Risk is the potential that events, expected or unexpected, may have an adverse effect on a credit union’s net worth and earnings. Every product or service a credit union offers carries some risk of financial exposure or loss.
Taking on risk presents the opportunity for increased reward, and a well-balanced risk/reward relationship can result in stable profitability and increased net worth. Each credit union must determine its own risk tolerance and figure out how to balance risk and reward responsibly.
The NCUA has always placed significant supervisory emphasis on the adequacy of a credit union’s risk management, including its system of internal controls, when assessing the condition of the organization. A credit union’s failure to establish a management structure that adequately identifies, measures, monitors, and controls the risks involved in its various products and lines of business has long been considered unsafe and unsound conduct.
There are seven areas of risk for credit union supervision purposes, which fall into two major categories:
- Market risks, which are generally more objective and, therefore, can be measured quantitatively, and
- Institution risks, which are more subjective and are generally measured qualitatively.
|Market Risks (quantitative measure)
|Institution Risks (qualitative measure)
Although the risk-focused examination and supervision process identifies the seven risks as discreet and individual, in reality, these risks are interrelated and inseparable. They often overlap, and risk in one area can cause or increase risk exposure in one or more additional areas.
For example, compliance laws exist for consumer protection. If the credit union does not adhere to these laws, its reputation could suffer, resulting in increased reputation risk and possibly member loss. Further, civil money penalties could diminish or even eliminate a credit union’s reserves, which could result in increased liquidity risk.
Each of these risk areas is discussed in greater detail below.
Credit risk arises from the possibility that a borrower or counterparty will fail to meet terms of any contract with the credit union or otherwise fail to perform as agreed, impacting the credit union’s earnings or net worth. Credit risk exists in all activities where the credit union invests or loans funds with the expectation of repayment.
Interest rate risk is the risk that changes in market rates will adversely affect a credit union’s net worth and earnings. Interest rate risk arises from:
- Differences between the timing of rate changes and the timing of cash flows (repricing risk)
- Changing rate relationships among different yield curves (basis risk)
- Changing rate relationships across the spectrum of maturities (yield curve risk)
- Interest-related options embedded in credit union products (options risk)
Not only can a move in interest rates affect the price of investments, it also has an effect on the value of the loan portfolio and on fee income, which is sensitive to changes in interest rates.
The assessment of interest rate risk should consider risk from both an accounting perspective (for example, the effect of interest rate changes on the credit union’s accrual earnings, including held-to-maturity and AFS investments) and the economic perspective (for example, the effect on the market value of the credit union’s loans and investments). In some credit unions, the broader category of market risk captures interest rate risk.
Liquidity risk is the current and prospective risk to earnings or net worth that arises from a credit union’s inability to meet its obligations when they come due, without incurring material costs or unacceptable losses. Liquidity risk includes the inability to manage funding sources, including unplanned decreases or changes. Liquidity risk also arises from the credit union’s failure to recognize or address changes in market conditions that affect the ability to liquidate assets quickly and with minimal loss in value.
Transaction risk is the risk to earnings or net worth arising from fraud or errors that result in an inability to deliver products or services, maintain a competitive position, and manage information. This risk (also referred to as operating or fraud risk) is a function of internal controls, information systems, employee integrity, and operating processes. This risk arises on a daily basis in all credit unions as they process transactions.
Compliance risk is the current and prospective risk to earnings or net worth arising from violations of, or nonconformance with, laws, rules, regulations, prescribed practices, internal policies and procedures, or ethical standards. Compliance risk may also arise in situations where ambiguous or untested laws or rules govern certain credit union products or activities of the members. Compliance risk exposes the credit union to fines, civil money penalties, payment of damages, and the voiding of contracts. Compliance risk can lead to a diminished reputation, limited opportunities, reduced potential to expand the field of membership, and lack of contract enforceability.
Compliance risk goes beyond a failure to comply with consumer protection laws. It encompasses all laws as well as compliance with exam reports, prudent ethical standards, contractual obligations, and exposure to litigation. Compliance risk can blend into operational risk, transaction risk, and even legal risk, increasing the difficulty of identifying this risk.
Strategic risk is the current and prospective risk to earnings or net worth arising from adverse business decisions, improper implementation of decisions, or lack of responsiveness to industry changes. This risk is a function of the compatibility of a credit union’s strategic goals, the business strategies developed to achieve those goals, the resources deployed to accomplish these goals, and the quality of implementation. The tangible and intangible resources needed to carry out business strategies include communication channels, operating systems, delivery networks, monitoring systems, and managerial capacities and capabilities.
Reputation risk is the current and prospective risk to earnings or net worth arising from negative public opinion or perception. Reputation risk affects the credit union’s ability to establish new relationships or services, or to continue servicing existing relationships. This risk, which occurs in activities such as asset management decisions and transactions, can expose the credit union to litigation, financial loss, or a decline in membership base. Reputation risk exposure appears throughout the credit union organization. The officials, management, and staff must accept responsibility to exercise an abundance of caution in dealing with members and the community.
In addition to the seven categories of risk for credit union supervision purposes, credit unions also face concentration risk, which occurs when a concentration—in a particular investment, product or service offering, or other area—creates the potential for losses large enough (relative to net worth, total assets, or overall risk level) to threaten the credit union’s solvency. 10-CU-03, Concentration Risk , provides additional guidance on concentration risk.
Workpapers & Resources
Last updated October 11, 2016