A risk mitigation strategy, by definition, is taking steps to reduce the risk (the severity of the impact and/or probability of the occurrence). A credit union should have at least a general plan for how it would systematically reduce an adverse IRR exposure that goes beyond its established risk tolerance threshold.
A credit union can take a number of actions to mitigate its IRR exposure. The appropriate action will depend upon the level and source of the exposure. High and extreme measures of IRR elevate the degree of potential urgency with which a credit union may need to act.
Proactive strategies to de-risk (such as to sell assets or enter hedge transactions) may be necessary when risk levels are excessive or otherwise outside of risk tolerance limits. Passive strategies (for example, letting riskier assets roll off the books by letting them mature and reinvesting proceeds in less risky instruments) can be acceptable when the time horizon for de-risking in this manner occurs within a relatively short time period.
An effective risk management program will include a systematic and timely approach to dealing with IRR measures that fall outside of policy. A credit union should avoid a “wait-and-see” strategy when holding excessive levels of IRR on its balance sheet. Losses can quickly accumulate if rates rapidly change and, at that point, reducing the risk becomes considerably more costly. Given this possibility, credit unions should be vigilant in generating NII and NEV simulations with sufficient frequency to identify adverse exposures and they must be adequately and properly prepared to incur the loss of necessary risk reduction when identified. Risk mitigation is most effective when it is integrated into the credit union’s formal discipline of measuring, monitoring and managing IRR.
Active Mitigation Strategies
Active mitigation strategies are typically necessary when a credit union has experienced a significant change in its portfolio holdings and it determines that it has an unsafe level of IRR exposure as a result. A credit union in this position should consider the sources of its risk exposure, the time it would realistically need to reduce or unwind unfavorable risk positions, and management’s willingness to recognize losses in order to restructure its risk profile.
Each credit union has its own individual risk profile, tolerance for risk exposure and policy limits. A credit union’s respective risk tolerance notwithstanding, if NEV measurements are low, declining, or even negative, or if income simulations indicate unsafe reductions in earnings, management should be prepared to take the necessary steps to bring risk within acceptable levels timely. A lack of action by credit union management when unsafe exposure to IRR is evident may indicate a failure in risk governance.
Active strategies to restructure the balance sheet could include the sale of assets that are primarily contributing most to IRR (longer duration assets), reinvesting the proceeds in shorter duration loans and investments (including variable-rate products), and lengthening liability durations (such as term borrowings, CD programs, or interest rate derivative hedging). This strategy may include product pricing that incentivizes member movement to the desired product.
Another active strategy for credit unions with the appropriate expertise, is the use of interest rate derivative instruments. Generally, credit unions will use derivative instruments as a hedge to mitigate IRR, and help protect earnings and net worth under potential interest rate changes.
Passive Mitigation Strategies
Passive mitigation strategies include reinvesting regularly scheduled cash flows from loan amortizations and investment maturities into shorter-term loans and investments (including variable-rate instruments). These strategies are intended to reduce the overall IRR exposure periodically (for example, quarterly). Passive strategies are more appropriate when a credit union has a demonstrably strong risk management platform, is highly familiar with its risk exposures, and has a clear alternative strategy if the urgency of its risk exposure increases significantly before the passive approach has succeeded.
Last updated October 11, 2016
