows a credit union to serve member 
needs without incurring unreasonable levels of risk and make informed 
decisions about balance sheet composition, growth and product mix, 
while remaining within its defined tolerance level. An IRR program 
enables credit unions to meet their liquidity needs and implement 
flexible pricing strategies in response to changes in market interest 
rates while maintaining adequate earnings and net economic value.
    NCUA recognizes it is impossible to establish specific, regulatory 
requirements for IRR that would be appropriate for all FICUs. IRR 
management involves judgment by a FICU based on its own individual 
mission, structure, and circumstances. Any rule must take into account 
the diversity of FICUs and avoid a one-size-fits-all approach. 
Accordingly, FICUs should devise a policy and risk management program 
appropriate to their own situation.
    The guidance in the Appendix does not identify specific metrics 
because NCUA recognizes IRR programs will differ among credit unions. 
There are, nevertheless, fundamental elements applicable to all credit 
unions, as explained in the appendix. Developing a sound IRR program is 
the responsibility of the board of directors, involving all relevant 
phases of operation, and NCUA believes the proposed guidance provides a 
helpful framework for directors. NCUA is presenting guidance in the 
form of an appendix to the rule to assist FICUs in establishing a 
written policy and effective program as part of asset liability 
management.

B. Proposed Rule

    Section 741.3 generally addresses the criteria NCUA will consider 
in determining and continuing the insurability of a credit union and 
paragraph (b) lists various factors and requirements for a credit 
union's financial condition and its policies. Currently, Sec.  741.3(b) 
includes requirements, among others, of written lending and investment 
policies, 12 CFR 741.3(b)(2) and (3), and, therefore, placement of the 
proposed amendment within this provision is appropriate. The Board 
proposes to amend Sec.  741.3(b) to add the requirement of a written 
policy on IRR and an effective program. This is an additional factor to 
be considered in determining whether a credit union's financial 
condition and

[[Page 16572]]

policies are safe and sound. 12 CFR 741.3(b).

C. Regulatory Procedures

Regulatory Flexibility Act

    The Regulatory Flexibility Act requires NCUA to prepare an analysis 
to describe any significant economic impact a rule may have on a 
substantial number of small entities, those credit unions with less 
than ten million dollars in assets. The proposed rule does not apply to 
credit unions with less than ten million dollars in assets. 
Accordingly, the Board determines that this proposed rule will not have 
a significant economic impact on a substantial number of small credit 
unions and that a Regulatory Flexibility Analysis is not required.

Paperwork Reduction Act

    The Paperwork Reduction Act of 1995 (PRA) applies to rulemakings in 
which an agency by rule creates a new paperwork burden on regulated 
entities or modifies an existing burden. 44 U.S.C. 3507(d). For 
purposes of the PRA, a paperwork burden may take the form of a either a 
reporting or a recordkeeping requirement, both referred to as 
information collections. NCUA has determined that the requirement to 
have a written interest rate policy creates a new information 
collection requirement. NCUA is applying to the Office of Management 
and Budget (OMB) for approval of the proposed information collection 
requirement.
    As required by the PRA, NCUA is submitting a copy of this proposed 
regulation to the OMB for its review and approval. Persons interested 
in submitting comments with respect to the information collection 
aspects of the proposed rule should submit them to the OMB at the 
address noted below.

Written policy requirements

    The proposed rule would require a written interest rate policy and 
would apply to all Federally insured credit unions (FICUs) as follows. 
FICUs with assets over $50 million must meet the requirement for a 
written policy. FICUs with assets $10 million or over and less than or 
equal to $50 million must meet the requirement for a written policy if 
the total of first mortgage loans held plus total investments with 
maturities greater than five years is equal to or greater than 100% of 
its net worth. FICUs with assets $10 million or over and less than or 
equal to $50 million are not required to have a written policy if the 
total of first mortgage loans held plus total investments with 
maturities greater than five years is less than 100% of its net worth. 
FICUs less than $10 million in assets are not required by the rule to 
have a written policy even if the total of first mortgage loans held 
plus total investments with maturities greater than five years is 
greater than 100% of its net worth.
    A FICU is considered to hold a first mortgage loan for its own 
portfolio when it has not demonstrated the intent and ability to sell 
the loan to an independent third party within 120 days. Investments 
with maturities greater than five years are defined as those reported 
by the FICU to have maturities of 5-10 years and greater than 10 years 
in the statement of financial condition of its most recent call report.
    For example, Credit Union A has assets of $51 million. The 
percentage of first mortgage loans held by Credit Union A plus its 
investments with maturities greater than five years is 75% of its net 
worth. It is required by the rule to have a written interest rate 
policy because of its asset size. Credit Union B has $45 million in 
assets. The percentage of first mortgage loans held by Credit Union B 
plus its investments with maturities greater than five years is 75% of 
its net worth. Credit Union B is therefore not required by the rule to 
have a written interest rate policy since this percentage is less that 
100%. Credit Union C has assets of $10 million and the percentage of 
first mortgage loans held by Credit Union C plus its investments with 
maturities greater than five years is 125% of its net worth. It is 
required to have a written interest rate policy because it has assets 
$10 million or over and less than or equal to $50 million, and the 
percentage of first mortgage loans held by Credit Union C plus its 
investments with maturities greater than five years is greater than 
100% of its net worth. Credit Union D has assets of $9 million and the 
percentage of first mortgage loans held by Credit Union D plus its 
investments with maturities greater than five years is 125% of its net 
worth. Credit Union D is not required by the rule to have a written 
interest rate policy because its asset size is below $10 million, even 
though the percentage of first mortgage loans held by Credit Union D 
plus its investments with maturities greater than five years is greater 
than 100% its net worth.
    As of December 31, 2010, there were 7339 FICUs, of which 3184 had 
assets over $50 million, or had assets $10 million or over and less 
than or equal to $50 million, and total first mortgage loans plus total 
investments with maturities greater than five years were equal to or 
greater than 100% of net worth. NCUA estimates, however, that 
approximately 75% of these credit unions already have interest rate 
risk policies in place as part of their lending and asset management 
policies. Therefore, they will not have to undertake any significant 
additional burden as a result of this rulemaking. NCUA estimates that 
those credit unions with existing policies will only need to undertake 
a review of those policies to determine if they are in line with the 
guidance accompanying this rule change. While minor adjustments to 
existing policies may be appropriate, NCUA estimates that approximately 
only 25% of the credit unions will need to prepare a written policy. 
Therefore, NCUA estimates that approximately 800 credit unions will 
need to develop a written interest rate risk policy to meet the 
requirement for a written policy; NCUA notes that periodic review of 
the policy, while included as part of the guidance, may require no 
additional paperwork burden or engender very limited additional 
paperwork.
    The proposed rule requiring a written interest rate risk policy is 
accompanied by guidance on how to establish this policy and the 
guidance essentially provides a template or list of the eight points 
the written policy should address. As provided in the guidance, the 
points to be covered are:
     Identify committees, persons or other parties responsible 
for review of the credit union's IRR exposure;
     Direct appropriate actions to ensure management takes 
steps to manage IRR so that IRR exposures are identified, measured, 
monitored, and controlled;
     State the frequency with which management will report on 
measurement results to the board to ensure routine review of 
information that is timely (e.g. current and at least quarterly) and in 
sufficient detail to assess the credit union's IRR profile;
     Set risk limits for IRR exposures based on selected 
measures (e.g. limits for changes in repricing or duration gaps, income 
simulation, asset valuation, or net economic value);
     Choose tests, such as interest rate shocks, that the 
credit union will perform using the selected measures;
     Provide for periodic review of material changes in IRR 
exposures and compliance with board approved policy and risk limits;
     Provide for assessment of the IRR impact of any new 
business activities prior to implementation (e.g. evaluate the IRR 
profile of introducing a new product or service) ; and
     Provide for annual evaluation of policy to determine 
whether it is still

[[Page 16573]]

commensurate with the size, complexity, and risk profile of the credit 
union.
    The actual length of a policy may vary significantly depending on 
the complexity of the credit union's activities. For example, a credit 
union that offers basic share accounts, only short-term loans, i.e., no 
mortgage loans, and makes relatively simple investments should be able 
to establish a written policy in one to two hours. The policy could 
establish maturity limits for loans, establish the minimum amount of 
short-term funds, and basically restrict the types of permissible 
investments (e.g. Treasuries). More complex balance sheets, especially 
those containing mortgage loans and complex investments, may warrant a 
comprehensive IRR policy due to the uncertainty of cash flows.

Burden Calculation

    While the burden will vary depending on the complexity of credit 
union activities, for purposes of providing an estimated average, NCUA 
estimates each of the eight segments of policy will have a burden of an 
equal weight of two hours. The maximum time for all segments of the 
policy is therefore sixteen hours. NCUA estimates the burden associated 
with this collection as follows: 800 x 16 hours = 12,800 hours.
    Organizations and individuals that wish to submit comments on this 
information collection requirement should direct them to the Office of 
Information and Regulatory Affairs, OMB, Attn: Shagufta Ahmed, Room 
10226, New Executive Office Building, Washington, DC 20503, with a copy 
to Mary Rupp, Secretary of the Board, National Credit Union 
Administration, 1775 Duke Street, Alexandria, Virginia 22314-3428.
    The NCUA considers comments by the public on this proposed 
collection of information in:
     Evaluating whether the proposed collection of information 
is necessary for the proper performance of the functions of the NCUA, 
including whether the information will have a practical use;
     Evaluating the accuracy of the NCUA's estimate of the 
burden of the proposed collection of information, including the 
validity of the methodology and assumptions used;
     Enhancing the quality, usefulness, and clarity of the 
information to be collected; and
     Minimizing the burden of collection of information on 
those who are to respond, including through the use of appropriate 
automated, electronic, mechanical, or other technological collection 
techniques or other forms of information technology; e.g., permitting 
electronic submission of responses.
    The Paperwork Reduction Act requires OMB to make a decision 
concerning the collection of information contained in the proposed 
regulation between 30 and 60 days after publication of this document in 
the Federal Register. Therefore, a comment to OMB is best assured of 
having its full effect if OMB receives it within 30 days of 
publication. This does not affect the deadline for the public to 
comment to the NCUA on the proposed regulation.

Executive Order 13132

    Executive Order 13132 encourages independent regulatory agencies to 
consider the impact of their actions on State and local interests. In 
adherence to fundamental federalism principles, NCUA, an independent 
regulatory agency as defined in 44 U.S.C. 3502(5), voluntarily complies 
with the executive order. This rule will not have substantial direct 
effects on the States, on the relationship between the national 
government and the States, or on the distribution of power and 
responsibilities among the various levels of government. NCUA has 
determined that this rule does not constitute a policy that has 
federalism implications for purposes of the executive order.

The Treasury and General Government Appropriations Act, 1999--
Assessment of Federal Regulations and Policies on Families

    The NCUA has determined that this rule will not affect family well-
being within the meaning of the Treasury and General Government 
Appropriations Act, 1999, Public Law 105-277, 112 Stat. 2681 (1998).

Agency Regulatory Goal

    NCUA's goal is to promulgate clear and understandable regulations 
that impose minimal regulatory burden. We request your comments on 
whether the proposed rule is understandable and minimally intrusive.

List of Subjects in 12 CFR Part 741

    Credit unions, Requirements for insurance.

    By the National Credit Union Administration Board on March 17, 
2011.
Mary F. Rupp,
Secretary of the Board.
    For the reasons set forth above, NCUA proposes to amend 12 CFR part 
741 as follows:

PART 741--REQUIREMENTS FOR INSURANCE

    1. The authority citation for part 741 continues to read:

    Authority:  12 U.S.C. 1757, 1766(a), 1781-1790, and 1790d; 31 
U.S.C, 3717.

    2. In Sec.  741.3, add paragraph (b)(5) to read as follows:


Sec.  741.3  Criteria

* * * * *
    (b) * * *
    (5)(i) The existence of a written interest rate risk policy and an 
effective interest rate risk management program as part of asset 
liability management in all Federally insured credit unions (FICUs) as 
follows. FICUs with assets over $50 million must meet the requirement 
for a written policy and an effective interest rate risk management 
program. FICUs with assets $10 million or over and less than or equal 
to $50 million must meet the requirement for a written policy and an 
effective interest rate risk management program if the total of first 
mortgage loans held plus total investments with maturities greater than 
five years is equal to or greater than 100% of its net worth. FICUs 
with assets $10 million or over and less than or equal to $50 million 
are not required to have a written policy and an effective interest 
rate risk management program if the total of first mortgage loans held 
plus total investments with maturities greater than five years is less 
than 100% of its net worth. FICUs less than $10 million in assets are 
not required by the rule to have a written policy and an effective 
interest rate risk management program even if the total of first 
mortgage loans held plus total investments with maturities greater than 
five years is greater than 100% of its net worth.
    (ii) A FICU is considered to hold a first mortgage loan for its own 
portfolio when it has not demonstrated the intent and ability to sell 
the loan to an independent third party within 120 days. Investments 
with maturities greater than five years are defined as those reported 
by the FICU to have maturities of 5-10 years and greater than 10 years 
in the statement of financial condition of its most recent call report.
    (iii) For example, Credit Union A has assets of $51 million. The 
percentage of first mortgage loans held by Credit Union A plus its 
investments with maturities greater than five years is 75% of its net 
worth. It is required by the rule to have a written interest rate 
policy and an effective interest rate risk management program because 
of its asset size. Credit Union B has $45

[[Page 16574]]

million in assets. The percentage of first mortgage loans held by 
Credit Union B plus its investments with maturities greater than five 
years is 75% of its net worth. Credit Union B is therefore not required 
by the rule to have a written interest rate policy and an effective 
interest rate risk management program since this percentage is less 
that 100%. Credit Union C has assets of $10 million and the percentage 
of first mortgage loans held by Credit Union C plus its investments 
with maturities greater than five years is 125% of its net worth. It is 
required to have a written interest rate policy and an effective 
interest rate risk management program because it has assets $10 million 
or over and less than or equal to $50 million, and the percentage of 
first mortgage loans held by Credit Union C plus its investments with 
maturities greater than five years is greater than 100% of its net 
worth. Credit Union D has assets of $9 million and the percentage of 
first mortgage loans held by Credit Union D plus its investments with 
maturities greater than five years is 125% of its net worth. Credit 
Union D is not required by the rule to have a written interest rate 
policy and an effective interest rate risk management program because 
its asset size is below $10 million, even though the percentage of 
first mortgage loans held by Credit Union D plus its investments with 
maturities greater than five years is greater than 100% its net worth.
    (iv) Appendix B to this part provides guidance on how to establish 
an interest rate risk policy and effective program. The guidance 
describes widely accepted best practices in the management of interest 
rate risk and it may therefore be helpful to all FICUs.
* * * * *
    3. Part 741 is amended by adding Appendix B to read as follows:

Appendix B to Part 741--Guidance for an Interest Rate Risk Policy and 
an Effective Program

Table of Contents

I. Introduction
    A. Complexity
    B. IRR Exposure
II. IRR Policy
III. IRR Oversight and Management
    A. Board of Directors Oversight
    B. Management Responsibilities
IV. IRR Measurement and Monitoring
    A. Risk Measurement Systems
    B. Risk Measurement Methods
    C. Components of IRR Measurement Methods
V. Internal Controls
VI. Decision-Making Informed by IRR Measurement Systems
VII. Standards for Assessment of IRR Policy and Effectiveness of 
Program
VIII. Additional Guidance for Large Credit Unions With Complex or 
High Risk Balance Sheets
IX. Definitions

I. Introduction

    This appendix gives guidance to FICUs in the implementation of 
an interest rate risk (IRR) policy and program as aspects to overall 
asset liability management. An effective IRR management program 
identifies, measures, monitors, and controls IRR and is central to 
safe and sound credit union operations. Given the differences among 
credit unions, each credit union should formulate its own practices, 
metrics and benchmarks appropriate to its operations.
    These practices should be established in light of the nature of 
the credit union's operations and business, as well as its 
complexity, risk exposure, and size. As these elements increase, 
NCUA believes the IRR practices should be implemented with 
increasing degrees of rigor and diligence to maintain safe and sound 
operations in the area of IRR management. In particular, rigor and 
diligence are required to manage complexity and risk exposure. 
Complexity relates to the intricacy of financial instrument 
structure, and to the composition of assets and liabilities on the 
balance sheet. In the case of financial instruments, the structure 
can have numerous characteristics that act simultaneously to affect 
the behavior of the instrument. In the case of the balance sheet, 
which contains multiple instruments, assets and liabilities can act 
in ways that are compounding or can be offsetting because their 
impact on the IRR level may act in the same or opposite directions. 
High degrees of risk exposure require a credit union to be 
diligently aware of the potential earnings and net worth exposures 
under various interest rate and business environments because the 
margin for error is low.

A. Complexity

    In influencing the behavior of instruments and balance sheet 
composition, complexity is a function of the predictability of the 
cash flows. As cash flows become less predictable, the uncertainty 
of both instrument and balance sheet behavior increases. For 
example, a residential mortgage is subject to prepayments which will 
change at the option of the borrower. Mortgage borrowers may pay off 
their mortgage loans due to geographical relocation, or may increase 
the amount of their monthly payment above the minimum contractual 
schedule due to other changes in the borrower's circumstances. This 
cash flow unpredictability is also found in investments, such as 
collateralized mortgage obligations because these are comprised of 
mortgage loans. Additionally, cash flow unpredictability affects 
liabilities. For example, nonmaturity share balances vary at the 
discretion of the depositor making deposits and withdrawals, and 
this may be influenced by a credit union's pricing of its share 
accounts.

B. IRR Exposure

    Exposure to IRR is the vulnerability of a credit union's 
financial condition to adverse movements in market interest rates. 
Although some IRR exposure is a normal part of financial 
intermediation, a high degree of this exposure may negatively affect 
a credit union's earnings and net economic value. Changes in 
interest rates influence a credit union's earnings by altering 
interest-sensitive income and expenses (e.g. loan income and share 
dividends). Changes in interest rates also affect the economic value 
of a credit union's assets and liabilities, because the present 
value of future cash flows and, in some cases, the cash flows 
themselves may change when interest rates change. Consequently, the 
management of a credit union's pricing strategy is critical to the 
control of IRR exposure.
    All FICUs over $50 million, and all FICUs with assets $10 
million or over and less than or equal to $50 million if the total 
of first mortgage loans held plus total investments with maturities 
greater than five years is equal to or greater than 100% of its net 
worth, should incorporate the following five elements into their IRR 
program:
    1. Board-approved IRR policy;
    2. Oversight by the board of directors and implementation by 
management;
    3. Risk measurement systems assessing the IRR sensitivity of 
either or both:
    a. Earnings;
    b. Asset and liability values;
    4. Internal controls to monitor adherence to IRR limits;
    5. Decision making that is informed and guided by IRR measures.

II. IRR Policy

    The board of directors is responsible for ensuring the adequacy 
of an IRR policy and its limits. The policy should be consistent 
with the credit union's business strategies and should reflect the 
board's risk tolerance, taking into account the credit union's 
financial condition and risk measurement systems and methods 
commensurate with the balance sheet structure. The policy should 
state actions and authorities required for exceptions to policy, 
limits, and authorizations.
    Credit unions have the option of either creating a separate IRR 
policy or incorporating it into investment, ALM, funds management, 
liquidity or other policies. Regardless of form, credit unions must 
clearly document their IRR policy in writing.
    The scope of the policy will vary depending on the complexity of 
the credit union's balance sheet. For example, a credit union that 
offers short-term loans, invests in non-complex or short-term bullet 
investments (i.e. a debt security that returns 100 percent of 
principal on the maturity date), and offers basic share products may 
not need to create an elaborate policy. The policy for these credit 
unions may limit the loan portfolio maturity, require a minimum 
amount of short-term funds, and restrict the types of permissible 
investments (e.g. Treasuries, bullet investments). More complex 
balance sheets, especially those containing mortgage loans and 
complex investments, may warrant a comprehensive IRR policy due to 
the uncertainty of cash flows.
    The policy should establish responsibilities and procedures for 
identifying, measuring, monitoring,

[[Page 16575]]

controlling, and reporting IRR, and establish risk limits. A written 
policy should:
     Identify committees, persons or other parties 
responsible for review of the credit union's IRR exposure;
     Direct appropriate actions to ensure management takes 
steps to manage IRR so that IRR exposures are identified, measured, 
monitored, and controlled;
     State the frequency with which management will report 
on measurement results to the board to ensure routine review of 
information that is timely (e.g. current and at least quarterly) and 
in sufficient detail to assess the credit union's IRR profile;
     Set risk limits for IRR exposures based on selected 
measures (e.g. limits for changes in repricing or duration gaps, 
income simulation, asset valuation, or net economic value);
     Choose tests, such as interest rate shocks, that the 
credit union will perform using the selected measures;
     Provide for periodic review of material changes in IRR 
exposures and compliance with board approved policy and risk limits;
     Provide for assessment of the IRR impact of any new 
business activities prior to implementation (e.g. evaluate the IRR 
profile of introducing a new product or service); and
     Provide for annual evaluation of policy to determine 
whether it is still commensurate with the size, complexity, and risk 
profile of the credit union.
    IRR policy limits should maintain risk exposures within prudent 
levels. Examples of limits are as follows.
    GAP: Less than  10 percent change in any given 
period, or cumulatively over 12 months.
    Income Simulation: Net interest income after shock change less 
than 20 percent over any 12 month period.
    Asset Valuation or Net Economic Value: After shock change in 
book value net worth less than 25 percent or after shock value of 
net worth greater than 6 percent.
    NCUA emphasizes these are only for illustrative purposes, and 
management should establish its own limits that are reasonably 
supported. Where appropriate, management may also set IRR limits for 
individual portfolios, activities, and lines of business.

III. IRR Oversight and Management

A. Board of Directors Oversight

    The board of directors is responsible for oversight of their 
credit union and for approving policy, major strategies, and prudent 
limits regarding IRR. To meet this responsibility, understanding the 
level and nature of IRR taken by the credit union is essential. 
Accordingly, the board should ensure management executes an 
effective IRR program.
    Additionally, the board should annually assess if the IRR 
program sufficiently identifies, measures, monitors, and controls 
the IRR exposure of the credit union. Where necessary, the board may 
consider obtaining professional advice and training to enhance its 
understanding of IRR oversight.

B. Management Responsibilities

    Management is responsible for the daily management of activities 
and operations. In order to implement the board's IRR policy, 
management should:
     Develop and maintain adequate IRR measurement systems;
     Evaluate and understand IRR risk exposures;
     Establish an appropriate system of internal controls 
(e.g. separation between the risk taker and IRR measurement staff);
     Allocate sufficient resources for an effective IRR 
program. For example, a complex credit union with an elevated IRR 
risk profile will likely necessitate a greater allocation of 
resources to identify and focus on IRR exposures.
     Develop and support competent staff with technical 
expertise commensurate with their IRR program;
     Identify the procedures and assumptions involved in 
implementing the IRR measurement systems; and
     Establish clear lines of authority and responsibility 
for managing IRR; and
     Provide a sufficient set of reports to ensure 
compliance with board approved policies.
    Where delegation of management authority by the board occurs, 
this may be to designated committees such as an asset liability 
committee or other equivalent. In credit unions with limited staff, 
these responsibilities may reside with the board or management. 
Significant changes in assumptions, measurement methods, tests 
performed, or other aspects involved in the IRR process, should be 
documented and brought to the attention of those responsible.

IV. IRR Measurement and Monitoring

A. IRR Measurement Systems

    Generally, credit unions should have IRR measurement systems 
that capture and measure all material and identified sources of IRR. 
An IRR measurement system quantifies the risk contained in the 
credit union's balance sheet and integrates the important sources of 
IRR faced by a credit union in order to facilitate management of its 
risk exposures. The selection and assessment of appropriate IRR 
measurement systems is the responsibility of credit union boards and 
management.
    Management should:
     Rely on assumptions that are reasonable and 
supportable;
     Document any changes to assumptions that should be 
based on observed information;
     Ensure calculation techniques are appropriate in rigor 
and use accepted financial concepts;
     Monitor positions with uncertain maturities, rates and 
cash flows, such as nonmaturity shares, fixed rate mortgages where 
prepayments may vary, adjustable rate mortgages, and instruments 
with embedded options, such as calls; and
     Require any interest rate measures and tests to be 
sufficiently rigorous to capture risk.

B. IRR Measurement Methods

    The following discussion is intended only as a general guide and 
should not be used by credit unions as a checklist. An IRR 
measurement system may rely on a variety of different methods. 
Common examples of methods available to credit unions are GAP 
analysis, income simulation, asset valuation, and net economic 
value. Any measurement method(s) used by a credit union to analyze 
IRR exposure should correspond with the complexity of the credit 
union's balance sheet and display any material sources of IRR.

GAP Analysis

    GAP analysis is a simple IRR measurement method that reports the 
mismatch between rate sensitive assets and rate sensitive 
liabilities over a given time period. GAP can suffice for simple 
balance sheets that primarily consist of short-term bullet type 
investments and non mortgage-related assets. GAP analysis can be 
static, behavioral, or based on duration.

Income Simulation

    Income simulation is an IRR measurement method used to estimate 
earnings exposure to changes in interest rates. An income simulation 
analysis projects interest cash flows of all assets, liabilities, 
and off-balance sheet instruments in a credit union's portfolio to 
estimate future net interest income over a chosen timeframe. 
Generally, income simulations focus on short-term time horizons 
(e.g. one to three years). Forecasting income is assumption 
sensitive and more uncertain the longer the forecast period. 
Simulations typically include evaluations under a base-case 
scenario, and instantaneous parallel rate shocks, and may include 
alternate interest-rate scenarios. The alternate rate scenarios may 
involve ramped changes in rates, twisting of the yield curve, and/or 
stressed rate environments devised by the user or provided by the 
vendor.

NCUA Asset Valuation Tables

    For credit unions lacking advanced IRR methods that seek simple 
valuation measures, the NCUA Asset Valuation Tables are available 
and prepared quarterly by the NCUA Office of Capital Markets (OCM). 
These are located at https://www.ncua.gov/Resources/ALManagementInvest/Review Procedures.aspx.
    These measures provide an indication of a credit union's 
potential interest rate risk, based on the risk associated with the 
asset categories of greatest concern--(e.g., mortgage loans and 
investment securities).
    The tables provide a simple measure of the potential devaluation 
of a credit union's mortgage loans and investment securities that 
occur during +/- 300 basis point parallel rate shocks, and report 
the resulting impact on net worth.

Net Economic Value (NEV)

    NEV measures the effect of interest rates on the market value of 
net worth by calculating the present value of assets minus the 
present value of liabilities. This calculation measures the credit 
union's balance sheet long-term IRR at a fixed point in time. By 
capturing the impact of interest rate changes on the value of all 
future cash flows, NEV provides a comprehensive measurement of IRR. 
Generally, NEV computations demonstrate the economic value of net 
worth under current interest rates and shocked interest rate 
scenarios.

[[Page 16576]]

    One NEV method is to discount cash flows by a single interest 
rate path. Credit unions with a significant exposure to assets or 
liabilities with embedded options should consider alternative 
measurement methods such as discounting along a yield curve (e.g. 
the U.S. Treasury curve, LIBOR curve) or using multiple interest 
rate paths. Credit unions should apply and document appropriate 
methods, based on available data (e.g. utilizing observed market 
values), when valuing individual or groups of assets and 
liabilities.

C. Components of IRR Measurement Methods

    In the initial setup of IRR measurement, critical decisions are 
made regarding numerous variables in the method. These variables 
include but are not limited to the following.

1. Chart of Accounts

    Credit unions using an IRR measurement method should define a 
sufficient number of accounts to capture key IRR characteristics 
inherent within their product lines. For example, credit unions with 
significant holdings of adjustable-rate mortgages should 
differentiate balances by periodic and lifetime caps and floors, the 
reset frequency, and the rate index used for rate resets. Similarly, 
credit unions with significant holdings of fixed-rate mortgages 
should differentiate at least by original term, e.g., 30 or 15-year, 
and coupon level to reflect differences in prepayment behaviors.

2. Aggregation of Data Input

    As the credit union's complexity, risk exposure, and size 
increases, the degree of detail should be based on data that is 
increasingly disaggregated. Because imprecision in the measurement 
process can materially misstate risk levels, management should 
evaluate the potential loss of precision from aggregation and 
simplification used in its measurement of IRR.

3. Account Attributes

    Account attributes define a product, including: principal type, 
rate type, rate index, repricing interval, new volume maturity 
distribution, accounting accrual basis, prepayment driver, discount 
rate.

4. Assumptions

    IRR measurement methods rely on assumptions made by management 
in order to identify IRR. The simplest example is of future interest 
rate scenarios. The management of IRR will require other assumptions 
such as: projected balance sheet volumes; prepayment rates for loans 
and investment securities; repricing sensitivity, and decay rates of 
nonmaturity shares. Examples of these assumptions follow.
    Example 1. Credit unions should consider evaluating the balance 
sheet under flat (i.e. static) and/or planned growth scenarios to 
capture IRR exposures. Under a flat scenario, runoff amounts are 
reinvested in their respective asset or liability account. 
Conducting planned growth scenarios allows management to assess the 
IRR impact of the projected change in volume and/or composition of 
the balance sheet.
    Example 2. Loans and mortgage related securities contain 
prepayment options that enable the borrower to prepay the obligation 
prior to maturity. This prepayment option makes it difficult to 
project the value and earnings stream from these assets because the 
future outstanding principal balance at any given time is unknown. A 
number of factors affect prepayments, including the refinancing 
incentive, seasonality (the particular time of year), seasoning (the 
age of the loan), member mobility, curtailments (additional 
principal payments), and burnout (borrowers who don't respond to 
changes in the level of rates, and pay as scheduled). Prepayment 
speeds may be estimated or derived from numerous national or vendor 
data sources.
    Example 3. In the process of IRR measurement, the credit union 
must estimate how each account will reprice in response to market 
rate fluctuations. For example, when rates rise 300 basis points, 
the credit union may raise its asset or liability rates in a like 
amount or not, and may choose to lag the timing of its pricing 
change.
    Example 4. Nonmaturity shares include those accounts with no 
defined maturity such as share drafts, regular shares, and money 
market accounts. Measuring the IRR associated with these accounts is 
difficult because the risk measurement calculations require the user 
to define the principal cash flows and maturity. Credit unions may 
assume that there is no value when measuring the associated IRR and 
carry these values at book value or par. Many credit unions adopt 
this approach because it keeps the measurement method simple.
    Alternatively, a credit union may attribute value to these 
shares (i.e. premium) on the basis that these shares tend to be 
lower cost funds that are core balances by virtue of being 
relatively insensitive to interest rates. This method generally 
results in nonmaturity shares priced/valued in a way that will 
produce an increased net economic value. Therefore, the underlying 
assumptions of the shares require scrutiny.
    Credit unions that forecast share behavior and incorporate those 
assumptions into their risk identification and measurement process 
should perform sensitivity analysis. Guidance on the evaluation of 
nonmaturity shares is available in NCUA's Letter to Credit Unions 
03-CU-11.

V. Internal Controls

    Internal controls are an essential part of a safe and sound IRR 
program. If possible, separation of those responsible for the risk 
taking and risk measuring functions should occur at the credit 
union.
    Staff responsible for maintaining controls should periodically 
assess the overall IRR program as well as compliance with policy. 
Internal audit staff would normally assume this role; however, if 
there is no internal auditor, management, or a supervisory committee 
that is independent of the IRR process, may perform this role. Where 
appropriate, management may also supplement the internal audit with 
outside expertise to assess the IRR program. This review should 
include policy compliance, timeliness, and accuracy of reports given 
to management and the board.
    Audit findings should be reported to the board or supervisory 
committee with recommended corrective actions and timeframes. The 
individuals responsible for maintaining internal controls should 
periodically examine adherence to the policy related to the IRR 
program.

VI. Decision-Making Informed by IRR Measurement Systems

    Management should utilize the results of the credit union's IRR 
measurement systems in making operational decisions such as changing 
balance sheet structure, funding, pricing strategies, and business 
planning. This is particularly the case when measures show a high 
level of IRR or when measurement results approach board-approved 
limits.
    NCUA recognizes each credit union has its own individual risk 
profile and tolerance levels. However, when measures of fair value 
indicate net worth is low, declining, or even negative, or income 
simulations indicate reduced earnings, management should be prepared 
to identify steps, if necessary, to bring risk within acceptable 
levels. In any case, management should understand and use their IRR 
measurement results, whether generated internally or externally, in 
the normal course of business. Management should also use the 
results proactively as a tool to adjust asset liability management 
for changes in interest rate environments.

VII. Standards for Assessment of IRR Policy and Effectiveness of 
Program

    The following standards will assist credit unions in determining 
the adequacy of their IRR policy and assess the effectiveness of 
their program to manage IRR. This section provides examples of 
adequate and inadequate elements of IRR policies and programs based 
on the preceding sections. Specific instances of inadequate policies 
and programs are in some cases identified for purposes of 
illustration.

------------------------------------------------------------------------
                                    Adequate             Inadequate
------------------------------------------------------------------------
Policy:
    Board oversight.........  Policy is consistent  Policy is not
                               with credit union     consistent with
                               strategy, and the     credit union
                               board states          complexity. Board
                               actions required to   has not reviewed
                               address policy        limits specified in
                               exceptions.           policy and does not
                                                     require management
                                                     to take corrective
                                                     action when policy
                                                     limitations are
                                                     exceeded.

[[Page 16577]]

 
    Responsible parties       A committee or        No committee or
     identified.               management is         individual
                               designated to         specified to review
                               review and monitor    credit union's IRR
                               IRR.                  exposure.
    Direct appropriate        Policy states all     Omissions in policy
     action to measure,        actions that are      cause material
     monitor, control IRR.     sufficient to         deficiency in
                               manage IRR.           controlling risk
                                                     (e.g. method of
                                                     measuring IRR is
                                                     not identified or
                                                     risk measurement
                                                     not required with
                                                     stated frequency).
    Reporting frequency       Reporting of results  Reporting is
     specified.                is required with      infrequent and does
                               sufficient            not provide
                               frequency to alert    adequate detail to
                               management to         control IRR (e.g.
                               emerging IRR.         semi-annual
                                                     reporting on an
                                                     aggregate balance
                                                     sheet).
    Risk limits stated with   Risk limits are       Key risk limit
     appropriate measures.     established and are   omitted from policy
                               appropriate for the   (e.g. NEV ratio or
                               size and complexity   volatility post
                               of the credit union.  shock, NII post
                                                     shock, or
                                                     sensitivity gap at
                                                     stated period), or
                                                     limit is not
                                                     reasonable (e.g.
                                                     limits allow IRR
                                                     measures to
                                                     approach
                                                     dangerously low
                                                     levels under
                                                     plausible interest
                                                     rate scenarios).
    Tests for limits........  Tests substantially   Tests do not
                               display the level     indicate level or
                               and range of credit   source of risk
                               union IRR.            (e.g. NEV @ only +/-
                                                     100 bps, or
                                                     repricing gap only
                                                     at one month).
    Review of material IRR    Any changes beyond a  Review is required,
     changes.                  stated level are      but need for
                               reported to           compliance with
                               management and,       policy limits and
                               where appropriate,    corrective action
                               the Board.            is unclear.
    Impact of new business..  IRR impact of all     The credit union
                               business              does not evaluate
                               initiatives is        the impact of new
                               required where        business on its IRR
                               these will affect     profile and is at
                               future IRR.           risk from new
                                                     business booked.
    Periodic policy review..  Review by Board       Policy review is
                               required annually     required only if
                               to ensure continued   risks are
                               relevance and         unchanged, at the
                               applicability of      Board's discretion.
                               policy to
                               management of IRR.
IRR Oversight & Management:
    Oversight...............  Board approves        Board is aware of
                               policy and            the types of IRR
                               strategies and        present to credit
                               understands IRR       unions in general,
                               faced by its own      but does not have
                               credit union.         knowledge of the
                                                     IRR risks
                                                     associated with the
                                                     credit union.
    Oversight assessment of   Board periodically    Board substantially
     program effectiveness.    evaluates program     relies on annual
                               effectiveness by      third party review
                               monitoring            to determine the
                               management's IRR      adequacy of
                               knowledge, using      oversight and
                               professional advice.  governance.
    Choice of IRR             Management selects    Systems used by the
     measurement systems.      and maintains         credit union do not
                               systems which are     capture IRR (e.g.
                               able to capture the   balance sheet
                               complexity of IRR     contains material
                               risks.                options in
                                                     investments,
                                                     mortgage loans or
                                                     core deposits,
                                                     which the system
                                                     cannot capture--
                                                     calls, prepayments,
                                                     or administered
                                                     rates).
    Evaluation of IRR risk    Credit union          Management relies on
     exposures.                understands all       outside parties to
                               material IRR          evaluate credit
                               exposures and         union's IRR and
                               evaluates these       cannot effectively
                               accordingly           explain the IRR
                               relative to credit    measurement method
                               union strategy.       or the results.
    System of internal        Internal controls     Internal audit has
     controls.                 encompass and         not identified or
                               effectively           addressed the
                               evaluate programs     correction of IRR
                               that manage           deficiencies (e.g.
                               elements of IRR at    processes for
                               the credit union.     tracking changes in
                                                     measurement
                                                     assumptions, such
                                                     as gap repricing of
                                                     core deposits).
    IRR resource management.  Credit union has      Credit union IRR
                               allocated initial     exposure has
                               or additional         materially
                               qualified staff       increased without
                               resources             allocating
                               sufficient to         additional,
                               manage IRR by means   qualified staff,
                               that address          consequently IRR
                               sources of risk.      exposures are not
                                                     identified or
                                                     properly measured.
    Expertise of IRR program  Staff responsible     Credit union relies
     staff.                    correctly             on staff who do not
                               identifies sources    understand or are
                               of IRR and can        not familiar with
                               quantify these        IRR at the credit
                               risks.                union (e.g.
                                                     management cannot
                                                     explain the impact
                                                     on IRR of
                                                     overstating core
                                                     deposit premiums).
    Procedures and            Credit union          Management delegates
     assumptions of IRR        identifies            assumptions to a
     measurement systems.      reasonable            third party and has
                               procedures and        no procedure to
                               supportable           review the
                               assumptions.          reasonableness of
                                                     the assumptions.
    Accountability of IRR     Responsibility for    Responsibility for
     management.               managing IRR is       managing IRR is too
                               specific and          broad, or unclear,
                               clearly delineated.   or not recognized
                                                     by management.
    Transparency of changes   Management requires   Changes in
     in assumptions, methods   clear disclosure of   assumptions are not
     and IRR tests.            relevant changes in   tracked, or
                               all material          monitored or
                               assumptions and       transparent to
                               methods.              those evaluating
                                                     efficacy of IRR
                                                     system.

[[Page 16578]]

 
IRR Measurement and
 Monitoring:
    Reasonable and            Credit union          Results are highly
     supportable assumptions.  carefully evaluates   dependent on key
                               all assumptions and   assumptions that
                               assesses the          have not been
                               sensitivity of        researched or
                               results relative to   demonstrated to be
                               each key assumption.  supportable (e.g.
                                                     mortgage
                                                     prepayments do not
                                                     reflect extension
                                                     risk and core
                                                     deposit premiums
                                                     overstate or do not
                                                     indicate reasonable
                                                     maturities).
    Assumption changes from   All material changes  Assumptions are not
     observed information.     in assumptions are    tested and changes
                               based on tested       are not supported
                               internal data or      by any associated
                               reliable industry     data on which the
                               sources.              credit union
                                                     relies.
    Rigor of calculations     Techniques used       Methods to attribute
     and conformity of         appropriately         cash flows, and
     concepts.                 capture complexity    rate sensitivities
                               of balance sheet      are based on
                               instruments.          incorrect
                                                     techniques (e.g.
                                                     misuse of
                                                     statistical
                                                     correlations).
    Positions with uncertain  Activity is           Actual behavior is
     maturities, rates and     monitored on a        not monitored or
     cash flows.               regular basis in      compared to
                               order to validate     projected behavior.
                               reasonableness of
                               modeling
                               assumptions.
    Rigor of interest rate    Measures and tests    Measures and tests
     measures and tests.       employed capture      employed do not
                               the material risks    capture material
                               embedded in the       risks embedded in
                               credit union's        the balance sheet
                               balance sheet.        (e.g. rate shocks
                                                     do not trigger the
                                                     embedded options in
                                                     some products).
Components of IRR
 Measurement Methods:
    Chart of accounts.......  A sufficient number   Accounts/products
                               of accounts have      with different IRR
                               been defined to       characteristics are
                               capture key IRR       modeled as one
                               characteristics       account/product
                               inherent within       (e.g. 15- and 30-
                               each product.         year fixed-rate
                                                     mortgages, with
                                                     various coupons and
                                                     prepayment
                                                     behaviors).
    Data aggregation........  The level of data     Data is combined for
                               disaggregation is     similar products
                               sufficient given      with a wide range
                               the credit union's    of variables,
                               complexity and risk   producing
                               exposure (e.g.        misleading weighted