How IRR Relates to Other Risks
The impact of IRR can expose a credit union to other risk areas, including:
IRR and credit risk can be closely correlated. Ignoring the impact of potential IRR on delinquency can lead to a severe underestimation of overall risk. For example, a rise in interest rates can exacerbate defaults, such as in adjustable-rate products, resulting in a decrease in NII.
Given time, a credit union with sufficient capital and liquidity can recover from the adverse effects that a rise in rates can have on credit performance. It’s expected that as asset rates eventually reset upwards to market, the net interest margin will recover. However, credit unions should understand that rapidly rising market rates can exacerbate credit risk exposures and should be considered in the overall risk management process when assessing how market risks threaten earnings and net worth. Therefore, it is important to assess the type of adjustable-rate loan products, as well as their potential to expose a credit union’s balance sheet to concentration risk.
Liquidity risk is the current and prospective risk to earnings or net worth arising from a credit union’s inability to meet its obligations at a reasonable cost when they come due. Changes in interest rates can impact a credit union’s primary source of funds (generally, member shares), which can lead to a strain on liquidity.
For example, some credit union non-maturity shares (regular shares, share drafts, and money market accounts) have no contractual maturity. While these non-maturity shares can be a long-term funding source, the timing of their cash flows are uncertain and they may be sensitive to changes in interest rates.
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. Any strategic business decision that alters a credit union’s balance sheet composition can impact its exposure to IRR. Credit unions should consider the potential impact of any new program or service on IRR exposure both prior to implementation and periodically thereafter.
Last updated October 11, 2016