Operational Considerations

Identifying relevant shock and stress scenarios for IRR, applying sound modeling approaches, and using stress-testing results appropriately require qualified staff with sufficient expertise in the credit union’s finance department, ALCO, and risk management functions. A stress-testing program for IRR should ensure that the outcomes and potential decision making are communicated to the ALCO, appropriate senior staff, and the board of directors.

In addition to the standard shock tests run for internal IRR policy compliance, a prudent credit union will stress the balance sheet using other rate scenarios. Static parallel NEV shock tests are meaningful, but they do not capture certain risks that may be relevant to a credit union’s balance sheet. For example, parallel rate shocks do not reveal how a change in the shape of the yield curve impacts capital-at-risk and EAR measures. Other relevant stress scenarios can include shocks to the level of prepayments, rate sensitivity factors for NMS, and credit spreads.

The use of stress testing is an essential discipline within the IRR management process. By generating a variety of stress test results, a credit union gains critical insight into the specific factors that have a material impact on the risk measurement results. Risk management decisions are better supported when the decision makers have a range of information available to guide risk mitigation actions.

When developing interest rate shock and stress scenarios for IRR, credit union management should:

  • Assess the possible interaction of IRR with its related risks (such as credit risk and liquidity risk)

  • Assess the effect of adverse changes in the spreads of new assets/liabilities replacing those assets/liabilities that mature over the horizon of the forecast on NII

  • Estimate the potential change in relevant interest rates (such as prime rates or retail deposit rates, as opposed to those that are purely market-driven). Management should document how these assumptions are derived.

  • Validate that the scenario testing is sufficient to fully identify material levels of IRR within the balance sheet.

  • Compare the scenario testing with the existing level of rates and market environment and adjust as necessary. For example, in low-rate environments, scenarios involving significant declines in market rates may be de-emphasized (though negative rate scenarios could be relevant if actively considered by monetary policy makers at the time of testing). Instead, the credit union should test alternative rising rate scenarios (for example, test various non-parallel short-term and long-term rates). In addition, there may be instances where more extreme stress tests (immediate and parallel 500 basis points) are appropriate.

  • Assess IRR exposure on a regular basis and whenever the credit union’s risk profile changes significantly (for example, because of a merger, sudden growth, a significant new product, or new hedging program).

By generating stress test scenarios periodically, credit unions will hone their understanding of the alternative scenarios and assumptions to which they should be more sensitive.

Last updated on December 06, 2024