Methods and Process to Measure IRR
A credit union may use a number of methods to identify, measure, monitor, and control IRR. The method should be commensurate with a credit union’s size, level of risk, and complexity. As these factors increase, supervisory expectations scale upward accordingly. Each credit union should employ a measurement method that captures all material balance sheet items and is capable of quantifying IRR exposure to both earnings and net worth. The most common methods for measuring IRR are:
- Net Interest Income Simulation – Measures the changes to earnings, typically in the short term (for example, 12 to 36 months), caused by changes in interest rates.
- Net Economic Value – Measures the changes in the economic value of net worth caused by changes in interest rates.
Interagency guidance encourages institutions to use both NII and NEV methods. When used together, these measures provide a more comprehensive view of potential IRR.
There are also two important instrument-level measures also can provide information about price sensitivity and valuations, and serve as the underpinning of the NEV computation:
- Duration – Duration analysis measures the change in the valuation of an asset or liability that may occur given discrete change in interest rates. Duration measures the average price change for a plus and minus 1 percent change in rates.
- Convexity – This method measures the curvature in the relationship between prices and yields, and reflects how the duration of a financial instrument changes as interest rates change.
A less common method of interest rate measurement that may be utilized by smaller credit unions is gap analysis. This is a simple IRR measurement method that identifies maturity and repricing mismatches between assets and liabilities over a given time period (for example, 3, 6, or 12 months). Generally, gap analysis is appropriate only for simple balance sheets that consist primarily of short-term investments, non-mortgage-related loans, and basic funding sources (like regular shares).
However, gap analysis can be used to determine whether a credit union’s balance sheet is more asset or liability sensitive. For example, if earnings move upward as interest rates increase, the balance sheet is more asset-sensitive (positive gap). If earnings deteriorate as interests rate increase, the balance sheet is more liability sensitive (negative gap).
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Last updated October 11, 2016