IRR Types and Sources
IRR may arise in various forms and can quickly impact a credit union’s earnings and net worth. IRR is inherent in a variety of transactions and the degree of its impact is driven by changes in market rates. Types of IRR include repricing risk, basis risk, yield curve risk, option risk, and price risk.
Types of Interest Rate Risk
Repricing risk arises from the possibility that a credit union’s assets and liabilities will reprice at different times or amounts and potentially negatively affect the credit union’s earnings, net worth, and financial position. Repricing differences create a mismatch between sources and uses of funds. For example, a portfolio of long-term, fixed-rate loans or securities (such as credit union assets) funded with short-term deposits (such as credit union liabilities) could significantly decrease in value when rates increase, because the loan rates are fixed, while funding costs increase. Nevertheless, maintaining some degree of repricing mismatch is fundamental to the credit union business. Repricing gaps can occur from either borrowing short-term to fund longer-term assets or borrowing long-term to fund shorter-term assets. Such mismatches expose a credit union to adverse changes in both the overall level of interest rates (that is, parallel shifts in the yield curve) and the relative level of rates across the yield curve (that is, nonparallel shifts in the yield curve).
Basis risk arises from a change in the relationship of rates in different financial markets. Basis risk occurs when market rates, or the indices used to price assets and liabilities, change at different times or by different amounts. The relationship between different market indices can change over time and this means that if sources of funds are priced in relation to one market index while uses of funds are priced on a different index, the spread between them can potentially change. For example, a credit union may use funds from 6-month certificates to purchase 6-month Treasury bills. The market interest rate for the 6-month Treasury bill might remain constant while local market interest rates for certificates increase due to competitive pressures. Thus, changes in the spreads of instruments that are being repriced off of different market indices will affect a credit union’s net interest margin, and quite possibly reduce earnings.
Yield curve risk reflects exposure to various changes in the shape or slope of the yield curve. It occurs when assets and funding sources are linked to similar indices with different maturities. The most typical exposure for depositories is to “borrow short” (typically demand deposits) and “lend long.” If the relationship between short- and long-term rates changes, it will impact earnings. The relationship changes when the shape of the yield curve for a given market flattens, steepens, or becomes inverted or negatively sloped during an interest rate change.
- In a parallel yield curve, all maturities on the yield curve move by an equal amount. In a parallel shift, a credit union would see a yield increase or decrease in all maturities by the same amount.
- In a steepening yield curve, long-term rates increase faster than short-term rates or short-term rates decrease faster than long-term rates. For example, long-term rates may change by 100 basis points, while short-term rates may change by only 50 basis points.
- In a flattening yield curve, the difference between long-term rates and short-term rates narrow as either long-term rates or short-term rates move closer to the other.
- In an inverted yield curve, long-term rates are below short-term rates. This historically has been a short-term phenomenon when the market is anticipating a recessionary period where rates are expected to fall. For example, the yield on a long-term asset drops to 200 basis points, while the yield on a short-term asset remains constant at 250 basis points.
Changes in the shape of the yield curve can change the IRR of a credit union’s position by magnifying the effect of maturity mismatches.
Option risk is the risk that a financial instrument’s cash flows (timing or amount) will change at the exercise of the option holder (such as a depositor, borrower, or other transaction counterpart), who may be motivated to exercise an option by changes in market interest rates. The exercise of options can adversely affect a credit union’s earnings by reducing asset yields or increasing funding costs. Balance sheet accounts that present option risk include, but are not limited to, the following.
- Non-maturity shares (deposits), such as regular shares, share drafts, and money market accounts, present option risk because they have no contractual maturities. While balances in these accounts can be withdrawn on demand (depositor has the option to withdraw the funds at any time), typically such accounts experience periodic inflows and outflows (for example, share deposits and withdrawals). Therefore, while these shares can be a long-term funding source, the uncertain timing of inflows and outflows can make the appropriate treatment of non-maturity shares challenging. It is not possible to predict with any degree of certainty what the future balances in non-maturity accounts will be, how long they will need to remain open, or what future rates will be paid to members on these accounts.
For more information, see NCUA Letters to Credit Unions 03-CU-11, Non-Maturity Shares and Balance Sheet Risk and 01-CU-19, Managing Share Inflows in Uncertain Times.
- Loans that give borrowers the option to refinance or make prepayments present option risk. For example, a mortgage holder may elect to refinance a mortgage in a falling interest rate environment in order to take advantage of a lower interest rate. This will reduce the credit union’s yield on assets. Similarly, if a borrower makes prepayments on a loan, credit union income will potentially be reduced.
- Investments, such as callable bonds, present option risk because they can be redeemed by the issuer prior to maturity. For example, assume that a credit union purchased a 5-year callable bond at a market yield of 2 percent. If market rates subsequently decline to 0.5 percent, the bond’s issuer will be motivated to call the bond and issue new debt at the lower market rate. At the call date, the issuer effectively repurchases the bond from the credit union. As a result, the credit union will not receive the originally expected yield (such as, 2 percent for 5 years). Instead, the credit union may re-invest the principal at the new, lower market rate. On the other hand, in a rising rate environment, the issuer will likely not call the bond and the credit union will have a below market-yielding investment.
See NCUA IRPS 98-2, Investment Securities and End-User Derivatives and NCUA Letter to Federal Credit Unions 98-FCU-4, Interpretive Ruling and Policy Statement 98-2 Examiner Guidance. The Examiner Guidance on IRPS 98-2 covers a broad range of instruments, including all securities in held-to-maturity and AFS accounts (as defined in the Statement of Financial Accounting Standards No. 115 (ASC320) and the more recent Guidance on “Financial Instruments – Credit Losses” (Topic 326)), certificates of deposit held for investment purposes, and end-user derivative contracts not held in trading accounts.
Price risk is the risk that the fair value of a financial instrument will change due to market factors. Generally, long-term assets have more price risk than short-term assets because, as cash flows become more distant, the present value or price of the investment declines. When market interest rates rise, the market value of a credit union’s assets will typically decrease; when market interest rates decline, the market value of the credit union’s assets will typically increase.
However, this does not hold true for all types of assets. For example, changes in market interest rate have the opposite impact on mortgage servicing rights. Anything that increases the amount of unscheduled principal payments (such as refinances and prepayments) will adversely affect the expected earnings stream from mortgage servicing rights and cause their value to decline. When interest rates decrease, the value of a credit union’s mortgage servicing rights generally decrease, because the total servicing fees fall as consumers refinance. Because servicing assets are measured at fair value, or carried at amortized cost and tested for impairment, the fair value adjustment or any impairment is reflected in current earnings.
Sources of Interest Rate Risk
Mortgage-related products potentially create price risk within a loan pipeline, on a balance sheet portfolio of loans and investments, and mortgage servicing rights. Interest rate changes affect not only current values, but also future lending volumes and related fee income. Some examples of the types of these activities are:
- Long-term, fixed-rate mortgage loans
- Long-term, fixed-rate investments (for example, mortgage-backed securities)
- Variable-rate loans where the rate is based on a market index
- Variable-rate loans with caps and floors
- Asset-backed securities where the cash flows and maturity of the security vary as market rates change
See NCUA Letter to Credit Unions 10-CU-03, Concentration Risk , which discusses the evaluation of concentration risk as it relates to a credit union’s current balance sheet, how strategic plans may affect the level of concentration risk, and how to determine if risk management practices are commensurate with the level of risk.
Embedded options associated with assets and liabilities can create IRR. Embedded options are features that provide the holder with the right, but not the obligation, to buy, sell, pay down, payoff, withdraw, or otherwise alter the cash flow of an instrument. Embedded options can create various risks, such as prepayment risk, extension risk, and negative convexity.
Prepayment and call risk increases when rates decline and borrowers can refinance at a lower rate, requiring a credit union to reinvest maturing proceeds at the lower current market rates. Extension risk describes the increase in expected average life that results from a rise in market rates that, in turn, diminishes the incentive to call, refinance, or make other unscheduled principal payments. Higher rates will change the forecasted amount of call and prepayment options and lead to a longer expected average life than previously estimated. The lengthening of expected average life is called “extension.”
The holder of the option may be the credit union, credit union member, the issuer, or a counterparty. Many instruments contain embedded options that can alter cash flows and impact the IRR profile of the credit union. Here are some examples:
|Non-maturity shares||Member depositors have the option to withdraw funds at par any time|
|Callable bonds||The issuer has the option to redeem at a stated price all or part of a bond before maturity (based on contractual call dates)|
|Structured notes||Options can vary by the type of instrument and may include step-up or step-down features, interest rate caps and floors, call features, and rules that change the priority and timing of cash flows received by different classes of investors within the deal structure|
|Wholesale borrowings||Market lenders may have a right to call an advance prior to its stated maturity (requiring credit unions to repay the funding amount), or the borrowing credit union may have a right to prepay an advance early (allowing it to “put” back the funds prior to scheduled maturity)|
|Derivatives||Purchasers of interest rate caps or floors|
|Mortgage loans||Borrowers may have the option to partially or fully prepay the loan at par|
|Mortgage-backed securities||Borrowers’ options to prepay individual mortgage loans included in an MBS loan pool can shorten the life of a tranche of loans within a security; some MBS are issued as structured instruments that add additional optionality|
Non-maturity share-based funding sources, which are a significant source of funding for credit unions, may increase IRR, especially when matched to a longer-term asset portfolio. For example, long-term, fixed-rate loans funded by member shares may involve repricing risk, basis risk, or yield curve risk. As a result, certain interest rate changes could cause funding costs to increase substantially while the yields on fixed-rate assets remain unchanged.
Derivative contracts and IRR hedging. Approved federal credit unions (and some state-chartered credit unions) can use interest rate derivatives to hedge IRR. Depending on the specific structure of the derivative, the instrument may create repricing, basis, yield curve, option, or price risk. Although derivatives can be used to mitigate IRR, they potentially expose a credit union to basis risk because the spread relationship between the cash instrument (that is, the hedged item) and the derivative instrument may change. For example, a credit union using interest rate swaps (priced off Libor) to hedge its Treasury securities portfolio may face basis risk because the spread between the swap rate and Treasuries may change.
A credit union using derivative instruments, such as interest rate futures, swaps, and options to hedge or alter the IRR characteristics of on-balance-sheet positions needs to consider how the off-balance-sheet contract’s cash flows may change with changes in interest rates and in relation to the positions being hedged.
Fee income businesses may be influenced by IRR, particularly mortgage origination and credit card servicing. Fluctuating interest rates can affect the volume and returns of such activities.
Product pricing may introduce IRR, particularly basis risk or yield curve risk. Basis risk exists if funding sources and assets are linked to different market indices. Yield curve risk exists if funding sources and assets are linked to similar indices with different maturities.
Workpapers & Resources
- 03-CU-11, Non-Maturity Shares and Balance Sheet Risk
- 01-CU-19, Managing Share Inflows in Uncertain Times
- NCUA IRPS 98-2, Investment Securities and End-User Derivatives<![CDATA[ ]]>
- NCUA Letter to Federal Credit Unions 98-FCU-4, Interpretive Ruling and Policy Statement 98-2 Examiner Guidance
Last updated October 11, 2016