Stress testing, which includes both scenario and sensitivity analysis, is an integral part of IRR management. Scenario analysis simulates possible outcomes given an event or series of events, while sensitivity analysis estimates the impact of change in one or only a few of a simulation model’s significant assumptions.
With IRR stress testing, the modeled scenarios involve changing interest rates by defined amounts and potentially severe magnitudes. At a minimum, standard stress tests typically include instantaneous, parallel, and sustained shocks in the yield curve of +/- 300 basis points.
Parallel and static interest rate shocks in the yield curve of only +/- 300 basis points may not be sufficient to adequately assess IRR. In addition to the standard IRR policy limits, a credit union must determine the number of potential interest rate movements, including meaningful stress situations for which it will measure and analyze its IRR. In developing these appropriate rate scenarios, management should consider a variety of factors, such as the shape and level of the current and historical term structure of interest rates. Credit unions should produce scenarios that provide useful estimates of risk to allow management to understand the risk inherent in the credit union’s balance sheet.
The rate scenarios used should be significant enough to expose all material sources of IRR in the credit union’s balance sheet. The range of scenarios should be sufficient enough to fully identify repricing, basis, and changes to the yield curve, as well as the risk of embedded options. When conducting stress tests, management should:
- Focus on products and characteristics where concentrations in portfolios exist, especially when concentrated positions may be difficult to sell or hedge during periods of market volatility with no material losses.
- Compare stress test results against approved limits to better understand the elasticity of the limit structure. It is not necessary to adopt new limits for stress-testing simulations. Results that exceed standard limits should not be identified as violations of policy, but used to inform the board and senior management of potential risk exposures that should be discussed and understood. Contingency actions should be evaluated proactively.
- Ensure the scenarios are rigorous and consistent with the existing level of rates and the market environment.
A credit union’s stress-testing framework for IRR should be commensurate with its size and complexity, as well as business activities and overall risk profile. The framework should include clearly defined objectives, scenarios tailored to the credit unions various products and risks, well-documented assumptions, and sound measurement methodologies. The framework will be used to assess the potential impact of the scenarios on the credit union’s financial condition, enable ongoing and effective review processes for stress tests, and recommend actions based on the stress test results. For example, in low-rate environments, scenarios involving significant declines in market rates should be de-emphasized with additional emphasis on rising-rate scenarios. Alternatively, there may be instances where more extreme stress tests should be considered.
Last updated September 14, 2016